Options-based Sourcing Strategies for Producers with Limited Capacity and Volatile Demand

In this study, we investigate the strategy of increasing the production capacity temporarily by means of contingent contractual agreements. These agreements are viewed as capacity options. A continuous material flow production system that supplies materials to meet a random demand that switches randomly between a high level and a low level is considered. The production system does not have enough capacity to meet the demand by production when the demand is high. Therefore, it either produces to stock in advance or uses a subcontractor. The contractual agreement with the subcontractor gives the right to receive additional production capacity when needed. The problem of determining the policies for production and subcontracting is formulated as an optimal control problem and analyzed analytically.