This research looks into the incentive issues as applied to the relationship between the manufacturers and their suppliers. I conducted first a field study to better understand how the manufacturers structure their supply contracts with their suppliers, the negotiation process between the two, and the incentives built into the contracts, etc; followed by modeling a manufacturer's sourcing problem using the linear cost structure. Specifically, I derived how the contract should be designed to induce the suppliers to exert optimal level of cost-reducing effort. The results of my research are important in several ways. First, it will help us evaluate the strengths and weaknesses of the Taiwanese way of conducting business. Second, I contributed to the pure theory of contracting and incentives with testable, empirical implications. Third, the combination of field study and analytical work toward a certain sector of the economy may provide not only normative guidelines but also new direction for accounting research in Taiwan's business practices.