Dual sourcing and backup production: Coexistence versus exclusivity

Abstract

Supply risk is one of the most important enterprise risks. Dual sourcing and backup production are the two operational strategies that firms most commonly use to mitigate supply risk. The base model examines the strategic use of dual sourcing and backup supply options in a two-stage dynamic programming model for one period. In the first stage the firm decides whether to employ single or dual sourcing for primary supply and whether to reserve backup option. In the second stage, if backup option has been reserved, the firm decides the backup production quantity after observing the realized primary delivery. The optimal sourcing strategies are separately characterized under deterministic and uncertain demand. The results show that dual sourcing coexists with backup production when the two primary suppliers have similar and moderate reliabilities and the backup reservation cost is relatively small. When the reliabilities of the two primary suppliers differ significantly, dual sourcing and backup can become mutually exclusive strategies. Furthermore, the existence of the backup production option decreases the probability of selecting dual sourcing; compared with deterministic demand, uncertain demand increases the area of coexistence of dual sourcing and backup production. In particular, when the firm employs dual sourcing, backup production is activated under deterministic demand only when both primary suppliers fail, while can be activated under uncertain demand when one of the primary suppliers fails. We extend the base model to a two-period structure where the reliability of one primary supplier is uncertain, and the firm updates its assessment of supplier reliability based on the delivery in previous period. Based on Bayesian forecast-updating approach, we find that reliability learning weakly increases the area of coexistence of dual sourcing and backup, and weakly decreases the probability of contingent backup production in the coexistence area.