Supply Contracts

2

Introduction

Significant level of outsourcing Many leading brand OEMs outsource complete

manufacturing and design of their products Search for lower cost manufacturers Development of design and manufacturing

expertise by suppliers

Procurement function in OEMs becomes very important

OEMs have to get into contracts with suppliers

3

Supply Contracts

In a supply contract, the buyer and supplier may set terms on: Pricing and volume discounts Minimum and maximum purchase quantities Delivery lead times Product or material quality Product return policies

In the supply chain context, supply

contract is a useful tool to align/coordinate the interests of different parties so that the total profit is increased

4

2-Stage Sequential Supply Chain

A buyer and a supplier. Buyers activities:

generating a forecast Purchase based on forecast of customer demand determining how many units to order from the

supplier placing an order to the supplier so as to optimize

his own profit Suppliers activities:

reacting to the order placed by the buyer. Make-To-Order (MTO) policy

5

Swimsuit Example

2 Stages: a retailer who faces customer demand a manufacturer who produces and sells

swimsuits to the retailer. Retailer Information:

Summer season sale price of a swimsuit is $125 per unit.

Wholesale price paid by retailer to manufacturer is $80 per unit.

Salvage value after the summer season is $20 per unit

Manufacturer information: Fixed production cost is $100,000 Variable production cost is $35 per unit

6

Swimsuit Demand Scenarios

Demand Scenarios

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The Retailers Decision

A newsvendor model

Solution: P{D Q*} = Cu/(Cu + Co) where Q* is the optimal stocking quantity, Cu is the unit cost of under-stocking, and Co is the unit cost of over-stocking. This is also known as the critical ratio formula.

P{D Q*} = 45/(45 + 60) Q* = 12000

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The Optimal Solution

Retailer optimal policy is to order 12,000 units for an average profit of $470,700.

If the retailer places this order, the manufacturers profit is 12,000(80 - 35) - 100,000 = $440,000

9

How to Compute the Retailers Average Profit

We first calculate the profits for different realized demands: When D=Q, profit=Q*(p-c) when D=12000, 14000, 16000,18000, profit=12,000*(125-80)=540,000

According to the graph in page 6, P(D=8,000)=P(D=10,000)=0.11; P(D=12,000)=0.28; P(D=14,000)=0.22;P(D=16,000)=0.18; P(D=18,000)=0.1 Thus the average profit =120,000*0.11+330,000*0.11+540,000*(0.28+0.22+0.18+0.1)=470,700

10

Risk Sharing

In the sequential supply chain: Buyer assumes all of the risk of having more inventory than

sales while supplier takes no risk Supplier would like the buyer to order as much as possible Buyer limits his order quantity because of the huge financial

risk. Since the buyer limits his order quantity, there is a

significant increase in the likelihood of out of stock.

If the supplier shares some of the risk with the buyer may be profitable for buyer to order more reducing the likelihood of out of stock increasing profit for both the supplier and the buyer

Supply contracts enable this risk sharing

11

Wholesale Price Contract

Fixed Production Cost =$100,000

Variable Production Cost=$35

Wholesale Price=$80

12

Expect Profits

Q*

Manufacturers profit = (w-c)Q

13

Profits

Retailer optimal order quantity is 12,000 units

Retailer expected profit is $470,000

Manufacturer profit is $440,000

Supply Chain Profit is $910,000

14

Buy-Back Contracts

Seller agrees to buy back unsold goods from the buyer for some agreed-upon price.

Buyer has incentive to order more

Suppliers risk clearly increases.

15

Manufacturer Manufacturer DC Retailer

Customers

Fixed Production Cost =$100,000

Variable Production Cost=$35

Selling Price=$125

Salvage Value=$20

Wholesale Price =$80

Buy-Back Supply Contracts

Buy-back price of unsold units= $55

PresenterPresentation NotesNotice that in the previous strategy, the retailer takes all the risk and the manufacturer takes zero risk. This is way the retailer has to be very conservative with the amount he orders.

If the retailer can transfer some of the risk to the manufacturer, the retailer may be willing to increase his order quantity and thus increase both his profit and the manufacturer profit

16

Retailers Profit

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$513,800

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Manufacturers Profit

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fit $471,900

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Revenue Sharing Contracts

Buyer shares some of its revenue with the supplier in return for a discount on the wholesale

price.

