Supply Chain Contracting in Environments with Volatile Input Prices and Frictions

40 Pages Posted: 22 Mar 2016 Last revised: 14 Jun 2017

See all articles by Panos Kouvelis

Panos Kouvelis

Washington University in St. Louis

Danko Turcic

University of California, Riverside (UCR) - A. Gary Anderson Graduate School of Management

Wenhui Zhao

Shanghai Jiao Tong University (SJTU) - Antai College of Economics and Management

Date Written: June 14, 2017

Abstract

Problem description: Purchase costs of raw materials required in production tend to fluctuate over time. Mild cost fluctuations merely affect firms' profitability. Significant variations can lead to supply chain disruption. What are the best contracts to be used in supply chains exposed to fluctuating raw material costs? We ask this question in two contexts -- in the presence and the absence of working capital constraint.

Academic/Practical Relevance: We add framework on how to optimally contract in the presence of stochastic costs and working capital constraints and help managers understand how they can increase profitability.

Methodology: We present a game-theoretic study of a bilateral monopoly supply chain with stochastic demand, stochastic input costs, production lead times, and working capital constraints. The upstream firm announces a supply contract to which the downstream firm responds with an order quantity. The contract is a single-price, multi-instrument contract with optional default penalties. Many previously studied coordinating contracts, as well as some non-coordinating ones are special cases of our general contract.

Results: We derive necessary and sufficient conditions that the instruments of the general contract must satisfy for the contract to induce a coordinated outcome -- both with and without working capital constraints. Then we translate these requirements into implementable contracts. Indexing on raw material prices and using default penalties is necessary and an I&P revenue-sharing contract turns out to be the most versatile contract for these environments.

Managerial Implications: We provide clear guidelines on how to contract in situations, where production costs of every supply chain member fluctuate significantly, possibly in the presence of working capital constraints.

Keywords: Supply chain management, risk management, interface of operations and finance

Suggested Citation

Kouvelis, Panos and Turcic, Danko and Zhao, Wenhui, Supply Chain Contracting in Environments with Volatile Input Prices and Frictions (June 14, 2017). Available at SSRN: https://ssrn.com/abstract=2752628 or http://dx.doi.org/10.2139/ssrn.2752628

Panos Kouvelis

Washington University in St. Louis ( email )

One Brookings Drive
Campus Box 1156
St. Louis, MO 63130-4899
United States

HOME PAGE: http://www.panoskouvelis.info

Danko Turcic (Contact Author)

University of California, Riverside (UCR) - A. Gary Anderson Graduate School of Management ( email )

Riverside, CA 92521
United States

Wenhui Zhao

Shanghai Jiao Tong University (SJTU) - Antai College of Economics and Management ( email )

1954 Huashan Road
Shanghai, Shanghai 200030
China

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