Ensuring responsive capacity: How to contract with backup suppliers

Abstract

Firms that source from offshore plants frequently perceive the lack of reliability and flexibility to be among the major drawbacks of their strategy. To mitigate against imminent mismatches of uncertain supply and demand, establishing capacity hedges in the form of responsive backup suppliers is a way out that many firms follow. This article analyzes how firms should contract with backup suppliers, inducing the latter to install responsive capacity. We show that supply options are appropriate to achieve sourcing channel coordination under forced compliance, whereas any firm commitment contract imposes a deadweight loss on the system. Whereas price-only contracts are unable to coordinate the sourcing channel under voluntary compliance, utilization-dependent price-only contracts are. Under the former contract, a price-focused strategy on the part of the manufacturer turns out to diminish the system’s service level and possibly has negative implications on installed backup capacity, and not least on the manufacturer’s profit.

Introduction

Firms that offshore their sourcing activities typically face two potential drawbacks (Fraunhofer, 2008, PRTM, 2008). First, sourcing from offshore plants or suppliers curtails supply-side flexibility because the distance to supply sources increases either from a geographical, organizational, or cultural perspective. Long delivery times and lack of sourcing flexibility (PRTM, 2008), which is an antecedent of supply chain agility (Swafford et al., 2006), decreases one’s ability to respond to demand-side fluctuations (Christopher and Peck, 2004). Second, the comparatively low reliability of offshore plants in terms of delivery performance and product quality is an ongoing issue for a large number of supply chain or purchasing managers. Firms seek to balance the cost advantages that come with offshoring with the responsiveness of backup supply bases close to their operating sites. Relying on backup suppliers is one major strategy to mitigate (Chopra and Sodhi, 2004) against these diseconomies of vulnerability (Hayes et al., 2005). In other words, firms attempt to install operational hedges (Huchzermeier and Cohen, 1996) in the form of backup supply sources, enabling them to smooth out the two-sided supply and demand uncertainty they face.

However, being more costly, the responsive supplier is relegated to a backup role. He only comes into the operation if demand is greater than offshore supply. Provided that offshore sources are able to cover demand entirely, the manufacturer will give preference to the cheap offshore alternative and avoid costly responsive production. If, on the other hand, offshore production capabilities do not suffice to serve demand, the manufacturer critically relies on her responsive supplier in order to save severe mismatch costs. The question that arises is: How can the manufacturer ensure responsive capacity, given that the backup supplier is aware of his replacement function.

While firms in numerous industries – such as automotive (Sheffi, 2005), pharmaceuticals (Chopra et al., 2007), and electronics (Tomlin, 2006) – reap the benefits of responsive backup supply, little attention has been paid on how to contract for it. One contracting strategy is to compensate for backup deliveries with high prices upon large deliveries, as is practiced in the following example. Kolbus, a leading manufacturer of bookbinding machinery relies on a network of small suppliers located within 20 kilometre of its headquarters in Germany. Kolbus’s customers in the print industry demand quick delivery times of about 6 weeks; high service levels are among the most important sales points for this complex project business. The majority of parts are produced or purchased on a make-to-stock basis through in-house production or from offshore suppliers, respectively. In addition, for 70% of its purchased parts, Kolbus is connected to one alternative backup supplier close to its plant. Kolbus’s COO, states that “if we actually need the local suppliers as an extended workbench on a full scale, we compensate them for their deliveries generously. And they are prepared, still knowing that they cannot reckon on us for steadily incoming orders”.

In this article we analyze how a manufacturer should contract with her backup supplier to ensure responsive capacity and, at the same time, benefit from offshore sourcing. We investigate how the manufacturer can obtain a responsive capacity hedge against two-sided supply and demand uncertainty to achieve Pareto efficient alignment of the manufacturer’s offshore capacity and the backup supplier’s responsive capacity investments via contracting mechanisms. We consider several types of contracts that reflect different degrees of flexibility, including firm commitments, supply options, price-only strategies, and utilization-dependent price-only strategies. Designing a contract requires the manufacturer to account for the backup supplier’s awareness of his backup role. Being conscious about the manufacturer’s offshore investment option, the backup supplier has to decide on a relationship-specific investment (Williamson, 1985), that is, the installment of dedicated responsive capacity, before demand and offshore supply uncertainty materializes.

The remainder of this article is structured as follows. We review the literature in Section 2 and present our model in Section 3. The backup and offshore capacity investment and contracting games under both forced compliance and voluntary compliance regimes are studied in Section 4 for firm commitments, supply options, and price-only contracts. We present a simple utilization-dependent contract that coordinates the decentralized system under voluntary compliance in Section 5. We present our conclusions in Section 6.