UV6009

Rev. Oct. 26, 2011

SUPPLY CHAIN COORDINATION AND CONTRACTS

Introduction

In this note, we discuss the importance of coordination in a supply chain. When different
parties in the supply chain operate in their own best interest, without considering the rest of the
supply chain, the overall supply chain profits may be much worse than if supply chain decisions
were coordinated. This is due to the fact that the decisions that maximize one party’s profit do
not necessarily maximize the overall supply chain profit. This phenomenon is known as double
marginalization.

In a supply chain, an upstream company sells goods to a downstream company, which

then sells them to customers. When either company can influence the level of customer demand
through its actions, this will have an impact on the quantity sold by both companies and hence on
the profits of both. We will show that when acting independently, companies will usually adopt a
policy of higher prices and lower volumes in the supply chain than would be optimal for the
supply chain as a whole.

When the supply chain as a whole operates in a way that maximizes supply chain profit
(as one would expect in cases of common ownership), then we say that the supply chain is
coordinated. Coordination can often be achieved through contractual arrangements between
parties that allow revenue sharing, profit sharing, or buybacks (Return Policies).

The way supply chain profits are distributed among parties is important and because
these will be a result of negotiation, they usually depend on the relative strengths of the parties’
bargaining positions. But it is helpful to separate the question of profit division among the
parties, from the question of how to coordinate in order to maximize the total supply chain profit.
A supply chain can be well coordinated but still have one party taking all the profit.

We will now consider two important supply chain decisions faced by retailers: pricing
(How much to charge for the product?) and stocking (How many units to order from the
upstream supplier?). We will see how double marginalization can distort these two decisions
when made individually rather than from the perspective of the supply chain as a whole.
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Pricing Decisions

Consider a manufacturer supplying a retailer who sells to a final consumer. Suppose the
manufacturer sets a price per unit that will be charged to the retailer, who then sets the retail
price to the customer. Moreover, suppose that both parties have complete knowledge of the costs
of the other party and the way consumer demand depends on price. What might we expect to
happen?

The retail price set by the retailer will affect the volume of goods sold, so it will have an
impact on both the manufacturer and the retailer’s profits. From the retailer’s perspective, setting
the optimal price is a trade-off between margin and volume. A one-cent reduction in price
produces a greater volume of sales, but the additional profit from these sales is offset by the loss
in profit due to the reduced margin on all the other sales. At the optimum, these two factors
exactly balance each other (otherwise we could obtain an improvement in profit by either
increasing the price slightly or decreasing it slightly). However, a reduction of one cent in price
by the retailer, since it leads to a greater volume of sales, gives an increase in profit to the
manufacturer as well. While the optimal price for the retailer maximizes its own profit, it does
not optimize the profits of the supply chain as a whole. In fact, the optimal retail price from the
point of view of the combined profit of the retailer and manufacturer will always be less than the
price set by the retailer acting on its own.

Consider a specific example: La-La Toys is a Charlottesville-based toy store selling a

variety of products for kids. One of the products sold by the store is a Snow White doll supplied
by a Maryland-based manufacturer. The management of La-La Toys expect that the demand for
the dolls is price-dependent and defined by D(p) = 100 – 5p, where p is the retail price for the
doll. The manufacturer charges the toy store $10.00 for each doll, and the production cost for the
manufacturer is $4 per unit. The profit of La-La Toys from the doll is equal to its margin
multiplied by the volume sold, thus:

La-La Toys’ profit = (p – 10)(100 – 5p).

The manufacturer’s profit also depends on the retail price chosen by La-La Toys and is
equal to his own margin multiplied by the order quantity from La-La Toys. Since there is no
uncertainty, the order quantity in this case will be exactly equal to the volume the store will sell,
thus:

Manufacturer’s profit = (10 – 4)(100 – 5p) = 6(100 – 5p).

Figure 1 presents the profits of La-La Toys and the manufacturer as well as the total
supply chain profits as a function of the retail price set by La-La Toys. As can be seen in the
figure, the optimal retail price for La-La Toys is equal to $15 and results in 25 dolls ordered and
sold. The profits of La-La Toys and its manufacturer are equal to $125 and $150, respectively,
resulting in total supply chain profits of $275.
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Figure 1. Supply chain profit as a function of the retail price p.

