Supply Contracts

Dr Prashant Gupta

SnowTime Sporting Goods

Fashion items have short life cycles, high variety
of products
SnowTime Sporting Goods
New designs are completed one year in advance
One production opportunity
Based on past sales, knowledge of the industry, and
economic conditions, the marketing department has
a probabilistic forecast

Supply Chain Time Lines

Jan 14

Jan 15
Design

Production

Feb 14

Jan 15

Production
Sep 14

Feb 15

Retailing
Sep 15

SnowTime Demand Scenarios

Demand

Probability

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

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

SnowTime Demand Scenarios

P robability

Demand Scenarios
30%
25%
20%
15%
10%
5%
0%

Sales

SnowTime Demand Scenarios

Demand

Probability

8,000
10,000
12,000
14,000
16,000
18,000
Forecast Average

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

Weighted Demand
880
1,100
3,360
3,080
2,880
1,800
13,100

SnowTime Sporting Goods

SnowTime Sporting Goods
The forecast averages about 13,100, but there is a
chance that demand will be greater or less than this.

SnowTime Costs

Production cost per unit (C) : $80

Selling price per unit (S)
: $125
Salvage value per unit (V) : $20
Fixed production cost (F)
: $100,000
Q is production quantity, D is demand

Profit =
Revenue - Variable Cost - Fixed Cost + Salvage

SnowTime Best Solution

Find order quantity that maximizes weighted
average profit.
Question: Will this quantity be less than, equal
to, or greater than average demand?

SnowTime Scenarios
Scenario One:
Suppose you make 12,000 jackets and demand ends
up being 13,000 jackets.
Profit = 125(12,000) - 80(12,000) - 100,000 = $440,000

Scenario Two:
Suppose you make 12,000 jackets and demand ends
up being 11,000 jackets.
Profit = 125(11,000) - 80(12,000) - 100,000 + 20(1000) = $
335,000

How Many to Make?

Average demand is 13,100
Look at marginal cost Vs. marginal profit
if extra jacket sold, profit is 125-80 = 45
if not sold, cost is 80-20 = 60

So we will make less than average

SnowTime Demand Scenarios

Demand

Probability

Cumulative
Probability
upto

Cumulative
Probability
equal to &
Above

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

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

11%
22%
50%
72%
90%
100%

100%
89%
78%
50%
28%
10%

Expected Profit
If the production is 8,000, expected profit (In
Thousands) is:
= 125 x (1.0 x 8) 80 x 8 100
= 1,000 640 100 = 260

Expected Profit
If the production is 10,000, expected profit (In
Thousands) is:
= 125 (0.89 x 10 + 0.11 x 8) 80 x 10 100 +
20(0.11 x 2)
= 125 x 9.78 800 100 + 4.4
= 326.90

Expected Profit
If the production is 12,000, expected profit (In
Thousands) is:
= 125 (0.78 x 12 + 0.11 x 10 + 0.11 x 8) 80 x
12 100 + 20(0.11 x 2 + 0.11 x 4)
= 125 (9.36 + 1.10 + 0.88) - 960 100 + 20(0.22
+ 0.44)
= 125 x 11.34 1,060 + 13.2
= 370.70

Expected Profit
If the production is 14,000, expected profit (In
Thousands) is:
= 125 (0.50 x 14 + 0.28 x 12 + 0.11 x 10 + 0.11 x 8) 80
x 14 100 + 20(0.28 x 2 + 0.11 x 4 + 0.11 x 6)
= 125 (7.00 + 3.36 + 1.10 + 0.88) 1,120 100 +
20(0.56 + 0.44 + 0.66)
= 125 x 12.34 1,220 + 33.2
= 355.70

Expected Profit
If the production is 16,000, expected profit (In
Thousands) is:
= 125 (0.28 x 16 + 0.22 x 14 + 0.28 x 12 + 0.11 x 10 +
0.11 x 8) 80 x 16 100 + 20(0.22 x 2 + 0.28 x 4 + 0.11
x 6 + 0.11 x 8)
= 125 (4.48 + 3.08 + 3.36 + 1.10 + 0.88) 1,280 100 +
20(0.44 + 1.12 + 0.66 + 0.88)
= 125 x 12.90 1,380 + 20(3.10)
= 1612.50 1,380 + 63.00
= 295.50

SnowTime Expected Profit

Demand

Cumulative
Probability equal to &
Above

Expected Profit

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

100%
89%
78%
50%
28%
10%

260,000
326,900
370,700
355,700
295,500
195,500

SnowTime Expected Profit

Expected Profit
$400,000

Profit

$300,000
$200,000
$100,000
$0
8000

12000

16000

Order Quantity

20000

SnowTime Expected Profit

Expected Profit
$400,000

Profit

$300,000
$200,000
$100,000
$0
8000

12000

16000

Order Quantity

20000

SnowTime: Important Observations

Tradeoff between ordering enough to meet
demand and ordering too much.
Several quantities have the same average profit.
Average profit does not tell the whole story.
Question: 9000 and 16000 units
lead to about the same average
profit, so which do we prefer?

