SCM - Lessius Chapter 4 - Supply Contracts

SUPPLY CONTRACTS
Supply Chain Management 1112 supply contracts
Slide 1
Roel Leus
Sequential optimization vs. global optimization

Sequential Optimization
Procurement Planning
Manufacturing Planning
Distribution Planning
Demand Planning
Global Optimization
Supply Contracts/Collaboration/Information Systems and DSS
Procurement Planning
Manufacturing Planning
Distribution Planning
Demand Planning
Slide 2
Roel Leus
Supply contracts

A contract is an agreement between two parties. The raison dtre for contracts is two parties with conflicting objectives. Differences in costs at the buyer and supplier can lead to decisions that increase total supply chain costs. E.g.: replenishment order placed by the buyer. The buyers EOQ ignores the suppliers costs. A quantity discount contract may encourage the buyer to purchase a larger quantity. This may result in lower total supply chain costs. [ but misleading demand information because of order batching ] A contract is said to be coordinating a supply chain if the sum of the profits of various decision makers under the contract is globally optimal Important especially for strategic components, not for commodities. Last few years, significant increase in level of outsourcing; many leading brand-name manufacturers outsource complete manufacturing (to OEMs*) and design (to ODMs) of their products (Apple, Dell, Sony and Toshiba to Quanta). The procurement function in OEMs* becomes critical to remain in control of their destiny.
*http://en.wikipedia.org/wiki/Original_equipment_manufacturer
Slide 3 Roel Leus
Coordination
1. Contracts for MTO supply chains

2. Contracts for MTS 3. Other issues
SUPPLY CONTRACTS
Slide 4
Roel Leus
Case swimsuit production Chapter 2
Consider a company that designs, produces, and sells summer fashion items such as swimsuits. About six months before summer, the company must commit itself to specific production quantities. Demand is forecasted and certain probabilities are attached to specific quantities. Overestimating demand will result in unsold inventory while underestimating it will lead to inventory stockouts and loss of potential customers. The probabilistic forecast suggests that average customer demand is 13 100 units for the summer season.
Demand Scenarios
Demand Probability Weighted Demand
30%
8000 10000 12000 14000 16000 18000 Average
11% 11% 28% 22% 18% 10%
880 1100 3360 3080 2880 1800 13100
Probability
25% 20% 15% 10% 5% 0% 8000 10000 12000 14000 16000 18000 Sales
Slide 5
Roel Leus
Swimsuits
Chapter 2
Fixed Production Cost =$100,000 Variable Production Cost=$35
Wholesale Price =$80 Selling Price=$125 Salvage Value=$20

Manufacturer
Manufacturer DC
Retail DC
Stores
Supply Chain Management 1112 supply contracts Slide 6 Roel Leus
Swimsuits
Chapter 2 (2)
To start production, the manufacturer has to invest $100 000 independent of the amount produced. This is fixed production cost. The variable production cost per unit equals $80. During the summer season, the selling price of a swimsuit is $125 per unit. Any swimsuit not sold during summer is sold to a discount store for $20.
To identify the best production quantity, the firm needs to understand the relationship between the production quantity, customer demand, and profit. Suppose the manufacturer produces 10 000 units while demand realises at 12 000 units. Profit equals revenue from summer sales less variable and fixed production costs: Profit = 125 (10 000) 80 (10 000) 100 000 = $350 000 and the probability of realising this profit is 28%
Swimsuits
Chapter 2 (3)
In similar fashion, one can calculate the profit associated with each demand scenario, given that the manufacturer produces 10 000 swimsuits. This allows us to calculate the expected profit associated with producing 10 000 units.
Demand Probability Production = 10 000
8000 10000 12000 14000 16000 18000 Average
11% 11% 28% 22% 18% 10%
$140,000.00 $350,000.00 $350,000.00 $350,000.00 $350,000.00 $350,000.00 $326,900.00
We would like to find the production quantity that maximizes expected profit. Should the optimal production quantity be equal to, more than or less than the average demand? With $45 understocking cost vs. $60 overstocking cost, the best production quantity will probably be less than average demand for these particular cost parameters.
Swimsuits
Chapter 2 (4)
Expected profit is maximised for a production quantity of 12 000 units

