Dual sourcing under internal and external volatilities

Abstract

We study a dual sourcing problem in an increasingly volatile world. We consider two types of volatilities. External volatilities reflect fluctuating economic conditions via an underlying Markov-modulated state-of-the-world which affects the two suppliers’ cost structures, capacity limits, supply mechanisms and demands. Internal volatilities affect the demand distributions and the actual outputs resulting from random supply processes. We show how the optimal combined ordering strategy from the two suppliers, along with a salvaging policy, can be efficiently computed, and characterize the relatively simple structure of the optimal policies. We systematically compare the two types of volatilities. By exploiting the dual sourcing options, we find that the firm can benefit from external volatilities; indeed, benefits increase as volatilities increase in specific ways. Numerical studies illustrate these results and reject other reasonable conjectures.