SUBCONTRACTING STRATEGIES WITH STOCHASTIC THIRD-PARTY CAPACITY AND TARDINESS PENALTY CONTRACTS

Abstract We study a subcontracting model where a manufacturer cannot process all his workload before the customer due date. Therefore, he subcontracts part of his workload to a third- party who has prior customer commitments. Prior committed orders require processing that follows a general distribution and hence the available capacity at the third-party is uncertain. The manufacturer wants to maximize his expected profits by partitioning his workload among his in-house production capacity and the third-party. We study two different contracts; (i) the manufacturer pays a unit processing fee for workload processed by the third-party, (ii) in addition to the unit processing fee, the third-party shares the tardiness penalties incurred by the manufacturer. We show that this production chain cannot be coordinated under the first contract unless the third-party accepts to merely break even. Under the second contract, coordination is possible if the unit processing fee and the tardiness sharing fraction are negotiated jointly. In this case, the coordinating contract Pareto-dominates non-coordinating contracts. We show that with the coordinating contract, the tardiness sharing fraction coincides with the third-party’s share of the additional profits generated by the coordinated chain. We also studied the tardiness penalty sharing contract when one of the parameters is chosen exogenously and compared its merit to the unit processing fee contract. Despite being more difficult to administer