Sharing demand and supply risk in a supply chain

This article studies two contract mechanisms to share demand and supply risk in a decentralized supply chain. In an option contract, the buyer reserves capacity with a supplier who guarantees delivery up to this limit. This insulates the buyer from any disruption risk, but the supplier faces both demand and supply risk. The second mechanism, the firm order contract, represents a conventional dyadic channel relationship where the buyer places a firm order and the supplier builds capacity but does not guarantee delivery if any disruption occurs. It is shown that the buyer's preference for using the different risk-sharing mechanisms switches back and forth (as the probability of disruption increases). Consequently, a supplier with a higher disruption risk may make higher expected profits compared to one with lower risk. In addition, the buyer may benefit from a higher wholesale price since it provides incentive for the supplier to participate without requiring the buyer to use higher order quantities. Two operational mitigation strategies that can be used by the buyer to hedge against the disruption risk are considered: the use of an alternate reliable supplier during a shortage and use of a direct subsidy for the supplier to improve reliability. It is found that the value of the reliable supplier depends on the type of contract with the unreliable supplier: interestingly, it is in the option contract—where supply is guaranteed—that the buyer almost always uses the reliable supplier as well. Also, it is found that offering a subsidy for reliability improvement acts as a strategic alternative to placing large pre-orders as a way to improve supplier operations.