Modeling Capacity Reservation in High-Tech Manufacturing

Abstract: The high-tech manufacturing industry is characterized by rapid innovation and volatile demands. Capacity reservation provides a risk sharing mechanism that encourages the manufac-turer to expand capacity more readily, while improving the revenue potential for the OEM cus-tomers. We propose a deductible reservation (DR) contract where the customer reserves future capacity with a fee that is deductible from the purchasing price. We show that the DR contract provides channel coordination and is individually rational for all players involved. This has prac-tical importance since reservation has intuitive benet for the manufacturer, but less so for the customers. We start the analysis with a one-manufacturer, one-customer system with stochastic demand, then generalize the analysis to the case of n customers. A unique feature of the DR con-tract is that the manufacturer announces ex ante the “excess ” capacity she will expand in addition to (and regardless of) the customer reservation amount. We show that the reservation fee should be increasing in the excess capacity amount, and coordination could be achieved with different com-binations of the two. To establish practical insights we compare the DR contract with a contract known in the industry as take-or-pay. We show that while the manufacturer is no worse off under take-or-pay, there may not exist a contract setting that guarantees to benet the customers. We discuss the similarities and differences between the capacity reservation contracts and other well known supply chain contracts