Service level agreements: ready-rate analysis with lump-sum and linear penalty structures

In operations management, service level agreements (SLAs) are widely used to evaluate and manage supplier performance. In a typical SLA, a target ready rate is periodically measured and a financial penalty is incurred if this target is not met. The ready rate considered in this study is defined as the long-run fraction of periods in which all customer demand is filled immediately from on-hand stock. Previous studies of SLAs have been solely concerned with one supplier serving one-customer, whereas in practice a supplier usually deals with more than one-customer. In multiple-customer cases, the supplier has an SLA with each customer and a penalty is incurred whenever the agreement is violated. In this work, we examine the impacts of various factors such as the base-stock level, the type of penalty and the review period duration on the supplier’s cost function when the supplier deals with multiple-customers. The results show that dealing with more customers is preferable for a supplier (assuming the overall demand is the same) and that a longer performance review phase is beneficial under a lump-sum penalty contract.