Author’s Accepted Manuscript

Outsourcing strategy and production disruption of

supply chain with demand and capacity allocation
uncertainties

Kebing Chen, Tiaojun Xiao

www.elsevier.com/locate/ijpe

PII: S0925-5273(15)00366-7
DOI: http://dx.doi.org/10.1016/j.ijpe.2015.09.028
Reference: PROECO6235
To appear in: Intern. Journal of Production Economics
Received date: 28 June 2013
Revised date: 9 February 2015
Accepted date: 16 September 2015
Cite this article as: Kebing Chen and Tiaojun Xiao, Outsourcing strategy and
production disruption of supply chain with demand and capacity allocation
u nc e r t a i nt i e s , Intern. Journal of Production Economics,
http://dx.doi.org/10.1016/j.ijpe.2015.09.028
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 Outsourcing strategy and production disruption of supply chain
with demand and capacity allocation uncertainties
Kebing Chen
Department of Mathematics, Nanjing University of Aeronautics and Astronautics, Nanjing, Jiangsu 210016, China

Tiaojun Xiao*
School of Management Science and Engineering, Nanjing University, Nanjing, Jiangsu 210093, China

Abstract:
This paper develops supply chain game models with multiple uncertainties, and studies the impact of channel power on
the efficiency of supply chain. Besides the regular production run, the manufacturer may choose the outsourcing mode
due to his production disruption risk and uncertainty of capacity allocation. We find that the manufacturer has no
incentive to outsource when both the disruption risk is low enough and his production capacity is large enough. When the
disruption risk is sufficiently high, the manufacturer will fully outsource production regardless of the production capacity.
There is a zone of order-difference outsourcing where the manufacturer just outsources the part in excess of the certain
threshold value. Under the retailer-Stackelberg (RS) game, the manufacturer’s order-difference outsourcing strategy can
induce the retailer to order more items. Unlike RS, the retailer in the manufacturer-Stackelberg (MS) game always orders
a quantity equal to that in the classic newsvendor model. Meanwhile, we find that the channel power does not affect the
player’s decision except in the zone of order-difference outsourcing. Compared with MS, the dominant retailer can better
deal with the uncertainties and make better use of demand information. From the channel’s perspective, the two players
have the different attitudes towards the risks. The dominant manufacturer prefers to forcibly offload production risks to
his partner, while the dominant retailer in RS actively takes the partner’s risks.

Keywords: Supply chain management; disruption; channel power; capacity allocation; coordination mechanism; game
theory

* Corresponding author. Tel: +86 25 83686733

E-mail addresses: kbchen@nuaa.edu.cn (K. Chen), xiaotj@nju.edu.cn (T. Xiao ).
1
1. Introduction
Owing to the complexity and dynamicity of supply chain environment, the disruption in supply networks is identified
as one of the important supply chain risks. Supply disruptions may be caused by natural or man-made disasters such as
equipment breakdowns, labor strikes, traffic interruptions, earthquakes, floods, and hurricanes. The recent research in this
field focuses on the study of inventory systems in the presence of supply disruptions. Supply disruptions can lead to
excessive down time of production resources, significant delay in customer delivery, financial loss, and eventually a loss
in the market value of firm (Burke et al., 2007). As the risk of supply disruption increases, it is crucial for firms to learn
how to anticipate and manage it. A firm’s performance may drop sharply once the full impact of the disruption hits
(Sheffi and Rice, 2005; Matsuo, 2015.). Examples of supply chain vulnerabilities are widespread:
Example 1. According to a study performed by Computer Sciences Corporation in 2003, 43% of 142 companies,
ranging from consumer goods to health care, reported that their supply chains were vulnerable to disruptions, and 55% of
these companies had no documented contingency plans (Poirier and Quinn, 2003). Additionally, according to another
survey performed by CFO Research Services, 38% of 247 companies acknowledged that they had too much unmanaged
supply chain disruption risk (Eskew, 2004).
Example 2. A representative example is the March 2000 fire at the Philips microchip plant in Albuquerque, New
Mexico. Nokia changed product configurations and took advantage of outsourcing strategy in the nick of time to meet
customer demand during a supply disruption (Latour, 2001).
Example 3. To handle both the uncertain demand fluctuation and supply disruption, HP used the Singapore plant for
the base volume production and outsourced the remaining portion of their production to a contract manufacturer in
Malaysia. A flexible supply base not only enables a firm to handle the uncertain demand risk, but also it can be used to
maintain continuous supply of materials when supply disruption occurs (Billington and Johnson, 2002).
The potential economic impact of a disruption is a critical issue for supply chain management, while it increases the
awareness of significant risks posed by supply failures which highlights the need for effective disruption management.
Therefore, supply disruption has made companies aware of the need for active disruption management. Risk
management provides alternative ways to hedge against disruption risks. One of the most common policies for risk
mitigation is flexible multiple-sourcing (Chen et al., 2001). The multiple-sourcing supply becomes a common business
practice to lessen the risk of supply disruption, especially in the high-technology industries. For example, many product
categories, from car batteries to printer cartridges and computers, can be supplied from the alternative outsourcing if the
supply disruptions occur. Therefore, our first objective is to investigate the manufacturer’s outsourcing strategy and the
retailer’s order strategy when facing the supply disruption.
Our paper analyzes how uncertainty risks affect both sides of the manufacturer-retailer relationship under the two
channel leadership structures. The channel leadership structure represents relative channel power. One is
manufacturer-Stackelberg (MS) structure, and the other is retailer-Stackelberg (RS) structure. We explore both structures
2
and show that the double marginalization effect results in a lower outsourcing quantity, which leads to supply
insufficiency for the buyer. The overwhelming majority of studies in game-theoretic supply chains examine MS
structures. However, in the past decades many powerful retailers have appeared around the world. For a dominant retailer
such as Wal-Mart, there are many manufacturers producing similar types of products and most are willing to make
concessions and vigorous cooperation because they are keen to sell their products through it. Thus, a dominant retailer
has many choices and, consequently, owns the power to dictate prices of products. Therefore, the second objective of our
paper is to investigate how the channel power affects the behavior of players as well as the channel profit.
The third objective of the paper is to investigate how to coordinate each channel structure with multiple uncertainties,
including the outside demand uncertainty, and the inside allocation uncertainty and disruption risk. The objective is to
formally analyze how the dominant player deals with the uncertain risks to avoid the double marginalization effect and
establish channel competitive advantage. A coordinated supply chain performs better than the uncoordinated one.
However, each player in the supply chain is primarily concerned with optimizing his own objective, which decreases
channel profit and lowers channel competitive advantage. It has been proven in the literature that some effective contracts
can be designed to access channel coordination, which leads to an improved channel profit. Therefore, from the channel’s
perspective, we will investigate how the uncertainties from both supply side and demand side affect the behavior of
players and study how the dominant player deals with the uncertainties.
To be specific, we consider the supply chain consisting of one manufacturer and one retailer, where the manufacturer
supplies product to his partner with a random capacity allocation and possible production disruption risk, and the retailer
faces the uncertain market demand. In addition to a regular production run, the manufacturer may choose the outsourcing
mode. We find that there is a zone of order-difference outsourcing where the manufacturer partly resorts to outsourcing.
Meanwhile, the manufacturer’s order-difference outsourcing strategy can induce the retailer to order more items.
Compared with MS, RS can effectively compensate the manufacturer for the risk exposure associated with demand
uncertainty, which results in the higher level of outsourcing quantity for the manufacturer. From the channel’s perspective,
we design the all-accepted punishment contract for each structure to avoid the double marginalization effect. In our
unpredictable setting, the mechanism needs both players to collaborate fully in order to deal with production and demand
uncertainties caused by channel decentralization. ‘All-accepted’ in the contract is expected to extend fullest cooperation
between both players. Our main results also provide several insights regarding how the dominant player could use
contracting and outsourcing to manage procurement decisions when facing demand uncertainty and supply disruption.

2. Literature review

Supply disruption is defined as the sudden stop of supply. That is, when unexpected events occur, the main source
becomes unavailable. Supply disruption is an infrequent risk but has a large impact on the channel (Kleindorfer and Saad,
2005; Ellisa et al., 2010; Schmitt et al., 2010), because it can cut off the cash flow and stop the operation of the entire

3
supply chain. Since the financial losses caused by supply disruptions may be huge, the problem of how to manage and
control the potential supply disruption becomes very critical for the firms. Tomlin (2006) studies a single-product setting
in which a firm can source from two suppliers, one is unreliable and the other is reliable but more expensive. He finds
that the sourcing mitigation is increasingly favored over inventory mitigation as disruptions become less frequent but
longer for a given percentage uptime. Furthermore, Schmitt et al. (2011) examine the expected costs and cost variances
of the system with both the stochastic demand and supply disruptions. Additionally, the information of supply disruption
may be symmetric between both players (Hou et al., 2010) or asymmetric (Yang et al., 2009). Wagner and Gunther
(2007) investigate whether a firm switches from a single sourcing to dual sourcing when there is either symmetric or
asymmetric information about the alternative supplier’s cost structure. However, the current literature considers either the
integrated decision or the decentralized decision, and few consider how to coordinate the supply chain with the supply
disruption.
There are some papers focusing on disruption recovery. In the disruption-recovery models, the changes to the original
plan induced by a disruption may impose considerable deviation costs throughout the system. For examples, Qi et al.
(2004) investigate a simple supply chain that experiences a demand disruption during the planning horizon. Yang et al.
(2005) study the problem of recovering a production plan after a disruption. Furthermore, the more complex disruption
cases are investigated for the symmetrical retailers (Xiao and Qi, 2008; Zhang et al., 2012), or for the asymmetrical
competing retailers (Chen and Xiao, 2009). The current disruption-recovery model usually assumes that there is a sole
sourcing in the channel, that is, the supply base contains only one supplier. Unlike these studies, our paper provides the
manufacturer with an outsourcing option in the case of supply disruption, and mainly focuses on how the channel
leadership affects outsourcing strategies of the manufacturer, and how to manage the relationship between disruption risk
and demand uncertainty from the perspective of coordination mechanism.
In the actual operations, there are many various strategies for managing supply disruptions, including backup option,
outsourcing, multi-sourcing and increasing buffer stock or capacity (Dada et al., 2007; Yu et al., 2009; Chen and Xiao,
2015). This paper considers the outsourcing option. In the related literature, various outsourcing-related issues have been
proposed, for example, outsourcing pros and cons (Weidenbaum, 2005), outsourcing partially substitutable products in a
quantity- setting duopoly situation (Xiao et al., 2007), outsourcing or not outsourcing production when the cost is
uncertain (Choi, 2007), outsourcing for competing manufacturers on price and product quality (Xiao et al., 2014),
outsourcing for insufficient production capacity (Sinha and Sarmah, 2007), outsourcing under exchange rate risk and
competition (Liu and Nagurney, 2011). Outsourcing decision can allow firms not only to reduce expected costs, but also
to enhance their portfolio of capabilities as well as the potential to create value (Holcomb and Hitt, 2007). Unlike the
literature, our research considers how capacity allocation, production disruption and channel game scenarios affect the
manufacturer’s outsourcing decisions.
This paper also researches the dominant player’s behavior in a supply chain. In a manufacturer–retailer supply chain,

