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Jishnu Hazra, IIMB
Contracts in Supply Chain
Jishnu Hazra, IIMB
Contracts in Supply Chain Using Contracts to Manage Supply Chain Demand
Risk
Demand Risk
Supply Risk
Price/Currency Risk
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Two-Player Supply Chain
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A Buyer and a Supplier. Buyers (Retailer) 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 (or Manufacturer) activities: reacting to the order placed by the buyer. Make-To-Order (MTO) policy
Retailer-Manufacturer Coordination
Manufacturers Production cost is Rs. 30/unit
Wholesales Price to Retailer is Rs. x/unit
Retailers selling price is Rs. 100/unit
Salvage value (unsold units) Rs. 20/unit
R=100; W=x; S=20; M=30;
Mean Demand = 1000; Std dev =300; Assume
Normal Distribution
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I use the term Manufacturer or Supplier interchangeably;
Similarly Retailer or Buyer is used interchangeably
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Retailer-Manufacturer Coordination
Sequence of events: Manufacturer chooses a wholesale price W.
Retailer chooses a purchase quantity Q.
Manufacturer produces the Q units at cost =M Q
Retailer offers Q in the market but Demand is
RandomN(1000,300)
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Retailer-Manufacturer Coordination
As a Manufacturer what wholesale price W
will you choose?
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Retailer-Manufacturer Coordination
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[ ]
)()()(
)(Pr
WQMWW
SR
WRWQD
M =
=
Manufacturers Expected Profit
Quantity bought by Retailer Q is a function of W
Newsvendor problem
Expected Profit as a Function of Wholesale Price
Jishnu Hazra, IIMB
Whalesale Retailer's Expected Retailer's Mfg's SC
price Qty Sales profits profits profits
30 1345 981 65060 0 65060
40 1202 955 52373 12023 64396
50 1096 922 40899 21912 62811
60 1000 880 30425 30000 60425
70 904 826 20899 36176 57076
80 798 753 12373 39883 52256
90 655 636 5060 39294 44353
100 0 0 0 0 0
Manufacturers maximum
profit happens at a wholesale
price between 80 and 90
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Retailer- Manufacturer Coordination
Manufacturer would choose W to maximize his
Profits Manufacturers Profit = (W-M)*Q(W)
Q(W) is decided by the Retailer
Profit maximizing Wholesale Price for the
Manufacturer is Rs. 84/unit
Manufacturers profit is Rs. 40366
Retailer would procure Q* = 748 units
Retailers profit = Rs. 9281
Total Supply Chain profit is Rs. 49,647
Jishnu Hazra, IIMB
From the
Newsvendor Model
Retailer-Manufacturer Coordination
Can we do better?
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A Coordinated Strategy
What is the best strategy for the entire
supply chain?
Consider a Hypothetical case:
Treat both Manufacturer and Retailer as one
entity: An Integrated Firm
Transfer of money between the parties is
ignored
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Retailer-Manufacturer Coordination: A Coordinated Strategy
What would an Integrated Firm do?
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Retailer-Manufacturer Coordination: A Coordinated Strategy
What would an Integrated Firm do?
Assume a single firm
R=100; W=x; S=20; M=30
Q* = 1345 units
Expected Profit = Rs. 65,059
31% more Profit than the two-firm supply
chain (or two decision-makers)
Jishnu Hazra, IIMB
Jishnu Hazra, IIMB
Local Optimization
Each entity (Manufacturer and Retailer) tries
to optimize its own profit function without
caring about the impact on the other player or
on the total supply chain
Manufacturer chooses W> C, which is too
high
Retailers order quantity is too low because
the Manufacturer does not consider the
Retailers risk
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Retailer-Manufacturer Coordination: A Coordinated Strategy
How do you ensure the retailer orders the
same quantity as a optimal single firm?
