Sourcing Flexibility, Spot Trading, and Procurement Contract Structure

We analyze the structure and pricing of option contracts for an industrial good in the presence of spot trading. We combine the analysis of spot trading and buyers’ disparate private valuations for different suppliers’ products, and jointly endogenize the determination of three major dimensions in contract design: (i) sales contracts versus options contracts; (ii) flat-price versus volume-dependent contracts; (iii) volume discounts versus volume premia. We build a model where a supplier of an industrial good transacts with a manufacturer who uses the supplier’s product to produce an end good with an uncertain demand. We show that, consistent with industry observations, volume-dependent optimal sales contracts always demonstrate volume discounts (i.e., involve concave pricing). However, options are more complex agreements, and optimal option contracts can involve both volume discounts and volume premia. Three major contract structures commonly emerge in optimality. First, if the seller has a high discount rate relative to the buyer and the seller’s production costs or the production capacity is low, the optimal contracts tend to be flat-price sales contracts. Second, when the seller has a relatively high discount rate compared to the buyer but production costs or production capacity is high, the optimal contracts are sales contracts with volume discounts. Third, if the buyer’s discount rate is high relative to the seller’s, then the optimal contracts tend to be volume-dependent options contracts and can involve both volume discounts and volume premia. However, when the seller’s production capacity is sufficiently low, it is possible to observe flat price option contracts. We further provide links between production and spot market characteristics, contract design, and efficiency. ∗United BioSource 430 Bedford Street, Suite 300, Lexington Office Park, Lexington, MA 02420 e-mail: [email protected] †Operations Research Center, 77 Massachusetts Avenue, Massachusetts Institute of Technology, Cambridge, MA 02137. e-mail: dslevi.mit.edu ‡Graduate School of Business, 518 Memorial Way, Stanford University, Stanford, CA 94305-5015. e-mail: tunca [email protected] §We thank the Associate Editor and three referees as well as Izak Duenyas, Steve Graves, Evan Porteus, Jin Whang, Thomas Olavson from Hewlett-Packard Strategic Planning and Modeling group, and Venu Negali from Hewlett-Packard Procurement Risk Management Group for helpful comments and discussions. David Simchi-Levi’s work was sponsored by NSF Contracts CMMI-0758069 and DMI-0245352.