4
‘dominant’ means that one member of supply chain has the power of controlling or bargaining with another member’s
decisions, and we define it as ‘channel power’. The phenomenon of channel power has been given rather regular
empirical attention in the marketing literature (Iyer and Villas-Boas, 2003). They regard the bargaining power as the
ability or skill of a party to bargain for a greater share of channel profit. Most of the existing literature assumes that
manufacturers take absolute bargaining power. Manufacturers push their products to the market by offering contracts and
sell them to the retailers, while seldom considering the effect of the channel leadership of their retailers (Özer and Wei,
2006; Ha and Tong, 2008).
In recent years, some industries, such as pharmaceuticals, consumer packaged goods, hardware, apparel, and furniture,
show that the balance of channel power between manufacturers and retailers is shifting (Kumar, 1996). In consumer
goods industries, Porter (1974) defines retailer power as the ability of the retailer to influence the manufacturer’s product
differentiation and finds that the retailer’s bargaining power will increase with his effect on product differentiation. Zhang
(2010) studies a buyer’s procurement strategies in a two-stage supply chain with price-sensitive demand. Pan et al. (2009)
consider this scenario and construct a two-period model to discuss pricing and ordering problems for a dominant retailer
in a declining price environment. Wang et al. (2012) design two new contract formats explicitly for a dominant retailer to
implement, and show that the two new formats perform substantially better than the currently-used practical formats.
Similarly, one can also refer to Tsay (2002). Unlike the current literature, we formally analyze how uncertainties affect
both sides of a manufacturer-retailer relationship and dynamics outsourcing/ order strategies under two scenarios of
channel leadership.
It is well known that decentralization of the supply chain can result in suboptimal supply chain performance due to
double marginalization. Designing coordination mechanism has been an important issue aimed at reconciling conflicts
among players. Various coordination mechanisms have been proposed to improve supply chain profits, e.g., buyback
(Pasternack, 1985), quantity flexibility (Bernstein and Federgruen, 2003), revenue sharing (Cachon and Lariviere, 2005),
and non-linear wholesale price (Raju and Zhang, 2005), rebate induced contracts (Saha, 2013), and wholesale price
discount plus credit option (Du et al., 2013). Previous most studies mainly aim at coordination in the deterministic setting
or the setting with one uncertain factor. In our paper, we investigate the coordination mechanism for supply chain with
multiple uncertainties. The uncertain contingencies considered in our paper are: (1) demand uncertainty; (2) supply
uncertainties with two factors (i) uncertain allocation rate of normal production, (ii) disruption risk. Therefore, how to
effectively manage these uncertainties becomes one of our main focus points.
Under demand uncertainty, Donohue (2000) examines the problem of developing supply contracts that encourage
proper coordination of forecast demand information and production decisions. Gerchak and Wang (2004) show that a
revenue-sharing contract with surplus subsidies can be used to coordinate the assembly system with uncertain demand.
On the other hand, coordination mechanism for supply uncertainty can be studied in random yield (Gupta and Cooper,
2005), random deteriorating loss (Cai et al., 2010), random used product acquisition (Kaya, 2010) and supply disruption

5
risk (Hsieh and Wu, 2008). These supply uncertainties challenge supply chain management. The behavior of the supply
chain with uncertainties from both internal uncertainty (e.g., supply risk) and outside uncertainty (e.g., demand risk) has
generally received limited attention. For example, Xia et al. (2011) investigate the balance of sharing demand information
and supply risk only in a decentralized channel; however, they do not investigate how to coordinate such a supply chain.
Li and Zheng (2006) study joint inventory replenishment and pricing problem for production systems with random
demand and yield; however, they do not investigate the decentralized operation as well as coordination mechanism. Li et
al. (2013) explore a supply chain coordination model with supply uncertainty. Unlike current studies, we consider the
manufacturer’s outsourcing strategies in the case of supply disruption, and investigate how outsourcing decisions are
affected by capacity allocation, production disruption, and channel game scenarios besides the unit production costs.
Compared with the existing literature, our model is new in the following aspects. First, our model is more practical by
considering both outside uncertainty (demand uncertainty) and internal uncertainties (capacity allocation uncertainty,
disruption risk), and we study how the uncertain factors affect decisions of the supply chain with an outsourcing option.
Second, we compare outsourcing/ order strategies to investigate how the channel power influences the behavior and
performances of players. Unlike the MS scenario, the dominant retailer does not offload risk to the partner; meanwhile,
RS can better cope with the adverse effect of uncertainties. Third, we provide the coordination mechanism for each
channel structure to investigate how the dominant player deals with his own risk, i.e., seeking to shift this burden to the
other party or taking it himself. An all-accepted (i.e., inventory pooling) punishment contract can be used to coordinate
each channel leadership structure. Unlike MS, RS may not achieve a ‘win-win’ situation between both players by using
all-accepted punishment contract unless a two-part tariff is incorporated into it.

3. Model formulation and problem description

3.1. The Setting
We consider a supply chain consisting of one manufacturer and one retailer. The retailer faces a random demand for a
finished product that he orders from the manufacturer. Regular production capacity of the manufacturer is denoted by Y .
Since a supply chain usually is embedded into a complex supply network, the manufacturer may not have just one but
several distributors. That is, the regular capacity is shared by all the customers whose orders arrive randomly and
independently, the proportion of normal capacity shall be allocated to the retailer’s order is uncertain for the manufacturer
before all the customers’ orders have been realized. To capture this influence of the network, we describe the
manufacturer’s normal supply to process the order of the considered distributor as being limited to a portion  Y
(  (0,1)) . We also assume that the share ( ) is preplanned as a rule of thumb, and an added share is not to be
diverted even if the normal supply can not satisfy the order of the retailer. Otherwise, the manufacturer loses potential
customers in the other parts of network. At the time the retailer places his order, the manufacturer does not know the
actual value of  (because he is still waiting for further orders) but only its probability density function. This leads to
supply uncertainty in the considered supply chain. Similar assumptions can be found in Zimmer (2002) and Hsieh and
6
Wu (2008).
It’s important to note that the supply uncertainty in our model is different with the yield uncertainty studied by the
existing literature, e.g., see Gurnani and Gerchak (2007) and Wang (2009), where the manufacturer can decide how
much to input raw materials at the beginning of the selling season. In our models, the regular capacity looks more like an
empirical constant rather than a decision value.
Another unreliable aspect of the manufacturer is that its regular production is subject to a random disruption risk. It is
subject to random supply disruptions due to material shortage, equipment breakdown, labor shortage, and the like. When
the supply disruption occurs, the manufacturer can not fulfill the order from the retailer. Therefore, we assume that in
addition to a regular production run, the manufacturer has access to an outsourcing option with the higher procurement
cost and the outsourcing production is perfectly reliable (Yang et al., 2009). These uncertainties include the information
about demand market, allocation rate, and disruption risk of the normal production. We can divide these uncertainties into
two categories, i.e., outside uncertainty such as demand uncertainty, and inside uncertainties such as disruption risk and
allocation uncertainty. How to effectively manage these uncertainties becomes one of our focus points.
For convenience, we introduce following notations.
c1 : The unit cost of the manufacturer under the regular production;
c2 : The unit outsourcing cost of the manufacturer, c1  c2 ;
p: The retail price of the retailer;
w: The unit wholesale price;
g: The unit stock-out/shortage cost of the retailer;
h: The unit holding cost;
: Disruption probability of the manufacturer’s regular supply, and 0    1 ;
: The allocation rate of regular production follows a cumulative distribution function (CDF) G() , and its
probability density function (PDF) is g () with mean  ;
Y: The regular (long-term) production capacity of the manufacturer;
Y : The allocation of the manufacturer to the retailer with the normal production;
X: The market demand follows a CDF F () , and its PDF is f () with mean  ;
Q: The order quantity of the retailer;
I: The outsourcing quantity of the manufacturer;
i : The share of the retailer in the total expected profit of channel, i [0,1] , i  1,2 .

We assume that the delivery time of outsourcing product is relatively long such that, the manufacturer should decide
how much to outsource at the beginning of his regular production run. This scenario is motivated by the real life example
of CarCo. In the actual operation, CarCo has to maintain high inventory levels to avoid supply shortages of parts because
of the different delivery times of new and remanufactured parts-combined with engine variant proliferation and the
inability to predict what types of engine will be returned (Seitz and Peattie, 2004). The assumption requires the
7
manufacturer to determine the outsourcing quantity before observing the actual capacity allocation. Additionally, for
simplicity, we assume that the unit holding costs for both the manufacturer and the retailer are identical.

3.2. The centralized decision

To provide a benchmark, we first analyze a centralized system in which a central planner makes all decisions to
maximize the channel profit. The channel profit can be denoted as follows.
 c ( I )  c2 I  [ p min{I , X }  g ( X  I )  h(I  X ) ]
(1   )[ p min{X ,Y  I }  c1Y  g ( X  Y  I )  h(Y  I  X ) ] . (1)

where ( x)  max{x,0} . The first term in Eq. (1) represents the total cost of outsourcing I items. The second term is
the revenue of supply chain when the disruption occurs at the manufacturer, which is composed of three parts: the first
part is the total revenue, the second part is the shortage cost, and the third part is the holding cost or the salvage value
when h is negative. The last term is the revenue of supply chain without supply disruption. From Eq. (1), the expected
profit of supply chain can be denoted as follows.
I   I
E[ c ( I )]  c2 I  [ p  xdF ( x)  p  IdF ( x)  g  ( x  I )dF ( x)  h  ( I  x)dF ( x)]
0 I I 0
1 Y  I  
(1   )[ { p  xdF ( x)  p  (Y  I )dF ( x)  g  ( x  Y  I )dF ( x)
0 0 Y  I Y  I
Y  I
h  (Y  I  x)dF ( x)  c1Y }dG( )] . (2)
0

It is easy to show that the function E[ c ( I )] is concave in the manufacturer’s outsourcing quantity, I , and then we
can derive the following.
Proposition 1. The optimal outsourcing quantity of the centralized system at the beginning of regular production run
should be I c*  max{0, I 0 } , where I 0 should satisfy
1
c2  [ p  g  ( p  g  h) F ( I 0 )]  (1   )  [ p  g  ( p  g  h) F (Y  I 0 )]dG( )  0 .
0

Proofs of propositions and corollaries are given in Appendix.

