Supply chain risk management considering put options and service level constraints

Abstract This paper considers a supply chain composed of a supplier and a retailer who commits to a service level to make end-users happy and promote sales. To reduce the losses resulting from the high demand volatility, the retailer purchases put options from the supplier to adjust its initial order. The optimal ordering and production policies with and without put options under the service level constraint are derived. We find that, in the two cases, the expected profits of the retailer are non-increasing in the service level constraint while that of the supplier are non-decreasing in it. Model comparison reveals that with put options, the retailer will offer higher service level and earn more profit than without; such effect is more salient when the demand is more variable. However, the put option contract will not always benefit the supplier especially when the service constraint is high. We also find that put option contract can effectively improve the decentralized system’s performance, but this only happens when the service constraint is low. In addition, we find that put option contract have no better capability than wholesales price contract in coordinating the supply chain in the presence of a service level constraint.