Supply Chain Management

Week 8: Supply Contracts

Tai Pham
Introduction

I Significant level of outsourcing

I Many leading brand OEMs outsource complete manufacturing

and design of their products

I More outsourcing has meant

I Search for lower cost manufacturers
I Development of design and manufacturing expertise by
suppliers

I Procurement function in OEMs becomes very important

I OEMs have to get into contracts with suppliers

I For both strategic and non-strategic components
Strategic Components

Supply Contract can include the following:

I Pricing and volume discounts.
I Minimum and maximum purchase quantities.
I Delivery lead times.
I Product or material quality.
I Product return policies.
2-Stage Sequential Supply Chain

I A buyer and a supplier.

I Buyer’s activities:
I generating a forecast
I determining how many units to order from the supplier
I placing an order to the supplier so as to optimize his own profit
I Purchase based on forecast of customer demand

I Supplier’s activities:
I reacting to the order placed by the buyer.
I Make-To-Order (MTO) policy
Swimsuit Example

I 2 Stages:
I a retailer who faces customer demand
I a manufacturer who produces and sells swimsuits to the
retailer.

I Retailer Information:
I Summer season sale price of a swimsuit is $125 per unit.
I Wholesale price paid by retailer to manufacturer is $80 per
unit.
I Salvage value after the summer season is $20 per unit

I Manufacturer information:
I Fixed production cost is $100, 000
I Variable production cost is $35 per unit
What Is the Optimal Order Quantity?
I Retailer marginal profit is the same as the marginal profit of
the manufacturer, $45.

I Retailer’s marginal profit for selling a unit during the season,

$45, is smaller than the marginal loss, $60, associated with
each unit sold at the end of the season to discount stores.

I Optimal order quantity depends on marginal profit and

marginal loss but not on the fixed cost.

I Retailer optimal policy is to order 12,000 units for an average

profit of $470, 700.

I If the retailer places this order, the manufacturer’s profit is

12, 000 × ($80 − $35) − $100, 000 = $440, 000
Sequential Supply Chain
Risk Sharing
I In the sequential supply chain:
I Buyer assumes all of the risk of having more inventory than
sales
I Buyer limits his order quantity because of the huge financial
risk.
I Supplier takes no risk.
I Supplier would like the buyer to order as much as possible
I Since the buyer limits his order quantity, there is a significant
increase in the likelihood of out of stock.

I If the supplier shares some of the risk with the buyer

I it may be profitable for buyer to order more
I reducing out of stock probability
I increasing profit for both the supplier and the buyer.

I Supply contracts enable this risk sharing

Buy-Back Contract

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

I Buyer has incentive to order more

I Supplier’s risk clearly increases.

I Increase in buyer’s order quantity

I Decreases the likelihood of out of stock
I Compensates the supplier for the higher risk
Buy-Back Contract: Swimsuit Example

I Assume the manufacturer offers to buy unsold swimsuits from

the retailer for $55.

I Retailer has an incentive to increase its order quantity to

14, 000 units, for a profit of $513, 800, while the
manufacturer’s average profit increases to $471, 900.

I Total average profit for the two parties = $985, 700 =

($513, 800 + $471, 900)

I Compare to sequential supply chain when total profit =

$910, 700 = ($470, 700 + $440, 000)
Buy-Back Contract: Swimsuit Example
Revenue Sharing Contract

I Buyer shares some of its revenue with the supplier

I in return for a discount on the wholesale price.

I Buyer transfers a portion of the revenue from each unit sold

back to the supplier
Revenue Sharing Contract: Swimsuit Example

I Manufacturer agrees to decrease the wholesale price from $80

to $60

I In return, the retailer provides 15 percent of the product

revenue to the manufacturer.

I Retailer has an incentive to increase his order quantity to

14, 000 for a profit of $504, 325

I This order increase leads to increased manufacturer’s profit of

$481, 375

I Supply chain total profit = $985, 700 = ($504, 325+$481, 375).

Revenue Sharing Contract: Swimsuit Example
Other Types of Contracts

I Quantity-Flexibility Contracts
I Supplier provides full refund for returned (unsold) items
I As long as the number of returns is no larger than a certain
quantity.

