Agenda

Sequential (Retail-Driven) SC Profit Maximization

Global (Integrated) SC Profit Maximization
Risk Sharing Contracts
Buyback
Revenue Sharing
Bsic Sequential Q1
Model: Manufacturer Retailer
Retailer maximizes
its profit

Global Model: Q2
Retailer maximizes SC Manufacturer Retailer
profit
Q2> Q1

Contract Model: Incentive

Manufacturer
incentivizes Q3
Manufacturer Retailer
retailer
Retailer maximizes
its profit Q1<Q3<Q2
 Basic Sequential Model
Retailer
Buys from manufacturer and sells to consumers
No variable or fixed costs
No beginning inventory
Decides how much to buy according to the price offer from the
manufacturer
Goal is to select an order quantity that will maximize own profits

Manufacturer
Sells quantity ordered by retailer
No beginning inventory
Variable and fixed costs
Cannot influence quantity ordered by retailer
 Notation

Description Value
D Consumer Demand T.B.D.
Q Retailer Order Quantity T.B.D.
S Retail Price to Consumers 125
C Mfg Price to Retailer 80
P Mfg Variable Cost of Production 35
F Mfg Fixed Cost 100,000
V Salvage Value for Excess Stock 20
QE Excess Inventory T.B.D.
B Buyback Price for Excess Stock T.B.D.
 Basic Sequential Model
Q8,000 units in increments of 2,000 units.
Demand has a probability distribution .
Retailer wants to order the amount that will maximize its expected
profit.
Expected profit for each quantity level in sequence is calculated until
profit begins to decline. the quantity at which expected profit is
maximum, is the optimal order quantity
D Probability
8000 .11
10000 .11
12000 .28
14000 .22
16000 .18
18000 .10
 Retailers Profit

Retailer buys a quantity of product (Q) from the

manufacturer at $ 80 per unit (C) and sells them for $ 125 per
unit (S)
If D > Q then:
profit = Q*S Q*C

If D < Q the excess inventory (QE) can be disposed of at a

salvage value (V). Then
profit = D*S + QE*V Q*C
where QE = Q - D
 Manufacturers Profit

Manufacturer
sells quantity (Q) to retailer at a wholesale price of $ 80
per unit (C)
Fixed costs (F) of $ 100,000
Variable production cost (P) of $ 35 per unit

Therefore manufacturer profit = Q*C Q*P F =Q(C P) F

 C=$80 S=$125
Q=? D=?
Manufacturer Retailer

P=$35
V=$20
F= $100000
QE = max(Q-D, 0) D Probability
8000 .11
10000 .11
Manufacturers Profit 12000 .28
=Q(C P) F 14000 .22
Retailers Profit 16000 .18
=QS*S Q*C + QE*V
18000 .10
QS=min(Q , D)
 Long Form Process

Go through each order quantity in sequence beginning

with the 8,000 level and calculate the expected profit
Continue through the various order quantity levels until
expected profit begins to decline
Select previous order quantity where expected profit is
maximized
Calculate manufacturer profit based on retailer optimal
order quantity
Calculate Total SC Profit
 Long Form Process contd

ORDER QUANTITY Q = 8000 units , S=$125, V=$20, C=$80

Demand Quantity sold Excess Quantity Revenue ($)
(D) Probability S
Q = Minimum (Q, D) E
Q = Maximum (Q D, 0) R = QSS + QEV
8000 0.11 8000 0 8000* 125=1,000,000
10000 0.11 8000 0 1,000,000
12000 0.28 8000 0 1,000,000
14000 0.22 8000 0 1,000,000
16000 0.18 8000 0 1,000,000
18000 0.1 8000 0 1,000,000
Expected profit = sum of (R values multiplied by their probabilities) (C*Q) =
1000000(0.11+0.11+0.28+0.22+0.18+0.1) (80*8000) = 360000
 Long Form Process contd