$360
Retail profit
$320
Manufacturing profit
$280 Total profit

$240
Supply $200
chain
profit $160
$120
$80
$40
$0
$10.00 $11.00 $12.00 $13.00 $14.00 $15.00 $16.00 $17.00 $18.00 $19.00 $20.00
Retail price p

Source: Created by case writer.

What if instead of La-La Toys and its manufacturer maximizing their individual profits,
they worked cooperatively to maximize the total supply chain profits. In this case, the margin of
the supply chain as a whole is equal to the retail price minus the production cost and the total
profits are equal to that margin multiplied by the volume, thus:

Total supply chain profit = (p – 4)(100 – 5p)

As can be seen in Figure 1, when the supply chain operates in a way that maximizes total
supply chain profits, the optimal retail price is $12.00, and results in 40 dolls ordered and sold.
The total supply chain profits in this case are equal to $320.00.

Comparing the results of the decentralized case (in which the companies operated
without regard for the other members of the supply chain) to the centralized case (in which they
operated cooperatively), we observe that:

 The retail price in the centralized case ($12) is lower than that of the decentralized case
($15), and the volume is higher (40 versus 25 units).
 The total supply chain profits in the centralized case ($320) are higher than those of the
decentralized case ($275).

From these observations, it is clear that the decentralization of the supply chain is
distorting the supply chain decision making. By this we mean that, although it is optimal for the
supply chain as a whole to set the retail price at $12, when each of the two companies tries to
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optimize its own profit, the result will be a higher retail price of $15, dampening sales and
decreasing profits.

This is typical of double marginalization, in which each party makes decisions

considering only a portion of the total supply chain margin. In this case, a decision by the
manager of La-La Toys (retail price) affects the profits of its Maryland manufacturer. The
manager of La-La Toys, however, does not consider the manufacturer’s profits when making the
decision, and as a result, this decision does not maximize the total supply chain profits.

Stocking Decisions

To explore this idea further, we will look at the problem of deciding on product
availability (the retailer’s order quantity decision) in the newsvendor setting. (For more on the
newsvendor model, see “Managing Inventories: The Newsvendor Model,” UVA-OM-1456.)

Consider this example: Virginia Air Conditioner Inc. (VAC) produces air conditioners
for sale in the U.S. market. An important component in each unit is a compressor obtained from
a supplier in China. To meet its summer demand, VAC must order compressors in February
from its supplier. The forecasted summer demand for air conditioners is given in Table 1.
During the summer, air conditioners are assembled to order, and delivery lead times for materials
other than compressors are so short that demand is essentially known by the time they have to be
purchased.

Table 1. Probabilistic forecast for summer demand for air conditioners.

Demand, D 100 150 200 250 300
Probability 5% 15% 30% 33% 17%
F(D) 5% 20% 50% 83% 100%

The selling price of an air conditioner is $450. Compressors remaining in inventory at the
end of October are discarded. If demand exceeds the supply of compressors, then customers will
go elsewhere. Production cost data appear in Table 2.

Table 2. VAC cost data.

Direct labor costs $50
Variable overhead (per unit) $50
Direct material costs (other than compressor) $50
Compressor Wholesale price $150
Total: $300

In order to find the optimal ordering quantity for the compressors, we use the
newsvendor model and the critical ratio. When deciding on the optimal ordering quantity, we
have two types of costs to take into account.
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The understocking cost (what you lose if you don’t stock enough) is the margin from the
air conditioners. So here, c u = $450 – $300 = $150.

The overstocking cost (what you lose if you stock too much) is the cost of the
compressor, which you cannot salvage: c o = $150.

We know from the newsvendor model that we should choose an amount to stock that
makes the probability that demand is less than the order quantity equal to the critical ratio
cu
cu c o .

*
Thus, Q , the optimal amount to order, can be found by solving Equation 1:

c 150
F (Q * )    0.5
cu u c o 150  150 . (1)

Using the probabilistic forecast from Table 1, the optimal ordering quantity therefore is
*
Q = 200.