In the following, we develop two Stackelberg-game models of supply chain to investigate how the channel power
affects the decisions of the players.

4. The retailer-Stackelberg (RS) supply chain

4.1. RS game
We now model the relationship between the manufacturer and the retailer as a sequential non-cooperative game with
the retailer as the leader and the manufacturer as the follower. The solution of this game is called RS equilibrium. The
simplest contract, i.e., the price-only contract, can be used as an inferiority benchmark for evaluating the performance of
other contract formats. The corresponding steps of the game are presented as follows: (i) The retailer determines the order
quantity; (ii) The manufacturer accordingly chooses the outsourcing quantity. We can solve this game by employing
backward induction technique.
For the given wholesale price ( w ) and the order quantity ( Q ) in RS, the manufacturer maximizes his expected profit
8
function. The manufacturer’s problem is to solve how much to outsource at the beginning of the regular production run
when facing the order quantity Q from the retailer. Since the manufacturer can satisfy the retailer’s part or all demand if
the regular production is not disrupted, the optimal outsourcing quantity should be always less than the total order
quantity of the retailer, i.e., I  Q . The expected profit of the manufacturer will be denoted as follows.

E[ RS
M
( I )]  E{c2 I   wI  (1   )[w min{Q,Y  I }  c1Y  h{Y  I  Q} ]} . (3)

It is easy to show that E[ RS

M
( I )] is concave in the outsourcing quantity, I , and then we can derive the following.
Proposition 2. Under RS, the manufacturer’s outsourcing quantity at the beginning of regular production run should be

 Q,   d
 c h  
I RS  0, Q  YG (e),0     d , where  d  2
1
and e  d .
Q  YG 1 (e), Q  YG 1 (e),0     wh 1 
 d

Proposition 2 shows the manufacturer’s optimal outsourcing strategy in RS channel. It can be found that the
manufacturer’s outsourcing decision depends on the supply risks from both disruption risk and allocation uncertainty.
When the level of supply disruption is large enough, the manufacturer will have entirely relied on outsourcing regardless
of the retailer’s order quantity (Q) or the capacity of the manufacturer’s production (Y ) . However, when both the
disruption risk and the manufacturer’s production capacity are small enough, the manufacturer will partly resort to
outsourcing. When the disruption risk is small enough and the scale of the manufacturer’s production is large enough,
simultaneously, the manufacturer will have no incentive to outsource. In the case of Q  YG 1 (e) and 0    d ,
i.e., when the order quantity of the retailer is larger than a certain threshold value ( YG 1 (e) ), the manufacturer just
executes the strategy of outsourcing the part in excess of the threshold value, i.e., order-difference outsourcing strategy.
We name the scale of this case as zone of order-difference outsourcing to facilitate the following contrastive analysis.
Additionally, we can also explain the manufacturer’s outsourcing decision from the outsourcing cost’s perspective
when the disruption risk is fixed as a constant. When the unit outsourcing cost is low enough, the manufacturer will
outsource the entire production. When both unit outsourcing cost and the manufacturer’s production capacity are large
enough, the manufacturer will not outsource. Otherwise, the manufacturer will outsource partly in the zone of
order-difference outsourcing.
According to the manufacturer’s outsourcing decision, the retailer should decide the order quantity, and the retailer’s
profit can be written as follows.

 RS
R
(w, Q)  [ p min{X , I }  wI  g ( X  I )  h( I  X ) ]  (1   )[ p min{X , Q, Y  I }
w min{Q,Y  I }  g ( X  min{Q,Y  I })  h(min{Q,Y  I }  X ) ] . (4)

The two terms in Eq. (4) represents the profits of the retailer under disruption and no disruption, respectively. Each term
consists of four parts. The first part is the retailer’s revenue, the second part is the procurement cost, the third part is the
shortage cost and the last part is the holding cost or the salvage value when h is negative. In the RS game, the dominant
retailer has the direct right to adjust the decision-value of order quantity to obtain the required outsourcing level, because

9
that the outsourcing production quantity is uniquely induced for the order quantity of the retailer. Combing with the
outsourcing response functions of the manufacturer, we can obtain the equilibrium solution of RS game, which is
presented in the following proposition.
*
Proposition 3. Under RS, the manufacturer’s outsourcing quantity ( I RS ) and the retailer’s order quantity ( QRS
*
) should
satisfy the following, respectively.
 0, if 0    d , Q* (w)  YG 1 (e)
 2  I 2  YG 1 (e), if 0    d , Q* (w)  YG 1 (e)
*
I RS   I RS , if 0    d , Q* ( w)  YG 1 (e) and QRS
*
  RS * ,
Q* ( w), if   d  Q (w), otherwise

2
where I RS should satisfy the following equation

p  g  w   ( p  g  h) F ( I RS
2
)  (1   )( p  g  h) 
0
G 1 ( e )
F (Y  I RS
2
)dG( )  
1

G 1 ( e )
F (YG 1 (e)  I RS
2

)dG( )  0 .

and Q* (w)  F 1 (( p  g  w) ( p  g  h)) .

The order quantity, Q* ( w) , can be characterized as the solution of the classic newsvendor problem. From Proposition
3, the retailer’s order quantity will be equal to the classic newsvendor solution when (i) 0    d , Q* (w)  YG 1 (e)
and (ii)   d . In the first case, the manufacturer will not need to outsource any items when the manufacturer’s
capacity is large enough and the risk of disruption is low enough. However, when the disruption risk is higher than the
threshold  d , the manufacturer entirely resorts to outsourcing regardless of the capacity. Both cases imply that the risks
of supply side will have little impact on the retailer’s order decision. Additionally, the retailer’s order function is same as
that in classic newsvendor model except in the zone of order-difference outsourcing.
In the decentralized setting, we just give the analytical solutions for both the manufacturer’s outsourcing quantity and
the retailer’s order quantity under all possible situations of the unit wholesale price w with the scale of
w [c2 , p  g ) . The emphasis is not on how to obtain the optimal wholesale price, but on material flow optimization.
Of course, it is very difficult for us to give the analytical solutions for the optimal unit wholesale price in this paper. Much
of the extant supply chain literature has also avoided giving the analytical solution for the optimal wholesale prices
because of their complexity in mathematics, for example, see, Anand and Goyal (2009), Hou et al. (2010), Khanjari et al.
(2013), etc. From Proposition 3, we can derive the following

Corollary 1. In the zone of order-difference outsourcing, i.e., 0    d and Q* (w)  YG 1 (e) , we have
*
QRS  Q* (w) .

Corollary 1 implies that the manufacturer’s order-difference outsourcing strategy can induce the retailer to order more
items. From Propositions 1 and 3, we have

Corollary 2. Comparing the manufacturer’s outsourcing quantity in the decentralized system with that in the centralized
system, we derive the following
(i) When c2  w  p  g , we have
(a) if   d , then I c*  I RS
*
;
(b) if 0    d and Y  Q* (w) G 1 (e) , then I c*  I RS
*
if and only if w  c2  (1   )( p  g  h) 
10
 1
G 1 ( e )
[ F (Y  I c* ) F (YG 1 (e)  I c* )]dG( ) ;

(c) if 0    d and Y  Q* (w) G 1 (e) , then I c*  I RS

*
;
(ii) When w  c2 , we have I c*  I RS
*
if Y  Q* (c2 ) ; otherwise, I c*  I RS
*
0.

From Corollary 2, we find that, when the disruption risk is higher than the threshold  d , it is obvious that the
decentralized setting will result in the less outsourcing quantity for the manufacturer. That is, the decentralized system
cannot achieve the performance of centralized system due to double marginalization effect. Unlike the classic
newsvendor model, the double marginalization effect may be not completely eliminated even if w  c2 , e.g., see the
scenario of Y  Q* (c2 ) . That is, when the capacity is large enough, the manufacturer may have enough confidence that
the expected supply can satisfy the retailer’s order with relatively little dependent on the outsourcing decision. Meanwhile,
the double marginalization effect may be eliminated by the constraint condition from the efforts of the retailer in the zone
of order-difference outsourcing, see Part (b).

4.2. Coordination mechanism for RS supply chain

In RS game, a dominant retailer might drive the terms of trade, and he can have many choices and, consequently, the
power to dictate traded prices of products. In addition to choosing the order quantity and retail price by evaluating the
product, the retailer can dictate the wholesale price, or specify his charged profit margin to maximize his objective, see
Tsay (2002), Pan et al. (2009). For example, owners of many major international brands can procure much of their
manufacturing activities from independent factories in developing countries, while controlling the wholesale price.
Hence, in one sense, the dominant retailer can also control all decisions of channel.
The retailer negotiates with the manufacturer on the unit wholesale price, order quantity and punishment for not being
fulfilled items at the end of the period. In order to achieve maximum performance, the inventories of the manufacturer
and retailer should be gathered together in the retailer. In fact, if the manufacturer’s total quantity of the product including
outsourcing quantity exceeds the retailer’s order, the leftover items are kept by the manufacturer instead of delivering to
the retailer to meet the potential demand. As a result, even if this contract can induce the centralized optimal outsourcing
level, the expected channel profit cannot reach maximization when both the actual supply quantity of the product and the
market demand are larger than the designated order quantity. It is definitely detrimental to the channel performance when
this case occurs. Therefore, leftover items kept by the retailer will be better for the improvement of channel performance.
As the designer of mechanism, the dominant retailer should induce the manufacturer to outsource the centralized quantity,
meanwhile accept all the items supplied by the manufacturer.
In order to facilitate the operation and management, we assume that the dominant retailer declares a supply target,
denoted by Z , and pays the unit wholesale price w for each item within the order. The manufacturer will be punished if
his actual supply can not satisfy the supply target, and unfulfilled supply should be paid k1 per unit. That is, the shortage
penalty will be imposed on the manufacturer when the transferred quantity below the supply target. We define the
contract as all-accepted punishment contract. To avoid trivialities, we make the following assumption.

