Managing the supply disruption risk: option contract or order commitment contract?

Abstract

Supply disruption is a common phenomenon in many industries. Motivated by the cases of “Nokia and Ericsson” and “HP”, our study investigates how a core firm utilizes the option contract and the order commitment contract to share and mitigate the supply disruption risk. In a decentralized supply chain, we establish the Stackelberg game models to explore the option and order commitment contracts in single and dual sourcing cases, respectively. We obtain the optimal production and procurement strategies under the two types of contracts, after which we investigate the value of the option contract and the optimal contract selection strategy of the core firm. The results demonstrate that the firm is insulated from the supply disruption risk, and that its profit is independent of the disruption risk and production investment under the option contract. In the single or dual sourcing case, the preference of the core firm for the two contracts depends on the disruption risk level and switches back and forth as the probability of disruption increases. A relatively low option price or a medium-risk operational environment heightens the value of the option contract; hence, the core firm is likely to choose the option contract correspondingly. When a reliable supplier is available, the existence of a reliable supplier is always beneficial to the core firm, however is a threat to an unreliable supplier.