ORDER QUANTITY Q = 10000 units , ,S=$125, V=$20, C=$80

Demand Quantity sold Excess Quantity Revenue ($)
(D) Probability S
Q = Minimum (Q, D) E
Q = Maximum (Q D, 0) R = QSS + QEV

8000 0.11 8000 2000 8000* 125 + 2000*20=

1000000+40000=1040000
10000 0.11 10000 0 10000*125=12500000
12000 0.28 10000 0 12500000
14000 0.22 10000 0 12500000
16000 0.18 10000 0 12500000
18000 0.1 10000 0 12500000
Expected profit = sum of (R values multiplied by their probabilities) (C*Q) =
1040000(0.11)+1250000 (0.11+0.28+0.22+0.18+0.1) 80*10000 = 426900
 Long Form Process contd
ORDER QUANTITY Q = 12000 units , , S=$125, V=$20, C=$80
Demand Quantity sold Excess Quantity Revenue ($)
(D) Probability S
Q = Minimum (Q, D) E
Q = Maximum (Q D, 0) R = QSS + QEV

8000 0.11 8000 4000 8000* 125 + 4000*20=

1000000+40000=1080
000
10000 0.11 10000 2000 10000* 125 +
2000*20=1290000
12000 0.28 12000 0 12000* 125 =1500000
14000 0.22 12000 0 1500000
16000 0.18 12000 0 1500000
18000 0.1 12000 0 1500000
Expected profit = sum of (R values multiplied by their probabilities) (C*Q) =
1080000*0.11 + 1290000*0.11 + 1500000*(0.28+0.22+0.18+0.1) (80*12000) =
$470,700
 Long Form Process contd

ORDER QUANTITY Q = 14000 units , S=$125, V=$20, C=$80

Demand Quantity sold Excess Quantity Revenue ($)
(D) Probability S
Q = Minimum (Q, D) E
Q = Maximum (Q D, 0) R = QSS + QEV
8000 0.11 8000 6000 8000*125+6000*20=
1000000+120000=1120000
10000 0.11 10000 4000 10000*125+4000*20=
1250000+80000=1330000
12000 0.28 12000 2000 12000*125+2000*20=
1500000+40000=1540000
14000 0.22 14000 0 14000*125= 1750000
16000 0.18 14000 0 1750000
18000 0.1 14000 0 1750000
Expected profit = sum of (R values multiplied by their probabilities) (C*Q) =
(1120000*0.11 + 1330000*0.11 + 1540000*0.28+1750000*0.5) (80*14000) = 455700
STOP !!! $455,700< $470,700
 Long Form Process contd

ORDER QUANTITY Q = 16000 units , S=$125, V=$20, C=$80

Demand Quantity sold Excess Quantity Revenue ($)
(D) Probability S
Q = Minimum (Q, D) E
Q = Maximum (Q D, 0) R = QSS + QEV
8000 0.11
10000 0.11
12000 0.28
14000 0.22
16000 0.18
18000 0.1
Expected profit = sum of (R values multiplied by their probabilities) (C*Q)

In class assignment:
Submit the completed table as a single slide Power Point file to the in-class
assignment drop box. File name: your ID#-assignment1
 Long Form Process contd
Profit
500000
400000
300000
200000 Profit
100000
0
8000 10000 12000 14000 16000

Manufacturers profit= Q(C P) F = 12,000(80 35) 100,000 = 440,000

SC expected profit = 470,700 + 440,000 = 910,700
 Short Cut Method
We know that if the retailer underestimates consumer demand that he
will incur a potential profit loss (CU) of $ 125 - $ 80 = $ 45 per unit
(retail selling price less wholesale cost)

But we also know that if the retailer overestimates demand then he will
incur a cost (CO) of $ 80 - $20 = $ 60 per unit
(cost less salvage value)

Set the quantity (Q) such that the probability of demand satisfies:

P(D < Q) = CU / (CO + CU)

= 45/(60+45) = .429
 Cumulative Probabilities

The objective is to find a cumulative probability that is equal to or greater than the
critical ratio of .429

In this case, we select the order quantity of 12,000 units at the cumulative
probability distribution of .50

Demand (D) Probability Cumulative

Units
8000 .11 .11
10000 .11 .22
12000 .28 .50
14000 .22 .72
16000 .18 .90
18000 .10 1
 Global Optimization

If the manufacturer sells directly to the consumer, what will be their

revenues and costs?

