Facilitating Demand Risk-Sharing with the Percent Deviation Contract

Abstract

Suppliers do not have much incentive to build capacity for supply chainswith stochastic demand in which the buyer bears little or no inventoryrisk. This hinders the supply chain from satisfying the optimal amountof customer demand from a channel perspective. We describe and analyzethe percent deviation contract as an innovative mechanism to improve theoverall performance of this type of supply chain. This contract inducesa dynamic game of perfect information, and we characterize thesubgaine-perfect Nash Equilibria under various contract scenarios. Weestablish ways to set the contract parameters to coordinate the supplychain under uncertainty and show that the percent deviation contract isable to achieve channel coordination in some cases where the quantityflexibility contract fails. In order to aid the implementation of thepercent deviation contract in practice, we develop ways to set theparameters to satisfy the buyer's individual-rationality constraint.