Risk Ownership in Contract Manufacturing

During the Supply Chain Forum on Contract Manufacturing organized at the institution, the authors observed two conflicting points of view regarding the best location for risk ownership in a supply chain. The contract manufacturers (CMs) argued that the original equipment manufacturers (OEMs) should be responsible for managing the risks due to demand uncertainty since they have better information about the market. This was countered by the OEM point of view that the CM should be responsible for managing these risks since they can hedge their risks by pooling their resources for many different customers. The goal of this study is to investigate these claims and to identify conditions under which they are valid. The authors consider scenarios where only one of the parties makes a quantity decision in the face of uncertain demand and incurs the total cost due to demand uncertainty. The authors show that depending on the relative accuracy of information and the number of OEMs, the OEM or the CM may carry risks more effectively from a supply chain point of view. However, it is also observed that each party would prefer the other to take the responsibility. The authors therefore investigate the payment of premiums to the risk-bearing party as a mechanism to achieve supply chain optimal behavior. It is observed that there always exists a range of premiums that induces one of the parties to voluntarily bear the risk; however, this party is not always the right one from a supply chain perspective. The authors conclude with recommendations on risk sharing in contract manufacturing.