The impact of demand signal quality on optimal decisions in supply contracts

In this chapter, we consider two-stage "flexible" supply contracts for advanced reservation of capacity or advanced procurement of supply. With a contract of this type, an initial quantity decision(s) is made with limited demand information. After learning new information about the demand (a demand signal), a final decision can be made that is constrained by the initial decision(s). We consider the scenario in which a large supplier offers a standard contract to a small manufacturer. Motivated by contracts in the semiconductor industry, we focus on a general options-futures contract that allows for initial reservation of capacity as a less expensive, non-refundable firm commitment or as a more expensive but flexible option. We also consider other contracts in the literature that are special cases of the options-futures contract: the options contract, the backup contract, and the quantity-flexibility contract. The purpose of this chapter is not to present and formulate the solution to a new contract structure or to find contract terms that lead to coordination benefits for the supply chain. Instead the purpose is to study existing contracts from a single-party perspective to develop very general results regarding the impact of the demand signal quality on order decisions. The demand signal quality is a measure of the amount of learning that the demand signal provides about the demand - essentially the correlation between the demand signal and the demand. We capture demand signal quality in a very general manner using stochastic ordering relations. Our contribution to the literature is analytically characterizing the impact of demand signal quality on quantity decisions under general conditions. For the options-futures contract, we show that the number of options increases and the number of futures decreases with increasing demand signal quality. The rate of increase for options is greater than the rate of decrease for futures. For the backup and quantity flexibility contracts, we find that the initial order quantity does not behave monotonically with demand signal quality.