Common Process and Option Capacity

In our model, there are three types of flexibility that the manufacturer can use to cope with the demand uncertainty: common processes, flexible resources, and option contracts. In this section, we will discuss the effects of using common processes and option contracts through a series of examples. Finally, we will draw some managerial insights into how to use these flexibilities.

Consider a supply chain given in Figure 2-8 that contains two products, four processes, and four resources. Each process has a dedicated resource and we will view them as synonymous and use the terms interchangeably.

Figure 2-8: A supply chain with two products and four processes.

Figure 2-9: Replacing the process 2a and 2b in Figure 2-8 with a common process with the same price.

Both products have the same unit profit. The unit prices of the fixed-price capacity are

[p1, p2a, p2b, p3] = [10, 50, 50, 10].

The demand of each product follows normal distribution with mean and standard deviation:

E[D1] = 502; σ(D1) = 99; E[D2] = 496; σ(D2) = 99.

To study the effects of common processes and option contracts, we will consider the following four scenarios:

1. The optimal capacity strategy for the supply chain given in Figure 2-8.

2. The same problem in scenario 1 except that we replace processes 2a and 2b with a common process with the same price. The supply chain after the replacement is given in Figure 2-9.

3. The same problem in scenario 1 except that we add an option contract to process 2a and 2b. The option contract has a unit reservation price 5 and unit exercise price 50.

4. We combine scenario 2 and 3.

We will compare the change to the maximum expected profit in the four scenarios as we increase the unit profits for both products from 66 to 150. The results are given in Table 2.9. We use the maximum expected profit in scenario 1 as the reference point. We then quantify the benefit gained in the other scenarios as the percentage increase in profit compared to the reference. We have plotted the benefits versus profit margin in Figure 2-10. From this example, we have the following observations:

Profit Margin S1 S2 S3 S4 S2 vs. S1 S3 vs. S1 S4 vs. S1 66 1.54% 3,849 3,849 3,849 3,996 0.00% 0.00% 3.81% 67 3.08% 4,584 4,584 4,585 4,804 0.00% 0.04% 4.81% 68 4.62% 5,329 5,329 5,355 5,629 0.00% 0.49% 5.63% 69 6.15% 6,085 6,085 6,158 6,472 0.00% 1.20% 6.36% 70 7.69% 6,850 6,850 6,979 7,326 0.00% 1.87% 6.94% 80 23.08% 14,902 15,039 15,858 16,319 0.92% 6.41% 9.50% 90 38.46% 23,418 23,842 25,222 25,704 1.81% 7.70% 9.76% 100 53.85% 32,268 32,900 34,799 35,287 1.96% 7.84% 9.36% 110 69.23% 41,286 42,131 44,471 44,967 2.05% 7.71% 8.92% 150 130.77% 78,399 79,902 83,580 84,141 1.92% 6.61% 7.32%

Table 2.9: The benefits of using common processes and option contracts.

0 20 40 60 80 100 120 140 0 2 4 6 8 10 12 Profit Margin (%) Extra Revenue (%)

Benefit of using common process and option contract

(1) Only using common process (2) Only using option contract Sum of (1) and (2) Using both common process and option

1. The benefits of using common process and option contract are small when the profit margin is low. The benefits increase and then decrease as the profit margin increases.

The benefit of common process comes from risk pooling. In this example, when the profit margin is very low, the loss from excess dedicated capacity is higher than the gain from the risk pooling on the common process. Therefore, the benefit of using common process is small.

The benefit of using option contract is to reduce the overage cost (from the excess capacity) when the demand is low. When the profit margin is very low, the reduced overage cost is still too high compared to the underage cost (from the unfilled demands). Therefore, the option contract is also not very effective. When the profit margin is high, the underage cost is more significant compared to the overage cost. The manufacturer is willing to bear the cost of excess capacity as to not fill demands. Therefore, any savings from reducing common process capacity or reducing the cost of excess capacity become less significant when the profit margin is high.

2. Using an option contract with small reservation price is more effective than using common process.

In Figure 2-10, the red line representing the benefit of using option contract is always above the blue line, which represents the benefit of using common process. We assume that the option contract has a 10% reservation price. The effective price of the option capacity, which is the sum of reservation price and exercise price, is 10% more than the price of the fixed-price capacity. In this case, option capacity can help the manufacturer to increase the expected profit by as high as 7.84% in the case where the profit margin is 53.83%. This example shows that an option contract with a small upfront price can be very effective. As the reservation price increases, the benefit of using an option contract decreases. For example, if we hold q + e = 55 and increase q from 5 to 25, the profit drops from 34,799 to 32,915. The increase in the expected profit

c1 c2a c2b c3 g1 g2a g2b g3

Combined 437 760 - 426 437 863 - 426 Only option 406 378 367 397 406 406 397 397 Only common 384 763 - 378 384 763 - 378

Table 2.10: Studying the effects of common processes and option capacity: the opti- mal solutions of different strategies.

is 2.00%, which is slightly better than the 1.95% increase achieved from using a common process. If we further increase the reservation price to 40, the profit drops to 32,287. The percentage increase in profit is only 0.06%.

3. When the profit margin is low, the strategy of using common process and an option contract with small reservation price together can gain extra benefits compared to using these two strategies separately.

Implementing both strategies, using common process and option contract, at the same time is better than just deploying one of them. Furthermore, there is a synergy in that the manufacturer gains an extra benefit by combining these two strategies at low profit margins. In Figure 2-10, the green line is the sum of the benefits of using common process and option contract separately. When the profit margin is lower than 40%, the benefit of combining two strategies, represented by the purple line, is higher than the green line. The gap between these two lines is the extra benefit that the manufacturer gets. Moreover, this extra benefit can be significant. For example, when the profit margin is 4.62%, using common process and option contract can increase the profit by 0% and 0.49% respectively. However, the combined strategy can achieve a 5.63% profit increase. To see the reasons behind this phenomenon, we can look at the optimal solution of the different strategies in Table 2.10. We note that in the combined strategy, the manufacturer first buys more capacity and second uses a larger portion of option capacity. The effectiveness of an option capacity depends on two factors: the price structure and the standard deviation of the demand. After replacing the process 2a and 2b with a common process, the standard

deviation of the demand for the common process in larger than the standard deviation of the original dedicated process. Therefore, using common process amplifies the effectiveness of the option contract. On the other hand, the option contract makes the capacity for the common process more flexible. As a result, using the option contracts also amplifies the effectiveness of the risk pooling effect. Therefore, the combined strategy achieves a much higher percentage of profit increase.