1 Managing High - Tech Capacity Expansion Via Reservation Contracts

We study capacity reservation contracts in high-tech manufacturing, where the manufacturer (the supplier) shares the risk of capacity expansion with her OEM customer (the buyer). We focus on shortlife-cycle, make-to-order products under stochastic demand. The supplier and the buyer are partners who enter a "design-win" agreement to develop the product, and who share demand information. The supplier would expand her capacity in any case, but reservation may encourage her to expand more aggressively. To reserve capacity, the buyer pays a fee upfront while (a pre-specified portion of) the fee is deductible from the order payment. As capacity expansion demonstrates diseconomy of scale in this context, we assume convex capacity costs. We first analyze the players' incentives as a means to evaluating the value of reservation. We show that as the buyer's revenue margin decreases, the supplier faces a sequence of four profit scenarios with decreasing desirability. We examine the effects of market size and demand variability to the contract conditions, and show that it is the demand variability that affects the reservation fee, and that the convex cost assumption leads to somewhat different insights than the linear cost cases in the literature. We propose two channel coordination contracts, and discuss how such contracts can be tailored for situations where the supplier has the option of not complying with the contract, and when the buyer's demand information is only partially updated during the supplier's capacity lead time. We conclude the paper by summarizing insights useful for high-tech capacity management.