Profit
Expected Profit
$370,700.00
$400,000 $350,000 $300,000 $250,000 $200,000 $150,000 $100,000 $50,000 $0 5000 6000 7000 8000 9000 10000 11000 12000 13000 14000 15000 16000 Production Quantity
We can also do this without graph:
Slide 9
Roel Leus
Swimsuits
Chapter 2 (5)
Let cu = 60, co = 45. We look for the smallest Q such that
Pr[D Q]
co 60 60 0.5714 co cu 60 45 105
Note that this probability is a measure of the risk the manufacturer is willing to take. We use an inequality in this case, because the demand scenarios we have are discrete, i.e. demand is not continuous.
Demand Probability Q Pr(D>Q)
8000 10000 12000 14000 16000 18000
0.11 0.11 0.28 0.22 0.18 0.10
8 000 10 000 12 000 14 000 16 000 18 000
0.89 0.78 0.50 0.28 0.10 0.00
(while average demand is 13 100)

Swimsuits
Chapter 2 (6)
As we increase the production quantity, the risk that is, the probability of large losses always increases. At the same time, the probability of large gains also increases. This is the risk/reward trade-off. This is clear from comparing the figures for production quantities 9 000 and 16 000, which bring about the same average profit but have a different risk profile.
Probability
Demand 8000 10000 12000 14000 16000 18000 Average Profit
Probability 11% 11% 28% 22% 18% 10%
Profit for a Given Production Level 9000 12000 16000 $200,000.00 $20,000.00 -$220,000.00 $305,000.00 $230,000.00 -$10,000.00 $305,000.00 $440,000.00 $200,000.00 $305,000.00 $440,000.00 $410,000.00 $305,000.00 $440,000.00 $620,000.00 $305,000.00 $440,000.00 $620,000.00 $293,450.00 $370,700.00 $294,500.00
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%
Revenue
Q=9000 Q=16000
Of course, a production quantity of 9 000 does not make much sense, since the probability of demand being equal to 9 000 is zero, unless we have an initial inventory of 1 000 and should bring it up to 10 000.
Slide 11 Roel Leus
Swimsuits
Chapter 2 (7)
Suppose now that the swimsuit under consideration is a model produced last year, and that the manufacturer has an initial inventory of 5 000 units. Assume that demand follows the same pattern as before. Fixed production costs ($100 000) are charged independent of the amount produced. Should the manufacturer start production and if so, how many swimsuits should be produced?
If nothing is produced, average profit is equal to the sales of the 5000 initial
inventory, where no fixed production cost and no variable production costs are taken into account: profit is 5000 125 = $625 000 If the manufacturer decides to produce to bring inventory to 12 000 units (what we found is the optimum), the profit he gains would be: 0.11(8000125 + 400020) + 0.11(10 000125 + 200020) + 0.28(12 000125 + 020) + 0.22(12 000125 + 020) + 0.18(12 000125 + 020) + 0.10(12 000125 + 020) 700080 100 000 = $770 700 In conclusion: the optimal policy is to produce 7000 = 12000 5000 units
Case swimsuit production Chapter 4
In the analysis of the case in Chapter 2 it is assumed that the manufacturer has adequate supply of raw materials, delivered on time. In order to ensure this, buyers and suppliers agree on supply contracts. Supply contracts are very powerful tools that can be used for far more than to ensure adequate supply of, and demand for goods. In a supply contract, the buyer and the supplier may agree on:
Pricing and volume discounts. Minimum and maximum purchase quantities. Delivery lead times. Product or material quantity. Product return policies.
We assume now that there are two companies involved in the supply chain: a retailer who faces customer demand and a manufacturer. Demand follows the same pattern as before.
Slide 13
Roel Leus
Swimsuits
Chapter 4
Wholesale Price =$?? Selling Price=$125 Salvage Value=$20

Manufacturer
Manufacturer DC
Retail DC
Stores
Case swimsuit production (cntd)
For the retailer:

Selling price of swimsuit during the summer season: $125
Wholesale price paid to the manufacturer: $80 Salvage value: $20
For the manufacturer:

Fixed production cost: $100 000
Variable production cost: $35
Seller
fixed production cost: 100 000 wholesale price: 80
Buyer
selling price: 125
Manufacturer
variable production cost: 35
Retailer
salvage value: 20
Slide 15
Roel Leus
Case swimsuit production (cntd)
Marginal profit (understocking cost) for both actors are:

retailer: 125 80 = $45
manufacturer: 80 35 = $45
Retailers marginal cost (overstocking cost) is 80 20 = $60 and following the analysis of the case in Chapter 2, it is optimal for the retailer to order 12 000 swimsuits. Expected profit of retailer = 370 700 (supra) + 100 000 = $470 700 Expected profit of manufacturer = 12 000 (80 35) 100 000 = $440 000 Total for Supply Chain = 470 700 + 440 000 = $910 700

In the previous example, we had a sequential supply chain, where the manufacturer reacts to decisions made by the retailer. The retailer bears all risk (of having excess inventory), the supplier does not bear any risk. It is natural to look for mechanisms that the supply chain parties can use to improve profits, which means they would move to global optimization.
Slide 16 Roel Leus
Swimsuit production
Buy-back contract
Buy-back contracts the seller (manufacturer) agrees to buy back unsold goods from the buyer (retailer) for some agreed-upon price. Suppose the manufacturer offers to buy unsold swimsuits from the retailer for $55. The retailer can either salvage goods, or the manufacturer will buy them back and salvage them himself. Such a construction is valuable when the increase in order quantity placed by the retailer more than compensates the suppliers increase in risk.
Item Price
Seller 100 000 35 20

Buyer
Retailer sells for: Manufacturer sells for: Salvage: Manufacturer buy back: Fixed Production Cost: Variable Production Cost:
$125.00 $80.00 $20.00 $55.00 $100,000.00 $35.00
80
55
125
Slide 17
Roel Leus
Swimsuit production
Buy-back contract (2)
profit retailer:
demand = 12 000, order level = 10 000
profit = min{10 000, 12 000}*125 10 000 * 80 + max{10 000 12 000, 0}*max{20, 55} = 10 000 * 125 10 000 * 80 + 0 * 55 = 1 250 000 800 000 = $450 000
profit = min{14 000, 12 000}*125 14 000 * 80 + max{14 000 12 000, 0}*max{20, 55} = 12 000 * 125 14 000 * 80 + 2 000 * 55 = 1 500 000 1 120 000 + 110 000 = $490 000
Retailers expected profit:

Demand 8000 10000 12000 14000 16000 18000 Expected Profit Probability 11% 11% 28% 22% 18% 10% 8000 $360,000.00 $360,000.00 $360,000.00 $360,000.00 $360,000.00 $360,000.00 $360,000.00 Profit for a Given Retailer Order Level 10000 12000 14000 $310,000.00 $260,000.00 $210,000.00 $450,000.00 $400,000.00 $350,000.00 $450,000.00 $540,000.00 $490,000.00 $450,000.00 $540,000.00 $630,000.00 $450,000.00 $540,000.00 $630,000.00 $450,000.00 $540,000.00 $630,000.00 $434,600.00 $493,800.00 $513,800.00
Slide 18
16000 $160,000.00 $300,000.00 $440,000.00 $580,000.00 $720,000.00 $720,000.00 $503,000.00

Roel Leus
Swimsuit production
profit manufacturer:
profit = 12 000 * 80 100 000 12 000 * 35 max{12 000 14 000, 0} * (55 20) [ aangezien 55 > 20 ] = 960 000 100 000 420 000 0 = $440 000 demand = 10 000, order level = 14 000 profit = 14 000 * 80 100 000 14 000 * 35 max{14 000 10 000, 0} * (55 20) = 1 120 000 100 000 490 000 4 000*55 + 20*4 000 =120 000 100 000 490 000 220 000 + 80 000 = $390 000
Manufacturers expected profit:

Slide 19
18000 $360,000.00 $430,000.00 $500,000.00 $570,000.00 $640,000.00 $710,000.00 $538,500.00

