The Value of Information and Flexibility with Temporal Commitments

Abstract

Problem definition: We study the combined value of observing future demand realizations (partial demand visibility) and flexible capacity, two hedging mechanisms against demand uncertainty, when signing capacity contracts with short temporal commitment. Academic/practical relevance: With new technological innovations, short commitment contracts are found in dynamic environments like distribution, processing, and manufacturing, a trend likely to grow in the future. In contrast to classic procurement, where commitments are long, short commitments lead to new dynamics in which demand visibility allows companies to use flexible resources more efficiently by adapting to demand observations. Methodology: We incorporate flexible capacity and demand visibility simultaneously using a multiperiod newsvendor network model with two nodes that are supplied using dedicated and flexible capacity contracts with short temporal commitment. Results: The optimal commitment to capacity contracts adapts within bounds to the observed demand at each node. The ability to adapt to visible demand becomes more valuable when flexible capacity contracts are available. This allows us to show that demand visibility and flexible capacity can act as complements. Managerial implications: In contrast to conventional wisdom, when contracts have short commitment, companies can enhance the value of demand visibility if flexible capacity is also available as an option.