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SUPPLY CONTRACTS

Supply Chain Management 1112 supply contracts

Slide 1

Roel Leus

Sequential optimization vs. global optimization


Sequential Optimization

Procurement Planning

Manufacturing Planning

Distribution Planning

Demand Planning

Global Optimization
Supply Contracts/Collaboration/Information Systems and DSS

Procurement Planning

Manufacturing Planning

Distribution Planning

Demand Planning

Supply Chain Management 1112 supply contracts

Slide 2

Roel Leus

Supply contracts

A contract is an agreement between two parties. The raison dtre for contracts is two parties with conflicting objectives. Differences in costs at the buyer and supplier can lead to decisions that increase total supply chain costs. E.g.: replenishment order placed by the buyer. The buyers EOQ ignores the suppliers costs. A quantity discount contract may encourage the buyer to purchase a larger quantity. This may result in lower total supply chain costs. [ but misleading demand information because of order batching ] A contract is said to be coordinating a supply chain if the sum of the profits of various decision makers under the contract is globally optimal Important especially for strategic components, not for commodities. Last few years, significant increase in level of outsourcing; many leading brand-name manufacturers outsource complete manufacturing (to OEMs*) and design (to ODMs) of their products (Apple, Dell, Sony and Toshiba to Quanta). The procurement function in OEMs* becomes critical to remain in control of their destiny.
*http://en.wikipedia.org/wiki/Original_equipment_manufacturer
Slide 3 Roel Leus

Supply Chain Management 1112 supply contracts

Coordination

1. Contracts for MTO supply chains


2. Contracts for MTS 3. Other issues

SUPPLY CONTRACTS

Supply Chain Management 1112 supply contracts

Slide 4

Roel Leus

Case swimsuit production Chapter 2

Consider a company that designs, produces, and sells summer fashion items such as swimsuits. About six months before summer, the company must commit itself to specific production quantities. Demand is forecasted and certain probabilities are attached to specific quantities. Overestimating demand will result in unsold inventory while underestimating it will lead to inventory stockouts and loss of potential customers. The probabilistic forecast suggests that average customer demand is 13 100 units for the summer season.
Demand Scenarios
Demand Probability Weighted Demand

30%

8000 10000 12000 14000 16000 18000 Average

11% 11% 28% 22% 18% 10%

880 1100 3360 3080 2880 1800 13100

Probability

25% 20% 15% 10% 5% 0% 8000 10000 12000 14000 16000 18000 Sales

Supply Chain Management 1112 supply contracts

Slide 5

Roel Leus

Swimsuits
Chapter 2

Fixed Production Cost =$100,000 Variable Production Cost=$35

Wholesale Price =$80 Selling Price=$125 Salvage Value=$20


Manufacturer

Manufacturer DC

Retail DC

Stores
Supply Chain Management 1112 supply contracts Slide 6 Roel Leus

Swimsuits
Chapter 2 (2)

To start production, the manufacturer has to invest $100 000 independent of the amount produced. This is fixed production cost. The variable production cost per unit equals $80. During the summer season, the selling price of a swimsuit is $125 per unit. Any swimsuit not sold during summer is sold to a discount store for $20.

To identify the best production quantity, the firm needs to understand the relationship between the production quantity, customer demand, and profit. Suppose the manufacturer produces 10 000 units while demand realises at 12 000 units. Profit equals revenue from summer sales less variable and fixed production costs: Profit = 125 (10 000) 80 (10 000) 100 000 = $350 000 and the probability of realising this profit is 28%
Supply Chain Management 1112 supply contracts Slide 7 Roel Leus

Swimsuits
Chapter 2 (3)

In similar fashion, one can calculate the profit associated with each demand scenario, given that the manufacturer produces 10 000 swimsuits. This allows us to calculate the expected profit associated with producing 10 000 units.
Demand Probability Production = 10 000

8000 10000 12000 14000 16000 18000 Average

11% 11% 28% 22% 18% 10%

$140,000.00 $350,000.00 $350,000.00 $350,000.00 $350,000.00 $350,000.00 $326,900.00

We would like to find the production quantity that maximizes expected profit. Should the optimal production quantity be equal to, more than or less than the average demand? With $45 understocking cost vs. $60 overstocking cost, the best production quantity will probably be less than average demand for these particular cost parameters.
Supply Chain Management 1112 supply contracts Slide 8 Roel Leus