Roel Leus
Swimsuit production
Retailer: profit from $470 700 to $513 800; quantity from 12 000 to 14 000 Manufacturer: profit from $440 000 to $ 471 900. The total average profit increases from $910 700 with sequential optimization to $985 700 (= $ 513 800 + $471 900) with buy-back contract The buy-back contract is effective because it allows the manufacturer to share some of the risk and thus incites the retailer to increase order quantity
Profit ($)
$1200000,000 $1000000,000 $800000,000
retailer's profit
$600000,000
manufacturer's profit total profit
$400000,000
$200000,000 $,000 5000,0
8000,0
11000,0
14000,0
17000,0
Quantity
Buyback
Downsides:
effective reverse logistics needed
Incentive for retailer for selling competing products Surplus inventory for the supplier that must be disposed of, which increases
supply chain costs Inflated retail orders, not actual customer demand
Most effective for products with low variable cost, such as music, software, books, magazines and newspapers so that
profit margin is high, product availability is critical
consequence of suppliers surplus inventory is little (or proof of destruction)
Which of these are true? Buyback contract increases the expected supply chain profit / supplier profit / retailer profit / sales to the market / sales to the retailer / demand
Slide 21
Roel Leus
Swimsuit production
Revenue-sharing contract
In the sequential supply chain, one important reason for the retailer to order only 12 000 units is the high wholesale price. If somehow the retailer can convince the manufacturer to reduce the wholesale price, then clearly the retailer would order more. Of course, price reduction will decrease manufacturers profit if the retailer is unable to sell more units. This issue is addressed by revenue-sharing contracts. Suppose the swimsuit manufacturer and retailer have a revenue-sharing contract with the following conditions: the manufacturer reduces the price he charges from $80 to $60 and the retailer transfers 15% of the sales revenue back to the manufacturer in return.
8060
Item Price
Seller
Manufacturer Transfer
Buyer
Retailer
Retailer sells for: Manufacturer sells for: Salvage: Revenue Sharing: Fixed Production Cost: Variable Production Cost:
$125.00 $60.00 $20.00 15% $100,000.00 $35.00
15% of sales revenue

Swimsuit production
Revenue-sharing contract (2)
Profit retailer:
profit = min{10 000,12 000}*125*85% 10 000*60 + max{10 000 12 000,0}*20 = 1 062 500 600 000 = $462 500 demand = 12 000, order level = 14 000 profit = min{14 000, 12 000)*125*85% 14 000*60 + max{14 000 12 000, 0}*20 = 1 275 000 840 000 + 40 000 = $475 000
Retailers expected profit:

Slide 23
16000 $50,000.00 $222,500.00 $395,000.00 $567,500.00 $740,000.00 $740,000.00 $472,625.00

Roel Leus
Swimsuit production
Profit manufacturer:
profit = 12 000*60 100 000 12 000*35 + min{12 000,10 000}*125*15% = 720 000 100 000 420 000 + 187 500 = $387 500
profit = 10 000*60 100 000 10 000*35 + min{10 000, 12 000}*125 *15% = 600 000 100 000 350 000 + 187 500 = $337 500
Manufacturers expected profit:

Slide 24
18000 $500,000.00 $537,500.00 $575,000.00 $612,500.00 $650,000.00 $687,500.00 $595,625.00

