Dual sourcing in managing operational and disruption risks in contract manufacturing

We study a US OEM that outsources its production to two contract manufacturers, a local manufacturer (e.g. in the US or Mexico) and a foreign manufacturer (e.g. in China). The local manufacturer is relatively reliable, but low margin. The foreign manufacturer offers high margin, but is subject to disruption risks. Both manufacturers experience some level of operational uncertainties, and the operational risks can be positively or negatively correlated. Disruption risks are modelled as a Poisson jump process at a random magnitude, and operational risks are modelled as correlated stochastic diffusion processes. We develop a stochastic dynamic programming formulation to characterise the OEM’s optimal capital allocation decision to contract manufacturers, and provide the necessary and sufficient conditions for each optimal decision. The objective of our study is to investigate how dual sourcing balances the risks and opportunities, when the OEM bears disruption risks and correlated operational risks. We find that the two manufacturers can be substitutes or complements to each other. Risk of disruption renders the unreliable foreign manufacturer less attractive, but has a moderating effect on the allocation to the local manufacturer. We also provide managerial implications of our study.