Swimsuits
Chapter 2 (4)

Expected profit is maximised for a production quantity of 12 000 units


Profit

Expected Profit
$370,700.00

$400,000 $350,000 $300,000 $250,000 $200,000 $150,000 $100,000 $50,000 $0 5000 6000 7000 8000 9000 10000 11000 12000 13000 14000 15000 16000 Production Quantity

We can also do this without graph:

Supply Chain Management 1112 supply contracts

Slide 9

Roel Leus

Swimsuits
Chapter 2 (5)

Let cu = 60, co = 45. We look for the smallest Q such that

Pr[D Q]

co 60 60 0.5714 co cu 60 45 105

Note that this probability is a measure of the risk the manufacturer is willing to take. We use an inequality in this case, because the demand scenarios we have are discrete, i.e. demand is not continuous.
Demand Probability Q Pr(D>Q)

8000 10000 12000 14000 16000 18000

0.11 0.11 0.28 0.22 0.18 0.10

8 000 10 000 12 000 14 000 16 000 18 000

0.89 0.78 0.50 0.28 0.10 0.00

(while average demand is 13 100)


Supply Chain Management 1112 supply contracts Slide 10 Roel Leus

Swimsuits
Chapter 2 (6)

As we increase the production quantity, the risk that is, the probability of large losses always increases. At the same time, the probability of large gains also increases. This is the risk/reward trade-off. This is clear from comparing the figures for production quantities 9 000 and 16 000, which bring about the same average profit but have a different risk profile.
Probability

Demand 8000 10000 12000 14000 16000 18000 Average Profit

Probability 11% 11% 28% 22% 18% 10%

Profit for a Given Production Level 9000 12000 16000 $200,000.00 $20,000.00 -$220,000.00 $305,000.00 $230,000.00 -$10,000.00 $305,000.00 $440,000.00 $200,000.00 $305,000.00 $440,000.00 $410,000.00 $305,000.00 $440,000.00 $620,000.00 $305,000.00 $440,000.00 $620,000.00 $293,450.00 $370,700.00 $294,500.00

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%
Revenue

Q=9000 Q=16000

Of course, a production quantity of 9 000 does not make much sense, since the probability of demand being equal to 9 000 is zero, unless we have an initial inventory of 1 000 and should bring it up to 10 000.
Slide 11 Roel Leus

Supply Chain Management 1112 supply contracts

Swimsuits
Chapter 2 (7)

Suppose now that the swimsuit under consideration is a model produced last year, and that the manufacturer has an initial inventory of 5 000 units. Assume that demand follows the same pattern as before. Fixed production costs ($100 000) are charged independent of the amount produced. Should the manufacturer start production and if so, how many swimsuits should be produced?
If nothing is produced, average profit is equal to the sales of the 5000 initial

inventory, where no fixed production cost and no variable production costs are taken into account: profit is 5000 125 = $625 000 If the manufacturer decides to produce to bring inventory to 12 000 units (what we found is the optimum), the profit he gains would be: 0.11(8000125 + 400020) + 0.11(10 000125 + 200020) + 0.28(12 000125 + 020) + 0.22(12 000125 + 020) + 0.18(12 000125 + 020) + 0.10(12 000125 + 020) 700080 100 000 = $770 700 In conclusion: the optimal policy is to produce 7000 = 12000 5000 units
Supply Chain Management 1112 supply contracts Slide 12 Roel Leus

Case swimsuit production Chapter 4

In the analysis of the case in Chapter 2 it is assumed that the manufacturer has adequate supply of raw materials, delivered on time. In order to ensure this, buyers and suppliers agree on supply contracts. Supply contracts are very powerful tools that can be used for far more than to ensure adequate supply of, and demand for goods. In a supply contract, the buyer and the supplier may agree on:
Pricing and volume discounts. Minimum and maximum purchase quantities. Delivery lead times. Product or material quantity. Product return policies.

We assume now that there are two companies involved in the supply chain: a retailer who faces customer demand and a manufacturer. Demand follows the same pattern as before.

