Supply Contracts and Risk Management David Simchi-Levi Professor of Engineering Systems...

Supply Contracts and Risk Management

David Simchi-Levi

Professor of Engineering SystemsMassachusetts Institute of Technology

Tel: 617-253-6160E-mail: [email protected]

©Copyright 2005 D. Simchi-Levi

Outline

• Supply Chain Strategies

• Supply Contracts


Supply Chain Strategies

• Achieving Global Optimization• Managing Uncertainty

– Risk Pooling– Risk Sharing


Procurement Planning

ManufacturingPlanning

DistributionPlanning

DemandPlanning

Sequential Optimization

Supply Contracts/Collaboration/Integration/DSS

Procurement Planning

ManufacturingPlanning

DistributionPlanning

DemandPlanning

Global Optimization

Sequential Optimization vs. Global Optimization

Source: Duncan McFarlane


Supply Contracts

• Fashion items – short life cycles– High product variety– One production opportunity– Simple supply chain structure– High demand uncertainty


Supply Chain Time Lines

Jan 00 Jan 01 Jan 02

Feb 00 Sep 00 Sep 01

Design Production Retailing

Feb 01Production


Manufacturer Manufacturer DC Retail DC

Stores

Fixed Production Cost =$100,000

Variable Production Cost=$35

Selling Price=$125

Salvage Value=$20

Wholesale Price =$80

Supply Contracts


Demand Scenarios

Demand Scenarios

0%5%

10%15%20%25%30%

Sales

P

robabili

ty


Distributor Expected Profit

Expected Profit

0

100000

200000

300000

400000

500000

6000 8000 10000 12000 14000 16000 18000 20000

Order Quantity


Supply Contracts (cont.)

• Distributor optimal order quantity is 12,000 units

• Distributor expected profit is $470,000

• Manufacturer profit is $440,000• Supply Chain Profit is $910,000–IS there anything that the distributor

and manufacturer can do to increase the profit of both?



Stores



Selling Price=$125

Salvage Value=$20


Supply Contracts


Retailer Profit (Buy Back=$55)

0

100,000

200,000

300,000

400,000

500,000

600,000

Order Quantity

Re

tail

er

Pro

fit


Retailer Profit (Buy Back=$55)

0

100,000

200,000

300,000

400,000

500,000

600,000

Order Quantity

Re

tail

er

Pro

fit

$513,800


Manufacturer Profit (Buy Back=$55)

0

100,000

200,000

300,000

400,000

500,000

600,000

Production Quantity

Ma

nu

fact

ure

r P

rofi

t


Manufacturer Profit (Buy Back=$55)

0

100,000

200,000

300,000

400,000

500,000

600,000

Production Quantity

Ma

nu

fact

ure

r P

rofi

t $471,900


Buy Back Contracts: Main Limitations

• Requires suppliers to have an effective reverse logistics systems

• Provides retailers with incentives to push competing products from suppliers with whom the buyer does not have buy back agreements



Stores



Selling Price=$125

Salvage Value=$20


Supply Contracts


Retailer Profit (Wholesale Price $70, RS 15%)

0

100,000

200,000

300,000

400,000

500,000

600,000

Order Quantity

Re

tail

er

Pro

fit


Retailer Profit (Wholesale Price $70, RS 15%)

0

100,000

200,000

300,000

400,000

500,000

600,000

Order Quantity

Re

tail

er

Pro

fit

$504,325


Manufacturer Profit (Wholesale Price $70, RS 15%)

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

Production Quantity

Ma

nu

fact

ure

r P

rofi

t


Manufacturer Profit (Wholesale Price $70, RS 15%)

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

Production Quantity

Ma

nu

fact

ure

r P

rofi

t

$481,375


Supply Contracts

Strategy Retailer Manufacturer TotalSequential Optimization 470,700 440,000 910,700 Buyback 513,800 471,900 985,700 Revenue Sharing 504,325 481,375 985,700



Stores



Selling Price=$125

Salvage Value=$20


Supply Contracts


Supply Chain Profit

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

Production Quantity

Su

pp

ly C

ha

in P

rofi

t


Supply Chain Profit

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

Production Quantity

Su

pp

ly C

ha

in P

rofi

t $1,014,500


Supply Contracts

Strategy Retailer Manufacturer TotalSequential Optimization 470,700 440,000 910,700 Buyback 513,800 471,900 985,700 Revenue Sharing 504,325 481,375 985,700 Global Optimization 1,014,500


Supply Contracts: Key Insights

• Effective supply contracts allow supply chain partners to replace sequential optimization by global optimization

• Buy Back and Revenue Sharing contracts achieve this objective through risk sharing


