Supply Base Design for the Procurement of Multiple Items

Abstract

Sourcing new products in advance entails significant risks for a buyer. To reduce the possibility of bringing a mediocre item to the market, buyers can build a large supply base and pick the best available products after uncertainties have materialized. Designing such a supply base is a challenging task: the buyer needs to decide how many suppliers to recruit, and how to split them across potential groups, such as product types or geographies. In this study, we propose a framework to design optimal supply bases when multiple items must be sourced from potential suppliers that are subject to uncertainties on the profitability of their supplies. We start with the case of independent supplier profits: we characterize the optimal supply base size and find that it is optimal to recruit a much larger number of suppliers compared to the number of products needed, which increases in the riskiness of supplier designs so as to better exploit the potential upside in profitability deviations. We then study the case where different supplier groups are correlated. While the exact solution can be obtained in simple cases, the general stochastic problem can only be solved numerically. Hence, we propose three approximations that provide excellent solutions, especially when the number of products to source is large. Our framework thus provides guidelines for buyers that want to control their sourcing risks through supply base design and to improve their profits by exploiting the option value of diversification.