Modeling flexible supply options for risk-adjusted performance evaluation

Flexible Supply Options (FSO's) represents a class of supply sources that provide the buyer, usually a manufacturer, with the flexibility required to react to continuously improving demand information. They are primarily intended for settings where traditional replenishment is impractical, and are used to complement a reduced initial order quantity from the standard low-cast supplier. Formally, FSO's are defined as a source of finished goods inventory apart from the primary low-cost means characterized by: (1) the option price, or initial investment required to reserve a unit of capacity; (2) the exercise price, which is a variable charge for each unit requested; and (3) a finite lead-time to complete an order. A manufacturer derives value from FSO's primarily by utilizing early season sales data to better plan for demand later in the time horizon. Exercising the appropriate number of options to augment the existing inventory effectively reduces the inventory risk normally faced in a single-order environment.; A number of risk-sharing contracts binding manufacturers and their suppliers have been proposed in the supply-chain literature and put into practice. These are useful examples of FSO's, and include Options-Futures Contracts, Options-only Contracts, Backup Contracts, and Quantity flexibility contracts. However, one point of emphasis here will be the generalization of this strategy to include any alternative means of production with a very short lead-time compared to the standard low-cost supplier, including in-house, off line production processes.; A one period, two-stage Markov Decision Model is created to study the potential benefits of FSO's. Closed-form solutions for determining profit-maximizing order quantities and exercising policies are developed, along with a series of useful insights that govern the strategic use of FSO's. Value-at-risk (VaR) is then proposed as a suitable risk measure for various supply strategies and is used to demonstrate an additional benefit of FSO strategies; namely, that less investment is exposed throughout the selling season. VaR can also be used to adjust an FSO strategy to appeal to various levels of risk aversion. The model is then extended to incorporate multiple time periods and decision nodes, necessitating the use of simulation to formulate illustrative approximations.