Demand Visibility and Capacity Pooling With Temporal Commitments

Problem definition: We study the combined value of limited demand visibility and capacity pooling, two hedging mechanisms against demand uncertainty, when signing capacity contracts with temporal commitment. Academic/Practical Relevance: With new technological innovations, short commitment contracts are found in dynamic environments like distribution, processing and manufacturing; a trend likely to grow in the future. In contrast to classic procurement, where commitments are long, short commitments lead to new dynamics in which demand visibility allows companies to use pooling resources more efficiently by adapting to demand observations. When companies can adapt to observed demand, demand visibility and capacity pooling can act as both substitutes and complements. Methodology: We incorporate capacity pooling and demand visibility simultaneously using a multi-period newsvendor network model with two nodes that are supplied using dedicated and flexible capacity contracts with temporal commitment. Results: The optimal plan commits to customized capacity contracts depending on the observed demand at each node. We find the use of extra capacity pooling between nodes to be most effective when observed demands of the nodes are far apart with high observed demand at one node and low observed demand at the other. If flexible capacity is inexpensive, pooling capacity removes most of the demand variability and reduces the value of demand visibility, confirming the intuition found in previous studies. However, as flexible capacity becomes more expensive, companies that use dedicated and flexible capacity can further increase the value of flexibility with demand visibility in the presence of commitment. Hence, demand visibility and flexible contracts act as complements also. In the presence of seasonal demand surges and prediction uncertainty, the two hedging mechanisms further complement each other. Managerial Implications: In contrast to conventional wisdom, when contracts have short commitment, companies have high incentives to combine capacity pooling and demand visibility against demand uncertainty.