Dynamic Supply Risk Management with Signal-Based Forecast, Multi-Sourcing, and Discretionary Selling

We examine the critical role of advance supply signalssuch as suppliers' financial health and production viabilityin dynamic supply risk management. The firm operates an inventory system with multiple demand classes and multiple suppliers. The sales are discretionary and the suppliers are susceptible to both systematic and operational risks. We develop a hierarchical Markov model that captures the essential features of advance supply signals, and integrate it with procurement and selling decisions. We characterize the optimal procurement and selling policy, and the strategic relationship between signal-based forecast, multi-sourcing, and discretionary selling. We show that higher demand heterogeneity may reduce the value of discretionary selling, and that the mean value-based forecast may outperform the stationary distribution-based forecast. This work advances our understanding on when and how to use advance supply signals in dynamic risk management. Future supply risk erodes profitability but enhances the marginal value of current inventory. A signal of future supply shortage raises both base stock and demand rationing levels, thereby boosting the current production and tightening the current sales. Signal-based dynamic forecast effectively guides the firm's procurement and selling decisions. Its value critically depends on supply volatility and scarcity. Ignoring advance supply signals can result in misleading recommendations and severe losses. Signal-based dynamic supply forecast should be used when: (a) supply uncertainty is substantial, (b) supply-demand ratio is moderate, (c) forecast precision is high, and (d) supplier heterogeneity is high.