Outsourcing strategy and production disruption of supply chain with demand and capacity allocation uncertainties

Abstract

This paper develops supply chain game models with multiple uncertainties, and studies the impact of channel power on the efficiency of supply chain. Besides the regular production run, the manufacturer may choose the outsourcing mode due to his production disruption risk and uncertainty of capacity allocation. We find that the manufacturer has no incentive to outsource when both the disruption risk is low enough and his production capacity is large enough. When the disruption risk is sufficiently high, the manufacturer will fully outsource production regardless of the production capacity. There is a zone of order-difference outsourcing where the manufacturer just outsources the part in excess of the certain threshold value. Under the retailer-Stackelberg (RS) game, the manufacturer׳s order-difference outsourcing strategy can induce the retailer to order more items. Unlike RS, the retailer in the manufacturer-Stackelberg (MS) game always orders a quantity equal to that in the classic newsvendor model. Meanwhile, we find that the channel power does not affect the player’s decision except in the zone of order-difference outsourcing. Compared with MS, the dominant retailer can better deal with the uncertainties and make better use of demand information. From the channel׳s perspective, the two players have the different attitudes towards the risks. The dominant manufacturer prefers to forcibly offload production risks to his partner, while the dominant retailer in RS actively takes the partner׳s risks.

Introduction

Owing to the complexity and dynamicity of supply chain environment, the disruption in supply networks is identified as one of the important supply chain risks. Supply disruptions may be caused by natural or man-made disasters such as equipment breakdowns, labor strikes, traffic interruptions, earthquakes, floods, and hurricanes. The recent research in this field focuses on the study of inventory systems in the presence of supply disruptions. Supply disruptions can lead to excessive down time of production resources, significant delay in customer delivery, financial loss, and eventually a loss in the market value of firm (Burke et al., 2007). As the risk of supply disruption increases, it is crucial for firms to learn how to anticipate and manage it. A firm׳s performance may drop sharply once the full impact of the disruption hits (Sheffi and Rice, 2005, Matsuo, 2015). Examples of supply chain vulnerabilities are widespread:

Example 1. According to a study performed by Computer Sciences Corporation in 2003, 43% of 142 companies, ranging from consumer goods to health care, reported that their supply chains were vulnerable to disruptions, and 55% of these companies had no documented contingency plans (Poirier and Quinn, 2003). Additionally, according to another survey performed by CFO Research Services, 38% of 247 companies acknowledged that they had too much unmanaged supply chain disruption risk (Eskew, 2004).

Example 2. A representative example is the March 2000 fire at the Philips microchip plant in Albuquerque, New Mexico. Nokia changed product configurations and took advantage of outsourcing strategy in the nick of time to meet customer demand during a supply disruption (Latour, 2001).

Example 3. To handle both the uncertain demand fluctuation and supply disruption, HP used the Singapore plant for the base volume production and outsourced the remaining portion of their production to a contract manufacturer in Malaysia. A flexible supply base not only enables a firm to handle the uncertain demand risk, but also it can be used to maintain continuous supply of materials when supply disruption occurs (Billington and Johnson, 2002).

The potential economic impact of a disruption is a critical issue for supply chain management, while it increases the awareness of significant risks posed by supply failures which highlights the need for effective disruption management. Therefore, supply disruption has made companies aware of the need for active disruption management. Risk management provides alternative ways to hedge against disruption risks. One of the most common policies for risk mitigation is flexible multiple-sourcing (Chen et al., 2001). The multiple-sourcing supply becomes a common business practice to lessen the risk of supply disruption, especially in the high-technology industries. For example, many product categories, from car batteries to printer cartridges and computers, can be supplied from the alternative outsourcing if the supply disruptions occur. Therefore, our first objective is to investigate the manufacturer’s outsourcing strategy and the retailer׳s order strategy when facing the supply disruption.

Our paper analyzes how uncertainty risks affect both sides of the manufacturer–retailer relationship under the two channel leadership structures. The channel leadership structure represents relative channel power. One is manufacturer-Stackelberg (MS) structure, and the other is retailer-Stackelberg (RS) structure. We explore both structures and show that the double marginalization effect results in a lower outsourcing quantity, which leads to supply insufficiency for the buyer. The overwhelming majority of studies in game-theoretic supply chains examine MS structures. However, in the past decades many powerful retailers have appeared around the world. For a dominant retailer such as Wal-Mart, there are many manufacturers producing similar types of products and most are willing to make concessions and vigorous cooperation because they are keen to sell their products through it. Thus, a dominant retailer has many choices and, consequently, owns the power to dictate prices of products. Therefore, the second objective of our paper is to investigate how the channel power affects the behavior of players as well as the channel profit.

The third objective of the paper is to investigate how to coordinate each channel structure with multiple uncertainties, including the outside demand uncertainty, and the inside allocation uncertainty and disruption risk. The objective is to formally analyze how the dominant player deals with the uncertain risks to avoid the double marginalization effect and establish channel competitive advantage. A coordinated supply chain performs better than the uncoordinated one. However, each player in the supply chain is primarily concerned with optimizing his own objective, which decreases channel profit and lowers channel competitive advantage. It has been proven in the literature that some effective contracts can be designed to access channel coordination, which leads to an improved channel profit. Therefore, from the channel׳s perspective, we will investigate how the uncertainties from both supply side and demand side affect the behavior of players and study how the dominant player deals with the uncertainties.

To be specific, we consider the supply chain consisting of one manufacturer and one retailer, where the manufacturer supplies product to his partner with a random capacity allocation and possible production disruption risk, and the retailer faces the uncertain market demand. In addition to a regular production run, the manufacturer may choose the outsourcing mode. We find that there is a zone of order-difference outsourcing where the manufacturer partly resorts to outsourcing. Meanwhile, the manufacturer׳s order-difference outsourcing strategy can induce the retailer to order more items. Compared with MS, RS can effectively compensate the manufacturer for the risk exposure associated with demand uncertainty, which results in the higher level of outsourcing quantity for the manufacturer. From the channel׳s perspective, we design the all-accepted punishment contract for each structure to avoid the double marginalization effect. In our unpredictable setting, the mechanism needs both players to collaborate fully in order to deal with production and demand uncertainties caused by channel decentralization. ‘All-accepted’ in the contract is expected to extend fullest cooperation between both players. Our main results also provide several insights regarding how the dominant player could use contracting and outsourcing to manage procurement decisions when facing demand uncertainty and supply disruption.