9. Designing Flexible Supply Chain Contracts with Options

In many industries, original equipment manufacturers (OEMs) are focusing on a limited range of core competencies and choosing to procure nonessential goods or services from suppliers and third-party service providers. The result is a highly decentralized supply chain, where each supply chain partner attempts to maximize its own profit objective, based on its own private information. Given the uncertainties present in both procurement decisions, often manifested in substantial forecast errors in materials or service requirements, the execution of supply agreements can have a significant impact on the firm’s operational and financial performance. Supply chain contracts are contractual agreements governing the pricing and exchange of goods or services between independent partners in a supply chain. Properly designed supply contracts are an effective means to share the demand and supply risk and better coordinate such decentralized supply chains. It is widely recognized that suppliers and buyers can benefit from coordination and thereby improve the overall performance of the supply chain as a whole, as well as, frequently the performance of each individual party.