The supplier’s profit is equal to his margin from the compressor multiplied by the order
quantity. Assuming the supplier’s cost of the compressor is $51,

Supplier profit = ($150 – $51)  200 = $19,800.

Next, we would like to calculate the expected profit for VAC, and to do that we need to
consider the profits that result from different possible demands and multiply them by the
appropriate probabilities.

VAC makes a profit of $150 on each air-conditioning unit sold. If demand is less than
200, then we have to subtract from profits the wholesale cost of the unused compressors, which
we have bought but will be scrapped.

Hence if the demand is 100, VAC makes a profit from sales of $150  100 but has to
subtract $150 for each of 100 unused compressors. This gives an overall profit of $0. If the
demand is 150, VAC makes a profit from sales of $150  150 and has to subtract $150 for each
of 50 unused compressors. This gives an overall profit of $15,000. If the demand is 200 or more,
VAC makes a profit of $150  200 = $30,000. Thus the expected profit for VAC is

VAC’s profit = 0.05  $0 + 0.15  $15,000 + (0.30 + 0.33 + 0.17)  $30,000

= $26,250.

The total supply chain profits are therefore $46,050.

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In this example, we can see how the supply chain profits are divided between the supplier
and the retailer in the supply chain. It is interesting to ask whether it would be advantageous for
VAC and its Chinese supplier to cooperate their decision making about the number of air
conditioners to produce. Now we will explore this question.

When VAC and its Chinese supplier work cooperatively, we need to solve a newsvendor
problem for the supply chain as a whole. This means that the cost of the compressors is reduced
from $150 to $51. This will consequently affect the understocking cost and overstocking cost.
The overstocking cost is now c o = $51, while the understocking cost is c u = $450 – $150 – $51 =
$249.
*
Using the newsvendor model, the optimal amount to order, Q , is given by Equation 2:

c 249
F (Q * )    0.83 . (2)
cu u c o 249  51
*
Using the probabilistic forecast in Table 1, the optimal ordering quantity is Q = 250.

The total expected supply chain profits can be calculated in the same way as before. We
consider the supply chain profits that occur at different levels of demand. For the supply chain as
a whole, a single sale is worth $249 in profit, and unused compressors cost $51 each.

If the demand is 100, the supply chain makes a profit from sales of $249  100, but we
have to take away $51 for each of 150 unused compressors. This gives an overall profit of
$17,250. If the demand is 150, we make a profit from sales of $249  150 and have to take away
$51 for each of 100 unused compressors. This gives an overall profit of $32,250. If the demand
is 200, we make a profit from sales of $249  200 and have to take away $51 for each of 50
unused compressors. This gives an overall profit of $47,250. If the demand is 250 or more, we
make a profit of $249  250 = $62,250.

Supply chain profit = 0.05  $17,250 + 0.15  $32,250 + 0.30  $47,250 + 0.50  $62,250
= $51,000

Comparing the results of the decentralized case (in which the companies operated without
regard for the other members of the supply chain) to the centralized case (in which they operated
cooperatively), we observe that:

 The supply chain ordering quantity in the centralized case (250) is higher than that of the
decentralized case (200).
 The total supply chain profits in the centralized case ($51,000) are higher than those of
the decentralized case ($46,050).
 -7- UV6009

From these observations, it is clear that similar to the case of the pricing decision, the
decentralization of the supply chain is distorting the supply chain stocking decision. Although it
is optimal for the supply chain as a whole to order 250 units, when there are two companies
involved and each one is trying to maximize its own profit, the result will be that the supply
chain as a whole orders less (200 units) and so underperforms with respect to its total profits.

As discussed above, this is typical of double marginalization in which each party makes
decisions considering only a portion of the total supply chain margin. In this case, a decision by
the manager of VAC (order size) affects the profits of its Chinese supplier. The manager of
VAC, however, does not consider the supplier’s profits when making the decision, and as a
result, this decision does not maximize the total supply chain profits.

