Independence of Capacity Ordering and Financial Subsidies to Risky Suppliers

The risk of supply disruptions because of suppliers' financial problems plays a prominent role in manufacturers' risk portfolios. Even large suppliers (e.g., Delphi) could file for bankruptcy, and manufacturers' actions, such as financial subsidies to suppliers, profoundly affect suppliers' financial health. Using a dynamic, stochastic, periodic-review model of the manufacturer's joint capacity reservation and financial subsidy decisions and a general firm-value model of the supplier's financial state, this paper addresses the following questions: What is the optimal joint capacity ordering and financial subsidy policy for the manufacturer? Must subsidy and capacity ordering decisions be made jointly? How good are the recommendations from the traditional procurement models, which ignore the benefits of controlling the supplier's financial state through subsidies? The paper presents general assumptions that allow the manufacturer to make ordering decisions independent of subsidy decisions and investigates interactions between ordering and subsidy decisions when these assumptions are violated. Conditions are presented for the optimal subsidy policy to have a “subsidize-up-to” structure and for the optimal ordering decisions to be newsvendor fractiles.