Bonus or Penalty? Designing Service-Level Agreements for a Decentralized Supply Chain: The Implication of Return on Investment

Abstract

We study the coordination of two-echelon supply chains via service level-dependent bonus and penalty contracts and assume that the manufacturer maximizes its profit while enabling the supplier to achieve its performance target. Profit and return on investment (ROI) are considered as the supplier’s performance measures. We compute optimal contract parameters and perform a numerical study. In addition, we perform a simulation-based study to analyze the profit risk of the considered parties. For supplier profit targets, bonus and penalty contracts lead to the same profit for both parties, but bonus contracts lead to lower costs, hence, a higher ROI. For supplier ROI targets, bonus contracts always lead to higher manufacturer profit, and no optimal penalty contracts exist. For every contract service level, optimal bonus contracts exist that maximize profit and ROI of the manufacturer simultaneously. Thus, we analyze the profit risk for the manufacturer and the supplier and show that it can be significantly reduced by setting an appropriate contract service level. The manufacturer usually should prefer bonus contracts. They allow to optimize profit and ROI simultaneously and even offer an additional degree of freedom to reduce the profit risk.