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

Jishnu Hazra, IIMB

Two-Player Supply Chain

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

Jishnu Hazra, IIMB

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
I use the term Manufacturer or Supplier interchangeably;
Similarly Retailer or Buyer is used interchangeably
Jishnu Hazra, IIMB

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
Random N(1000,300)

Jishnu Hazra, IIMB

Retailer-Manufacturer Coordination
As a Manufacturer what wholesale price W
will you choose?

Jishnu Hazra, IIMB

Retailer-Manufacturer Coordination
Quantity bought by Retailer

Q is a function of W

R W
Pr[D Q(W )] =

RS
M (W ) = (W M )Q(W )

Newsvendor problem

Manufacturers Expected Profit

Jishnu Hazra, IIMB

Expected Profit as a Function of Wholesale Price

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

Jishnu Hazra, IIMB

Manufacturers maximum
profit happens at a wholesale
price between 80 and 90

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
From the
Retailers profit = Rs. 9281
Newsvendor Model
Total Supply Chain profit is Rs. 49,647
Jishnu Hazra, IIMB

Retailer-Manufacturer Coordination
Can we do better?

Jishnu Hazra, IIMB

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
Jishnu Hazra, IIMB

Retailer-Manufacturer Coordination: A Coordinated Strategy

What would an Integrated Firm do?

Jishnu Hazra, IIMB

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

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
Jishnu Hazra, IIMB

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

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.

Jishnu Hazra, IIMB

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

Revenue Sharing Model

C: unit cost

Q: Quantity bought by buyer

Vendor

Buyer
W: Vendors Unit Price

(1 ) R

R: unit revenue
D: Demand
S: Salvage Value
for unsold units

: Fraction of unit revenue retained by the buyer

Jishnu Hazra, IIMB

Revenue Sharing Model

Unit Cost
Retail Price
Wholesale Price
Salvage Value
Mean Demand

30
100
30
20
1000

: Fraction of unit revenue retained by the buyer

Unit Cost: Production cost for Supplier
Please note, I have assumed the Salvage revenue
goes to the Retailer; it need not be the case
Jishnu Hazra, IIMB

Revenue Sharing Model

Std Dev

300

Jishnu Hazra, IIMB

Acceptable

Delta ( )W/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

Revenue Sharing Model

Std Dev: 300

W/S Price Retailer's Profit Supplier's profit Total profit
25
13093
51303
64397
25
22751
42220
64971
25
32530
32530
65060
25
42368
22652
65019
25
52240
12697
64937
84
9281
40366
49647

Combination of (Delta) and Wholesale Price

will determine the Supply Chain profit split
Jishnu Hazra, IIMB

Revenue Sharing in Practice

Telecom operator distributing music, video, ring
tones to end consumers
Ring tones account for $ 3.5 billion in 2004
Revenue sharing in the Indian Malls: Real Estate
Owner and the Stores
If both parties are better off why isnt everybody
using it?

Jishnu Hazra, IIMB

Acceptable

Delta
0.4
0.5
0.6
0.7
0.8
1

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 at Rs. C/unit
Buyer gets Demand Information and orders
Z ( Q) units at price Rs. x
Buyers profit: b (Q) = E[( R x) min( D, Q) CQ ]
Suppliers Profit:
m (Q ) = E[(C M )Q + x min( D, Q) + S max(0, Q D)]

Notations: R-revenue, S-salvage value, Mmanufacturing cost

Jishnu Hazra, IIMB

Newsboy with Options

R xC
Rx
where Q is the optimum number of Options to buy
Define

Pr( D Q ) =

ku = R x C

Opportunity Cost of buying too few options

ko = C

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
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

Jishnu Hazra, IIMB

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 higher
profits 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, and
newspapers
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 W and
buyback percentage b.
Retailer orders Q units from the Supplier
Suppliers unit production cost is c and ships Q
Retailer sets the retail price P and stochastic
demand occurs
Unsold units are returned to supplier and retailer
receives bW per unit.
Jishnu Hazra, IIMB

Unit Cost
Retail Price
Wholesale Price
Salvage Value
Mean Demand

30
100
30
20
1000

Jishnu Hazra, IIMB

Buyback Price

Wholesale
Price
75
80
85
90
95

Jishnu Hazra, IIMB

71.421

Order
Quantity
1345
1157
1019
884
720

Retailer's Supplier's Total

Profits
Profits
Profits
23233
41827 65060
17018
46837 63856
11586
49382 60968
6825
49428 56252
2790
45319 48109

Acceptable to
both parties

Quantity Flexibility (QF)

Some flexibility issues come into play when a major
customer orders 250,000 unforecasted custom
semiconductors and needs them in three weeks.
Though our company strives for service and
customer satisfaction, it is important to determine
who bears the extra cost, with large unforecasted
orders. Unfortunately, these issues of
unforecasted demand and costs are real. Eddie
Maxie, VP Global Supply Base Management,
SOLECTRON
Jishnu Hazra, IIMB

Quantity Flexibility (QF)

The buyer (retailer) orders Q* units

The supplier will commit to produce Q = Q * (1 + )
The buyer commits to procure q = Q* (1 )
, are negotiated, 0 1

Jishnu Hazra, IIMB

Quantity Flexibility (QF)

Manufacturing Cost

30

Wholesale Price

84

Retail Price

100

Salvage Value

20

Mean Demand

1000

Std Deviation

300

Jishnu Hazra, IIMB

QF Contract

Retailer's Manuf SCM

W/S Price Alpha Beta Order Size

Profit

Profit Profit

84

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

Jishnu Hazra, IIMB

Ignore the Mathematics of the

QF Contracts; it is slightly involved

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

Jishnu Hazra, IIMB