Supply Chain Management 1112 supply contracts

Slide 13

Roel Leus

Swimsuits
Chapter 4

Fixed Production Cost =$100,000 Variable Production Cost=$35

Wholesale Price =$?? Selling Price=$125 Salvage Value=$20


Manufacturer

Manufacturer DC

Retail DC

Stores
Supply Chain Management 1112 supply contracts Slide 14 Roel Leus

Case swimsuit production (cntd)

For the retailer:


Selling price of swimsuit during the summer season: $125
Wholesale price paid to the manufacturer: $80 Salvage value: $20

For the manufacturer:


Fixed production cost: $100 000
Variable production cost: $35

Seller
fixed production cost: 100 000 wholesale price: 80

Buyer
selling price: 125

Manufacturer
variable production cost: 35

Retailer

salvage value: 20

Supply Chain Management 1112 supply contracts

Slide 15

Roel Leus

Case swimsuit production (cntd)

Marginal profit (understocking cost) for both actors are:


retailer: 125 80 = $45
manufacturer: 80 35 = $45

Retailers marginal cost (overstocking cost) is 80 20 = $60 and following the analysis of the case in Chapter 2, it is optimal for the retailer to order 12 000 swimsuits. Expected profit of retailer = 370 700 (supra) + 100 000 = $470 700 Expected profit of manufacturer = 12 000 (80 35) 100 000 = $440 000 Total for Supply Chain = 470 700 + 440 000 = $910 700

In the previous example, we had a sequential supply chain, where the manufacturer reacts to decisions made by the retailer. The retailer bears all risk (of having excess inventory), the supplier does not bear any risk. It is natural to look for mechanisms that the supply chain parties can use to improve profits, which means they would move to global optimization.
Slide 16 Roel Leus

Supply Chain Management 1112 supply contracts

Swimsuit production
Buy-back contract
Buy-back contracts the seller (manufacturer) agrees to buy back unsold goods from the buyer (retailer) for some agreed-upon price. Suppose the manufacturer offers to buy unsold swimsuits from the retailer for $55. The retailer can either salvage goods, or the manufacturer will buy them back and salvage them himself. Such a construction is valuable when the increase in order quantity placed by the retailer more than compensates the suppliers increase in risk.

Item Price

Seller 100 000 35 20


Supply Chain Management 1112 supply contracts

Buyer

Retailer sells for: Manufacturer sells for: Salvage: Manufacturer buy back: Fixed Production Cost: Variable Production Cost:

$125.00 $80.00 $20.00 $55.00 $100,000.00 $35.00

80
55

125

Slide 17

Roel Leus

Swimsuit production
Buy-back contract (2)

profit retailer:
demand = 12 000, order level = 10 000

profit = min{10 000, 12 000}*125 10 000 * 80 + max{10 000 12 000, 0}*max{20, 55} = 10 000 * 125 10 000 * 80 + 0 * 55 = 1 250 000 800 000 = $450 000
demand = 12 000, order level = 14 000

profit = min{14 000, 12 000}*125 14 000 * 80 + max{14 000 12 000, 0}*max{20, 55} = 12 000 * 125 14 000 * 80 + 2 000 * 55 = 1 500 000 1 120 000 + 110 000 = $490 000

Retailers expected profit:


Demand 8000 10000 12000 14000 16000 18000 Expected Profit Probability 11% 11% 28% 22% 18% 10% 8000 $360,000.00 $360,000.00 $360,000.00 $360,000.00 $360,000.00 $360,000.00 $360,000.00 Profit for a Given Retailer Order Level 10000 12000 14000 $310,000.00 $260,000.00 $210,000.00 $450,000.00 $400,000.00 $350,000.00 $450,000.00 $540,000.00 $490,000.00 $450,000.00 $540,000.00 $630,000.00 $450,000.00 $540,000.00 $630,000.00 $450,000.00 $540,000.00 $630,000.00 $434,600.00 $493,800.00 $513,800.00
Slide 18

16000 $160,000.00 $300,000.00 $440,000.00 $580,000.00 $720,000.00 $720,000.00 $503,000.00


Roel Leus

Supply Chain Management 1112 supply contracts

Swimsuit production
Buy-back contract (3)

profit manufacturer:
demand = 14 000, order level = 12 000

profit = 12 000 * 80 100 000 12 000 * 35 max{12 000 14 000, 0} * (55 20) [ aangezien 55 > 20 ] = 960 000 100 000 420 000 0 = $440 000 demand = 10 000, order level = 14 000 profit = 14 000 * 80 100 000 14 000 * 35 max{14 000 10 000, 0} * (55 20) = 1 120 000 100 000 490 000 4 000*55 + 20*4 000 =120 000 100 000 490 000 220 000 + 80 000 = $390 000