SnowTime Expected Profit

Expected Profit
$400,000

Profit

$300,000
$200,000
$100,000
$0
8000

12000

16000

Order Quantity

20000

Probability of Outcomes
Production = 9,000
Expected Profit (In Thousands) at demand of 8,000
= 125 x 8 80 x 9 + 20 x 1 100
= 1,000 720 + 20 100
= 200 at probability of 0.11
Expected Profit (In Thousands) at demand of 9,000
= 125 x 9 80 x 9 100
= 1,125 720 100
= 305 at probability of 0.89

Probability of Outcomes
Production = 16,000
Expected Profit (In Thousands) at demand of 8,000
= 125 x 8 80 x 16 + 20 x 8 100
= 1,000 1,280 + 160 100
= - 220 at probability of 0.11
Expected Profit (In Thousands) at demand of 10,000
= 125 x 10 80 x 16 + 20 x 6 100
= 1,250 1,280 + 120 100
= -10 at probability of 0.11

Probability of Outcomes
Production = 16,000
Expected Profit (In Thousands) at demand of 12,000
= 125 x 12 80 x 16 + 20 x 4 100
= 1,500 1,280 + 80 100
= 200 at probability of 0.28
Expected Profit (In Thousands) at demand of 14,000
= 125 x 14 80 x 16 + 20 x 2 100
= 1,750 1,280 + 40 100
= 410 at probability of 0.22

Probability of Outcomes
Production = 16,000
Expected Profit (In Thousands) at demand of 16,000
= 125 x 16 80 x 16 100
= 2,000 1,280 100
= 620 at probability of 0.18
Expected Profit (In Thousands) at demand of 18,000
= 125 x 16 80 x 16 100
= 2,000 1,280 100
= 620 at probability of 0.10

Probability of Outcomes
Demand

Expected Profit at Production of

9,000
16,000
8,000
200,000 at 0.11 -220,000 at 0.11
Above 9,000 305,000 at 0.89
10,000
-10,000 at 0.11
12,000
200,000 at 0.28
14,000
410,000 at 0.22
16,000
620,000 at 0.18
18,000
620,000 at 0.10

Probability of Outcomes

P r o b a b ility

100%
80%
60%

Q=9000

40%

Q=16000

20%
0%

Cost

Key Insights from this Model

The optimal order quantity is not necessarily equal to
average forecast demand.
The optimal quantity depends on the relationship
between marginal profit and marginal cost.
As order quantity increases, average profit first
increases and then decreases.
As production quantity increases, risk increases. In
other words, the probability of large gains and of large
losses increases.
Risk / Reward Trade-off.

Contracts
A Contract specifies the parameters within which a
buyer places orders and a supplier fulfills them.
Example of parameters: Quantity, Price, Time,
Quality.
Double marginalization: Buyer and seller make
decisions acting independently instead of acting
together gap between potential total supply chain
profits and actual supply chain profits results

Supply Contracts
In a supply contract, the buyer and supplier may
agree on:

Pricing and volume discounts

Minimum and maximum purchase quantities
Delivery lead times
Product or material quality
Product return policies

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

Wholesale Price =$80

Selling Price=$125
Salvage Value=$20
Manufacturer

Manufacturer DC

Retail DC

Stores

Demand Scenarios
P robability

Demand Scenarios
30%
25%
20%
15%
10%
5%
0%

Sales

Retailers Expected Profit

Expected Profit
500000
400000
300000
200000
100000
0
6000

8000

10000

12000

14000

Order Quantity

16000

18000

20000

Retailers Expected Profit

Expected Profit
500000
400000
300000
200000
100000
0
6000

8000

10000

12000

14000

Order Quantity

16000

18000

20000

Supply Contracts (cont.)

Retailers optimal order quantity is 12,000 units
Retailers expected profit is $470,700
Manufacturer profit is $440,000 ( 80 x 12,000
35 x 12,000 100,000).
Supply Chain Profit is $910,700 ($470,700
+ $440,000)

Supply Contracts (cont.)

Is there anything that the
retailer and the
manufacturer can do to
increase the profit of
both?

