Supply Risk in Fragile Contracts

Increasing length, complexity and interdependence in supply chain contracts is resulting in more critical and costly supply disruptions, yet commodity procurement is mainly handled via long-term, fixed-price contracts containing naive terms for contract breach. Fortunately, spot markets may be used by buyers to hedge this breach risk. Spot markets are getting more and more organized in their functionality, diverse in the range of commodities traded and efficient in providing economies of scale. This research on the interrelated issues of demand, spot prices and contract breach risks yielded the following strategic insights. First, it is almost always the correct strategy to procure a little less volume than expected demand and to rely on the spot market to fill the gap. Procuring far more may actually increase the likelihood of large losses. Second, the reaction to an increase in demand uncertainty should be to decrease the contract volumes slightly. Third, while breach penalties mitigate risk to the buyers, they can also significantly increase the profit variance. Hence, breach penalty selection should be a prudent decision that reflects not just expected profits but also the variability of profits