“profit Sharing and Adjustment Options in Supply Contracts”

(Please do not quote without permission) 7 th ANNUAL INTERNATIONAL CONFERENCE ON REAL OPTIONS of Economics are duly noted and appreciated. ABSTRACT A common theme in the studies of flexible supply contracts has been the producer's profit maximization problem without regard for the suppliers' reactions to the producer's operating policies. However, suppliers do react and protect their downside against producer's operating policies by revising their strategies in a manner consistent with their profit maximization objectives. This fact motivates our work. Using a real options (contingent claims) approach, we analyze and value supply contracts in a setting characterized by exchange rate uncertainty, supplier-switching options, order quantity flexibility, profit sharing, and supplier reaction-options. We also use basic diversification concepts, from portfolio theory, to provide a unique framework for risk reduction. Given this set up, we explicitly model how flexibility can be mutually beneficial to the producer and his suppliers. We also analyze what induces the producer and the suppliers to accept flexibility in their contracts. 2 I. INTRODUCTION A common theme in the studies of (flexible) supply contracts is the profit-maximization problem for the producer without regard for the suppliers' reactions to the producer's optimal operating policies. Yet, suppliers react through counteroffers, or by imposing scenario specific contract clauses with penalty premiums attached. These protective measures by suppliers can be viewed as an option to react to the producer's policies. In this respect, suppliers' counteroffers reflect the flexibility to revise actions. It also represents the suppliers' preferences and aversions toward reward and risk, reduce the producer's initial expected profits, and are likely to induce a revised offer by the producer. Repeated offers and counteroffers constitute a sequence of bargaining games over time that ensure no one party's benefits may be obtained at the expense of the other's loss. In this context, the bargaining games are cooperative. The notion of benefit reassessment, policy revision, and bargaining define our profit sharing view to the problem of analyzing supply contracts in operations. This perspective, in the context of a portfolio theory based real options valuation approach, characterizes a major contribution of this paper. It is also a significant departure from the traditional approach where the suppliers' reactions are, at best, exogenously fixed and state independent policies. To the best of our knowledge, the existing literature has not addressed the impact of producer's decisions on the suppliers' actions and contract values, nor has it considered the …