A choice-based optimization approach for contracting in supply chains

• Choice-based optimization MINLP model for contracting in supply chains (SC). • Relaxes critical assumption of deterministic utilities and rational actors. • Quantitative decision support and qualitative insights for contract design. • Introducing more contract options can improve suppliers performance. • Moderate expansion sufficient for significant improvement. We consider a supplier-buyer supply chain. The buyer holds private forecast information (high/low), and the supplier offers a menu of capacity reservation contracts to align incentives. We analyze how the menu of contracts should be adapted when lifting the assumptions that buyers act rationally and/or that buyers’ utility is deterministic. We employ a novel choice-based optimization approach that integrates a multinomial logit model (capturing the buyer’s contract choice behavior) with a mixed-integer nonlinear program. The choice-based optimization model can be solved with off-the-shelf solvers and is therefore ready to use by management. We further derive qualitative insights on how to adapt existing contracts in a numerical study. We show that cutting off low-demand buyers, reducing reservation fees in a specific manner and introducing more contract options may increase suppliers’ and supply chains’ performance.