Managing High‐Tech Capacity Expansion via Reservation Contracts

We study capacity reservation contracts between a high‐tech manufacturer (supplier) and her OEM customer (buyer). The supplier and the buyer are partners who enter a ‘design‐win” agreement to develop the product, and who share the stochastic demand information. To encourage the supplier for more aggressive capacity expansion, the buyer reserves capacity upfront by paying a deductible fee. As capacity expansion demonstrates diseconomy of scale in this context, we assume convex capacity costs. We show that as the buyer's revenue margin decreases, the supplier faces a sequence of four profit scenarios with decreasing desirability. We examine the effects of market size and demand variability to the contract conditions. We propose two channel coordination contracts, and discuss how such contracts can be tailored for situations where the supplier has the option of not complying with the contract, and when the buyer's demand information is only partially updated during the supplier's capacity lead‐time.