Outsource planning with asymmetric supply cost information through a menu of option contracts

• Published date: 01 July 2019
• Date: 01 July 2019
• DOI: http://doi.org/10.1111/itor.12396
• Author: Iman Nosoohi,Ali Shahandeh Nookabadi

Intl. Trans. in Op. Res. 26 (2019) 1422–1450

DOI: 10.1111/itor.12396

INTERNATIONAL

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IN OPERATIONAL

RESEARCH

Outsource planning with asymmetric supply cost information

through a menu of option contracts

Iman Nosoohia,b and Ali Shahandeh Nookabadib

aDepartment of Supply Chain & Business Technology Management, JohnMolson School of Business, Concordia University,

1455 de Maisonneuve Blvd W, Montr´

eal, Qu´

ebec, H3G 1M8, Canada

bDepartment of Industrial and Systems Engineering, Isfahan University of Technology (IUT), Isfahan84156-83111, Iran

E-mail: iman.nosoohi@concordia.ca [Nosoohi]; ali-nook@cc.iut.ac.ir[Nookabadi]

Received 11 April 2016; received in revised form 8 October 2016; accepted 11 January2017

Abstract

This paper investigates a supplycontract design by a dominant manufacturer who faces a stochastic demand

during a selling season. The manufacturer has several estimations of the supplier’s cost with corresponding

probabilities, that is, asymmetric cost information. The manufacturer designs a menu of call option contracts

that include three variables:a supply order,an option, and an exercise price. Wedetermine the optimal negative

correlation between option and exercise prices as well as closed-form formulas for the optimal supply orders.

The results show that in the optimal menu of contracts either the option or the exercise price may be omitted

from the menu, whereas the supply orders should always be customized for each supplier type. We show

that in this problem, optimal profitassignment between contract partners under put and bidirectional option

contracts is the same as call option contract studied. Numerical analysis including managerial insights is

presented.

Keywords:outsourcing; optimization; information asymmetry; menu of contracts; call option contract

1. Introduction

In practice, we observe that manufacturers of new and innovative products, or those who are new

in a market or trade with a new supplier for the first time, might not fully understand the supplier’s

cost structure. Even if a manufacturer and supplier work together for a while, the supplier might

not want to share its cost information. These situations lead to cost information asymmetry at the

time of outsource planning. In addition, uncertainty of market demand increases the complexity of

outsourcing decisions for manufacturers.

Regarding these issues, in this research, we investigate an outsourcing problem from the view

of a manufacturer (referred to as “he”), against a supplier (referred to as “she”). We consider the

issue of information asymmetry in our study by assuming the supplier’s unit production cost, which

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International Transactionsin Operational Research C

2017 International Federation ofOperational Research Societies

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I. Nosoohi and A. S. Nookabadi / Intl. Trans. in Op. Res. 26 (2019) 1422–1450 1423

determines her type, is privatelyknown to her. The manufacturer’s working environment is assumed

based on innovative and fashion products with a short selling season, a stochastic demand and a

long supply lead-time. The manufacturer, as the dominant decision maker, has to decide about the

supply orders and purchasing costs from the supplier.

Option contracts are widely used in practice for outsource planning, especially in the case of

innovativeproducts like electronics (Wangand Tsao, 2006; Wang and Chen, 2015). Option contracts

usually include two stages. In the first stage, an option order is placed with information uncertainty

and in the second stage, options are exercised after information uncertainty is removed or updated.

Option contracts are categorized into three differenttypes: call option contract, put option contract,

and bidirectional option contract. Call (put) options provide the opportunity for the manufacturer

to increase (decrease) its initial order, while a bidirectional option provides the opportunity to either

increase or decrease the initial order (Zhao et al., 2013; Nosoohi and Nookabadi, 2016a).

In this research, we consider both supplier’s cost and demand uncertainties for the manufacturer.

The option contract used is based on call option contract to reduce the impact of demand uncer-

tainty. The market demand which is realized during the selling season determines how many call

options should be exercised.

The approach most often used for contract design in problems with information asymmetry is

designing a menu of contracts (Ha, 2001; Corbett et al., 2004). The menu of contracts includes

different contracts, each designed for a specific state of the supplier’s cost. Usually only two states

are considered for the asymmetric information such as cost or demand. However, in practice,

there might be several possibilities that include very pessimistic, moderate, optimistic, and very

optimistic states for the asymmetric information. Thus, in this research, we investigate how the

manufacturer can implement the option contract, given Ndifferent estimations of the supplier’s

cost with corresponding probabilities. In order to answer this question, we investigate the design of

a menu of call option contracts where each contract consists of a triple set of parameters: supply

order, option price, and exercise price.

Another question we address regarding implementation of the menu is the following: Are we

able to simplify the design of a menu of call option contracts by considering identical items for

all supplier types, or by removing one of the items from the triple? For instance, we may consider

the same supply order for all supplier types; or perhaps the triple can be reduced to a double by

considering the supply order and option price. In order to answer this question, we design the most

complete form of the menu, including customized triples, and investigate the other possible cases

or forms that might be easier to use in practice.

Therefore, we have two main contributions in this paper. First, we develop an outsourcing model

from the perspective of a dominant manufacturer by considering the supplier’s cost information

asymmetry and demand uncertainty. Unlike the common existing literature, we consider in general

Ndifferent states forthe asymmetric information and a model that is based on the most customized

form of a menu of call option contracts. Second, we provide insight into the optimal design of the

model and compare different forms of the menu from practical perspectives. The results show that

the manufacturer, while keeping a negative correlation between option and exercise prices, can omit

either the option or the exercise price from the menu of contracts. The manufacturer should always

consider a customized supply order for each supplier type. In this research, we focus on the call

option contract; however, our results on the optimal profit assignment to both parties hold true

under put and bidirectional option contracts as well.

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2017 The Authors.

International Transactionsin Operational Research C

2017 International Federation of OperationalResearch Societies