Unbiased decision-maker unrealistic Requires the firm to surrender decision-making power
to an unbiased decision maker (eg, Barilla case)
Jishnu Hazra, IIMB
Jishnu Hazra, IIMB
Refer to WSJ article on Blockbuster (on Moodle)
Blockbuster purchases a DVD for $65
(from producers) and rents it at $3
Subsequently, price reduction of video from
$65 to $8 and revenue sharing of 30-45%
with Rental companies.
Rentals increased by 75% in test markets;
Market share and cash flow increased.
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Bollywood suffers Rs 50 crore loss due to strike At issue is the producers' demand for a 50 percent
share of revenue earned from their film, following
practice in other countries Multiplex owners have agreed to give producers 50%,
42.5%, 37.5% and 30% of the total box-office
collections in the first, second, third and fourth week,
respectively
If the net box-office collections of a film, after
deducting entertainment tax, exceeds Rs 17.5 crore the
first two weeks terms would be increased by 2.5%
If a films collections net less than Rs 10 crore, the
second and third weeks terms would be brought down
by 2.5%Jishnu Hazra, IIMB
Jishnu Hazra, IIMB
Revenue Sharing Model
Vendor Buyer
R: unit revenue
W: Vendors Unit Price
C: unit cost
S: Salvage Value
for unsold units
Q: Quantity bought by buyer
Fraction of unit revenue retained by the buyer:
R)1(
D: Demand
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Revenue Sharing Model
Fraction of unit revenue retained by the buyer:
Unit Cost: Production cost for Supplier
Unit Cost 30
Retail Price 100
Wholesale Price 30
Salvage Value 20
Mean Demand 1000
Please note, I have assumed the Salvage revenue
goes to the Retailer; it need not be the case
Revenue Sharing Model
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Std Dev 300
Delta /S Price Order Quantity Retailer's Profit Supplier's profit Total profit
0.5 30 1129 16728 46700 63427
0.6 30 1202 26187 38210 64397
0.7 30 1252 35801 28995 64796
0.8 30 1290 45503 19468 64971
0.95 30 1320 55261 9781 65042
1 84 748 9281 40366 49647
)( A
cceptable
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Revenue Sharing Model
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Delta W/S Price Retailer's Profit Supplier's profit Total profit
0.4 25 13093 51303 64397
0.5 25 22751 42220 64971
0.6 25 32530 32530 65060
0.7 25 42368 22652 65019
0.8 25 52240 12697 64937
1 84 9281 40366 49647
Std Dev: 300
Acceptable
Combination of (Delta) and Wholesale Pricewill determine the Supply Chain profit split
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Revenue Sharing in Practice
Telecom operator distributing music, video, ringtones to end consumers
Ring tones account for $ 3.5 billion in 2004
Revenue sharing in the Indian Malls: Real EstateOwner and the Stores
If both parties are better off why isnt everybody
using it?
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Jishnu Hazra, IIMB
Uncertain Demand & Long Lead-time
In 2006 Jet Airways forecasts high demand in passenger
traffic over the next 10 years. In an optimistic scenario
requirement for upto 20 jets is forecasted in 2015. Each jet
costs around $75 million in 2006.
June 2009: We (Jet Airlines) had ordered 20 Boeing 777s of
which 10 aircraft were options. We are not exercising these
options and have decided to pull out aircraft from routes
where we had multiple frequencies, Goyal said on the side
lines of an industry conference here.