Manufacturers expected profit:


Demand 8000 10000 12000 14000 16000 18000 Expected Profit Probability 11% 11% 28% 22% 18% 10% 10000 $280,000.00 $350,000.00 $350,000.00 $350,000.00 $350,000.00 $350,000.00 $342,300.00 Profit for a Given Retailer Order Level 12000 14000 16000 $300,000.00 $320,000.00 $340,000.00 $370,000.00 $390,000.00 $410,000.00 $440,000.00 $460,000.00 $480,000.00 $440,000.00 $530,000.00 $550,000.00 $440,000.00 $530,000.00 $620,000.00 $440,000.00 $530,000.00 $620,000.00 $416,900.00 $471,900.00 $511,500.00
Slide 19

18000 $360,000.00 $430,000.00 $500,000.00 $570,000.00 $640,000.00 $710,000.00 $538,500.00


Roel Leus

Supply Chain Management 1112 supply contracts

Swimsuit production
Buy-back contract (4)

Retailer: profit from $470 700 to $513 800; quantity from 12 000 to 14 000 Manufacturer: profit from $440 000 to $ 471 900. The total average profit increases from $910 700 with sequential optimization to $985 700 (= $ 513 800 + $471 900) with buy-back contract The buy-back contract is effective because it allows the manufacturer to share some of the risk and thus incites the retailer to increase order quantity
Profit ($)
$1200000,000 $1000000,000 $800000,000

retailer's profit
$600000,000

manufacturer's profit total profit

$400000,000
$200000,000 $,000 5000,0

8000,0

11000,0

14000,0

17000,0

Quantity
Supply Chain Management 1112 supply contracts Slide 20 Roel Leus

Buyback

Downsides:
effective reverse logistics needed
Incentive for retailer for selling competing products Surplus inventory for the supplier that must be disposed of, which increases

supply chain costs Inflated retail orders, not actual customer demand

Most effective for products with low variable cost, such as music, software, books, magazines and newspapers so that
profit margin is high, product availability is critical
consequence of suppliers surplus inventory is little (or proof of destruction)

Which of these are true? Buyback contract increases the expected supply chain profit / supplier profit / retailer profit / sales to the market / sales to the retailer / demand

Supply Chain Management 1112 supply contracts

Slide 21

Roel Leus

Swimsuit production
Revenue-sharing contract

In the sequential supply chain, one important reason for the retailer to order only 12 000 units is the high wholesale price. If somehow the retailer can convince the manufacturer to reduce the wholesale price, then clearly the retailer would order more. Of course, price reduction will decrease manufacturers profit if the retailer is unable to sell more units. This issue is addressed by revenue-sharing contracts. Suppose the swimsuit manufacturer and retailer have a revenue-sharing contract with the following conditions: the manufacturer reduces the price he charges from $80 to $60 and the retailer transfers 15% of the sales revenue back to the manufacturer in return.
8060
Item Price

Seller
Manufacturer Transfer

Buyer
Retailer

Retailer sells for: Manufacturer sells for: Salvage: Revenue Sharing: Fixed Production Cost: Variable Production Cost:

$125.00 $60.00 $20.00 15% $100,000.00 $35.00

15% of sales revenue


Supply Chain Management 1112 supply contracts Slide 22 Roel Leus

Swimsuit production
Revenue-sharing contract (2)

Profit retailer:
demand = 12 000, order level = 10 000

profit = min{10 000,12 000}*125*85% 10 000*60 + max{10 000 12 000,0}*20 = 1 062 500 600 000 = $462 500 demand = 12 000, order level = 14 000 profit = min{14 000, 12 000)*125*85% 14 000*60 + max{14 000 12 000, 0}*20 = 1 275 000 840 000 + 40 000 = $475 000

Retailers expected profit:


Demand 8000 10000 12000 14000 16000 18000 Expected Profit Probability 11% 11% 28% 22% 18% 10% 8000 $370,000.00 $370,000.00 $370,000.00 $370,000.00 $370,000.00 $370,000.00 $370,000.00 Profit for a Given Retailer Order Level 10000 12000 14000 $290,000.00 $210,000.00 $130,000.00 $462,500.00 $382,500.00 $302,500.00 $462,500.00 $555,000.00 $475,000.00 $462,500.00 $555,000.00 $647,500.00 $462,500.00 $555,000.00 $647,500.00 $462,500.00 $555,000.00 $647,500.00 $443,525.00 $498,075.00 $504,325.00
Slide 23

