Incentives to improve the service level in a random yield supply chain: The role of bonus contractsby Zhe Yin, Shihua Ma

European Journal of Operational Research

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Incentives to improve the service level in a random yield supply chain: the role of bonus contracts

Zhe Yin, Shihua Ma

PII: S0377-2217(15)00085-5

DOI: 10.1016/j.ejor.2015.02.006

Reference: EOR 12775

To appear in: European Journal of Operational Research

Received date: 4 December 2013

Accepted date: 3 February 2015

Please cite this article as: Zhe Yin, Shihua Ma, Incentives to improve the service level in a random yield supply chain: the role of bonus contracts, European Journal of Operational Research (2015), doi: 10.1016/j.ejor.2015.02.006

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Highlights • We model a natural gas pipeline network with a system operator and a shipper. • We examine the effect of introducing interruptible transportation services. • We use stochastic programming to model uncertainty in prices and network capacity. • Interruptible transportation services increase network flow and profitability. • Increased security of supply levels increases the effect of interruptible services. 1

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Incentives to improve the service level in a random yield supply chain: the role of bonus contracts

Zhe Yin, Shihua Ma∗

School of Management, Huazhong University of Science and Technology, Wuhan 430074, China

Abstract

We consider a decentralized supply chain comprised of one manufacturer and one retailer where the manufacturer has random yield, and the retailer faces uncertain demand. To guarantee product availability, the retailer requires a service level of the product supply from the manufacturer.

However, we determine that the high service level indeed benefits the retailer whereas causes the manufacturer’s profit loss. Therefore, to promote the high-service-level cooperation, the retailer has to provide incentives for the manufacturer, such as bonuses. We consider two common bonus contracts: unit bonus and flat (or lump-sum) bonus. The primary question we address is whether the service-level based bonus contracts can achieve the two firms’ Pareto-improving for both service level and profits, which is a prerequisite for the retailer to carry out them with the manufacturer.

The results show that both bonus contracts can achieve Pareto-improving. While it is simpler for the retailer to carry out the unit bonus contract, the retailer can achieve a higher service level and higher profits under the flat bonus contract.

Keywords: Supply chain management; Random yield; Demand uncertainty; Bonus contract; Service-level requirement 1 Introduction

Given the increasingly intense global market competition, improving service level has become one of the “top two goals” for supply chain management (Chen and Shen, 2012; Gyorey et al., 2010). High customer service level plays an important role in enhancing competitiveness and continuous development for the entire supply chain. Fortunately, firms gradually identify this key point. According to the description of KPMG (2010), in the food, drink, and consumer goods (FDCG) industry, retailers often enter into a service-level agreement with their FDCG manufacturers. Additionally, in the automotive industry, many original equipment manufacturers cooperate with their first-tier suppliers under service-level contracts (Stratmann, 2006). ∗Corresponding author. shihuama@mail.hust.edu.cn(Shihua Ma). 2

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However, high degree supply chain risk, including supply and demand uncertainty, hinders the achievement of a high service level. A survey by McKinsey finds that 82 percent of the respondents in developed Asian countries claim that the supply chain risk will continue to increase in the next five years (Gyorey et al., 2010). Therefore, product availability, which is critical in keeping customers satisfied in the uncertain operations environment, is emphasized in service-level based contracts between supply chain parties. Based on these contracts, the upstream suppliers must achieve an ample supply with a certain probability (Chen and Shen, 2012; KPMG, 2010; Stratmann, 2006).

Although the high service level benefits the entire supply chain with respect to customer satisfaction, it may cause ineffective operations for the upstream parties. This problem is highly serious when the product has a short life cycle and random yield. Therefore, the service-level contracts between the supply chain parties should emphasize not only achieving a high service level but also providing the incentives (such as bonuses) for the contractors to improve performances (Tarakci et al., 2006).

This observation stems from the business practice of the leisure food chain store companies in China, such as LPPZ Foods. LPPZ Foods is an emerging and rapidly developing chain store company that purchases products from a large number of food manufacturers, including some seasonal perishable products with short life cycles such as green bean cake, zongzi, and mooncake. To guarantee product availability, LPPZ Foods measures the service level of the manufacturers and provides bonuses for the manufacturers with relatively high service levels.1 However, the lack of quantitative decision analysis hinders retailers such as LPPZ Foods from taking full advantage of service-level based bonus contracts to improve the performance of the entire supply chain.

The above discussion gives rise to three new quantitative research questions. Specifically, we elaborate them as follows. First, facing the supply and demand uncertainty, how does the retailer use the two common bonus regimes (i.e., unit bonus and flat or lump-sum bonus) to motivate the manufacturer to improve the service level? Second, can service-level based bonus contracts achieve the two parties’ Pareto-improving? Third, what are the differences between the flat bonus contract and the unit bonus contract?