Jishnu Hazra, IIMB
Newsboy with Options
Buyer purchases Q options atRs. C/unit
Buyer gets Demand Information and orders
Z ( Q) units at price Rs.x
Buyers profit:
Suppliers Profit:
Notations:R-revenue, S-salvage value,M-
manufacturing cost
]),min()[()( CQQDxREQb =
)],0max(),min()[()( DQSQDxQMCEQm ++=
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Jishnu Hazra, IIMB
Newsboy with Options
Ck
CxRk
Define
Qwhere
xRCxRQD
o
u
=
=
=
buytoOptionsofnumberoptimumtheis
)Pr(
Opportunity Cost of buying too few options
Cost of buying too many options
Jishnu Hazra, IIMB
An Example
R=100; S=20; M=30;
Mean Demand = 1000; Std dev =300
Case I: No Options
Suppliers Profit=40,366; Buyers Profit =9281; SC Profit = 49,647
Case II: Single Firm; Profit = 65,059
Case III: With Options: C=3;X=76 Buyers Profit=19,518; Suppliers Profit
=45,542; SC Profit =65059
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Jishnu Hazra, IIMB
Risk Sharing
Options provide a tool for the buyer to manage
demand uncertainty
Firm orders for demand relatively sure to sell
Options for products less likely to be needed
Hedge against both overstocking and understocking
risks
Pay a premium (over wholesale price) to purchase
options
Options also benefit the supplier
Inducing the buyer to purchase more products
Must hold inventories for options
Bottom-line: both parties are better off
Return Policy Allows a retailer to return unsold inventory (maybe up
to a specified amount) at an agreed upon price
Increases the optimal order quantity for the retailer,resulting in higher product availability and higherprofits for both the retailer and the supplier
Downside that buyback contract results in Surplus inventory for the supplier that must be disposed of,
which increases supply chain costs
Maybe misleading for the supply chain as it reacts to (inflated)retail orders, not actual customer demand
Most effective for products with low variable cost,such as music, software, books, magazines, andnewspapers
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Jishnu Hazra, IIMB
Why Return Policy?
Supplier is less risk averse than retailers Supplier faces less demand uncertainty than
retailers
Supplier may have a higher salvage value
Avoid selling expired products to end customers
Safeguard the brand
Induces supplier to promote the product
Ensures supplier do not introduce new versions
too soon
Jishnu Hazra, IIMB
Returns or Buyback
Supplier Chooses a wholesale price Wand
buyback percentage b.
Retailer orders Q units from the Supplier
Suppliers unit production cost is c and ships Q
Retailer sets the retail pricePand stochastic
demand occurs
Unsold units are returned to supplier and retailer
receives bWper unit.
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Unit Cost 30
Retail Price 100
Wholesale Price 30
Salvage Value 20
Mean Demand 1000
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Buyback Price 71.421
Wholesale Order Retailer's Supplier's Total
Price Quantity Profits Profits Profits
75 23233 41827 65060
80 17018 46837 63856
85
11586 49382 6096890 6825 49428 56252
95 2790 45319 48109
Acceptable to
both parties
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Quantity Flexibility (QF)
Some flexibility issues come into play when a majorcustomer orders 250,000 unforecasted custom
semiconductors and needs them in three weeks.Though our company strives for service andcustomer satisfaction, it is important to determinewho bears the extra cost, with large unforecastedorders. Unfortunately, these issues ofunforecasted demand and costs are real. Eddie
Maxie, VP Global Supply Base Management,SOLECTRON
Quantity Flexibility (QF)
The buyer (retailer) orders Q* units
The supplier will commit to produce
The buyer commits to procure
,are negotiated,
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)1(* +=QQ
)1(* =Qq
10
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Quantity Flexibility (QF)
Manufacturing Cost 30
Wholesale Price 84
Retail Price 100
Salvage Value 20
Mean Demand 1000
Std Deviation 300
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QF Contract
Retailer's Manuf SCM
W/S Price Alpha Beta Order Size q Q Profit Profit Profit
84 0 0 748 748 748 9281 40392 49673
84 0.2 0.2 1050 840 1260 11884 52955 64839
84 0.25 0.25 1050 788 1313 12926 52103 65029
Ignore the Mathematics of the
QF Contracts; it is slightly involved
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Summary
Increased Demand Uncertainty leads to
Higher Risk for one or more players in the
Supply Chain
The goal is to design Contracts that can lead
to sharing of risks/benefits among different
players in the Supply Chain