16000 $50,000.00 $222,500.00 $395,000.00 $567,500.00 $740,000.00 $740,000.00 $472,625.00


Roel Leus

Supply Chain Management 1112 supply contracts

Swimsuit production
Revenue-sharing contract (3)

Profit manufacturer:
demand = 10 000, order level = 12 000

profit = 12 000*60 100 000 12 000*35 + min{12 000,10 000}*125*15% = 720 000 100 000 420 000 + 187 500 = $387 500
demand = 12 000, order level = 10 000

profit = 10 000*60 100 000 10 000*35 + min{10 000, 12 000}*125 *15% = 600 000 100 000 350 000 + 187 500 = $337 500

Manufacturers expected profit:


Demand 8000 10000 12000 14000 16000 18000 Expected Profit Probability 11% 11% 28% 22% 18% 10% 10000 $300,000.00 $337,500.00 $337,500.00 $337,500.00 $337,500.00 $337,500.00 $333,375.00 Profit for a Given Retailer Order Level 12000 14000 16000 $350,000.00 $400,000.00 $450,000.00 $387,500.00 $437,500.00 $487,500.00 $425,000.00 $475,000.00 $525,000.00 $425,000.00 $512,500.00 $562,500.00 $425,000.00 $512,500.00 $600,000.00 $425,000.00 $512,500.00 $600,000.00 $412,625.00 $481,375.00 $541,875.00
Slide 24

18000 $500,000.00 $537,500.00 $575,000.00 $612,500.00 $650,000.00 $687,500.00 $595,625.00


Roel Leus

Supply Chain Management 1112 supply contracts

Swimsuit production
Revenue-sharing contract (4)

Retailer: profit from $470 700 to $504 325; quantity from 12 000 to 14 000 Manufacturer: profit from $440 000 to $ 481 375. The total average profit increases from $910 700 in the sequential supply chain to $985 700 (= $504 325 + $481 375) with the revenue-sh. contract. The reduction of the wholesale price coupled with revenue sharing leads to increased profits for both parties.
Profit ($)
$1200000,000 $1000000,000 $800000,000 $600000,000 $400000,000 $200000,000 $,000 5000,0

retailer's profit manufacturer's profit total profit

8000,0

11000,0

14000,0

17000,0

Quantity
Supply Chain Management 1112 supply contracts Slide 25 Roel Leus

Revenue sharing

The buyer pays a minimal amount for each unit purchased from the supplier but shares a fraction of the revenue for each unit sold Decreases the cost per unit charged to the retailer, which effectively decreases the cost of overstocking When the overstocking cost drops, retailers order quantity rises Misleading for the supply chain as it reacts to (inflated) retail orders, not to actual customer demand Supplier needs to monitor buyers revenue Incentive for buyer for pushing competing products with higher margins

Supply Chain Management 1112 supply contracts

Slide 26

Roel Leus

Blockbuster case

Demand for a newly released movie typically starts high and decreases rapidly; peak demand lasts about 10 weeks
Blockbuster purchases a copy from a studio for $65 and rents for $3.

Blockbuster (retailer) must rent the tape at least 22 times before earning profit Retailers cannot justify purchasing a movie (cassette) by covering the peak demand. In 1998, 20% of surveyed customers reported that they could not rent the movie they wanted because the Blockbuster stores did not have that movie.

In 1998, Blockbuster started revenue sharing with the major movie studios
Studio charges $8 per copy. Blockbuster (retailer) shares a portion (30-45%) of of the sales revenue (rental

income) with the supplier Even if Blockbuster keeps only half of the rental income, the breakeven point is 6 rentals per copy The impact of revenue sharing on Blockbuster was dramatic. Rentals increased by 75% in test markets due to higher video availability. Market share increased from 25% to 31% (the 2nd largest retailer only has 5% market share)
Supply Chain Management 1112 supply contracts Slide 27 Roel Leus

