Chapter4,SupplyContracts,4.1Introduction,SignificantlevelofoutsourcingManyleadingbrandOEMsoutsourcecompletemanufacturinganddesignoftheirproductsProcurementfunctioninOEMsbecomesveryimportantOEMshavetogetintocontractswithsuppliersForbothstrategicandnon-strategiccomponents,4.2StrategicComponents,WhatshouldbeincludedinaSupplyContract?,4.2StrategicComponents,SupplyContractcanincludethefollowing:Pricingandvolumediscounts.Minimumandmaximumpurchasequantities.Deliveryleadtimes.Productormaterialquality.Productreturnpolicies.,Whatarethepotentialimpactsofasupplycontractonsupplychainpartners?,2-StageSequentialSupplyChain,Abuyerandasupplier.Buyersactivities:generatingaforecastdetermininghowmanyunitstoorderfromthesupplierplacinganordertothesuppliersoastooptimizehisownprofitPurchasebasedonforecastofcustomerdemandSuppliersactivities:reactingtotheorderplacedbythebuyer.Make-To-Order(MTO)policy,SwimsuitExample,2Stages:aretailerwhofacescustomerdemandamanufacturerwhoproducesandsellsswimsuitstotheretailer.RetailerInformation:Summerseasonsalepriceofaswimsuitis$125perunit.Wholesalepricepaidbyretailertomanufactureris$80perunit.Salvagevalueafterthesummerseasonis$20perunitManufacturerinformation:Fixedproductioncostis$100,000Variableproductioncostis$35perunit,WholesalePrice=$80,SupplyContractsSequentialSupplyChain,DemandScenarios,WhatIstheOptimalOrderQuantity?,Retailermarginalprofitisthesameasthemarginalprofitofthemanufacturer,$45.Retailersmarginalprofitforsellingaunitduringtheseason,$45,issmallerthanthemarginalloss,$60,associatedwitheachunitsoldattheendoftheseasontodiscountstores.Retaileroptimalpolicyistoorder12,000unitsforanaverageprofitof$470,700.Iftheretailerplacesthisorder,themanufacturersprofitis12,000(80-35)-100,000=$440,000,SequentialSupplyChain,FIGURE4-1:Optimizedsafetystock,RiskSharing,Inthesequentialsupplychain:BuyerassumesalloftheriskofhavingmoreinventorythansalesBuyerlimitshisorderquantitybecauseofthehugefinancialrisk.Suppliertakesnorisk.SupplierwouldlikethebuyertoorderasmuchaspossibleSincethebuyerlimitshisorderquantity,thereisasignificantincreaseinthelikelihoodofoutofstock.Ifthesuppliersharessomeoftheriskwiththebuyeritmaybeprofitableforbuyertoordermorereducingoutofstockprobabilityincreasingprofitforboththesupplierandthebuyer.Supplycontractsenablethisrisksharing,Buy-BackContract,Selleragreestobuybackunsoldgoodsfromthebuyerforsomeagreed-uponprice.BuyerhasincentivetoordermoreSuppliersriskclearlyincreases.IncreaseinbuyersorderquantityDecreasesthelikelihoodofoutofstockCompensatesthesupplierforthehigherrisk,WholesalePrice=$80,SupplyContracts,Buy-BackContractSwimsuitExample,Assumethemanufacturerofferstobuyunsoldswimsuitsfromtheretailerfor$55.Whatwillhappenunderthisdesign?,Buy-BackContractSwimsuitExample,Retailerhasanincentivetoincreaseitsorderquantityto14,000units,foraprofitof$513,800,whilethemanufacturersaverageprofitincreasesto$471,900.,Buy-BackContractSwimsuitExample,Totalaverageprofitforthetwoparties=$985,700(=$513,800+$471,900)Comparetosequentialsupplychainwhentotalprofit=$910,700(=$470,700+$440,000),RevenueSharingContract,Buyersharessomeofitsrevenuewiththesupplierinreturnforadiscountonthewholesaleprice.Buyertransfersaportionoftherevenuefromeachunitsoldbacktothesupplier,WholesalePrice=$?,SupplyContracts,RevenueSharingContractSwimsuitExample,Manufactureragreestodecreasethewholesalepricefrom$80to$60Inreturn,theretailerprovides15percentoftheproductrevenuetothemanufacturer.Whatabouttherisksharing?,RevenueSharingContractSwimsuitExample,RevenueSharingContractSwimsuitExample,Retailerhasanincentivetoincreasehisorderquantityto14,000foraprofitof$504,325Thisorderincreaseleadstoincreasedmanufacturersprofitof$481,375Supplychaintotalprofit=$985,700(=$504,325+$481,375).,SupplyContracts,OtherTypesofContracts,Quantity-FlexibilityContractsSupplierprovidesfullrefundforreturned(unsold)itemsAslongasthenumberofreturnsisnolargerthanacertainquantity.,OtherTypesofContracts,SalesRebateContractsProvidesadirectincentivetotheretailertoincreasesalesbymeansofarebatepaidbythesupplierforanyitemsoldaboveacertainquantity.,Aretheabovesupplycontractstheoptimaltype?,GlobalOptimizationStrategy,TreatbothsupplierandretailerasoneentityTransferofmoneybetweenthepartiesisignored,WholesalePrice=$80,SupplyContracts,GlobalOptimizationSwimsuitExample,RelevantdataSellingprice,$125Salvagevalue,$20Variableproductioncosts,$35Fixedproductioncost.Supplychainmarginalprofit,90=125-35Supplychainmarginalloss,15=3520Supplychainwillproducemorethanaveragedemand.,GlobalOptimizationSwimsuitExample,GlobalOptimizationSwimsuitExample,Optimalproductionquantity=16,000unitsExpectedsupplychainprofit=$1,014,500.,SupplyContracts,Dontforget:sharingriskwithyourfriendsandyouwillberewardedwithit,oryouwilleatasmallcakeforever.,SupplyContracts:CaseStudy,Example:DemandforamovienewlyreleasedvideocassettetypicallystartshighanddecreasesrapidlyPeakdemandlastabout10weeksBlockbusterpurchasesacopyfromastudiofor$65andrentfor$3Hence,retailermustrentthetapeatleast22timesbeforeearningprofitWhatwillbetheresult?,SupplyContracts:CaseStudy,RetailerscannotaffordpurchasingenoughtocoverthepeakdemandIn1998,20%ofsurveyedcustomersreportedthattheycouldnotrentthemovietheywanted,SupplyContracts:CaseStudy,Startingin1998BlockbusterenteredarevenuesharingagreementwiththemajorstudiosStudiocharges$8percopyBlockbusterpays30-45%ofitsrentalincomeEvenifBlockbusterkeepsonlyhalfoftherentalincome,thebreakevenpointis6rentalpercopy,SupplyContracts:CaseStudy,TheimpactofrevenuesharingonBlockbusterwasdramaticRentalsincreasedby75%intestmarketsMarketshareincreasedfrom25%to31%(The2ndlargestretailer,HollywoodEntertainmentCorphas5%marketshare),WhatarethedrawbacksoftheSupplyContractsdiscussedabove?,Buy-backcontractsRequiresupplierstohaveaneffectivereverselogisticssystemandmayincreaselogisticscosts.Retailershaveanincentivetopushthesimilarproductsnotunderthebuybackcontract.Sinceretailersriskismuchhigherfortheproductsnotunderthebuybackcontract.,RevenuesharingcontractsRequiresupplierstomonitorthebuyersrevenueandthusincreasesadministrativecost.Buyershaveanincentivetopushcompetingproductswithhigherprofitmargins.Similarproductsfromcompetingsupplierswithwhomthebuyerhasnorevenuesharingagreement.,4.3ContractsforMake-to-Stock/Make-to-OrderSupplyChains,PreviouscontractsexampleswerewithMake-to-OrdersupplychainsWhathappenswhenthesupplierhasaMake-to-Stocksituation?,Example4-8,SupplyChainforFashionProductsSki-Jackets,Manufacturerproducesski-jacketspriortoreceivingdistributorordersunderMTS,SeasonstartsinSeptemberandendsbyDecember.Productionstarts12monthsbeforethesellingseasonDistributorplacesorderswiththemanufacturersixmonthslater.Atthattime,productioniscomplete;distributorreceivesordersfromretailers.,SupplyChainprocess,Thedistributorsellsski-jacketstoretailersfor$125perunit.Thedistributorpaysthemanufacturer$80perunit.Forthemanufacturer,wehavethefollowinginformation:Fixedproductioncost=$100,000.Thevariableproductioncostperunit=$55Salvagevalueforanyski-jacketnotpurchasedbythedistributors=$20.,SupplyChaindata,ProfitandLoss,ForthemanufacturerMarginalprofit=$25Marginalloss=$35.Sincemarginallossisgreaterthanmarginalprofit,thedistributorshouldproducelessthanaveragedemand,i.e.,lessthan13,000units.Howmuchshouldthemanufacturerproduce?,Make-to-StockSkiJackets,FIGURE4-5:Manufacturersexpectedprofit,Optimaldecision,Manufactureroptimalpolicy=12,000unitsAverageprofit=$160,400.Distributoraverageprofit=$510,300.Risksharing?ManufacturerassumesalltherisklimitingitsproductionquantityDistributortakesnorisk,Pay-BackContract,Buyeragreestopaysomeagreed-uponpriceforanyunitproducedbythemanufacturer,butnotpurchased.ManufacturerincentivetoproducemoreunitsBuyersriskclearlyincreases.Benefitsfromincreasingproductionquantitieshastocompensatethedistributorfortheincreaseinrisk.,Pay-BackContractSkiJacketExample,Assumethedistributorofferstopay$18foreachunitproducedbythemanufacturerbutnotpurchased.Manufacturermarginalloss=55-20-18=$17Manufacturermarginalprofit=$25.Manufacturerhasanincentivetoproducemorethanaveragedemand.Whataboutdistributorsmargin?,Pay-BackContractSkiJacketExample,FIGURE