Manufacturers Revenue = QS*S + QE*V,

Manufacturers Cost = Q*P + F
Where
QE=max(Q-D,0)
QS=min(Q ,D)

Manufacturers expected profit = (R values times their respective

probabilities) P*Q F
Q=?
P=$35
F= $100000

S=$125
D=?
Manufacturer Retailer

V=$20
QE = max(Q-D, 0)
 Global Optimization contd

Step 1 Determine optimal quantity

If D > Q, then CU = 125 35 = 90
If D < Q , then CO = 35 20 = 15
Therefore critical ratio = CU / CO + CU = 90/(90 +15) = .857

Demand (D) Probability Cumulative

Units
8000 .11 .11
10000 .11 .22
12000 .28 .50
14000 .22 .72
16000 .18 .90
18000 .10 1
Select 16,000 as the optimal quantity
 Global Optimization contd
Step 2 Calculate expected global profitability

Order Quantity = 16,000, S=$125, V=$20

Demand (D) Units Probability QS= QE = Total Revenue
Min(Q,D) Max(Q D,0) QS*S + QE*V
8000 .11 8000 8000 1,160,000
10000 .11 10,000 6,000 1,370,000
12000 .28 12,000 4,000 1,580,000
14000 .22 14,000 2,000 1,790,000
16000 .18 16,000 0 2,000,000
18000 .10 16,000 0 2,000,000
M = (R values times their respective probabilities) P*Q F
= (1,160,000*.11 + 1,370,000*.11 + 1,580,000*.28 + 1,790,000*.22 + 2,000,000*.28)
(35*16,000) 100,000
= 1,014,500
 Creating a Better Outcome
We know that expected profit for the global outcome is 1,014,500, but only 910,700 when
retailers act in their own interest and profits are calculated sequentially.

When we maintain the same price schedule and retailer expected profits on an order
quantity of 16,000, we see their net expected profits fall from 470,700 to 394,500 for a
difference 76,200

Manufacturers on the other hand saw their profits increase from 440,000 to 620,000 for a
difference of 180,000 when they moved from an order quantity of 12,000 to 16,000

Retailers will not increase their order size simply to satisfy the needs of the manufacturer if
in doing so they reduce their own net profits

Retailers therefore need some sort of incentive to increase order quantities

There may be a way to extract more profit out the market in such a manner that both the
retailer and the manufacturer could simultaneously benefit
 Buyback Contracts

Objective is for manufacturers to remove some of the risk incurred by

retailers when they place larger order quantities

Mechanism is for the manufacturers to agree to buyback unwanted stock

at a price that exceeds the salvage value currently available

If manufacturers agree to buy back excess inventory at $ 55 per unit, this

would reduce retailer risk of ordering too much product from the current
($80 $20) to ($80 $55).

Recalculating the optimal retailer order quantity, we find Q=14000

Cu=125-80=45 , Co=80-55=25 , Cu/(Cu+Co)=45/70=0.64
P=$35
F= $100000
C=$80 S=$125
Q=? D=?
Manufacturer Retailer

B=$55
V=$20
QE = max(Q-D, 0)

Manufacturers Profit
=Q(C P) F - QE*(B-V)

Retailers Profit
= QS *S + QE*B Q*C
 Buyback Contracts contd
(Retailers Expected Profit)
Order Quantity = 14,000, S=$125, B=$55, C=$80
Quantity Probability QS= QE= Total Revenue Expected Revenue
Demanded Min(Q,D) Max(Q-D,0) QS*S + QE*B