11
Assumption 1: In the all-accepted punishment contract, the traded wholesale price should satisfy c1  wR  c2 .
This assumption is necessary. If wR  c1 , the manufacturer always obtains a negative profit. If wR  c2 , it is
financially more attractive for the manufacturer to obtain the entire output provided by the outsourcing supplier since the
retailer will accept all items provided by manufacturer, which will result in a new higher supply level.
From the above, the expected profit of the manufacturer can be denoted as follows.
E[ RS
M
( I )]  E{c2 I  [wR I  k1 (  I )]  (1   )[wR (Y  I )  c1Y  k1 (  Y  I ) ]} . (5)

The following proposition gives a feasible contract combination.

Proposition 4. Under supply risks and demand uncertainty, an all-accepted punishment combination (Z * , wR* , k1* ) can

achieve channel coordination when the manufacturer’s reserved profit satisfies  M0  min{(1   )(c2  c1 )Y  , E[ c* ]} .
(1   )(c2  c1 )Y    M0 , wR*  c2   k1*  (1  ) k1* G(( *  I*c) Y) ,
k1*  *  I c*
  I  *
* *

   (1   )G( )  (   (1   )Y  )  (1   )Y 
c Y
 dG( )
 Y  0

and the supply target should satisfy *  ( I c* , Y  I c* ) . Meanwhile, the unit wholesale price satisfies c1  wR*  c2 , and
the expected profits of the manufacturer and the retailer are E[ RS
M
]   M0 and E[ RS
R
]  E[ c* ]   M0 , respectively.

In this contract, the retailer buys all items from the manufacturer at the wholesale price wR* , but charges the shortage
penalty k1* for each unit below the supply target. The all-accepted punishment contract can allow the supply chain
members to share the respective risks involved in the production and selling process, and eliminate the double
marginalization effect completely. Additionally, for any supply target, there is a continuum of price/ shortage penalty
combinations that achieve channel coordination.
The term ‘all-accepted’ implies that the retailer will voluntarily accept all items from the manufacturer with constraint
(Z * , wR* , k1* ) . It also implies that the retailer takes the manufacturer’s extra inventory risk caused by the uncertainty of
production processes. In the unpredictable environment, the coordination mechanism needs the players to collaborate
fully in order to deal with the uncertainty of market demand caused by channel decentralization and avoid the risks
intensification. ‘All-accepted’ in the contract is expected to extend fullest cooperation between both players, and it can
enhance a firm’s capability to manage supply risk and demand uncertainty better. ‘All-accepted’ also means that
inventory of the decentralized system is pooling at the retailer. The idea of inventory-pooling can be used in the contract
to stimulate the better channel performance.
Corollary 3. For the all-accepted punishment contract, we have dk1* dZ  0 . Additionally, if the allocation rate’s
PDF is a non-increasing function of  , i.e., dg ( ) d  0 , we have dwR* dZ  0 .
This non-increasing PDF holds for many distribution functions, e.g., uniform, (truncated) normal, and exponential
distributions, etc. One may be thinking that the dominant retailer can increase his revenue by extra punishment if the level
of supply target increases, however, he should pay for in terms of the high wholesale price and the low unit shortage
penalty. That is, the dominant retailer does not always prefer the unfettered right to punish insufficient supply, and the
manufacturer does not oppose the high supply target. However, the coordination mechanism presented in Proposition 4
12
also has its own deficiencies. The coordination mechanism can maximize the channel performance, but it cannot ensure
that the expected profit of each party is strictly greater than that under no channel policy. In Proposition 4, the
manufacturer just obtains his reserved profit. When the maximum expected profit of the manufacturer in the
decentralized supply chain satisfies E[ RS
M
,max ]  min{(1   )(c2  c1 )Y  , E[ c ]} , the policy combination of
*

(Z * , wR* , k1* ) can achieve a ‘win-win’ situation between both players. The combination of (Z * , wR* , k1* ) can not
achieve a ‘win-win’ situation if the minimum expected profit of the manufacturer is more than this value, i.e.,
E[ c* ]  E[ RS
M
,min ]  min{(1   )(c2  c1 )Y  , E[ c ]} . In the following, we further modify the above coordination
*

mechanism to achieve a perfect ‘win-win’ situation.

Here, based on the above coordination mechanism, we assume that the manufacturer will receive an additional lump-
sum payment, denoted by  , from the retailer. The manufacturer’s profit comes from two parts. One part is the total
purchase prices of the retailer, and the other part is additional payments of the retailer at the close of trading. We call such
a combination as the all-accepted two-part tariff punishment contract, which is presented in the following corollary.
Corollary 4. For the all-accepted two-part tariff punishment contract (Z * , wR* , k1* , ) , the additional payments of the
retailer to the manufacturer at the end of trading is   (1  1 ) E[ c* ]   M0 , where  M0  min{(1  1 ) E[ c* ],
(1   )(c2  c1 )Y } . In this contract, the expected profits of the manufacturer and the retailer are
E[ RS
M
]  (1  1 ) E[ c* ] and E[ RS
R
]  1E[ c* ] , respectively.
Under the modified contract, the allocation of channel’s profit can be realized by the value of parameter 1 , which is
positively related to the bargaining power of the retailer. In theory, Pareto improvements can directly be achieved by
setting the two-part tariffs into the all-accepted punishment contract. The manufacturer’s expected profit will satisfy the
condition of E[ c* ]  E[ RS
M
]  min{(1   )(c2  c1 )Y , E[ c* ]} , if 1 is less than a certain threshold value. Only when
E[ c* ]  (1   )(c2  c1 )Y  , we can have 1  1  {(1   )(c2  c1 )Y  E[ c* ]} . When E[ c* ]  (1   )(c2  c1 )Y  ,
however, there will be no need to use the two-part tariff. That is, a ‘win-win’ situation between both players can be
achieved by the contact of (Z * , wR* , k1* ) . Two-part tariffs can be found in the current literature on supply chain policy,
e.g., Chen (2012), Ghosh and Shah (2012), etc. Therefore, such a modified contract is attractive to both players.
Additionally, Corollary 4 also implies that the dominant player will not transfer his own risk burden to the partner. In fact,
when the dominant retailer controls all decisions, he can still do better by bearing all uncertain risks from both sides.

5. The manufacturer-Stackelberg (MS) supply chain

In this section, we investigate how the dominant manufacturer replenishes from the outsourcing supplier and deals
with his own risks, and study the impacts of both demand uncertainty and supply risks on the manufacturer. Meanwhile,
the coordination mechanism for MS channel is also designed.

5.1. MS game
We model the model the relationship between the manufacturer and the retailer as a Stackelberg game with the
manufacturer being the leader and the retailer being the follower. The solution of the game is hence called MS
13
equilibrium. Under MS, the corresponding steps of the game are presented as follows: (i) The manufacturer prepares the
outsourcing quantity to the outsourcing supplier; (ii) The retailer accordingly chooses the order quantity from the
manufacturer. We can solve this game by employing backward induction technique. In terms of the retailer’s decision, he
knows that the outsourcing strategy may be used by the manufacturer when the disruption risk is high enough or his
production capacity is low enough. Since the manufacturer acts first, the order quantity of the retailer may be larger or
less than the outsourcing quantity of the manufacturer. Therefore, the final delivery quantity will be min{Q, I } when
the disruption is occurred at the regular production in the manufacturer; otherwise, it will be min{Q,Y  I } .
Under the given wholesale price ( w ) and outsourcing quantity ( I ) of the manufacturer, the retailer’s expected profit is

E[ MS
R
(Q | w, I )]  E{[ p min{X , Q, I }  g ( X  min{Q, I })   h(min{Q, I }  X )   w min{Q, I }]
(1   )[ p min{X , Q,Y  I }  w min(Q,Y  I )  g ( X  min{Q,Y  I })  h(min{Q,Y  I }  X ) ]} . (6)

From Eq. (6), we can derive the following.

Proposition 5. Under the given wholesale price ( w ) and outsourcing quantity ( I ) in MS, the realized order quantity of
the retailer will be QMS  Q* (w) if I  Y  Q* (w) ; otherwise, QMS  I  Y .
Proposition 5 implies that the retailer’s realized order quantity under MS is independent of the manufacturer’s
uncertainties with regard to the allocation rate and the disruption risk, just depending on the maximal supply capacity,
including both the level of outsourcing and the normal capacity of the manufacturer. When the maximal supply capacity
to the retailer is less than the classical newsvendor’s order quantity, i.e., I  Y  Q* (w) , it is most favorable for the
retailer to order the supply capacity of the manufacturer, i.e., I  Y . Otherwise, the classical newsvendor’s order
quantity will be optimal for the retailer.
In the following, we investigate the optimal decision of the manufacturer based on the retailer’s order quantity ( QMS ) .
The expected profit of the manufacturer can be denoted as follows:

E[ MS
M
( I )]  E{c2 I  [w min{QMS , I }  h( I  QMS ) ]  (1   )[w min{QMS ,Y  I }
c1Y  h(Y  I  QMS ) ]} . (7)
For Eq. (7), Proposition 6 gives the equilibrium solution of MS game.
Proposition 6. Under MS, the retailer’s optimal order quantity and the manufacturer’s outsourcing quantity should
satisfy the following.
 Q* ( w),   d
 *
*
QMS  Q* (w) and I MS
*
 Q ( w)  YG (e), 0    d , Q* ( w)  YG 1 (e) ;
1

 0, 0    d , Q* ( w)  YG 1 (e)

where Q* (w)  F 1 (( p  g  w) ( p  g  h)) .

Unlike RS, the order function of the retailer in MS always equals to the value obtained in the classic newsvendor
model, and it is independent of the manufacturer’s uncertainties as well as the level of outsourcing. However, it implies
that the retailer’s order strategy in MS is more untargeted to the inside uncertainties when compared with RS. In addition,
from Propositions 5 and 6, it is interesting that the realized order quantity of the retailer is closely related to the
14
outsourcing strategy, because the retailer needs to build more comprehensive order plan with considering the possible
outsourcing strategy and production disruption of the manufacturer. However, the optimal order quantity of the retailer,
*
i.e., QMS  Q* (w) , is only related to the wholesale price and independent of the manufacturer’s outsourcing decision. On

the other hand, as the leader of supply chain, the manufacturer makes more clear regulations on the decisions of the
outsourcing level when anticipating a fixed order quantity, Q* ( w) . Such a uniform order strategy of the retailer can
result in the channel’s inefficiency, see Corollary 5, and even the less expected profit for each player when compared with
RS, see Corollary 6.
*
Corollary 5. Under MS, the decentralized outsourcing quantity is always less than the centralized one, i.e., I MS  I c* .

Corollary 5 also implies that the dominant manufacturer will not outsource the centralized quantity in MS channel, and
then such a decentralized system can not achieve the performance of centralized system.

5.2. Comparisons between RS and MS

From Propositions 3 and 6, we can derive the following.

