Optimal Capacity Choice and Allocation in Decentralized Supply Chains

We consider a supply chain in which a single supplier with fixed capacity sells to several independent retailers or manufacturers. The retailers have private information about their individual markets (e.g., mean market demand), which influences the size of their orders to the supplier. If the sum of all retailer orders exceeds the supplier’s capacity, the supplier uses a pre-declared rule, which maps retailer’s orders to allocations. A broad class of allocation mechanisms are prone to manipulation by retailers, as shown by Cachon and Lariviere (1999). We first use a mechanism-design approach to obtain the optimal capacity-allocation rule and pricing mechanism for the supplier. We then answer the following questions: What level of capacity should the supplier provide to maximize its profit, given an implementable profit-maximizing allocation policy? What forms do optimal (i.e., supplier profit-maximizing) allocation polices take in typical business scenarios? Is supplier profit sensitive to the type of allocation policy it employs? What are practical ways of implementing the optimal allocation policy to reduce transaction costs? Our analysis examines business scenarios for which the linear and proportional allocation mechanisms are optimal. We also conclude that both supplier and supply-chain profit can increase significantly if a manipulable allocation policy is replaced by the optimal truth-telling allocation policy. Finally, in order to implement the optimal allocation rule, we design an auction mechanism wherein retailers submit purchasing cost bids for supplier capacity. The authors acknowledge the support of the e-Enterprise center at Discovery Park, Purdue University