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Capacity Management for Contract Manufacturing

Graduate Program in Industrial and Systems Engineering, Department of Mechanical Engineering, University of Minnesota, Minneapolis, Minnesota 55455
SmartOps Corporation, One North Shore Center, 12 Federal Street, Pittsburgh, Pennsylvania 15212
guptad{at}me.umn.edu
lwang{at}smartops.com

Contract manufacturers sell capacity under different terms to different buyers. In a common practice, the supplier offers a market standard price and lead-time combination for products listed in its catalog. At the same time, it strikes contracts with some high-volume customers who require recurring delivery of a custom product at a short notice, usually timed to meet the buyer’s production schedule. Whereas the manufacturer is obligated to satisfy demand from these customers, it can dynamically choose which transactional orders to accept. In this paper, we analyze two scenarios. In the first scenario, the manufacturer produces contractual orders on a make-to-order basis, and in the second, it maintains finished goods inventory for such orders. At each decision epoch, the manufacturer decides which transactional orders to accept to maximize its long-run expected profit. When contractual items are made to stock, the manufacturer also chooses how much extra capacity to allocate to contractual items, over and above what is needed to meet realized demand. We establish the structure of the optimal policies and propose scalable heuristics when optimal policies are hard to compute/implement. Our models are then used to study the effect of demand variability on the optimal profit. We also show how the amount of capacity available, relative to demand, changes the desirability of serving either transactional-only or both markets.

Subject classifications: manufacturing; contract manufacturing; strategy; inventory/production; applications; policies; dynamic programming/optimal control; Markov.
History: Received October 2004; revision received March 2006; accepted March 2006.