Supply Contracts: Key Insights

• Effective supply contracts allow supply chain partners to replace sequential optimization by global optimization

• Buy Back and Revenue Sharing contracts achieve this objective through risk sharing

• Effective supply contracts are designed so that no party has an incentive to deviate from the set of actions defined by the contract– Unique Nash Equilibrium


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


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% (The 2nd

largest retailer, Hollywood Entertainment Corp has 5% market share)


What are the drawbacks of RS?• Administrative Cost

– Lawsuit brought by three independent video retailers who complained that they had been excluded from receiving the benefits of revenue sharing was dismissed (June 2002)

– The Walt Disney Company has sued Blockbuster accusing them of cheating its video unit of approximately $120 million under a four year revenue sharing agreement (January 2003)

• Impact on sales effort– Retailers have incentive to push products with higher

profit margins– Automotive industry: automobile sales depends on retail

effort


What are the drawbacks of RS?

• Retailer may carry complementary products from other suppliers– One supplier offers revenue sharing

while the other does not• Retailer may discount the product offered

under revenue sharing to motivate sales of the other product


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


Key Assumptions

S M

MAKE-TO-ORDER

Symmetric Information


Telecom Supply Chain

S M

Purchased material(80 to 85 %)

Value added

Note: Typical ratios for Telecom EMs

Operator

MTS MTO


Manufacturer Manufacturer DC Distributor DC

Stores



Selling Price=$125


Salvage Value =$20

Supply Contracts

MAKE-TO-STOCK


Demand Scenarios

Demand Scenarios

0%5%

10%15%20%25%30%

Sales

P

robabili

ty


Manufacturer Expected Profit

Expected Profit

$0

$25,000

$50,000

$75,000

$100,000

$125,000

$150,000

$175,000

6000 8000 10000 12000 14000 16000

Production Quantity

Pro

fit


Expected Profit

$0

$25,000

$50,000

$75,000

$100,000

$125,000

$150,000

$175,000

6000 8000 10000 12000 14000 16000

Production Quantity

Pro

fit

Manufacturer Expected Profit


Supply Contracts (cont.)

• Manufacturer optimal production quantity is 12,000 units

• Manufacturer expected profit is $160,400

• Distributor profit is $510,300• Supply Chain Profit is $670,700

–IS there anything that the distributor and manufacturer can do to increase the profit of both?



Stores



Supply Contracts

Selling Price=$125


Salvage Value =$20


Manufacturer Profit (Pay Back=$18)

0

25000

50000

75000

100000

125000

150000

175000

200000

6000 8000 10000 12000 14000 16000 18000

Production Quantity

Man

ufa

ctu

rer

Pro

fit


0

25000

50000

75000

100000

125000

150000

175000

200000

6000 8000 10000 12000 14000 16000 18000

Production Quantity

Man

ufa

ctu

rer

Pro

fit

Manufacturer Profit (Pay Back=$18)

$180,280


Distributor Profit (Pay Back=$18)

0

100000

200000

300000

400000

500000

600000

6000 8000 10000 12000 14000 16000 18000

Order Quantity

Dis

trib

uto

r P

rofi

t


Distributor Profit (Pay Back=$18)

0

100000

200000

300000

400000

500000

600000

6000 8000 10000 12000 14000 16000 18000

Order Quantity

Dis

trib

uto

r P

rofi

t

$525,420



Stores



Supply Contracts

Selling Price=$125


Salvage Value =$20

MAKE-TO-STOCK


Manufacturer Profit (Wholesale Price $62, CS 33%)

$0.00

$25,000.00

$50,000.00

$75,000.00

$100,000.00

$125,000.00

$150,000.00

$175,000.00

$200,000.00

6000 8000 10000 12000 14000 16000 18000

Production Quantity

Man

ufa

ctu

rer

Pro

fit


$0.00

$25,000.00

$50,000.00

$75,000.00

$100,000.00

$125,000.00

$150,000.00

$175,000.00

$200,000.00

6000 8000 10000 12000 14000 16000 18000

Production Quantity

Man

ufa

ctu

rer

Pro

fit

Manufacturer Profit (Wholesale Price $62, CS 33%)

$182,380


Distributor Profit (Wholesale Price $62, CS 33%)

$0.00

$100,000.00

$200,000.00

$300,000.00

$400,000.00

$500,000.00

$600,000.00

6000 8000 10000 12000 14000 16000 18000

Order Quantity

Dis

trib

uto

r P

rofi

t


$0.00

$100,000.00

$200,000.00

$300,000.00

$400,000.00

$500,000.00

$600,000.00

6000 8000 10000 12000 14000 16000 18000

Order Quantity

Dis

trib

uto

r P

rofi

t

Distributor Profit (Wholesale Price $62, CS 33%)

