Managing High-Tech Capacity via Reservation Contracts*

Wednesday, September 25, 2002 - 3:00pm - 3:50pm
Keller 3-180
David Wu (Lehigh University)
Note: Other related papers can be found on my web site under Papers.

We study capacity reservation contracts in a high-tech manufacturing environment. Motivated by our work at a major telecommunications device manufacturer in the U.S., we consider contracts that allow the manufacturer (the supplier) to share the risk of capacity expansion with her OEM customers (the buyer). This is important, as the capacity cost is enormous in this industry, while the market demand highly volatile. We focus on short-life-cycle, make-to-order products under stochastic demand. The supplier and the buyer are partners who enter a design-win agreement to develop the product, and who share demand information. The supplier would expand her capacity in any case, but reservation may encourage her to expand more aggressively. To reserve capacity, the buyer pays a fee upfront while (a pre-specified portion of) the fee is deductible from the order payment. As capacity expansion demonstrates diseconomy of scale in this context, we assume convex capacity costs. We first analyze the players' incentives in a one-supplier, one-buyer setting. We show that as the buyer's revenue margin decreases, the supplier faces a sequence of three profit scenarios with decreasing desirability. We examine the effects of market size and demand variability to the contract conditions, and show that it is the demand variability that affects the reservation fee, and that the convex cost assumption leads to different insights than the linear cost cases in the literature. We generalize the analysis to a one-supplier, two-buyer system where the buyers compete for capacity in a Nash game. We show that the game is sensitive to the reservation fee, and the supplier could dictate whether the buyers play a fixed capacity game (FCG), or a variable capacity game (VCG). We discuss buyer behaviors and their optimal strategy under both situations. We propose a number of channel coordination contracts, and discuss additional cases when the supplier has the option not to comply with the contract, and when the buyer's (in this case, a contract manufacturer) market size is only partially known. I will conclude the talk by summarizing insights useful for high-tech capacity management, and relevance to recent trends in contract manufacturing.

*(joint work with Murat Erkoc).

Dr. S. David Wu is Lee A. Iacocca Professor and Chairman of the Department of Industrial and Systems Engineering at Lehigh University. He is also founder and co-Director of the Manufacturing Logistics Institute (MLI), a research institute created in 1995 to promote the integration between academic and industrial research in Logistics. In 1999, Professor Wu created the Global Manufacturing Logistics Fellows program in partnership with the Wharton School at the University of Pennsylvania. With significant funding from the National Science Foundation, the fellows program forms global alliance with some 14 international institutions throughout Europe, Asia/Pacific and the Mid-East. Professor Wu.s research is in the areas of supply chain coordination; focus on combining the insights from game theoretic and optimization models. He has published more than 80 articles in this and related areas. He is currently co-editing the Handbook of Supply Chain Analysis in the eBusiness Era (Kluwer Academic Press) with David Simchi-Levi (MIT) and Max Shen (Florida). Professor Wu.s research has been supported by NSF, DOD, Sandia National Laboratory and industrial firms such as Agere Systems, Lucent Technologies, Ford, Unisys, and Bethlehem Steel. He currently serves on the editorial boards of IEEE Transactions on Robotics and Automation, IIE Transactions, and Journal of Manufacturing Systems. He holds an M.S. and Ph.D. degrees in Industrial Engineering from the Pennsylvania State University (1987). In 1995-1996, he was a visiting professor at the University of Pennsylvania.