Dual sourcing problem with real option

Abstract

This paper addresses a single-period dual sourcing problem with real option under uncertain supply and demand. A retailer, who faces the uncertain market demand, can source from a low-price but unreliable supplier and an expensive but reliable supplier. In order to manage the supply uncertainties and decrease the cost, the retailer orders product from the unreliable supplier and buys option from the reliable one at the beginning of the selling season. After the demand realizes and the order is delivered, the option is executed. We develop a model for this problem and characterize the optimal policy. Then we compare the new strategy with the traditional dual sourcing strategy and the instant replenishment strategy with capacity constraint. The conditions that the new strategy has an advantage over the other ones are identified. Numeric experiments are conducted to analyze the impact of the parameters on the optimal policy and the profit in the new strategy and to compare the performance of the traditional dual sourcing strategy and the instant replenishment strategy with capacity constraint.