Examining supply contracts under cost and demand uncertainties from supplier’s perspective: a real options approach

Abstract

Supply contracts have been widely utilised by practitioners to mitigate supply chain risks and disruptions while maintaining flexibility and stability. It is, thus, not surprising that buyers’ economically rational decisions towards supply contracts have been well studied. Missing in the literature, however, is examination of potential values and risks of supply contracts from supplier’s perspective. Motivated by this literature vacancy, this paper, using a real options approach, investigates a supplier’s acceptance decision towards a supply contract with variable cost and supply demand uncertainties. Through analytical and numerical examinations, conditions under which it is economically viable for the supplier to accept the supply contract are derived. This study also uncovers the impacts of variable cost and supply demand uncertainties as well as contract duration on the supplier’s acceptance decision. Also, there exists a range of contract duration beyond which the supplier should reject the supply contract offered by the client. To facilitate the understanding of this duration range, the corresponding shortest and longest contract duration is derived through numerical examples.

Keywords:

• supply contract
• supplier
• real options
• cost and demand uncertainties
• contract duration