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Article Excerpt
1. Introduction
The use of outsourcing to manufacture part of a product's volume or some components of a product that a firm makes has become very common in the last 20 years. In this paper we consider the case of (partial) subcontracting, where the firm is capable of in-house production, but chooses to purchase a portion of, or the entire production from an outside firm. In many situations, the firm has access to one or more outside suppliers and can outsource its production by signing a contract with one or more of them. The case of a single subcontractor can be justified for products that are application specific (see Deng and Yano (2002)), or for reasons of geographic proximity, established trust relationships, etc. By subcontracting, the firm has to pay an outsourcing price determined by the bargaining power of a single supplier or, in the case of an active spot market, by the degree of competition among suppliers. In the case of partial subcontracting, the contracting firm also has the ability to produce from its own capacity, thus avoiding paying a possibly high outsourcing price and total dependence on outsourcing. The firm's decision on whether and how much to produce using in-house capacity is determined by the potential demand, its production cost, its profit margin and the outsourcing price. Despite the wide use of outsourcing, and the recent increase in the number of firms that make a portion of total volume in-house and outsource the rest, there have been very few Operations Management papers focusing on these kinds of relationships even though they are becoming much more common. An example we are familiar with is one where Cummins makes engines for Scania who also has in-house production capacity to make the same engines for its trucks. The existence and stability of partial subcontracting or "concurrent sourcing" in the metal forming industry has been empirically studied and established in Parmigiani (2003). Such relationships require careful planning as both firms need to decide how much to produce, when and how much of each other's capacity would be used, etc. We are interested in modeling exactly this situation. Another example of concurrent sourcing with renegotiation that one of the authors has observed is in the case of the shoe industry where a major US shoe brand has a facility in Taiwan with which it has a long-term contract, and a factory in Indonesia that it uses as a secondary supplier, (In our model, the Taiwan factory would be treated as the shoe brand's own factory even though it is nominally owned by a local company in Taiwan due to the multi-year contract between the shoe company and the Taiwan factory.) The secondary supplier in Indonesia is given initial orders with a 3-month lead time at an agreed upon wholesale price per unit. However, in our work with the Indonesian factory, we observed that it was common for the shoe company to find 1 to 2 months after placing the initial order that they needed more shoes and to negotiate with the Indonesian factory for a rush order. The Indonesian factory was in fact used to this reorder occurring often enough that they would often make more than the initially contracted quantity in anticipation of a "rush" order that ended up being more lucrative.
In a subcontracting relationship between two firms, power dynamics play an important role. The relative bargaining power of each firm is reflected upon the contract's terms: basically the price that the buyer (he) must pay to the supplier (she). When the buyer is able to make products in-house, it is to the supplier's benefit to charge a competitive price if she wants part of the supply chain profit. By being able to produce in-house the buyer is better off, whereas the supplier would prefer transacting with a buyer incapable of in-house production. Furthermore, situations referred to as bilateral monopolies, where a single seller faces a single buyer, can also arise between two firms. For example, in a dynamic environment with demand uncertainty, the firm that faces demand might require additional product quantity after demand realization. In the absence of a spot market, the subcontracting supplier is the sole possible source for this additional quantity. One way to deal with a situation like this is through capacity options: the buyer buys the right to request more quantity than he originally committed to. Such capacity options have been analyzed in the literature (see Erkoc and Wu (2005) and references therein) but we have found that it is very common for many companies not to get into such agreements but to renegotiate if one party needs more than the contracted quantity (see Plambeck and Taylor (2007) for examples of contract renegotiation). In that case, it is up to the supplier to produce in excess of the commitment in the hope that it will be required after demand realization. The supplier's decision whether and how much excess quantity to produce, is greatly affected by the price she will potentially receive. That transfer price essentially determines how the two firms will split the extra supply chain profit generated by fulfilling demand through a post -demand realization transaction. It is common for firms to renegotiate when one firm has a need for more product than was predicted in advance and explicitly specified in a contract. The relative bargaining power of each firm in such a post-demand realization transaction is a function of its market size, industry competition, but might also reflect the possibility of contracting in the future. We are interested in whether and when significant bargaining power in such negotiations benefits firms. Conventional wisdom among many managers is that firms that have great bargaining power obtain significant benefits from such power; however, intuition suggests that when faced with such a powerful firm, the supplier may also decide to underproduce; which eventually hurts both the buyer and the whole supply chain. We are thus interested in establishing the role of bargaining power, and in-house production capacity in determining the profitability of buyers and suppliers in single buyer-supplier relationships.
Our analysis shows that in contrast to conventional wisdom, the bargaining power of the buyer may actually hurt both the supplier and the buyer beyond a certain point. (Thus, there is an "optimal" level of bargaining power from the supply chain's and the buyer's perspective.) We characterize the conditions under which the supplier is willing to speculate and produce more than the committed quantity and when she is never willing to do so. Finally, we are able to characterize the role that the in-house production capability of the buyer plays in determining the profitability of both parties.
In our analysis we consider a supply chain consisting of a single Original Equipment Manufacturer (OEM), that is the buyer, who is capable of producing a finished product with stochastic demand. Selling the product requires production prior to demand realization, and the firm has access to a single supplier (subcontractor), who can produce the same product for him. Examples of industries in which manufacturing of seasonal products must take place well...
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