Direct versus indirect penalties for supply contracts in high-tech industry

Unlike consumer goods industry, a high-tech manufacturer (OEM) often amortizes new product development costs over multiple generations, where demand for each generation is based on advance orders (i.e., known demand) and additional uncertain demand. Also, due to economic regulatory reasons, high-tech OEMs usually source from a single supplier. Relative to the high retail price, the costs for a supplier of producing high-tech components are low. Consequently, incentives are misaligned: the OEM faces relatively high under-stock costs and the supplier faces high over-stock costs. In this paper, we examine supply contracts that are intended to align the incentives between a high-tech OEM and a supplier so that the supplier will invest adequate and yet non-verifiable capacity to meet the OEM's demand. When focusing on a single generation, the manufacturer can coordinate a decentralized supply chain and extract all surplus by augmenting a traditional wholesale price contract with a "contingent penalty" should the supplier fail to fulfill the OEM's demand. When the resulting penalty is too high to be enforceable, we consider a new class of "contingent renewal" wholesale price contracts with a stipulation: the OEM will renew the contract with the incumbent supplier for the next generation only when the supplier can fulfill the demand for the current generation. By using non-renewal as an implicit penalty, we show that the contingent renewal contract can coordinate the supply chain. While the OEM can capture the bulk of the supply chain profit, this innovative contract cannot enable the OEM to extract the entire surplus.