Supply chain contracts with capacity investment decision: two-way penalties for coordination

Abstract

Supply chain contracting has been discussed usually under the two compliance regimes, forced and voluntary. Various contracts show different coordination characteristics in the two regimes. However, in practice, the enforcement of quantities in case of forced compliance is always an issue of concern. We propose a price compliance regime for contract where the penalties are enforceable on both parties, which are price for non compliance on quantities. In this paper, we attempt to model a contract where supplier needs to build capacity before demand is realized under the proposed price compliance regime. A need for investment in capacity can be of the form of new capacity installation or capacity enhancement or updating, and is prevalent in practice, especially in industries which witness shorter product life cycles, high rate of new product launches, and in high-tech industry. Since under-investment in capacity by supplier is a major concern for manufacturer, we model contract with supply chain capacity and cost to build the capacity are included in the model and analyze how the manufacturer can influence the capacity decision of supplier with the given contract. We analyze the impact of various penalty parameters on vendor's capacity decision, supply chain efficiency and relative allocation of supply chain profit across partners. Further, we consider a special case of uniformly distributed demand and find analytical closed form conditions for a sub-set of coordination conditions. We also consider a special case where buyer and supplier arrive at consensus on capacity related decision and capacity is verifiable by buyer. Key words: Supply chain coordination, contract, capacity reservation contracts, penalty