Buyer transfers a portion of the revenue

from each unit sold back to the supplier

19

Manufacturer Manufacturer DC Retail

Customers

Fixed Production Cost =$100,000

Variable Production Cost=$35

Selling Price=$125 Salvage Value=$20

Wholesale Price =$60

Revenue-Sharing Supply Contracts

The retailer provides 15% of revenue as a return

PresenterPresentation NotesWhat does wholesale price drive?How can manufacturer benefit from lower price?

20

0

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$504,325

Retailers profit

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Manufacturers profit

22

Manufacturer Manufacturer DC Retailer

Customers

Fixed Production Cost =$100,000

Variable Production Cost=$35

Selling Price=$125 Salvage Value=$20

Wholesale Price =$80

What about if both Manufacturer and Retailer are one Entity?

PresenterPresentation NotesWhat is the maximum profit that the supply chain can achieve? To answer this question, one needs to forget about the transfer of money from the retailer to the manufacturer.

23

Supply Contracts

Wholesale Price

24

Self-optimizing behavior Suboptimal supply chain performance Buyers optimal critical ratio = 0.43 Supply chains critical ratio = 0.86 The difference in the critical ratio leads to poor

performance

Incentive conflicts If every firm in a supply chain chooses action to maximize its

own expected profit, the total profit earned in the supply chain may be less than the entire supply chains maximum profit.

Suboptimal Supply Chain Performance

25

Aligning Incentives

Supply Chain Coordination If the retailers decision is the same as centralized

supply chains decision, then we say the chain is coordinated

Win-win deal The size of the total pie is increased. Allocation : the size of each partys pie also increases.

What they need is a method to share inventory risk so that the supply chains profit is maximized (coordinated) and both firms are better off.

26

Wholesale price (w)+ Buy-back price (b): Manufacturer buys back leftover inventory at the end of the

season.

Coordination can be achieved as long as retailers critical ratio is the same with supply chains critical ratio:

( )( )p w p sp c p w b pp s p b p c

= =

Buy-Back Contracts

Manufacturer Retailer Customer psales wQ

bleftover

27

Example

p=$120, w=$70, c=$40, s=$20, D~N(250,100^2)

Wholesale price contract: CR=0.5, z*=0, Q*=250 E(lost sales)=100x0.3989=40 E(sales)=250-40=210, E(leftover)=250-210=40

Retailers profit=($120-$70)x210-($70-$20)x40=$8,500

Manufacturers profit=($70-$40)x250=$7,500 Supply chain profit=$8,500+$7,500=$16,000

28

Example (Contd)

p=$120, w=$70, c=$40, s=$20, D~N(250,100^2) b=? can coordinate the supply chain? Whats the profit

of each party and the supply chain?

CR=0.8, z*=0.85, Q*=250+0.85x100=335 E(lost sales)=100x0.11=11 E(sales)=250-11=239, E(leftover)=335-239=96

Buyers profit=($120-$70)x239-($70-$57.5)x96=$10750 Suppliers profit=($70-$40)x335-($57.5-$20)x96=$6450 Supply chain profit=$10750+$ 6450 =$17200

( )( ) ( )( )120 70 120 20120 57.5120 40

p w p sb p

p c

= = =

29

Calculation Details in Page 27

Calculation Details in Page 28

30

More on Buy-back Contracts

How do they improve supply chain performance? The retailers overage cost is reduced, so the retailer stocks

more. With a buy-back the supplier shares with the retailer the risk of

leftover inventory.

What are the costs of buy-backs?

Where are they used

31

Supply Contracts: Case Study

Example: Demand for a movie newly released video cassette typically starts high and decreases rapidly Peak demand last about 10 weeks

Blockbuster purchases a copy from a studio for $65 and rent for $3 Hence, retailer must rent the tape at least 22

times before earning profit Retailers cannot justify purchasing enough to

cover the peak demand In 1998, 20% of surveyed customers reported

that they could not rent the movie they wanted

32

Supply Contracts: Case Study

Starting in 1998 Blockbuster entered a revenue sharing agreement with the major studios Studio charges $8 per copy Blockbuster pays 30-45% of its rental income

Even if Blockbuster keeps only half of the rental

income, the breakeven point is 6 rental per copy

The impact of revenue sharing on Blockbuster was dramatic Rentals increased by 75% in test markets Market share increased from 25% to 31%

33

Other Contracts

Quantity Flexibility Contracts Supplier provides full refund for returned

items as long as the number of returns is no larger than a certain quantity

Sales Rebate Contracts Supplier provides direct incentive for the

retailer to increase sales by means of a rebate paid by the supplier for any item sold above a certain quantity

