Outsource planning through option contracts with demand and cost uncertainty

This research considers a supply chain consisting of one supplier and one manufacturer that produces a kind of product, e.g. innovative products, with a long supply lead-time, a short selling season and a stochastic demand. Complete production of the final product requires both an initial and a final processing operation. The manufacturer performs the initial processing operation with a deterministic cost. The final processing operation may be either performed by the manufacturer or assigned to an outside firm through a bid process. At the time of the supply contract, the final processing cost (FPC) is estimated as a stochastic variable. The uncertainty on FPC is removed before the selling season starts. The present study is an attempt to determine how the manufacturer should place the supply orders within the framework of wholesale price, put, call and bidirectional options. Option contracts provide the manufacturer with the flexibility to adjust his initial orders by exercising purchased options after the FPC is realized. We find optimal exercised orders with each option contract, in addition to equations in which the optimal initial and option orders hold. According to our analysis, if the realized FPC is higher (lower) than a specific level, the manufacturer should decrease (increase) his initial orders. We obtain analytically these specific levels under all types of option contracts. The numerical analysis and managerial insights shed light on the value of option contracts considering different parameter settings.