Coordination mechanism for postponement strategy with downward substitutable products

We consider a supply chain implements postponement strategy to provide two kinds of products with different performance and cost. The high-performance product has the full function of the lower one, therefore the supplier can satisfy the demand of low-performance product with the higher one as it runs out. Recalling the manufacturing process of postponement strategy that consists of two periods: the one at the beginning for the common components and the other for differentiation as more information is available, we optimize this two-period dynamic decision process for downward substitutable products. Regarding the optimal behavior of the centralized supply chain as a benchmark, a bi-direction compensation contract with substitution premium is proposed for the decentralized system composed of a manufacturer and a retailer with local benefits. Through partly imposing the overproduction risk of the common components to the retailer, committing to buy back the overstocks and put a premium on each unit of substitution, the contract motivates the retailer to order as much as the centralized system's optimal output. Furthermore, this contract is not only effective to achieve coordination, but flexible to split the profit of the system between the channel members in an arbitrary ratio, thus the supply chain is expected to get Pareto-improving.