Roel Leus
Swimsuit production
Retailer: profit from $470 700 to $504 325; quantity from 12 000 to 14 000 Manufacturer: profit from $440 000 to $ 481 375. The total average profit increases from $910 700 in the sequential supply chain to $985 700 (= $504 325 + $481 375) with the revenue-sh. contract. The reduction of the wholesale price coupled with revenue sharing leads to increased profits for both parties.
Profit ($)
$1200000,000 $1000000,000 $800000,000 $600000,000 $400000,000 $200000,000 $,000 5000,0
retailer's profit manufacturer's profit total profit
8000,0
11000,0
14000,0
17000,0
Quantity
Revenue sharing
The buyer pays a minimal amount for each unit purchased from the supplier but shares a fraction of the revenue for each unit sold Decreases the cost per unit charged to the retailer, which effectively decreases the cost of overstocking When the overstocking cost drops, retailers order quantity rises Misleading for the supply chain as it reacts to (inflated) retail orders, not to actual customer demand Supplier needs to monitor buyers revenue Incentive for buyer for pushing competing products with higher margins
Slide 26
Roel Leus
Blockbuster case
Demand for a newly released movie typically starts high and decreases rapidly; peak demand lasts about 10 weeks
Blockbuster purchases a copy from a studio for $65 and rents for $3.
Blockbuster (retailer) must rent the tape at least 22 times before earning profit Retailers cannot justify purchasing a movie (cassette) by covering the peak demand. In 1998, 20% of surveyed customers reported that they could not rent the movie they wanted because the Blockbuster stores did not have that movie.
In 1998, Blockbuster started revenue sharing with the major movie studios
Studio charges $8 per copy. Blockbuster (retailer) shares a portion (30-45%) of of the sales revenue (rental
income) with the supplier Even if Blockbuster keeps only half of the rental income, the breakeven point is 6 rentals per copy The impact of revenue sharing on Blockbuster was dramatic. Rentals increased by 75% in test markets due to higher video availability. Market share increased from 25% to 31% (the 2nd largest retailer only has 5% market share)
Swimsuit production
Global optimization
Rather than investigate contracts modifying initial sales terms between two parties, we now consider supplier and buyer as two partners / two members of the same organization. In other words: we ignore the transfer of money between the parties and an unbiased decision maker will maximize the supply-chain profit. The only relevant data in this case are the selling price, the salvage value, the variable production costs, and the fixed production costs. The cost that the manufacturer charges the retailer becomes meaningless, since we consider them as one and we are only interested in external costs and revenues.
Seller 100 000 35 80 Buyer 125 20
Manufacturer
Retailer
Slide 28
Roel Leus
Swimsuit production
Global optimization (2)
Wholesale Price =$80 Selling Price=$125 Salvage Value=$20

Manufacturer
Manufacturer DC
Retail DC
Stores
Swimsuit production
Evidently, the supply chain marginal profit of 90 (= 125 35) is significantly higher than the marginal loss of 15 (= 35 20), and hence the supply chain will probably produce more than average demand.
Item Price
Retailer sells for: Salvage: Fixed Production Cost: Variable Production Cost:
$125.00 $20.00 $100,000.00 $35.00
Overall profit: Stel demand = 10 000, order level = 12 000: profit = min{12 000,10 000}*125 12 000 * 35 100 000 + max{12 000 10 000, 0}*20 = 10 000*125 12 000*35 100 000 + 2 000*20 = 1 250 000 420 000 100 000 + 40 000 = $770 000
Slide 30
Roel Leus
Swimsuit production
System Profit ($)

