Dual sourcing: Creating and utilizing flexible capacities with a second supply source

We study a finite horizon, single product, periodic review inventory system with two supply sources and a salvage option. These supply sources are typically capacitated and capacity levels often need to be reserved or installed in advance of the operational planning horizon. The supply sources may thus be differentiated by their lead times, capacities, and fixed and variable order costs. Salvage options allow for inventory reductions and incur fixed cost and variable revenues. We first analyze the tactical problem of determining an optimal procurement strategy under given capacity profiles at the two suppliers. We then address the strategic model in which optimal capacity profiles, both static and dynamically adjusted, are obtained based on two‐part capacity contracts. We characterize the structure of optimal procurement strategies when the lead times of the two suppliers differ by a single period and the lead time for salvage opportunities matches that of one of the suppliers. For general lead time combinations, we show that the optimal procurement strategies satisfy monotonicity and limited sensitivity properties, and construct effective heuristics and upper and lower bounds based on our structural results.