Procurement Flexibility under Price Uncertainty

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 opportunities of supplementing the long-term order 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 a capacity for each adjustment order in the contract. Under an overall capacity arrangement, she keeps the flexibility of using the reserved capacity in any periods during the planning cycle. We discuss the optimal procurement strategies and the criteria for capacity allocations, as well as the policy behavior and service performance under different arrangements.