1.0 Returns Policy: Buyback Contracts

A manufacturer specifies a wholesale price and a buyback
price at which the retailer can return any unsold items at the
end of the season.
Results in an increase in the salvage value for the retailer,
which induces the retailer to order a larger quantity.
The manufacturer is willing to take on some of the cost of
overstocking because the supply chain will end up selling
more on average.
Manufacturers profits and supply chain profits can increase.

Retailer Profit (Buy Back=$55)

600,000

Retailer Profit

500,000
400,000
300,000
200,000
100,000
0

Order Quantity

Retailer Profit (Buy Back=$55)

600,000

Retailer Profit

500,000

$513,800

400,000
300,000
200,000
100,000
0

Order Quantity

Manufacturer Profit (Buy Back=$55)

Manufacturer Profit

600,000
500,000
400,000
300,000
200,000
100,000
0

Production Quantity

Manufacturer Profit (Buy Back=$55)

Manufacturer Profit

600,000
500,000

$471,900

400,000
300,000
200,000
100,000
0

Production Quantity

2.0 Revenue Sharing Contracts

The manufacturer charges the retailer a low
wholesale price and shares a fraction of the
revenue generated by the retailer.
The lower wholesale price decreases the cost to
the retailer in case of an overstock.
The retailer, therefore, increases the level of
product availability, which results in higher profits
for both the manufacturer and the retailer.

Retailer Profit
(Wholesale Price $70, Rev. Sharing 15%)
600,000
Retailer Profit

500,000
400,000
300,000
200,000
100,000
0

Order Quantity

Retailer Profit
(Wholesale Price $70, Rev. Sharing %)
600,000
Retailer Profit

500,000

$504,325

400,000
300,000
200,000
100,000
0

Order Quantity

Manufacturer Profit
(Wholesale Price $70, Rev. Sharing 15%)
Manufacturer Profit

700,000
600,000
500,000
400,000
300,000
200,000
100,000
0

Production Quantity

Manufacturer Profit
(Wholesale Price $70, Rev. Sharing 15%)
Manufacturer Profit

700,000
600,000
500,000

$481,375

400,000
300,000
200,000
100,000
0

Production Quantity

Supply Contracts
Strategy
Sequential Optimization
Buyback
Revenue Sharing

Retailer Manufacturer
470,700
440,000
513,800
471,900
504,325
481,375

Total
910,700
985,700
985,700

Supply Chain Profit (Global Optimization)

Supply Chain Profit

1,200,000
1,000,000
800,000
600,000
400,000
200,000
0

Production Quantity

Supply Chain Profit (Global Optimization)

Supply Chain Profit

1,200,000
1,000,000

$1,014,500

800,000
600,000
400,000
200,000
0

Production Quantity

Supply Contracts
Strategy
Sequential Optimization
Buyback
Revenue Sharing
Global Optimization

Retailer Manufacturer
470,700
440,000
513,800
471,900
504,325
481,375

Total
910,700
985,700
985,700
1,014,500

3.0 Quantity Return Contracts

Quantity Return Contracts
Supplier provides full refund for returned items as
long as the number of returns is not larger than a
certain quantity.

4.0 Quantity Flexibility Contracts

Manufacturer allows retailer to change order
quantity after observing demand.
No returns are required.
The manufacturer bears some of the risk of excess
inventory.
Retailer increases order quantity.
Can result in higher manufacturer and supply chain
profits.

4.0 Quantity Flexibility Contracts

(Contd)
If a retailer orders O units, the manufacturer
commits to supply up to (1+)O and the
retailer commits to buy at least (1-)O.
Values of both and lie between 0 and 1.
No returns are required.Hence more
effective when the cost of returns is high.

5.0 Sales Rebate Contracts

Sales Rebate Contracts
Supplier provides direct incentive to the
retailer to increase sales by means of a
rebate for any item sold above a certain
quantity

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: Limitations

They do not provide mechanism to allocate the
supply chain profits.
No incentive for either the buyer or the seller to
deviate from the set of actions that will achieve
the global optimal solution.

Supply Contracts: Case Study

Example: Demand for a newly released movie video
cassette typically starts high and decreases rapidly
Peak demand lasts for 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 Video entered into a revenue
sharing agreement with the movie 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)

Vendor-Managed Inventories (VMI)

Manufacturer or supplier is responsible for all decisions regarding
inventory at the retailer.
Control of replenishment decisions moves to the manufacturer.
Requires that the retailer shares demand information with the
manufacturer.
Manufacturer can increase its profits and total supply chain profits by
reducing effects of double marginalization.
Having final customer demand data also helps manufacturer plan
production more effectively.
Campbells Soup, Proctor & Gamble.
Potential drawback when retailers sell products that are substitutes
in customers minds.