Proposition 7. Comparing RS channel with MS channel, we have
(i) *
I RS  I MS
*
( 0) and QRS
*
 QMS
*
( Q* (w)) if 0    d and Q* (w)  YG 1 (e) ;
(ii) *
I RS  I MS
* *
and QRS  QMS
*
if 0    d and Q* (w)  YG 1 (e) ;
(iii) *
I RS  I MS
*
 QRS
*
 QMS
*
( Q* (w)) if 1    d .

Proposition 7 has the following managerial insights: (1) the manufacturer determines the outsourcing quantity for the
given order quantity of the retailer in MS, and therefore, the outsourcing plan will become clearer when compared with
that in RS. It naturally results in the less outsourcing level, which, therefore, limits the total transferred quantity to the
*
retailer, and results in the less order quantity than that in RS (i.e., QMS  QRS
*
). Additionally, the dominant manufacturer
can better reduce the risk of excess inventory than that in RS. (2) When   d and Q* (w)  YG 1 (e) , each
manufacturer will not resort to the outsourcing supplier and the final actual order quantity can be appropriately satisfied
just from the manufacturer’s expected allocation. If Q* (w)  YG 1 (e) , the dominant retailer’s channel power in RS is
*
manifested in the outsourcing level of the manufacturer I RS  I MS
*
. (3) Additionally, with the increase of disruption risk
and the disruption level satisfying   d , the dominant retailer in RS will reduce his order quantity to the outsourcing
level in MS. That is, the high disruption risk emerged on the side of the manufacturer has a negative effect on the
behavior of the retailer. Additionally, the manufacturer will simultaneously increase the outsourcing level to the traditional
order quantity in both models.
From Proposition 7, we can derive the following.
Corollary 6. Comparing RS channel with MS channel, we have
(i) RS channel will result in the more expected retailer’s order quantity, therefore, the higher expected level of the
manufacturer’s outsourcing;
(ii) E[ RS
M
(w ) ] E [MS
M
] E[ RS
w( )and R
(w)]  E[ MS
R
(w)] .

15
 Three important managerial insights can be obtained from Corollary 6: (1) Compared with MS, the outsourcing level
of the manufacturer in RS is stochastically higher, therefore the expected profit of the retailer will be larger; otherwise, the
dominant retailer reduces his order quantity to the level in MS. Additionally, the order quantity of the retailer is
stochastically larger in RS, and then the manufacturer can expect to obtain more profit in RS channel when comparing
with the MS channel. (2) RS channel is dominant over MS channel from the perspective of member’s performance. In
fact, in RS channel, the dominant retailer better induces the manufacturer to obtain his desirous outsourcing level to meet
more potential stochastic demand, which can also improve the channel profit. Conversely, in MS channel, the
manufacturer may replenish his items to meet the retailer’s exact order instead of the marketed demand. Therefore, it is
natural that the decision of outsourcing strategy is certainly not ideal for each player and channel for the uncertain
demand. That is, the double marginalization effect can be further amplified in the MS channel. As the channel leader, the
dominant retailer has the responsibility for insuring a certain outcome for the follower. That is, compared with MS, RS
can compensate the manufacturer for the risk exposure associated with demand uncertainties effectively, which results
directly in the higher expected profit for the manufacturer. (3) It also implies that the dominant retailer can better deal with
the uncertainties in the decentralized system, and make the better use of the information of market demand to benefit both
individual and channel.

5.3. Coordination mechanism for MS supply chain

In MS, the retailer without channel power only decides whether to do business under the terms proposed by the
manufacturer. The manufacturer should first prepare the centralized outsourcing quantity, I c* ; otherwise, the channel can
not attain its maximum performance. Unlike coordination mechanism in RS, the manufacturer should induce the retailer
to accept all the items. That is, the coordination mechanism should induce the retailer to full cooperation and avoid the
risk intensification of market demand caused by channel decentralization.
In MS channel, we assume that the retailer will be punished if the realized total supply quantity of the manufacturer is
higher than the order quantity of the retailer, and pay k 2 per unit below the total supply quantity to subsidy for the
manufacturer’s holding surplus inventory. On this premise, the profit of the retailer is

 MS
R
(Q | w, I c* )  [ p min{X , Q, I c*}  g ( X  min{Q, I c*})  h(min{Q, I c*}  X )  w min{Q, I c*}

k2 ( I c*  Q) ]  (1   )[ p min{X , Q,Y  I c*}  w min{Q,Y  I c*}  g ( X  min{Q,Y  I c*}) 

h(min{Q,Y  I c*}  X )  k2 (Y  I c*  Q) ] . (8)

From Eq. (8), we can derive the following.

Proposition 8. Under MS, the punishment contract combination (wM* , k2* ,2 ) can achieve the channel coordination,
(1   2 ) E[ c* ]  c2 I c*  (1   )c1Y
where wM* ( 2 )  , { k 2 can be any value | k2  wM*  h } and 0  2  1 . The
I c*  (1   ) Y
expected profits of the manufacturer and the retailer are E[ MS
M
]  (1  2 ) E[ c* ] and E[ MS
R
]  2 E[ c* ] ,
respectively.

From Proposition 8, we can find that the combination of (wM* , k2* ,2 ) will induce the retailer to accept all items

16
provided by the manufacturer. Therefore, the combination (wM* , k2* ,2 ) can be regarded as the second version of
all-accepted punishment contract. The difference is that the retailer actively accepts all items in RS, but passively accepts
all items in MS. From Proposition 8, we find that the punishment contract has two sides to coordinate the behavior of
each player. One side is that with the mechanism, the excess inventory risk of the manufacturer is being passed to the
retailer, which is realized by k 2 . From the perspective of the whole channel, the surplus carried by the retailer is better
than by the manufacturer in order to meet potential demand. The other side is that the expected channel profit can be
arbitrarily allocated between both players, which can be realized by the wholesale price wM* (2 ) . The parameter  2
means the relative bargaining power between the manufacturer and the retailer. Furthermore, the wholesale prices in MS
and RS are identical if the dominant retailer in RS sets supply target as Z  I c* . That is, both mechanisms share some
common grounds in operation. Additionally, we can also find other similarities and differences, which are denoted as
follows.
Corollary 7. For the punishment contract combination (wM* , k2* ,2 ) , we have
(i) If the manufacturer expects to obtain profit that is less than the value, i.e., E[ MS
M
]  min{(1   )(c2  c1 )Y , E[ c* ]} ,
then the unit wholesale price satisfies c1  wM* (2 )  c2 ;
(ii) If the manufacturer expects to obtain profit that is more than the value, i.e., E[ c* ]  E[ MS
M
]
min{(1   )(c2  c1 )Y  , E[ c* ]} , then the unit wholesale price satisfies c2  wM* (2 )  p .

We can obtain the similar results in MS channel with that in RS channel, e.g., see Part (i). Unlike RS channel, the
wholesale price in MS channel can be larger than the unit outsourcing cost. In MS channel, the manufacturer can expect
to obtain any profit ( E[ MS
M
] [0, E[ c* ]] ) by adjusting the wholesale price or the parameter  2 . Since the wholesale
price is negative related with the parameter  2 . That is, with the increase of the wholesale price, the retailer’s share in the
channel will be decreasing. For example, when the wholesale price satisfies wM*  c2 , the retailer’s share will be
2  1  min{(1   )(c2  c1 )Y , E[ c* ]} E[ c* ] . That is, unlike coordination mechanism (Z * , wR* , k1* ) in RS
channel, the current mechanism combination (wM* , k2* ,2 ) can always achieve a ‘win-win’ situation between both
players by adjusting the parameter  2 without any modifications needed on this contact.
From the perspective of member’s self-interest, Propositions 4 and 8 illustrate that both the manufacturer and the
retailer have incentives to provide and perform their respective coordination mechanisms. The channel mechanism for
the MS channel also embodies inventory pooling, which can better stimulate the maximum channel performance.
Differing from coordination mechanism of RS, the dominant player will transfer both disruption risk and supply
uncertainty to his trading partner in MS. That is, the retailer will bear all risks passively. However, there is common point
between both coordination mechanisms, i.e., management of internal uncertainties must be always subject and serving to
the management of outside uncertainty, and it is a better way to establish channel competitive advantage. It also shows
how successful the supply chain is in performing all these functions depends on the effective management of market
demand. From the channel analysis for both structures, the dominant player should always come down to decide what is
best for managing the supply risk and demand uncertainty no matter how channel power changes.
17
6. Numerical Experiments

The main objective of our numerical experiments is to evaluate the impact of both outsourcing cost and disruption risk
on the optimal performances of channel members, outsourcing level and its value. In this section, we describe the results
for the basic case and some interesting sensitivity analysis with respect to the relevant parameters. The numerical
comparisons illustrate how the channel leadership affects the decisions and the expected profits. Without loss of
generality, we assume that the default values of parameters are given as follows:
p  55, c1  5, c2  15, g  3, h  2, w  25 ,   0.6 , Y  120 ,
and the market demand is exponentially distributed with mean   60 , and the random variable of allocation rate (  )
is uniformly distributed with U [0,1] . The setting of these parameters is consistent with the assumptions made in our
paper. In the following, we will give some numerical examples to analyze the impacts of both channel leadership and
disruption risk on the outsourcing quantity as well as the profits.
The main results are illustrative of an extensive computational study by using these values of parameters. That is, the
other possible settings of these parameters will not change the managerial insights obtained from our numerical
experiments.

6.1. The outsourcing decision under two channel leadership structures

Figs. 1-2 illustrate how the unit outsourcing cost and the disruption risk affect the order strategy of the retailer under
different channel leadership structures. In general, the market leadership power can result in decision differences for each
player in the zone of order-difference outsourcing. However, beyond the zone of order-difference outsourcing, there are
no differences for each player even under different leadership structures.

Figs. 1 and 2 are about here

Fig.1 implies that outsourcing level is decreasing with the unit outsourcing cost. The low outsourcing cost is very
attractive for the manufacturer to shift all production assignments to the outsourcing supplier when weighing in negative
effects of disruption risk in the normal production. Additionally, when the unit procurement cost is moderate, belonging
to the zone of order-difference outsourcing, we find that the higher outsourcing cost can result in the lower outsourcing
quantity of the manufacturer under RS, but the more order quantity for the retailer. Comparing with MS, we find that the
outsourcing level in RS decreases more slowly. It implies that the dominant retailer in RS can potentially enlarge the
order quantity to slow progress of the decrease of outsourcing quantity.
Fig. 2 presents the relationship between the outsourcing quantity and the order quantity under the different disruption
risks of regular production. When the disruption level is low enough, the manufacturer does not outsource any item.
When the level of supply disruption exceeds a certain threshold value, the manufacturer starts to partly rely on the
outsourcing supplier. We find that the outsourcing quantity will be increasing and reaching its highest point, and then
keeps constant when the level of disruption is high enough, which is equal to the order quantity. With the reliable supply
18
of outsourcing supplier in the zone of order-difference outsourcing, the retailer enlarges his order quantity. However,
when the disruption level is large enough, the order quantity will be independent of the disruption risk. In fact, the
manufacturer has to entirely recourse to the outsourcing supplier, which can always meet the retailer’s demand, and the
internal uncertainties, such as disruption risk of the manufacturer, will not affect the retailer’s decision.

