Capacity reservation under supply uncertainty

Abstract

Shortages of input materials and components used in the production process often adversely influence sales of manufacturing firms. Manufacturers can guarantee delivery of the inputs by initiating capacity reservation arrangements with their suppliers. We study a multi-period capacity reservation contract between a manufacturer and a long-term supplier when there is uncertainty about the quantity of an input item available in the spot market. The contract requires the manufacturer to pay a fixed amount to the supplier at each period. In return, the supplier guarantees availability of the input up to a predetermined level of volume. The manufacturer can also meet some of input needs from a spot market, which may exist in the form of a B2B electronic exchange. Optimal inventory policy for the manufacturer in this dual supplier environment is derived analytically. Numerical examples are used to explore the strategies of the manufacturer and the supplier in certain and uncertain supply environments. We find that uncertain input markets lead to an increase in the share of inputs purchased in advance via long-term contracts. Capacity reservation contracts are shown to increase capacity utilization of the supplier compared to the traditional unit-price based supply contracts.