Swimsuit production
Global optimization

Rather than investigate contracts modifying initial sales terms between two parties, we now consider supplier and buyer as two partners / two members of the same organization. In other words: we ignore the transfer of money between the parties and an unbiased decision maker will maximize the supply-chain profit. The only relevant data in this case are the selling price, the salvage value, the variable production costs, and the fixed production costs. The cost that the manufacturer charges the retailer becomes meaningless, since we consider them as one and we are only interested in external costs and revenues.
Seller 100 000 35 80 Buyer 125 20

Manufacturer

Retailer

Supply Chain Management 1112 supply contracts

Slide 28

Roel Leus

Swimsuit production
Global optimization (2)

Fixed Production Cost =$100,000 Variable Production Cost=$35

Wholesale Price =$80 Selling Price=$125 Salvage Value=$20


Manufacturer

Manufacturer DC

Retail DC

Stores
Supply Chain Management 1112 supply contracts Slide 29 Roel Leus

Swimsuit production
Global optimization (3)

Evidently, the supply chain marginal profit of 90 (= 125 35) is significantly higher than the marginal loss of 15 (= 35 20), and hence the supply chain will probably produce more than average demand.
Item Price

Retailer sells for: Salvage: Fixed Production Cost: Variable Production Cost:

$125.00 $20.00 $100,000.00 $35.00

Overall profit: Stel demand = 10 000, order level = 12 000: profit = min{12 000,10 000}*125 12 000 * 35 100 000 + max{12 000 10 000, 0}*20 = 10 000*125 12 000*35 100 000 + 2 000*20 = 1 250 000 420 000 100 000 + 40 000 = $770 000

Supply Chain Management 1112 supply contracts

Slide 30

Roel Leus

Swimsuit production
Global optimization (4)

System Profit ($)


$1,200,000.00 $1,000,000.00 $800,000.00 $600,000.00 $400,000.00 $200,000.00 $0.00 5,000

Profit vs Order Quantity

6,000

7,000

8,000

9,000 10,000 11,000 12,000 13,000 14,000 15,000 16,000 17,000 18,000

Quantity

Supply Chain Management 1112 supply contracts

Slide 31

Roel Leus

Swimsuit production
Global optimization (5)
Demand 8000 10000 12000 14000 16000 18000 Expected Profit Probability Profit for a Given Order Level 10000 12000 14000 11% $590,000.00 $560,000.00 $530,000.00 11% $800,000.00 $770,000.00 $740,000.00 28% $800,000.00 $980,000.00 $950,000.00 22% $800,000.00 $980,000.00 $1,160,000.00 18% $800,000.00 $980,000.00 $1,160,000.00 10% $800,000.00 $980,000.00 $1,160,000.00 $776,900.00 $910,700.00 $985,700.00 16000 $500,000.00 $710,000.00 $920,000.00 $1,130,000.00 $1,340,000.00 $1,340,000.00 $1,014,500.00 18000 $470,000.00 $680,000.00 $890,000.00 $1,100,000.00 $1,310,000.00 $1,520,000.00 $1,005,500.00

Or

Pr[D Q]
Demand

co 15 15 0.1429 co cu 15 90 105
Q Pr(D>Q)

Probability

8000 10000 12000 14000 16000 18000

0.11 0.11 0.28 0.22 0.18 0.10

8 000 10 000 12 000 14 000 16 000 18 000

0.89 0.78 0.50 0.28 0.10 0.00

The risk the manufacturer can take should be smaller than 0.1429. The first smaller value is 0.10 and it corresponds to production quantity of 16 000. This is exactly the result we got using expected profit as a measure. In this global optimization strategy, the optimal production quantity is 16 000, which implies an expected supply chain profit of $1 014 500.
Supply Chain Management 1112 supply contracts Slide 32 Roel Leus

Swimsuit production
Globally optimal buy-back contract

The difficulty with global optimization is that it requires the firm to surrender decision-making power to an unbiased (external) decision maker. It can be shown, however, that carefully designed supply contracts achieve exactly the same profit as global optimization.

