Safety Stock or Excess Capacity: Trade-offs under Supply Risk

This paper investigates the trade-offs between carrying safety stock and planning for excess capacity when a firm faces uncertain demand and supply. Using well-known results from queueing theory, we characterize a buyer’s optimal strategy regarding the amount of capacity that needs to be contracted with a supplier, and the corresponding inventory that it needs to hold. We typically find that both are higher when demand or supply variability are higher. We use our model to analyze multi-sourcing strategies: when multiple suppliers are available, we determine at optimality the size of the supply base, the amount of capacity to be installed, and the inventory levels to be maintained. 1