$1,200,000.00 $1,000,000.00 $800,000.00 $600,000.00 $400,000.00 $200,000.00 $0.00 5,000
Profit vs Order Quantity
6,000
7,000
8,000
9,000 10,000 11,000 12,000 13,000 14,000 15,000 16,000 17,000 18,000
Quantity
Slide 31
Roel Leus
Swimsuit production
Demand 8000 10000 12000 14000 16000 18000 Expected Profit Probability Profit for a Given Order Level 10000 12000 14000 11% $590,000.00 $560,000.00 $530,000.00 11% $800,000.00 $770,000.00 $740,000.00 28% $800,000.00 $980,000.00 $950,000.00 22% $800,000.00 $980,000.00 $1,160,000.00 18% $800,000.00 $980,000.00 $1,160,000.00 10% $800,000.00 $980,000.00 $1,160,000.00 $776,900.00 $910,700.00 $985,700.00 16000 $500,000.00 $710,000.00 $920,000.00 $1,130,000.00 $1,340,000.00 $1,340,000.00 $1,014,500.00 18000 $470,000.00 $680,000.00 $890,000.00 $1,100,000.00 $1,310,000.00 $1,520,000.00 $1,005,500.00
Or
Pr[D Q]
Demand
co 15 15 0.1429 co cu 15 90 105
Q Pr(D>Q)
Probability
8000 10000 12000 14000 16000 18000
0.11 0.11 0.28 0.22 0.18 0.10
8 000 10 000 12 000 14 000 16 000 18 000
0.89 0.78 0.50 0.28 0.10 0.00
The risk the manufacturer can take should be smaller than 0.1429. The first smaller value is 0.10 and it corresponds to production quantity of 16 000. This is exactly the result we got using expected profit as a measure. In this global optimization strategy, the optimal production quantity is 16 000, which implies an expected supply chain profit of $1 014 500.
Swimsuit production
Globally optimal buy-back contract
The difficulty with global optimization is that it requires the firm to surrender decision-making power to an unbiased (external) decision maker. It can be shown, however, that carefully designed supply contracts achieve exactly the same profit as global optimization.
Illustration: See Excel-sheet DMSCe3.xls Buy back (bis): the retailer can either salvage goods or the manufacturer will buy them back and salvage himself. Consider these parameters:
Item Price
Retailer sells for: Manufacturer sells for: Salvage: Manufacturer buy back: Fixed Production Cost: Variable Production Cost:
$125.00 $75.00 $20.00 $65.00 $100,000.00 $35.00
The wholesale price has decreased from $80 to $75 and the buy back value has increased from $55 to $65. In this case, the retailers individual optimum quantity and the globally optimum quantity coincide.
Other constructions
Quantity-flexibility contracts = buy back with full refund / allows the buyer to modify the order (within limits) as demand visibility increases towards the point of sale
Better matching of supply and demand
Increased overall supply chain profits if the supplier has flexible capacity
Lower levels of misleading demand information than either buyback contracts
or revenue sharing contracts Benetton: 40% allowance on colors, 10% on aggregate quantity across colors; guaranteed portion is manufactured by Benetton with an inexpensive but longlead-time process; the flexible part (about 35%) is manufactured using postponement
Sales rebate contracts = rebate beyond certain quantity
Slide 34
Roel Leus

SUPPLY CONTRACTS
Slide 35
Roel Leus
MTS instead of MTO

Fashion item ski jackets Short life cycles, one production opportunity Same data as before, but now MTS at supplier Time line:
Jan 00 Design Feb 00 Sep 00
Jan 01 Production Feb 01
Jan 02 Retailing Sep 01
Distributor places order
Contrary to the swimsuit example, the supplier now assumes all of the risk of building more capacity than sales!
Slide 36 Roel Leus
Ski jackets
It is now the manufacturer who needs to decide a (production) quantity, and thus faces a newsboy problem: lowest Q such that Pr[ D Q ] 0.2941 ?
Item Price
Demand Probability 8000 11% 10000 11% 12000 28% 14000 22% 16000 18% 18000 10%
Manufacturer sells for: Distributor sells for: Salvage: Fixed Production Cost: Variable Production Cost:
$80,00 $125,00 $20,00 $100.000,00 $55,00
Q = 12 000
Again, a variety of supply contracts enable risk sharing and hence reduce manufacturers risk and motivate him to increase production.
Pay-back contract: buyer pays a price for each unit produced but not purchased Cost-sharing contract: the buyer shares some of the production cost (e.g. set %)
in return for a discount on the wholesale price An issue here is the sharing of production-cost information. A possible solution to this is for the retailer to purchase one or more components. Again, globally optimal solutions can be achieved

SUPPLY CONTRACTS
Slide 38
Roel Leus
Asymmetric information
Implicit assumption so far: buyer and supplier share the same forecast
Inflated forecasts from buyers a reality
How to design contracts such that the information shared is credible?
Capacity Reservation Contract

Buyer pays to reserve a certain level of capacity at the supplier
A menu of prices for different capacity reservations provided by supplier Buyer signals true forecast by reserving a specific capacity level
Advance Purchase Contract

Supplier charges special price before building capacity When demand is realized, price charged is different Buyers commitment to paying the special price reveals the buyers true
forecast
Slide 39
Roel Leus
Contracts for non-strategic components
Traditionally, buyers have focused on long-term contracts for many of their purchasing needs Recently, trend towards more flexible contracts for non-strategic components:
Variety of suppliers
Market conditions dictate price Flexibility more important than long-term relationship:
Reduce supply chain costs Be more responsive and flexible to market conditions
Effective procurement strategy for commodity products has to focus on both driving costs down and reducing risks:
Inventory risk due to uncertain demand
Price, or financial, risk due to volatile market price Shortage risk due to limited component availability
Slide 40
Roel Leus
Contracts for non-strategic components (2)
Long-term contract = forward contract = fixed-commitment contract

