Coordinating Investment, Production, and Subcontracting

Jan A. Van Mieghem
Additional contact information
Jan A. Van Mieghem: Kellogg Graduate School of Management, Northwestern University, 2001 Sheridan Road, Evanston, Illinois 60208-2001

Management Science, 1999, vol. 45, issue 7, 954-971

Abstract: We value the option of subcontracting to improve financial performance and system coordination by analyzing a competitive stochastic investment game with recourse. The manufacturer and subcontractor decide separately on their capacity investment levels. Then demand uncertainty is resolved and both parties have the option to subcontract when deciding on their production and sales. We analyze and present outsourcing conditions for three contract types: (1) price-only contractswhere an ex-ante transfer price is set for each unit supplied by the subcontractor; (2) incomplete contracts, where both parties negotiate over the subcontracting transfer; and (3) state-dependentprice-only and incomplete contracts for which we show an equivalence result. While subcontracting with these three contract types can coordinate productiondecisions in the supply system, only state-dependent contracts can eliminate all decentralization costs and coordinate capacity investmentdecisions. The minimally sufficient price-only contract that coordinates our supply chain specifies transfer prices for a small number (6 in our model) of contingent scenarios. Our game-theoretic model allows the analysis of the role of transfer prices and of the bargaining power of buyer and supplier. We find that sometimes firms may be better off leaving some contract parameters unspecified ex-ante and agreeing to negotiate ex-post. Also, a price-focused strategy for managing subcontractors can backfire because a lower transfer price may decrease the manufacturer's profit. Finally, as with financial options, the option value of subcontracting increases as markets are more volatile or more negatively correlated.

Keywords: coordination; production; subcontracting; outsourcing; supply contracts; supply chain; capacity; investment (search for similar items in EconPapers)
Date: 1999
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (111)

Downloads: (external link)
http://dx.doi.org/10.1287/mnsc.45.7.954 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:45:y:1999:i:7:p:954-971

Access Statistics for this article

More articles in Management Science from INFORMS Contact information at EDIRC.
Bibliographic data for series maintained by Chris Asher ().