Supplier-Manufacturer Relationships Under Forced Compliance Contracts

Today, many retailers are adopting lean strategies to improve efficiency (see Abernathy et al. 1999). Manufacturers that supply lean retailers must fulfill orders accurately, rapidly, and efficiently, despite demand volatility, by appropriately structuring their production and transportation processes. The outsourcing of transportation has become common; in this case a contract might be struck that specifies how much capacity a logistics provider guarantees to the manufacturer. Given that the demand for transportation services varies day by day in the “lean-retailer” context, the contract must take into account the manufacturer’s risk of not fulfilling the retailer’s demand if the transportation requirements exceed the agreed upon capacity and the logistics provider’s risk of not using all of the committed capacity. The use of electronic spot markets for transportation has become prevalent and offers one means to mitigate these risks—the transportation provider can sell unused capacity while the manufacturer can secure additional transportation services when the logistics provider’s promised capacity is insufficient. In this paper we analyze a contract in this context and its capability to mitigate the effects of demand and spot-price uncertainties, as well as how each party, and the supply chain in total, benefits from the contract. We analyze a contract for options for nonstorable products or services, such as transportation, between a single supplier and a single manufacturer in the presence of a spot market, where the supplier has limited capacity and the manufacturer must fulfill periodic stochastic demand from a downstream supplychain link, such as a lean retailer, in full. We assume that the quantity of goods desired by the manufacturer is always available on the spot market at some price, that the spot-market price is exogenous, and that neither the supplier nor buyer is of sufficient size to have a perceptible effect on it. We model our problem as a two-stage Stackelberg game in which the supplier is the leader. At stage one, the supplier offers the manufacturer a contract for options with a reservation price and an exercise price. In response, the manufacturer purchases a certain number of options from the supplier, after which the supplier determines the total quantity of goods or services to make available to the manufacturer or the spot market. At the beginning of the second stage, demand and spot price are realized. After observing this information, the manufacturer decides how many options to exercise with the supplier and how much to purchase on the spot market. The manufacturer can view the spot market as an alternative source of the product: If the spot market price is below the supplier’s exercise price, then the manufacturer buys only from the spot market; otherwise, she buys from the spot market only if the reserved capacity is insufficient to satisfy the demand in full. After the manufacturer’s order is filled, we assume that the supplier can sell all his excess inventory to the spot market at some price, which may or may not be profitable. We assess the effectiveness of such a contract in coordinating the channel, how the optimal policies are set, and how the value of the contract is shared between the parties. Several papers analyze whether forward options can coordinate the channel and ensure incentive compatibility for both players, or whether additional