Download Supply Contracts

Supply chain
 Supply chain is a two or more parties linked by a flow of goods,
information, and funds
Financial
Material
Information
c
Manufacturer
W(Q)
Q
Q
Retailer
p
D(p)
Min {Q, D(p)}
This section builds heavily on excellent review by Tsay et al (1999)
Purpose of contracts
 Total supply chain profits are maximized when all
decisions are made by a single decision maker who
has access to all available information (referred to as
the first-best case, typically requires the central control
of supply chain). Let PC denote the supply chain profits
under this scheme.
 However, generally, neither the manufacturer, nor the
retailer has the control of the whole supply chain. Each
has his own incentive and state of information (referred
to as decentralized control). Let PD denote the total
supply chain profits under this scheme.
 Decentralized control is inefficient if PD< PC
 How do you make the supply chain efficient and just?
Purpose of contracts
 Risk-sharing: How to split PD between the two parties
 Example: The retailer is required to submit forecast information to the
manufacturer to make capacity and materials purchasing decisions
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No commitment for retailer
Retailer may cancel orders if demand is low,
Retailer may deliberately inflate forecasts to insure supply
Too much risk for the manufacturer: how to design contracts so that
manufacturer is protected against such risk
 System-wide performance improvement: How to bring PD closer to
PC (sometimes referred to as channel coordination)
 Example: Double marginalization
 Retailer buying at a price of t, selling at a price of p (a margin of p-t)
 Manufacturer buying at a price of c, selling at a price of t (a margin of t-c)
 Supply chain profits are maximized when a margin of p-c is used, when
making a supply decision
Purpose of contracts
 Long-term partnerships
 Example: Intel might be willing to consign a large portion of its
production of a new generation of microprocessors to a single
OEM such as Dell
 The microprocessor may sell for a higher price in open market
 However, Intel’s motivation would be to build long term
relationship in the hope that Dell would be a volume purchaser for
years
 Making the terms of the relationship explicit
 Making each party’s expectations legally concrete
 Lead times
 On-time delivery rates
 Product quality
Types of contracts
A.
B.
C.
D.
E.
F.
G.
H.
Specification of decision rights
Pricing
Minimum purchase commitments
Quantity flexibility
Buyback or returns policies
Allocation rules
Lead time
Quality
A- Specification of decision rights
 Specifications of decision rights: Reassigning the control of the
decision variables
 Shifting the control from one party to the other
 Eliminate double marginalization
 Better informed party making the decision
 Resale Price Maintenance (RPM): manufacturer deciding the sales
price
 Quantity Fixing (QF): manufacturer setting the order quantity for the
retailer
 Lee and Whang (1997)
 Decentralized multi-echelon inventory system
 If only most downstream level has a backlog cost, then that level would
carry extra inventory
 However inventory is most expensive at that level
 How could you modify inventory holding and backlog costs at each level
so that channel costs are minimized
B- Pricing and quantity discounts
 Traditionally, wholesale price is fixed and is not subject
to negotiation
 How could we use wholesale price as a coordination
mechanism?
 A sufficient discount can induce the buyer to order a quantity
that increases the supplier’s net profit
 Optimizing wholesale unit price
 Offering all units quantity discounts
 Offering a linear discount schedule
 Weng (1995)
 How to implement a mechanism to divide the additional profits
generated through channel coordination with quantity discounts?
 A franchise fee plus quantity discounts will optimize profits of both
parties
C- Minimum purchase commitments
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Traditional inventory models assume that the buyer can order any
quantity from the supplier at any time
However this is not desirable for the supplier
 Bullwhip effect
 Inefficient use of capacity (low at certain times, high at others)
 Supplier either quotes a long lead time, or high wholesale price
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One solution is an agreement in which the buyer agrees in advance to
accept delivery of at least a certain quantity of stock, either in each
individual order or cumulatively over some period of time.
The manufacturer offers some form of incentive
 Lower unit cost on items purchased
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Bassok and Anupindi (1997)
 Minimum purchase quantity of KN over N periods
 How much should the retailer purchase when he has a starting inventory level
of In and remaining commitment of Kn
 Result: a modified base stock policy is optimal
D- Quantity Flexibility
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The quantity the retailer ultimately obtains may deviate from the initial
order quantity under some conditions
 Limits on the range of allowable changes
 Pricing rules
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There is a clear advantage to the retailer as it provides more flexibility
 Retailer would be willing to pay more for its deviation from its initial order
quantity
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Questions
 How should the contract be designed so that both parties are better off?
 How should the retailer behave given the flexibility?
 Initial ordering decision + a revision based on the sales information
 How should the manufacturer behave given the flexibility?
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Eppen and Iyer (1997) – backup agreements
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The retailer commits to y units for the season
Initial ownership of (1-r) y at the unit price c before the season
Order up to r y at the original price during the season
A penalty cost of b for any of the backup units not purchased
E- Buyback or returns policies
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A buyback or return contract establishes who bears responsibility for
unsold inventory and to what extent
Similar to Quantity Flexibility contracts except that buyback or returns
take place after the whole demand is materialized
Types of return policies
 Unlimited returns at full credit
 Limited returns at full credit
 Unlimited returns at partial credit
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Pasternack (1985)
 The manufacturer sets the wholesale price, market selling price is fixed, the
retailer decides the order quantity
 Inefficient mechanism because of double-marginalization
 Policies that allows for unlimited returns at full credit or no returns are not
inefficient
 Channel coordination can be established using a policy that allows unlimited
returns at partial credit
 Wholesale and buyback prices can be set to guarantee Pareto improvement
and these prices are independent of the market demand distribution.
F- Allocation rules
 How to distribute manufacturer’s available stock or production
capacity among multiple retailers in a shortage scenario
 Possibility of rationing lead to strategic behavior and retailers tend
to inflate their orders causing information distortion (Lee et al
1997)
 Not enough research on how different allocation schemes may
help to increase channel profits
 Cachon and Lariviere (1997)
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Even allocation: Allocate capacity evenly
Turn and earn: Allocate capacity based on past sales
More profitable for the supplier
May not be profitable for the retailers: they end up decreasing their
prices to increase their sales to protect their allocation
G- Lead times
 Manufacturer offering the retailer multiple choices for the lead time
 Iyer and Bergen (1997)
 Manufacturer offering a reduction in lead time through a Quick
Response contract
 Retailer benefits since it is ordering based on an improved state of
information (with possible updating of demand distribution based on
sales)
 However the manufacturer may lose from reducing the lead time as it
is unaffected from the overage risk
 Manufacturer will prefer high retailer orders, even if this includes a large
amount of safety stock that never get sold
 Thus the manufacturer may resist efforts that will reduce lead time
reductions
 Lead time reduction efforts should be supported with other side
agreements such as
 Higher service levels to end customer, higher wholesale price, volume
commitments
H- Quality
 Production quality has a positive effect on both sales
volume and production cost
 Demand is increasing with quality and decreasing with
price
 What should be the quality of the product that will
maximize channel profits?
 Similar variables are advertising and service
 Other issues
 Who should inspect the material?
 What is the frequency of inspections?