Outsourcing has long been a strategy to decrease cost. Increasingly firms recognize the value in their supply chains and call on suppliers to innovate, both in products and processes. Innovation to increase quality and demand or to reduce costs is critical to firm and supply chain success. In a two-stage supply chain, we investigate the impact of focal firm and supplier innovation costs (and capabilities) on the type of outsourcing chosen and the resulting investments in process and product innovation. The focal firm determines whether to perform design (including product innovation in the form of quality enhancement) and manufacturing (including process innovation in the form of cost reduction) in-house, to outsource manufacturing/process innovation while insourcing design/product innovation, to outsource both manufacturing/process innovation and design/product innovation, or to codevelop product innovation while outsourcing manufacturing/process innovation. We also examine the conditions under which codevelopment is favorable, given the supply chain faces potential positive and negative synergies from either the colocation of the innovation activities or costs of collaboration. After characterizing the optimal outsourcing decision, we find that the decision to outsource is more nuanced than simply which activities to outsource but must include options to collaborate on particular activities and specifically product innovation. We offer the insight to managers that codevelopment, despite the costs of collaboration, can benefit the firm and result in higher profits. This occurs through the improvement of demand via higher quality products.