I Sales Rebate Contracts

I Provides a direct incentive to the retailer to increase sales by
means of a rebate paid by the supplier for any item sold above
a certain quantity.
Global Optimization: Swimsuit Example

I Relevant data
I Selling price, $125
I Salvage value, $20
I Variable production costs, $35
I Fixed production cost.
I Supply chain marginal profit, 90 = 125 − 35
I Supply chain marginal loss, 15 = 35–20
I Supply chain will produce more than average demand.
I Optimal production quantity = 16, 000 units
I Expected supply chain profit = $1, 014, 500.
Global Optimization: Swimsuit Example
Global Optimization and Supply Contracts
I Unbiased decision maker unrealistic
I Requires the firm to surrender decision-making power to an
unbiased decision maker

I Carefully designed supply contracts can achieve as much as

global optimization

I Global optimization does not provide a mechanism to allocate

supply chain profit between the partners.
I Supply contracts allocate this profit among supply chain
members.

I Effective supply contracts allocate profit to each partner in a

way that no partner can improve his profit by deciding to
deviate from the optimal set of decisions.
Implementation Drawbacks of Supply Contracts

I Buy-back contracts
I Require suppliers to have an effective reverse logistics system
and may increase logistics costs.
I Retailers have an incentive to push the products not under the
buy back contract.
I Retailer’s risk is much higher for the products not under the
buy back contract.

I Revenue sharing contracts

I Require suppliers to monitor the buyer’s revenue and thus
increases administrative cost.
I Buyers have an incentive to push competing products with
higher profit margins.
I Similar products from competing suppliers with whom the
buyer has no revenue sharing agreement.
Contracts for Make-to-Stock/Make-to-Order Supply
Chains

I Previous contracts examples were with Make-to-Order supply

chains

I What happens when the supplier has a Make-to-Stock

situation?
Supply Chain for Fashion Products: Ski-Jackets
Manufacturer produces ski-jackets prior to receiving
distributor orders
I Season starts in September and ends by December.
I Production starts 12 months before the selling season
I Distributor places orders with the manufacturer six months
later.
I At that time, production is complete; distributor receives firms
orders from retailers.
I The distributor sales ski-jackets to retailers for $125 per unit.
I The distributor pays the manufacturer $80 per unit.
I For the manufacturer, we have the following information:
I Fixed production cost = $100, 000.
I The variable production cost per unit = $55
I Salvage value for any ski-jacket not purchased by the
distributors= $20.
Profit and Loss
I For the manufacturer
I Marginal profit = $25
I Marginal loss = $60.
I Since marginal loss is greater than marginal profit, the
distributor should produce less than average demand, i.e., less
than 13, 000 units.

I How much should the manufacturer produce?

I Manufacturer optimal policy = 12, 000 units
I Average profit = $160, 400.
I Distributor average profit = $510, 300.

I Manufacturer assumes all the risk limiting its production

quantity

I Distributor takes no risk

Make-to-Stock: Ski Jackets
Pay-Back Contract

I Buyer agrees to pay some agreed-upon price for any unit

produced by the manufacturer but not purchased.

I Manufacturer incentive to produce more units

I Buyer’s risk clearly increases.

I Increase in production quantities has to compensate the

distributor for the increase in risk.
Pay-Back Contract: Ski Jacket Example

I Assume the distributor offers to pay $18 for each unit

produced by the manufacturer but not purchased.
I Manufacturer marginal loss = 55 − 20 − 18 = $17
I Manufacturer marginal profit = $25.
I Manufacturer has an incentive to produce more than average
demand.
I Manufacturer increases production quantity to 14, 000 units
I Manufacturer profit = $180, 280
I Distributor profit increases to $525, 420.
I Total profit = $705, 400
I Compare to total profit in sequential supply chain =
$670, 000 = ($160, 400 + $510, 300)
Cost-Sharing Contract

I Buyer shares some of the production cost with the

manufacturer, in return for a discount on the wholesale price.

I Reduces effective production cost for the manufacturer

I Incentive to produce more units
Cost-Sharing Contract: Ski-Jacket Example

I Manufacturer agrees to decrease the wholesale price from $80

to $62
I In return, distributor pays 33% of the manufacturer
production cost
I Manufacturer increases production quantity to 14, 000
I Manufacturer profit = $182, 380
I Distributor profit = $523, 320
I The supply chain total profit = $705, 700
Same as the profit under pay-back contracts
Cost-Sharing Contract: Ski-Jacket Example
Cost-Sharing Contract: Ski-Jacket Example (Cont.)
Implementation Issues

I Cost-sharing contract requires manufacturer to share

production cost information with distributor

I Agreement between the two parties:

I Distributor purchases one or more components that the
manufacturer needs.
I Components remain on the distributor books but are shipped
to the manufacturer facility for the production of the finished
good.
Global Optimization