Illustration: See Excel-sheet DMSCe3.xls Buy back (bis): the retailer can either salvage goods or the manufacturer will buy them back and salvage himself. Consider these parameters:
Item Price

Retailer sells for: Manufacturer sells for: Salvage: Manufacturer buy back: Fixed Production Cost: Variable Production Cost:

$125.00 $75.00 $20.00 $65.00 $100,000.00 $35.00

The wholesale price has decreased from $80 to $75 and the buy back value has increased from $55 to $65. In this case, the retailers individual optimum quantity and the globally optimum quantity coincide.
Supply Chain Management 1112 supply contracts Slide 33 Roel Leus

Other constructions

Quantity-flexibility contracts = buy back with full refund / allows the buyer to modify the order (within limits) as demand visibility increases towards the point of sale
Better matching of supply and demand

Increased overall supply chain profits if the supplier has flexible capacity
Lower levels of misleading demand information than either buyback contracts

or revenue sharing contracts Benetton: 40% allowance on colors, 10% on aggregate quantity across colors; guaranteed portion is manufactured by Benetton with an inexpensive but longlead-time process; the flexible part (about 35%) is manufactured using postponement

Sales rebate contracts = rebate beyond certain quantity

Supply Chain Management 1112 supply contracts

Slide 34

Roel Leus

1. Contracts for MTO supply chains


2. Contracts for MTS 3. Other issues

SUPPLY CONTRACTS

Supply Chain Management 1112 supply contracts

Slide 35

Roel Leus

MTS instead of MTO


Fashion item ski jackets Short life cycles, one production opportunity Same data as before, but now MTS at supplier Time line:

Jan 00 Design Feb 00 Sep 00

Jan 01 Production Feb 01

Jan 02 Retailing Sep 01

Distributor places order

Contrary to the swimsuit example, the supplier now assumes all of the risk of building more capacity than sales!
Slide 36 Roel Leus

Supply Chain Management 1112 supply contracts

Ski jackets

It is now the manufacturer who needs to decide a (production) quantity, and thus faces a newsboy problem: lowest Q such that Pr[ D Q ] 0.2941 ?
Item Price
Demand Probability 8000 11% 10000 11% 12000 28% 14000 22% 16000 18% 18000 10%

Manufacturer sells for: Distributor sells for: Salvage: Fixed Production Cost: Variable Production Cost:

$80,00 $125,00 $20,00 $100.000,00 $55,00

Q = 12 000

Again, a variety of supply contracts enable risk sharing and hence reduce manufacturers risk and motivate him to increase production.
Pay-back contract: buyer pays a price for each unit produced but not purchased Cost-sharing contract: the buyer shares some of the production cost (e.g. set %)

in return for a discount on the wholesale price An issue here is the sharing of production-cost information. A possible solution to this is for the retailer to purchase one or more components. Again, globally optimal solutions can be achieved
Supply Chain Management 1112 supply contracts Slide 37 Roel Leus

1. Contracts for MTO supply chains


2. Contracts for MTS 3. Other issues

SUPPLY CONTRACTS

Supply Chain Management 1112 supply contracts

Slide 38

Roel Leus

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?

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

Supply Chain Management 1112 supply contracts

Slide 39

Roel Leus

Contracts for non-strategic components

Traditionally, buyers have focused on long-term contracts for many of their purchasing needs Recently, trend towards more flexible contracts for non-strategic components:
Variety of suppliers
Market conditions dictate price Flexibility more important than long-term relationship:

Reduce supply chain costs Be more responsive and flexible to market conditions

Effective procurement strategy for commodity products has to focus on both driving costs down and reducing risks:
Inventory risk due to uncertain demand
Price, or financial, risk due to volatile market price Shortage risk due to limited component availability

Supply Chain Management 1112 supply contracts

Slide 40

Roel Leus

Contracts for non-strategic components (2)

Long-term contract = forward contract = fixed-commitment contract


Supplier and buyer agree on both price and quantity (at a future time)
Buyer bears no financial risk but takes huge inventory risks

Option contract:
Supplier commits to reserve capacity up to a certain level reservation price / premium up front Buyer can purchase any amount of supply up to the option level

(execution price or exercise price) flexible contract: fixed amount of supply; can differ by given %

Spot market:
Additional supply in the open market; here and now

Supply Chain Management 1112 supply contracts

Slide 41

Roel Leus

Contracts for non-strategic components (3)

Portfolio approach to supply contracts: appropriate mix of the foregoing:


Base commitment = long-term contracts;
option level = options;

remainder = uncommitted

50% 35% (Hewlett-Packard) rest

base commitment level


LOW HIGH Inventory risk for buyer n/a

option level

LOW HIGH

Price & shortage risks for buyer Inventory risk for supplier

Supply Chain Management 1112 supply contracts

Slide 42

Roel Leus