4-6:Manufacturersaverageprofit(pay-backcontract),Pay-BackContractSkiJacketExample(cont),FIGURE4-7:Distributorsaverageprofit(pay-backcontract),Pay-BackContractSkiJacketExample,Manufacturerincreasesproductionquantityto14,000unitsManufacturerprofit=$180,280Distributorprofitincreasesto$525,420.Totalprofit=$705,400Comparetototalprofitinsequentialsupplychain=$670,000(=$160,400+$510,300),Cost-SharingContract,Highmanufacturingcostrestrictstheproductionquantity.Buyersharessomeoftheproductioncostwiththemanufacturer,inreturnforadiscountonthewholesaleprice.ReduceseffectiveproductioncostforthemanufacturerIncentivetoproducemoreunits,Cost-SharingContractSki-JacketExample,Manufactureragreestodecreasethewholesalepricefrom$80to$62Inreturn,distributorpays33%ofthemanufacturerproductioncostWhatabouttheprofitandloss?,Cost-SharingContractSki-JacketExample,FIGURE4-8:Manufacturersaverageprofit(cost-sharingcontract),Cost-SharingContractSki-JacketExample(cont),FIGURE4-9:Distributorsaverageprofit(cost-sharingcontract),Cost-SharingContractSki-JacketExample,Manufacturerincreasesproductionquantityto14,000Manufacturerprofit=$182,380Distributorprofit=$523,320Thesupplychaintotalprofit=$705,700Sameastheprofitunderpay-backcontracts,ImplementationIssues,Cost-sharingcontractrequiresmanufacturertoshareproductioncostinformationwithdistributorAgreementbetweenthetwoparties:Distributorpurchasesoneormorecomponentsthatthemanufacturerneeds.Example4-12Foxconn,GlobalOptimization,Relevantdata:Sellingprice,$125Salvagevalue,$20Variableproductioncosts,$55Fixedproductioncost,100,000.Supplychainmarginalprofit,70=12555Supplychainmarginalloss,35=5520Supplychainwillproducemorethanaveragedemand.Optimalproductionquantity=14,000unitsExpectedsupplychainprofit=$705,700Sameprofitasunderpay-backandcostsharingcontracts,GlobalOptimization,FIGURE4-10:Globaloptimization,4.4ContractswithAsymmetricInformation,Implicitassumptionsofar:BuyerandsuppliersharethesameforecastInflatedforecastsfrombuyersarealityEspeciallywhenthesupplierbuildscapacitybasedonforecastreceivedfrombuyers.FlextronicsandEricssionOnereasonofBullwhipEffectHowtodesigncontractssuchthattheinformationsharediscredible?,TwoPossibleContracts,CapacityReservationContractBuyerpaystoreserveacertainlevelofcapacityatthesupplierAmenuofpricesfordifferentcapacityreservationsprovidedbysupplierBuyersignalstrueforecastbyreservingaspecificcapacitylevel,TwoPossibleContracts,AdvancePurchaseContractSupplierchargesspecialpricebeforebuildingcapacityWhendemandisrealized,pricechargedisdifferentBuyerscommitmenttopayingthespecialpricerevealsthebuyerstrueforecast,4.5ContractsforNon-StrategicComponents(withlowrisk),Commoditiessuchaselectricity,steel,oil,grain,cotton.Availablefromalargenumberofsuppliers.BuyersneedtobeabletochoosesuppliersandchangethemasneededFlexiblecontractsallowedandusuallyusedPurchasingnoworlater,Long-TermContracts,AlsocalledforwardorfixedcommitmentcontractsContractsspecifyafixedamountofsupplytobedeliveredatsomepointinthefutureSupplierandbuyeragreeonbothpriceandquantityPriceislowinthisdesignBuyertakeshugeinventoryrisksdueto:uncertaintyindemandinabilitytoadjustorderquantities.,FlexibleorOptionContracts,Buyerpre-paysarelativelysmallfractionoftheproductpriceupfrontSuppliercommitstoreservecapacityuptoacertainlevel.Initialpaymentisthereservationpriceorpremium.Ifbuyerdoesnotexerciseoption,theinitialpaymentislost.,FlexibleorOptionContracts,Buyercanpurchaseanyamountofsupplyuptotheoptionlevelby:payinganadditionalprice(executionpriceorexerciseprice)agreedtoatthetimethecontractissignedTotalprice(reservationplusexecutionprice)typicallyhigherthantheunitpriceinalong-termcontract.,Advantagesanalysis,ProvidebuyerwithflexibilitytoadjustorderquantitiesdependingonrealizeddemandReducesbuyersinventoryrisks.ShiftsrisksfrombuyertosupplierSupplierisnowexposedtocustomerdemanduncertainty.,SpotPurchase,Buyerslookforadditionalsupplyintheopenmarket.Mayuseindependente-marketsorprivatee-marketstoselectsuppliers.Focus:UsingthemarketplacetofindnewsuppliersForcingcompetitiontoreduceproductprice.,