I Relevant data:
I Selling price, $125
I Salvage value, $20
I Variable production costs, $55
I Fixed production cost.
I Cost that the distributor pays the manufacturer is meaningless
I Supply chain marginal profit, 70 = 125–55
I Supply chain marginal loss, 35 = 55–20
I Supply chain will produce more than average demand.
I Optimal production quantity = 14, 000 units
I Expected supply chain profit = $705, 700
Same profit as under pay-back and cost sharing contracts
Global Optimization (Cont.)
Contracts with Asymmetric Information

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

forecast

I Inflated forecasts from buyers a reality

I How to design contracts such that the information shared is

credible?
Two Possible Contracts

I Capacity Reservation Contract

I Buyer pays to reserve a certain level of capacity at the supplier
I A menu of prices for different capacity reservations provided by
supplier
I Buyer signals true forecast by reserving a specific capacity level

I Advance Purchase Contract

I Supplier charges special price before building capacity
I When demand is realized, price charged is different
I Buyer’s commitment to paying the special price reveals the
buyer’s true forecast
Contracts for Non-Strategic Components

I Variety of suppliers

I Market conditions dictate price

I Buyers need to be able to choose suppliers and change them

as needed

I Long-term contracts have been the tradition

I Recent trend towards more flexible contracts

I Offers buyers option of buying later at a different price than
current
I Offers effective hedging strategies against shortages
Long-Term Contracts

I Also called forward or fixed commitment contracts

I Contracts specify a fixed amount of supply to be delivered at

some point in the future

I Supplier and buyer agree on both price and quantity

I Buyer bears no financial risk

I Buyer takes huge inventory risks due to:

I uncertainty in demand
I inability to adjust order quantities.
Flexible or Option Contracts
I Buyer pre-pays a relatively small fraction of the product price
up-front

I Supplier commits to reserve capacity up to a certain level.

I Initial payment is the reservation price or premium.

I If buyer does not exercise option, the initial payment is lost.

I Buyer can purchase any amount of supply up to the option

level by:
I paying an additional price (execution price or exercise price)
I agreed to at the time the contract is signed
I Total price (reservation plus execution price) typically higher
than the unit price in a long-term contract.
Flexible or Option Contracts (Cont.)

I Provide buyer with flexibility to adjust order quantities

depending on realized demand

I Reduces buyer’s inventory risks.

I Shifts risks from buyer to supplier

I Supplier is now exposed to customer demand uncertainty.

I Flexibility contracts
I Related strategy to share risks between suppliers and buyers
I A fixed amount of supply is determined when the contract is
signed
I Amount to be delivered (and paid for) can differ by no more
than a given percentage determined upon signing the contract.
Spot Purchase

I Buyers look for additional supply in the open market.

I May use independent e-markets or private e-markets to select

suppliers.

I Focus:
I Using the marketplace to find new suppliers
I Forcing competition to reduce product price.
Portfolio Contracts

I Portfolio approach to supply contracts

I Buyer signs multiple contracts at the same time

I optimize expected profit
I reduce risk.

I Contracts
I differ in price and level of flexibility
I hedge against inventory, shortage and spot price risk.
I Meaningful for commodity products
I a large pool of suppliers
I each with a different type of contract.
Appropriate Mix of Contracts
I How much to commit to a long-term contract?
I Base commitment level.

I How much capacity to buy from companies selling option

contracts?
I Option level.

I How much supply should be left uncommitted?

I Additional supplies in spot market if demand is high

I Hewlett-Packard’s (HP) strategy for electricity or memory

products
I About 50% procurement cost invested in long-term contracts
I 35% in option contracts
I Remaining is invested in the spot market.
Risk Trade-Off in Portfolio Contracts
I If demand is much higher than anticipated
I Base commitment level + option level ¡ Demand,
I Firm must use spot market for additional supply.
I Typically the worst time to buy in the spot market
I Prices are high due to shortages.
I Buyer can select a trade-off level between price risk, shortage
risk, and inventory risk by carefully selecting the level of
long-term commitment and the option level.
I For the same option level, the higher the initial contract
commitment, the smaller the price risk but the higher the
inventory risk taken by the buyer.
I The smaller the level of the base commitment, the higher the
price and shortage risks due to the likelihood of using the spot
market.
I For the same level of base commitment, the higher the option
level, the higher the risk assumed by the supplier since the
buyer may exercise only a small fraction of the option level.
Risk Trade-Off in Portfolio Contracts