6.2. Impacts of channel leadership on the expected profit of each player

When looking into impacts of channel leadership on the performance of each player, we consider the following
numerical analysis, see, Figs. 3-4. Under each case, we take into account different scenarios of regular capacity, Y ,
which increases from 60 to 120 by a step 20.
From Fig. 3, we find that when the disruption level of normal production is low enough, the expected profit of the
manufacturer is decreasing with the disruption level in MS. When the disruption level is higher than a certain threshold
value, however, the expected profit of the manufacturer is increasing with the disruption level. In fact, in this case the
manufacturer fully relies on the outsourcing supplier. That is, the realized supply quantity can fully satisfy the retailer’s
order. With the increasing of disruption level, the extra holding cost will be decreasing for the manufacturer. Therefore,
there is the increasing trend of the expected profit for the manufacturer when the disruption risk increases. From the
perspective of regular capacity, when the disruption level is large enough, the expected profit of the manufacturer will be
lower when the regular capacity is higher, which implies that the uncertainty of normal production can be enlarged.
Additionally, from Part (a) of Fig. 3, we find that the expected profit of the manufacturer may increase suddenly when the
disruption risk increases. It signs that the manufacturer starts to partly rely on the outsourcing supplier, which has greatly
improved the prospects for the manufacturer.

Figs. 3 and 4 are about here

Compared with Fig. 3, the expected profit of the retailer is independent of the disruption level and the regular capacity
in both structures when the disruption level is large enough, see Fig. 4. In this case, the order quantity of the retailer can be
fully satisfied. Therefore, the performance of the retailer will not be influenced by either uncertainty of allocation rate or
disruption risk. As we can see that there is a discontinuity point for the expected profit of the retailer, e.g., Y  120, 100
or 80. For these three scenarios, the manufacturer will not outsource any items when the disruption level is low enough,
and the higher regular capacity can result in the higher expected profit for the retailer. It is natural that the higher regular
capacity can satisfy the retailer’s order better. However, for the scenario of Y  60 , the manufacturer with the low
regular capacity will always make outsource decision even if the disruption risk is very small. Additionally, when the
disruption level is belonging to the zone of order-difference outsourcing, the expected profit of the retailer is decreasing
with the regular capacity of the manufacturer. The realized supply quantity of the manufacturer is decreasing with the
regular capacity when the manufacturer partly relies on the outsourcing supplier.

6.3. The value of outsourcing under different channel leadership structures

19
 Here, we present the value of outsourcing for the manufacturer under two channel structures to investigate how the
disruption level and regular capacity affect the value of outsourcing. First, we give the following definition.

Definition 1: The value of outsourcing is the difference between using an outsourcing supplier and not using outsourcing
supplier in the same channel structure.

We use the following model to describe the value of outsourcing decision (  ), which can be written as

 XS   XS
M *
( I XS *
, QXS )   XS
M **
(QXS ) | I  0  , X  R,M , (9)
**
where QXS is the retailer’s order quantity when the manufacturer does not rely on outsourcing in XS channel. Fig. 5
illustrates how the value of outsourcing is affected by supply disruption level as well as by regular capacity.

Fig. 5 is about here

Under MS, two specific observations can be made. One is that the value of outsourcing increases with the disruption
risk of regular production. In general, when the disruption level increases, the value of outsourcing can be reflected
directly. When the disruption level is low enough, there may be not any value in outsourcing, excepted when the regular
capacity is low enough, e.g., see the case of Y  60 . The other is that value of outsourcing decreases with the scale of
regular production. That is, the manufacturer with the high regular capacity does not favor the use of the outsourcing
supplier. However, there also are unusual results in the zone of order-difference outsourcing, see Part (a). That is, under
RS, the high value of outsourcing can also be reflected in some of the high regular capacity. In zone of order-difference
outsourcing, the higher regular capacity results in the wider distribution for the actual supply (  Y ), which implies that
the uncertainty will be enlarger, and the regular supply becomes more ambiguous. Therefore, partly relying on
outsourcing is more valuable for the manufacturer.
Additionally, we know that when the disruption level is beyond the zone of order-difference outsourcing, there is no
difference for the manufacturer’s outsourcing decision between both channel leadership structures. In the zone of
order-difference outsourcing, the values of outsourcing under RS channel will have a larger impact on the manufacturer
than that under MS channel. That is, the dominant retailer is more likely to induce the manufacturer to turn to outsourcing
decision. From the channel’s perspective, it also implies that RS channel can better use outsourcing decision to deal with
the uncertainty of demand, and therefore, result in a higher expected channel profit.

7. Discussions and Conclusions

Although sourcing from a single supplier will enable a firm to reduce cost (lower supply management cost, lower unit
cost due to quantity discount, etc.), it could create problems for managing inherent supply disruptions or demand
fluctuations. Nokia’s success and HP’s operating model give effective management for these risks by using the
outsourcing decision. In this paper, we consider both the outsourcing decision and coordination mechanisms for two
Stackelberg-game structures with multiple uncertainties, including demand uncertainty, capacity allocation uncertainty
20
and disruption risk. From the channel’s perspective, the inventory pooling can be used in the coordination mechanism to
deal with the uncertain demand better and stimulate the maximal channel performance. We investigate the effect of
supply disruption on the mechanism and the effects of uncertainties coming from both supply and demand on the
outsourcing strategies as well as the retailer’s order plans. Meanwhile, we also analyze how these uncertainties affect both
sides of the manufacturer-retailer relationship under various scenarios of strategic power, and how to manage supply
disruption and demand uncertainty more effectively.
In RS channel, we find that when the disruption level is higher than a certain threshold value, the manufacturer will
outsource the entire the retailer’s order quantity regardless of the scale of his production capacity or the order quantity.
When the disruption risk is lower than this threshold value and the production capacity is large enough simultaneously,
the manufacturer will not need to outsource. Additionally, we can also find there is a zone of order-difference outsourcing,
where the manufacturer just outsources the part in excess of the certain threshold value. Meanwhile, the manufacturer’s
order-difference outsourcing strategy can induce the retailer to order more items. Differing from RS, the retailer in MS
always orders the quantity equaling to that the traditional threshold obtained in the classic newsvendor model, which are
independent of the manufacturer’s uncertainties as well as the manufacturer’s outsourcing level. Compared with MS, the
dominant retailer in RS can better deal with the uncertainty factors in the system, and make better use of the valuable
information of demand to benefit both individual and channel.
The idea of inventory-pooling at the retailer can be used to stimulate the better channel performance in each channel
leadership structure. ‘All-accepted’ in the contract is expected to extend fullest cooperation between both players, and it
can enhance a firm’s capability to manage supply risk and demand uncertainty better. In MS channel, we find that the
dominant manufacturer transfers his own risks to the retailer. It formalizes the mechanism by which the manufacturer is
compensated for exposure to disruption risk and uncertainty of normal supply. In RS channel, the dominant player will
not shift his own risk burden to the partner. In fact, when the retailer controls all channel decisions, he may still do better
by bearing all risks. Meanwhile, the dominant retailer does not always prefer the unfettered right to punish insufficient
supply, and the manufacturer does not oppose the high supply target. Meanwhile, we also find an interesting managerial
insight that the management of internal uncertainties should be subject and serving to the management of outside
uncertainty, and it will be better ways to handle and organize demand uncertainty.
The analysis of this paper can be extended in several directions. We assume that both players are risk neutral. A direct
extension of the paper is the case with risk-averse retailer, which is challenging and interesting. The risk attitude affects
the order quantity of the retailer, which can also affect the option of outsourcing strategy of the manufacturer. Secondly,
one can consider the case with the manufacturer’s asymmetric information on disruption risk. The asymmetric
information of supply disruption may enhance the benefit of the manufacturer deriving from his outsourcing decision. In
this case, the effect of information on the value of outsourcing will be more sophisticated. Thirdly, since we assume that
the manufacturer’s normal supply to process the retailer’s order as being limited to a portion, one can extend it to the
supply chain game model with the manufacturer selling its product through several retailers. Finally, we can also extend
21
the model to that with multiple sourcing capabilities. It would also give rise to a more intricate type of risk-management
strategy in which the buyer could allocate his total purchase across a portfolio of multiple resources. It is of interest to
analyze the relative benefits brought by multiple sourcing compared to the existing model studied in this paper.

Acknowledgements
The authors thank an associate editor and anonymous referees for their numerous constructive comments and
encouragement that have improved our paper greatly. The work was partly supported by (i) the National Natural Science
Foundation of China (71571100, 71371093 and 71201083); (ii) China National Funds for Distinguished Young
Scientists (71425001); (iii) Jiangsu Province Science Foundation for Youths (BK2012379); and (iv) the Fundamental
Research Funds for the Central Universities (NS2015076).

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Appendix A.
Proof of Proposition 1: The proof is obvious, here omitted. □

Proof of Proposition 2: Differentiating E[ RS

M
( I )] with respect to I , we have

dE[ RS
M
( I )]/ dI  c2   w  (1   )[(w  h)G((Q  I ) Y )  h] . (A.1)
From the concavity of profit function ( E[ RS
M
( I )] ), we derive that the manufacturer’s optimal outsourcing quantity
I RS  max{0, I RS
1 1
} , where I RS satisfies the equation as c2   w  (1   )[(w  h)G((Q  I ) Y )  h]  0 .