8000 .11 8000 6,000 1,330,000 1,330,000 * 0.11=

146,300
10000 .11 10000 4,000 1,470,000 161,700
12000 .28 12000 2,000 1610,000 450,800
14000 .22 14000 0 1,750,000 385,000
16000 .18 14000 0 1,750,000 315000
18000 .1 14000 0 1,750,000 175000
1,633,800
Costs: $80*14,000=1,120,000
Retailers Expected Profit (R)= 1,633,800 -1,120,000=513,800
 Buyback Contracts contd
(Manufacturers Expected Profit)
Order Quantity = 14,000, S=$125, B=$55, C=$80
Quantity Probability QS= QE= Buyback Cost = Expected Buyback
Demanded Min(Q,D) Max(Q-D,0) QE * (B-V) Cost

8000 .11 8000 6,000 210,000 210,000 * 0.11=

23,100
10000 .11 10000 4,000 140,000 15,400
12000 .28 12000 2,000 70,000 19,600
14000 .22 14000 0 0 0
16000 .18 14000 0 0 0
18000 .1 14000 0 0 0
Total Expected Buyback Costs 58,100
Manufacturer Expected Profit (M) = Q(C P) F Total Expected Buyback Costs
M =14,000*(80-35)-100,000 58,100= 471,900
 Buyback Contracts contd

Change in manufacturers profit = 471,900 440,000 =31,900

Change in retailers profit = 513,800 -470,700=43,100

Increase in SC profit = 43,100 + 31,900 = 75,000

 Revenue Sharing Contracts

Risk is shared through a renegotiation of the price paid by the retailer

to the manufacturer
Retailer pays a lower price
In return, the manufacturer receives a % of the gross retail sales
(excluding salvage value return)

In this case the retailer pays a price of $ 60 (rather than $ 80) but agrees
to give the manufacturer 15% of retail sales revenues
 Revenue Sharing Contracts contd

Retail expected profit :

R = (RR times their respective probabilities) (C*Q)
where RR is retailers sale revenue
RR = .85 *QS*S + QE*V

Manufacturer expected profit:

M = Q*(C P) + (RM times their respective probabilities) F
where RM is manufacturers share from retailers sale revenue
RM = .15 *QS*S

With the Revenue Sharing Contract:

R = 504,325 470,700 = + 33,625
M = 481,375 440,000 = + 41,375
 P=$35
F= $100000
C=$60 S=$125
Q=? D=?
Manufacturer Retailer

15% * Qs*S
V=$20
QE = max(Q-D, 0)

Qs=min(D, Q)

Manufacturers Profit
=Q(C P) F+ 15% Qs*S

Retailers Profit
=85% Qs*S+ QE*V Q*C
 Revenue Sharing Contracts contd
(Retailers Expected Profit)
Order Quantity = ?
Quantity Probability QS= QE= Total Revenue Expected
Demanded Min(Q, D) Max (Q D, 0) .85*Qs *S + QE*V Revenue

8000 .11
10000 .11
12000 .28
14000 .22
16000 .18
18000 .1

Total Expected Revenue ?

Total Expected Profit=Total Expected Revenue- Total Cost=?

 Revenue Sharing Contracts contd
(Manufacturers Expected Profit)

Order Quantity = ?
Quantity Probability QS= QE= RM = .15*Qs*S Expected RM
Demanded Min(Q, D) Max (Q D, 0)

8000 .11
10000 .11
12000 .28
14000 .22
16000 .18
18000 .1
Total Expected RM ?
Total Expected=Q*(C P) +Total Expected RM F=?
 Win-Win Contract Process

1. Calculate sequential expected retail profit and actual manufacturer profit

2. Calculate total supply chain profit = R + M

3. Calculate global solution assuming that manufacturer sells directly to

consumers

4. Compare sequential solution to global solution to determine unrealized

profits

5. Design a risk-sharing plan to make both the retailer and the

manufacturer better off
Buyback
Revenue Sharing