Designing Service Level Contracts
© 2011 EPFL
Prof. Ralf Seifert's article on "Designing Service Level Contracts for Supply Chain Coordination”, co-auhored with Marcel Sieke and Ulrich Thonemann has been accepted for publication in the journal of Production and Operation Management
Abstract
Supply contracts are used to coordinate the activities of the supply chain partners. In
many industries, service level based supply contracts are commonly used. Under such a
contract, a company agrees to achieve a certain service level and to pay a financial penalty if it
misses it. The service level used in our paper refers to the fraction of a manufacturer's demand
filled by the supplier. We analyze two types of service level based supply contracts that are
designed by a manufacturer and offered to a supplier. The first type of contract is a flat
penalty contract under which the supplier pays a fixed penalty to the manufacturer in each
period in which the contract service level is not achieved. The second type of contract is a unit
penalty contract under which a penalty is due for each unit delivered fewer than specified
by the parameters of the contract. We show how the supplier responds to the contracts
and how the contract parameters can be chosen such that the supply chain is coordinated.
We also derive structural results about optimal values of the contract parameters, provide
numerical results, and connect our service level measures to traditional service level measures.
The results of our analyses can be used by decision makers to design optimal service level
contracts and to provide them with a solid foundation for contract negotiations.