Supplier and buyer agree on both price and quantity (at a future time)
Buyer bears no financial risk but takes huge inventory risks
Option contract:
Supplier commits to reserve capacity up to a certain level reservation price / premium up front Buyer can purchase any amount of supply up to the option level
(execution price or exercise price) flexible contract: fixed amount of supply; can differ by given %
Spot market:
Additional supply in the open market; here and now
Slide 41
Roel Leus
Contracts for non-strategic components (3)
Portfolio approach to supply contracts: appropriate mix of the foregoing:

Base commitment = long-term contracts;
option level = options;
remainder = uncommitted
50% 35% (Hewlett-Packard) rest
base commitment level

LOW HIGH Inventory risk for buyer n/a
option level
LOW HIGH
Price & shortage risks for buyer Inventory risk for supplier
Slide 42
Roel Leus

SCM - Lessius Chapter 4 - Supply Contracts

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SUPPLY CONTRACTS

Supply Chain Management 1112 supply contracts

Sequential optimization vs. global optimization

Supply Chain Management 1112 supply contracts

Supply Chain Management 1112 supply contracts

1. Contracts for MTO supply chains

Supply Chain Management 1112 supply contracts

Case swimsuit production Chapter 2

8000 10000 12000 14000 16000 18000 Average

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

880 1100 3360 3080 2880 1800 13100

Supply Chain Management 1112 supply contracts

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

Wholesale Price =$80 Selling Price=$125 Salvage Value=$20

8000 10000 12000 14000 16000 18000 Average

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

$140,000.00 $350,000.00 $350,000.00 $350,000.00 $350,000.00 $350,000.00 $326,900.00

Expected profit is maximised for a production quantity of 12 000 units

We can also do this without graph:

Supply Chain Management 1112 supply contracts

Let cu = 60, co = 45. We look for the smallest Q such that

8000 10000 12000 14000 16000 18000

0.11 0.11 0.28 0.22 0.18 0.10

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

0.89 0.78 0.50 0.28 0.10 0.00

(while average demand is 13 100)

Demand 8000 10000 12000 14000 16000 18000 Average Profit

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

Supply Chain Management 1112 supply contracts

Case swimsuit production Chapter 4

Supply Chain Management 1112 supply contracts

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

Wholesale Price =$?? Selling Price=$125 Salvage Value=$20

Case swimsuit production (cntd)

For the retailer:

For the manufacturer:

Supply Chain Management 1112 supply contracts

Case swimsuit production (cntd)

Marginal profit (understocking cost) for both actors are:

Supply Chain Management 1112 supply contracts

Seller 100 000 35 20

$125.00 $80.00 $20.00 $55.00 $100,000.00 $35.00

Retailers expected profit:

16000 $160,000.00 $300,000.00 $440,000.00 $580,000.00 $720,000.00 $720,000.00 $503,000.00

Supply Chain Management 1112 supply contracts

Manufacturers expected profit:

18000 $360,000.00 $430,000.00 $500,000.00 $570,000.00 $640,000.00 $710,000.00 $538,500.00

Supply Chain Management 1112 supply contracts

manufacturer's profit total profit

Supply Chain Management 1112 supply contracts

$125.00 $60.00 $20.00 15% $100,000.00 $35.00

15% of sales revenue

Retailers expected profit:

16000 $50,000.00 $222,500.00 $395,000.00 $567,500.00 $740,000.00 $740,000.00 $472,625.00

Supply Chain Management 1112 supply contracts

Manufacturers expected profit:

18000 $500,000.00 $537,500.00 $575,000.00 $612,500.00 $650,000.00 $687,500.00 $595,625.00

Supply Chain Management 1112 supply contracts

retailer's profit manufacturer's profit total profit

Supply Chain Management 1112 supply contracts

Supply Chain Management 1112 supply contracts

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