Equation (A.1) can be changed into the following

dE[ RS
M
( I )] QI c  w
 (1   )( w  h)[G( ) [ 2  h]/(w  h)] .
dI Y (1   )
c2  h c  w dE[ RS
M
( I )]
When 1    d  , we can find that [ 2  h]/(w  h)  0 , and then  0 . Therefore, we
w h (1   ) dI
have the optimal outsourcing quantity I RS  Q ;
When 0    d , we can find that [(c2   w) /(1   )  h]/(w  h)  0 . Therefore, the optimal outsourcing
c2   w c  w
quantity should be I RS  Q  YG 1 ([  h]/( w  h)) if Q  YG 1 ([ 2  h]/( w  h)) 0 .
(1   ) (1  )
Hence, under the condition 0    d , we have (i) when YG1 (e)  Q  YG1 ( d ) , the optimal outsourcing quantity
c2   w
of the manufacturer should be I RS  Q  YG 1 ([  h]/( w  h))  Q  YG 1 (e) ; when Q  YG 1 (e) , the
(1   )
optimal outsourcing quantity should be I RS  0 ; (ii) when Q  YG 1 ( d ) , the optimal outsourcing quantity should be
I RS  Q  YG 1 (e) . Further, we can complete the proof of Proposition 2. □

Proof of Proposition 3: Case 1:   d , and the manufacturer’s outsourcing quantity is I RS  Q . It is easy to show
that expected profit of the retailer is concave in the order quantity ( Q ), and the optimal order quantity will be
Q  F 1 (( p  g  w) ( p  g  h)) ;
Case 2: Q  YG 1 (e) and 0    d , and the manufacturer’s outsourcing quantity is I RS  0 . It is easy to show

that the expected profit of the retailer is also concave in the order quantity ( Q ), and the optimal order quantity should be
Q  F 1 (( p  g  w) ( p  g  h)) when F 1 (( p  g  w) ( p  g  h))  YG 1 (e) ; otherwise, the optimal
25
outsourcing quantity of the manufacturer will be I RS  Q  YG 1 (e) ;

Case 3: Q  YG 1 (e) and 0    d . The manufacturer’s optimal outsourcing quantity is I RS  Q  YG 1 (e) .

From the retailer’s perspective, the optimal outsourcing quantity is uniquely induced for the order quantity. In this case,
the retailer has the right to adjust the decision-value of order quantity to obtain the required outsourcing level of the
manufacturer. Substituting Q  I  YG 1 (e) into Eq. (4), we can show that the expected profit of the retailer is also
concave in the outsourcing quantity ( I ). The equilibrium solutions are clear by using the first-order condition.
Additionally, when 0    d and Q* (w)  YG 1 (e) , we have I RS
*
 max{0, I RS
2
}  I RS
2
. In fact,

p  g  w   ( p  g  h) F ( I RS
2
)  (1   )( p  g  h) 0
G 1 ( e )
F (Y  I RS
2
)dG( )  
1

G 1 ( e )
F (YG 1 (e)  I RS
2

)dG( )

  ( p  g  h) F (YG 1 (e)  I RS
2
)  (1   )( p  g  h) F (YG 1 (e)  I RS
2
)  ( p  g  h)F (YG 1 (e)  I RS
2
).
2
Therefore, we have I RS  Q* (w)  YG 1 (e)  0 .
To sum up the above analysis, we can derive the main results of Proposition 3. □

Proofs of Corollaries1, 3 and 4: The proofs are obvious, here omitted. □

Proof of Corollary 2: When   d , we have
1
dE[ c ( I RS
*
)] dI  p  g  c2   ( p  g  w)  (1   )( p  g  h)  F (Y  I RS
*
)dG( )
0
1 1
 (1   )( p  g )  (  w  c2 )  (1   )( p  g ) F (Y  I )dG( )  (1   )h F (Y  I RS
*
RS
*
)dG( )
0 0

1 c2  h c h 1
 (  w  c2 )  (1   )h  F (Y  I RS
*
)dG( )  ( w  c2 )  (1  2 )h  F (Y  I RS
*
)dG( )
0 wh wh 0

( w  c2 )h (w  c2 )h 1
   F (Y  I RS )dG( )  0 .
*

wh wh 0

Therefore, we have I c*  I RS
*
for c2  w  p  g .

For the case of 0    d and Y  Q* (w) G 1 (e) , from Propositions 1 and 3, we derive the wholesale price as
1
w  c2  (1   )( p  g  h)  [ F (Y  I c* ) F (G 1 (e)Y  I c* )]dG( ) , which ensures that I c*  I RS
*
. For the
G 1 ( e )

wholesale price in this case, we can show that it also satisfies the conditions as c2  w  p  g . In fact, we have
w  c2  (1   )( p  g  h)(1  e) , i.e., w  c2  ( p  g  h)(w  c2 ) (w  h) , and then p  g  h  w  h .
Therefore, we have c2  w  p  g .
Additionally, when w  c2 , we have d  1 and G 1 (e)  1 . It is easy to show that I c*  I RS
*
if Y  Q* (c2 ) ,
otherwise, I c*  I RS
*
 0 . Other conclusions of Corollary 2 can be showed by performing some algebraic manipulation,
and the detailed processes of proofs are omitted. □

Proof of Proposition 4: Differentiating Eq. (5) with respect to I , we have

dE[ RS
M
( I )] dI  c2   (wR  k1 )  (1   )[wR  k1G((Z  I ) Y )] and d2 E[ RS
M
( I )] dI 2  0 ,

i.e., the second-order condition is satisfied, therefore, the expected profit function E[ RS
M
( I )] is concave in I. Solving

c2   (wR  k1 )  (1   )[wR  k1G((Z  I c* ) Y )]  0 for w , we have wR*  c2   k1  (1   )k1G(  I c* Y ) .

26
 Therefore, the manufacturer provides the same emergency production as that in the centralized supply chain. Since the

reservation profit of the manufacturer is  M0 , the retailer maximizes his own profit and takes as much profit away from
the manufacturer as possible, while securing the manufacturer’s cooperation. Therefore, we have
( Z  I c* ) Y
c2 I c*  [wR* I c*  k1 (  I c* )]  (1   )[wR* (Y  I c* )  c1Y  k1  (  Y  I c* )dG( )   M0 .
0

And then we can derive the solution of k1* given in the proposition.

In the following, we show that c1  wR*  c2 . First, wR*  c2 is obvious. Second, we show that
c2  c1
wR*  c1  c2  c1  (   (1   )G((*  I c* ) Y ))k1*  0 , i.e., k1*  .
  (1   )G((*  I c* ) Y )
The unit punishment cost k1* can be changed into the following.
(1   )(c2  c1 )Y    M0
k1*    Ic
 *  I c*  *
* *
*  I c*
                  ( *  I c*   Y )dG( )
* *
 
Y
(1 )G ( ) ( (1 )Y ) (1 )( I c ) G ( ) (1 )
 Y  Y 0

(1   )(c2  c1 )Y    M0 c2  c1
 
 *  I c*  * *
 I *
*  I c* .
   (1   )G ( )  (   (1   )Y  )  (1   )( *
 I *
c )G ( c
)   (1   )G ( )
 Y  Y Y
*  I c*
The first inequality is satisfied because (1   )  Y
( *  I c*  Y )dG( )  0 , and the second inequality can be
0

showed by performing some algebraic manipulation. Therefore, the condition wR*  c1 is always satisfied. □

Proof of Proposition 5: (i): When I  Q  Y  I , differentiating E[ MS

R
(Q | w, I )] with respect to Q , we have
dE[ MS
R
(Q | w, I )] QI
 (1   )[1  G( )][( p  g  w)  ( p  g  h) F (Q)] .
dQ Y

When F ( I  Y )  ( p  g  w) /( p  g  h) , we have dE[ MS

R
(Q | w, I )]/ dQ  0 for Q  ( I , Y  I ] .
Therefore, we obtain QMS  I  Y .
pgw dE[ MS
R
(Q | w, I )] dE[ MS
R
(Q | w, I )]
When F ( I  Y )  , we have  0 for Q  ( I , Q* (w)] , and 0
pgh dQ dQ

for Q  (Q* (w), I  Y ] . Therefore, we have QMS  Q* (w) .

(ii): When Q  I , we have E[ MS

R
]  EX {[ p min{X , Q}  g ( X  Q)  h(Q  X )  wQ]  (1   )[ p min{X , Q}
wQ  g ( X  Q)  h(Q  X ) ]} . From the first order condition, we have QMS  Q* (w) .
(iii): When Q  Y  I , the retailer’s profit is independent of his order quantity. Hence, let QMS  I  Y .
From the above cases, we can show Proposition 5. □

Proof of Proposition 6: When I  Y  Q* (w) , the order quantity of the retailer is QMS  I  Y according to

Proposition 5, and the manufacturer’s expected profit is E[ MS

M
( I )]  E {c2 I   wI  (1   )[w(Y  I )  c1Y ]} .

Since dE[ MS
M
( I )] dI  w  c2  0 , and the optimal outsourcing quantity will be I  Q* (w)  Y , therefore, the
*
optimal order quantity of the retailer will be QMS  Q* (w) . However, the optimal outsourcing quantity lies at the

27
boundary when I  Y  Q* (w) . That is, the optimal solution can be obtained under the condition of I  Y  Q* (w)

for the continuity of expected profit on the order quantity. For I  Y  Q* (w) , according to Proposition 5, we have that
the order quantity of the retailer is equal to the solution of classic newsvendor model, i.e., QMS  Q* (w) . In the
following, we discuss the manufacturer’s outsourcing quantities given Q* ( w) , which are presented as the following two
cases.

(i) If Q* (w)  I , the expected profit of the manufacturer can be denoted as follows

E[ MS
M
( I )]  E {c2 I   (wQ* (w)  h( I  Q* (w)))  (1   )[wQ* (w)  c1Y  h(Y  I  Q* (w))]} .

Since dE[ MS
M
( I )]/ dI  (c2  h)  0 , then the optimal outsourcing production level will be I  Q* (w) . Thus,
the optimal outsourcing production level should satisfy Q* (w)  I .