$523,320


Supply Contracts

Distributor Manufacturer Supply ChainSequential Optimization 510,300 160,400 670,700 Payback 525,420 180,280 705,700 Cost Sharing 523,320 182,380 705,700



Stores



Selling Price=$125

Salvage Value=$20


Supply Contracts


Supply Chain Profit

$0.00

$100,000.00

$200,000.00

$300,000.00

$400,000.00

$500,000.00

$600,000.00

$700,000.00

$800,000.00

5,000 8,000 11,000 14,000 17,000

Quantity

Sy

stem

Pro

fit

($)


Supply Chain Profit

$0.00

$100,000.00

$200,000.00

$300,000.00

$400,000.00

$500,000.00

$600,000.00

$700,000.00

$800,000.00

5,000 8,000 11,000 14,000 17,000

Quantity

Sy

stem

Pro

fit

($)

$705,700


Supply Contracts

Strategy Distributor Manufacturer TotalSequential Optimization 510,300 160,400 670,700 Payback 525,420 180,280 705,700 Cost Sharing 523,320 182,380 705,700 Global Optimization 705,700


“Forecasts by electronics and telecom companies are often inflated.”

“Now, Selectron has $4.7 billion in inventory.”

Business Week, March 19, 2001

Forecast inflation


Shared Forecast Evolution Semiconductor Equipment Supply

Chain

1999 Q1 1999 Q2 1999 Q3 1999 Q4 2000 Q1 2000 Q2 2000 Q3 2000 Q4 2001 Q1 2001 Q2 2001 Q3 2001 Q4

Year and Quarter

1999 Q1

1999 Q2

1999 Q3

1999 Q4

2000 Q1

2000 Q2

2000 Q3

2000 Q4

2001 Q1

Actual

Source: Wharton: Intel Tool Order data over time


Objective

• Can we design contracts that achieve credible information sharing?


Supply Chain Time Line

• Manufacturer send a forecast to the supplier– Forecast maybe inflated– Difficult for the supplier to verify the

forecast ex-post

• Supplier build capacity• Manufacturer decides


Supply Contracts

• Capacity reservation contracts– Manufacturer pays to reserve a

certain level of capacity and an additional cost for executing orders


Capacity Reservation Contracts• Concave capacity reservation contract • Supplier delegates the decision right to the

Manufacturer

25

30

35

40

45

50

55

6 11 16 21

capacity

pri

ce


Supply Contracts

• Advance purchase contracts:– Supplier charges the advance

purchase price for orders placed prior to building capacity and a different price for orders placed when demand is realized


From Local to Global Optimization

Study used Inventory Analyst™

Safety Stock Cost vs. Quoted Lead Time

$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

$70,000

$80,000

$90,000

$100,000

0 20 40 60 80 100

Lead Time Quoted to Customer (days)

Saf

ety

Sto

ck C

ost

($/

year

)

Local Optimization

Global Optimization





$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

$70,000

$80,000

$90,000

$100,000

0 20 40 60 80 100


Saf

ety

Sto

ck C

ost

($/

year

)

Local Optimization

Global Optimization

For a given lead-time, the optimized supply chain provides reduced costs





$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

$70,000

$80,000

$90,000

$100,000

0 20 40 60 80 100


Saf

ety

Sto

ck C

ost

($/

year

)

Local Optimization

Global Optimization

For a given lead-time, the optimized supply chain provides reduced costs

For a given cost, the optimized supply chain

provides better lead-times


Waltham Oil Field

• Two Companies:– SLNR operates, lift and manage– Subcontractor to build the facility

Capacity Cost 000s

40,000 $290,000

50,000 $360,000

60,000 $420,000

70,000 $490,000

80,000 $550,000

90,000 $570,000


SLNR Facility Cost• Cost of building the facility

Facility Size Cost40,000 300,000,000.00$ 50,000 370,000,000.00$ 60,000 440,000,000.00$ 70,000 510,000,000.00$ 80,000 580,000,000.00$ 90,000 650,000,000.00$


Sequential Optimization

• SLNR to build a facility of size 80,000BPD– Expected NPV is $700M

• Subcontractor profit is $30M


Global Optimization

Facility Size 90,000BPD, System NPV = $750B

Expected Profit

$0

$100,000,000

$200,000,000

$300,000,000

$400,000,000

$500,000,000

$600,000,000

$700,000,000

$800,000,000

40,000 50,000 60,000 70,000 80,000 90,000

Expected Profit

Supply Contracts and Risk Management David Simchi-Levi Professor of Engineering Systems...

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