Contracts 2015

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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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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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As a Manufacturer what wholesale price W

will you choose?

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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

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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

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From the

Newsvendor Model


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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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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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)

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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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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


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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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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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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.

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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

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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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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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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

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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


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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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

Contracts 2015

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