(ii) When Q* (w)  I , the expected profit of the manufacturer will be

E[ MS
M
( I )]  E {c2 I   wI  (1   )[w min{Q* (w),Y  I }  c1Y  h(Y  I  Q* (w)) ]} , and

dE[ MS
M
( I )] Q* (w)  I c  w
 (1   )( w  h)[G( ) [ 2  h]/( w  h)] .
dI Y (1   )
*
Similar to Proposition 2, we have I MS .
Combining the above analysis, we can derive the optimal equilibrium solutions for MS game. □

*
Proof of Corollary 5: Similar to Corollary 2, we can show that I MS  I c* when   d . When 0    d and
Q* (w)  YG 1 (e) , it is natural that I MS
*
 I c* . In the case of 0    d and Q* (w)  YG 1 (e) , we give the proofs
as follows. From Proposition 1, we know that
1
dE[ c ( I MS
*
)]/ dI  p  g  c2   ( p  g  h)F (I MS
*
)  (1   )( p  g  h)  F (Y  I MS
*
)]dG( )
0

G 1 ( e ) 1
 p  g  c2   ( p  g  h) F ( I MS
*
)  (1   )( p  g  h)[ F (Y  I MS
*
)]dG ( )   F (Y  I MS
*
)]dG ( )]
0 G 1 ( e )

 p  g  c2   ( p  g  h)F (I MS
*
)  (1   )( p  g  h)[F (G 1 (e)Y  I MS
*
)e  (1  e)]
c2  h c h
 p  g  c2   ( p  g  h) F ( I MS
*
)  ( p  g  w)(   )  ( p  g  h)(1  2 )
wh wh
c h c h
 p  g  c2  [( p  g  w)  ( p  g  h) F ( I MS
*
)]  ( p  g  w) 2  ( p  g  h)(1  2 )
wh wh
 0 . (Because of F ( I MS
*
)  F (QMS
*
) and ( p  g  w)  ( p  g  h) F ( I MS *
)  0 .)
*
Therefore, we have I MS  I c* . □

Proof of Proposition 7: Compared RS and MS, it is obvious that when 0    d and Q* (w)  YG 1 (e) , we have
*
I RS  I MS
*
 0 and QRS
*
 QMS
*
( Q* (w)) ; when   d , we have I RS
*
 I MS
*
 QRS
*
 QMS
*
( Q* (w)) .
When 0    d and Q* (w)  YG 1 (e) , then I RS
*
 max{0, I RS
2 *
} and I MS  Q* (w)  YG 1 (e) . From
Proposition 3, we have the following equation

p  g  w   ( p  g  h) F ( I RS
2
)  (1   )( p  g  h)  0
G 1 ( e )
F (Y  I RS
2
)dG( )  
1

G 1 ( e )
F (G 1 (e)Y  I RS
2
)dG( ) 
  ( p  g  h) F (G 1 (e)Y  I RS
2
)  (1   )( p  g  h) 
0
G 1 ( e )
F (G 1 (e)Y  I RS
2
)dG( )  
1

G 1 ( e )
F (G 1 (e)Y  I RS
2
)dG( ) 
28
 ( p  g  h) F (G1 (e)Y  I RS
2
).
2
Therefore, we have I RS  Q* (w)  YG 1 (e)  I MS
* *
, and it implies that I RS  I MS
*
. Additionally, from the inequality
2
of I RS  YG 1 (e)  Q* (w) , we derive that QRS
*
 QMS
*
. □

Proof of Corollary 6: First, the outsourcing level of the manufacturer in RS channel is more than that in the MS channel

when 0    d , Q* (w)  YG 1 (e) ; otherwise, the outsourcing levels under RS and MS are identical. Therefore, the
expected outsourcing level in RS is higher than that in MS channel. Similarly, we can obtain the higher order quantity of
the retailer in RS channel. Second, when comparing the expected profits of each player under different channel

leadership structures, we can derive that the profit function of the retailer remains the same between RS and MS because
the outsourcing level is always less than the order quantity. That is,
E[ R (Q) | I ]  E , X {[ p min{X , I }  wI  g ( X  I )  h( I  X ) ]  (1   )[ p min{X , Q, Y  I }

w min{Q,Y  I }  g ( X  min{Q,Y  I })  h(min{Q,Y  I }  X ) ]} .

Differentiating E[ R (Qw | I )] with respect to I , we have
( Qw  I ) / Y
dE[ R (Qw | I )] dI  ( p  g  h){[ F (Qw )  F ( I )]  (1   )  [ F (Qw )  F (Y  I )]dG( )} , and
0
( Qw  I ) / Y
d2 E[ R (Qw | I )] dI 2  ( p  g  h){  f ( I )  (1   )  f (Y  I )dG( )}  0 .
0

From the second-order condition, we can derive that dE[ R (Qw | I )] dI is decreasing with I . Therefore, we have

dE[ R (Qw | I )] dI  dE[ R (Qw | Qw )] dI  0 for I  Qw . Then, E[ R (Qw | I )] is increasing with I . Hence,

we can derive that E[ R (Qw | I MS

*
)]  E[ R (Qw | I RS
*
)] for *
I MS  I RS
*
. Additionally, E[ R (Qw | I RS
*
)]

 E[ R (QRS
* *
| I RS *
)] , because that (QRS *
, I RS ) is the optimal solutions for the retailer when given outsourcing level as
*
I RS . Therefore, we have E[ R (Qw | I MS
*
)]  E[ R (QRS
* *
| I RS )] , i.e., E[ RS
R
(w)]  E[ MS
R
(w)] .
Similarly, the profits of the manufacturer under RS and MS are identical. The expected profit of the manufacturer is
E[ M ( I | Q)]  E [c2 I   wI  (1   )[w min{Q,Y  I }  c1Y  h{Y  I  Q} ]]
 E [c2 I   wI  (1   )[w(Q  (Q  Y  I ) )  c1Y  h(Y  I  Q) ]] .
When 0    d and Q* (w)  YG 1 (e) or 1    d , we find that the results are identical. Here, we only give

the proof for the case of 0    d , Q* (w)  YG 1 (e) . In this case, we have QRS
*
 I RS
*
 QMS
*
 I MS
*
 YG 1 (e) .
E [ RS
M
]  E [ MS
M
]  c2 ( I RS
*
 I MS
*
)   w( I RS
*
 I MS
*
)  (1   )w(QRS
*
 QMS
*
)

 ( I RS
*
 I MS
*
)(c2   w  (1   )w)  0 . That is E[ RS
M
(w)]  E[ MS
M
(w)] .
Therefore, combining the above analysis, we can derive the main results of Corollary 6. □

Proof of Proposition 8: If Q  I c* , then the profit of the retailer can be denoted as follows

 MS
R
(Q | w, I c* )  p min{X , Q}  g ( X  Q)  h(Q  X )  wQ  k2 ( I c*  Q)  (1   )Yk2 .
Differentiating E[ MS
R
(w, Q)] with respect to Q , we have
dE[ MS
R
(Q | w, I c* )]/ dQ  ( p  g  w  k2 )  ( p  g  h) F (Q)  0 when k2  w  h .
If Q  I c* , then the profit for the retailer can be denoted as follows.

29
 MS
R
(Q | w, I c* )  [ p min{X , I c*}  g ( X  I c* )  h( I c*  X )  wI c* ]  (1   )[ p min{X , Q,Y  I c*}

w min{Q,Y  I c*}  g ( X  min{Q,Y  I c*})  h(min{Q,Y  I c*}  X )  k2 (Y  I c*  Q) ] .

Differentiating E[ MS
R
(w, Q)] with respect to Q , we have

dE[ MS
R
(Q | w, I c* )]/ dQ  (1   )[1  G((Q  I c* ) / Y )][( p  g  w  k2 )  ( p  g  h) F (Q)] .

Under the condition k2  w  h , we can also find that dE[ MS

R
(Q | w, I c* )] dQ  0 , and then the retailer will accept
all the items. Assume that retailer can obtain the share of the expected channel profit  2 , i.e.,

E[ MS
R
(w | I c* )]  2 E[ c* ] , 2 [0,1] .
Then, we have w*  ((1  2 ) E[ c* ]  c2 I c*  (1   )c1Y ) ( I c*  (1   )Y ) . □

Proof of Corollary 7. It is easy to show that w*  c1 . If (1   )(c2  c1 )Y   E[ c* ] , w*  c2 is equivalent to

E[ MS
M
]  (1   )(c2  c1 )Y  . And w*  c2 means that E[ MS
M
]  (1   )(c2  c1 )Y  , here we can show that
w*  p for 2  (0,1) as follows.
(1   2 ) E[ c* ]  c2 I c*  (1   )c1Y
w* 
I c*  (1   ) Y
 E , X [ [ p min{ X , I c*}  g ( X  I c* )   h( I c*  X )  ] 
 
 (1   )[ p min{ X , Y  I *}  c  Y  g ( X  Y  I * )   h( Y  I *  X )  ]] 
  c 1 c c 
I c  (1   ) Y
*


  pI *
c  (1   ) p( Y  I c* ) 
 p.
I c*  (1   ) Y

If (1   )(c2  c1 )Y   E[ c* ] , it is easy to show that c1  wM* (2 )  c2 . Combining the above analysis, we
can derive the main results of Corollary 7. □

30
 50 RS channel 90 RS channel
Outsourcing level of manufacturer

Order quantity of retailer

MS channel MS channel
40 80

30 70

20 60

10 50

0 40
10 15 c2 20 25 10 15 c2 20 25
(a) Outsourcing quantity of the manufacturer (b) Order quantity of the retailer
Fig. 1. Outsourcing quantity and order quantity vs. unit outsourcing cost.

60
Outsourcing level of manufacturer

RS channel RS channel
80
Order quantity of retailer

MS channel MS channel

40 70

60
20
50

0 40
0 0.2 0.4  0.6 0.8 1 0 0.2 0.4  0.6 0.8 1
(a) Outsourcing quantity of the manufacturer (b) Order quantity of the retailer
Fig. 2. Outsourcing quantity and order quantity vs. disruption risk.

900
])

700
])
RS

MS
Profit of manufacturer in RS (E[ M

Profit of manufacturer in MS (E[ M

Y=120 Y=120
800 Y=100 Y=100
Y=80 600 Y=80
700 Y=60 Y=60

600 500

500
400
400

300 300
0 0.2 0.4  0.6 0.8 1 0 0.2 0.4  0.6 0.8 1

(a) The retailer-Stackelberg channel (b) The manufacturer-Stackelberg channel

Fig. 3. Profits of the manufacturers under two channel leadership structures vs. disruption risk.

31
 600 600
])

])
RS

MS
Profit of retailer in RS (E[ R

Profit of retailer in MS (E[ R

500 500

400 400

300 Y=120 300 Y=120

Y=100 Y=100
200 Y=80 200 Y=80
Y=60 Y=60
100 100
0 0.2 0.4  0.6 0.8 1 0 0.2 0.4  0.6 0.8 1
(a) The retailer-Stackelberg channel (b) The manufacturer-Stackelberg channel
Fig. 4. Profits of the retailer under two channel leadership structures vs. disruption risk.

500 500
Value of backup supplier (  RS )

Value of backup supplier (  MS )

Y=120 Y=120
400 Y=100 400 Y=100
Y=80 Y=80
Y=60 Y=60
300 300

 RS  MS
200 200

100 100

0 0
0 0.2 0.4  0.6 0.8 1 0 0.2 0.4  0.6 0.8 1

(a) The retailer-Stackelberg channel (b) The manufacturer-Stackelberg channel

Fig. 5. Value of outsourcing under two channel leadership structures vs. disruption risk.

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