Procurement Flexibility under Price Uncertainty

Abstract

This chapter examines the interaction between supply price uncertainty and demand uncertainty. We consider a manufacturer who sources a key component using different procurement options: a long-term order on a price-only contract, short-term orders on an adjustment contract, and short-term purchases directly from the market. At the beginning of the planning cycle, the manufacturer places a long-term order and reserves a certain amount of supply capacity for the purpose of adjusting the long-term order, if needed. Before the selling season, the manufacturer has multiple options to place supplementary orders from the reserved capacity or from the market.

We compare two types of capacity arrangements: dedicated capacity and overall capacity. Under a dedicated capacity arrangement, the manufacturer reserves capacities separately for different adjustment opportunities. On the overall capacity arrangement, she keeps the flexibility of using the reserved capacity within the given period for possibly multiple adjustments. We discuss the optimal procurement strategies and the criteria for capacity allocations, as well as the policy behavior and service performance in different situations.

Keywords: Procurement Flexibility, Price Risk-Sharing, Capacity, Base-Stock Policy