Supply chain coordination by risk sharing contracts under random production yield and deterministic demand

From numerous contributions to literature we know that properly designed contracts can facilitate coordinated decision making of multiple actors in a supply chain (SC) so that efficiency losses for the whole SC can be avoided. In a newsvendor-type SC with stochastic demand it is well-known that the double marginalization effect hampers the simple wholesale price contract to achieve coordination. More complex contracts however can bring about coordination, especially those which enable appropriate sharing of risks between the actors. While the effectiveness of risk sharing contracts is well understood for SC situations with random demand and reliable supply, less is known about respective problems if demand is deterministic but supply is unreliable due to random production yield. This paper shows how in a buyer-supplier SC the distribution of risks affects the coordination of buyer’s ordering and supplier’s production decision in a basic random yield, deterministic demand setting. Both parties are exposed to risks of over-production or under-delivery, respectively, if a simple wholesale price contract is applied. The resulting risk distribution always impedes SC coordination. However, more sophisticated contract types which penalize or reward the supplier can change risk distribution so that SC coordination is possible under random yield. Additionally, it is proven that the wholesale price contract will guarantee SC coordination if the supplier has a second (emergency) procurement source that is more costly, but reliable. Moreover, it is shown that under wholesale price contracts it can be beneficial to utilize this emergency source even if it is unprofitable from a SC perspective. However, if such an emergency option is available to the buyer as opposed to the supplier, a wholesale price contract will not be able to coordinate the SC.