34

Contracts for MTS/MTO Supply Chains

Previous contracts examples were with Make-to-Order supply chains Supplier takes no risk while buyer takes all

the risk Contracts designed to transfer some of the

risk from the buyer to the supplier

What happens when the supplier has a Make-to-Stock supply chain? Supplier takes all the risk Buyer takes no risk

35

Example

Manufacturer produces ski-jackets prior to receiving distributor orders

Season starts in September and ends by December. Production starts 12 months before the selling season Distributor places orders with the manufacturer six months

later. At that time, production is complete; distributor receives

firms orders from retailers. The distributor sales ski-jackets to retailers for $125 per

unit. The distributor pays the manufacturer $80 per unit. For the manufacturer, we have the following information:

Fixed production cost = $100,000. The variable production cost per unit = $55 Salvage value for any ski-jacket not purchased by the

distributors= $20.

36

Solution

For the manufacturer Marginal profit = 80 55 =$25 Marginal loss = 55 20 = $35 Since marginal loss is greater than marginal

profit, the manufacturer should produce less than average demand.

How much should the manufacturer produce? Manufacturer optimal policy = 12,000 units Average profit = $160,400. Distributor average profit = $510,300.

Manufacturer assumes all the risk limiting its production quantity

Distributor takes no risk

37

Make-to-Stock: Manufacturers expected profit

38

Pay-Back Contracts

Buyer agrees to pay some agreed-upon price for any unit produced by the manufacturer but not purchased.

Manufacturer incentive to produce more units

Buyers risk clearly increases.

39

Example

Assume the distributor offers to pay $18 for each unit produced by the manufacturer but not purchased.

Manufacturer marginal loss = 55-20-18=$17 Manufacturer marginal profit = $25. Manufacturer has an incentive to produce more than

average demand. Manufacturer increases production quantity to 14,000

units Manufacturer profit = $180,280 Distributor profit increases to $525,420.

Total profit = $705,700 Compare to total profit in sequential supply chain = $670,000 (= $160,400 + $510,300)

40

Cost-Sharing Contract

Buyer shares some of the production cost with the manufacturer, in return for a discount on the wholesale price.

Reduces effective production cost for the manufacturer who has an incentive to produce more units

41

Example

Manufacturer agrees to decrease the wholesale price from $80 to $62

In return, distributor pays 33% of the manufacturer production cost

Manufacturer increases production quantity to 14,000

Manufacturer profit = $182,380 Distributor profit = $523,320 The supply chain total profit = $705,700

42

Global Optimization

Relevant data: Selling price, $125 Salvage value, $20 Variable production costs, $55 Fixed production cost.

Supply chain marginal profit, 70 = 125 55

Supply chain marginal loss, 35 = 55 20

Optimal production quantity = 14,000 units

Expected supply chain profit = $705,700 Same profit as under pay-back and cost sharing contracts

43

Contracts with Asymmetric Information

Implicit assumption so far: Buyer and supplier share the same forecast

Inflated forecasts from buyers a reality

How to design contracts such that the information shared is credible?

44

Two Possible Contracts

Capacity Reservation Contract Buyer pays to reserve a certain level of capacity

at the supplier A menu of prices for different capacity

reservations provided by supplier Buyer signals true forecast by reserving a specific

capacity level Advance Purchase Contract

Supplier charges special price before building capacity

When demand is realized, price charged is different

Buyers commitment to paying the special price reveals the buyers true forecast

Slide Number 1IntroductionSupply Contracts2-Stage Sequential Supply Chain Swimsuit ExampleSwimsuit Demand ScenariosThe Retailers DecisionThe Optimal SolutionHow to Compute the Retailers Average ProfitRisk SharingWholesale Price ContractExpect ProfitsProfitsBuy-Back ContractsBuy-Back Supply Contracts Retailers ProfitManufacturers ProfitRevenue Sharing ContractsRevenue-Sharing Supply ContractsRetailers profitManufacturers profitSlide Number 22Supply ContractsSuboptimal Supply Chain PerformanceAligning IncentivesBuy-Back ContractsExampleExample (Contd) Calculation Details in Page 27More on Buy-back ContractsSupply Contracts: Case StudySupply Contracts: Case StudyOther ContractsContracts for MTS/MTO Supply ChainsExampleSolutionMake-to-Stock: Manufacturers expected profitPay-Back ContractsExampleCost-Sharing ContractExampleGlobal OptimizationContracts with Asymmetric InformationTwo Possible Contracts