Coordinating the Supply Chain through Contracts

We have seen how decentralized decision making will not, in general, lead to the best
supply chain profits. It is clear that we could make all the players in the supply chain better off if
we used centralized decision making and then divided the supply chain profits in a way that
makes them higher for each player than the profits under the decentralized supply chain. We will
show how to do this by using contracts.

A contract specifies the parameters within which the buyer places orders and a supplier
fulfills them. A contract may contain specifications regarding quantity, price, lead time, and
quality. The type of contract designed affects the risk each party takes. For example, a contract
may require the buyer to specify the precise quantity required, with a long lead time, and then to
pay the supplier a cost per unit for the order. This is the contract we used in the decentralized
case above, in which VAC had to order the compressors in advance to receive them in time for
the summer, and VAC paid a constant price per unit. We refer to this contract as the wholesale
pricing contract. In this contract, the buyer bears the risk of overstocking and understocking,
while the supplier has exact information well in advance of the delivery. Because the buyer is
bearing all the risk but only getting part of the revenues (the double marginalization problem),
the buyer will order less than the optimal amount under a centralized supply chain system.

From this, we may guess that to achieve the solution of the centralized supply chain (i.e.,
achieve coordination), we need to use a contract that will share the risk among the different
parties. We consider three contracts: a buyback contract, a revenue-sharing contract, and a
profit-sharing contract. In a buyback contract, the supplier offers the retailer the opportunity to
return leftover products, while in a revenue-sharing (profit-sharing) contract, the supplier
receives a portion of the buyer’s revenues (profits) and thus reduces the wholesale price.
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The buyback contract (return policies)

A supplier can increase the quantity purchased by the retailer by offering to buy back any
leftover units at the end of the season at a fraction of the purchase price. This action has the
effect of increasing the salvage value per unit for the retailer (thus reducing overstocking risks)
who, as a result, increases ordering quantity. The supplier may benefit by taking on some of the
cost (and risks) of overstocking given that the supply chain as a whole will, on average, end up
selling more products. The buyback contract is prevalent in the publishing industry because of
low production cost compared with the value of the product.

To illustrate the use of the buyback contract, we will continue with the example of VAC.
Suppose that the Chinese supplier offers to buy any unused compressors back from VAC at a
price of $b. We will investigate how $b should be set. We assume the wholesale price is still set
at $150.

In this case, the compressors have a salvage value of $b per unit, and for any compressor
left at the end of the season, VAC will return it to the supplier and receive $b for it. Thus the
overstocking cost is now reduced by $b, and c o = $150 – $b, while the understocking cost is the
same as it was before, c u = $150.

Hence we have our usual critical ratio formula for order quantity (Equation 3):

150
F (Q * )  c c u 
u  co 150  150  b . (3)

In order to achieve the maximum supply chain profits, we need the optimal ordering quantity to
*
equal that of the centralized case. We need to have F(Q ) = 0.83, since then we get the optimal
*
ordering quantity, Q = 250, from Table 1. Therefore we should choose b so that (Equation 4):

150
F (Q * )  c c u   0.83.
u  co 150  150  b (4)
*
We solve this equation for b and call the result b . Multiplying both sides by (300 – b)
and dividing by 0.83 gives (Equations 5 and 6):

150
300  b*  .
0.83 (5)
So

150
b*  300   119.27.
0.83 (6)
*
We round this to b = $119 (which will make the calculations simpler).
 -9- UV6009
*
With this buyback contract and a choice of Q = 250, we can calculate the expected
profits for the two supply chain parties. A buyback price of $119 means a loss of $31 on each
compressor bought but not used.

We have the following different possible values of demand:

 Demand is 100. VAC makes a profit from sales of $150  100 but loses $31 for each of
150 unused compressors. This gives an overall profit of $10,350.
 Demand is 150. VAC makes a profit from sales of $150  150 but loses $31 for each of
100 unused compressors. This gives an overall profit of $19,400.
 Demand is 200. VAC makes a profit from sales of $150  200 but loses $31 for each of
50 unused compressors. This gives an overall profit of $28,450.
 Demand is 250 or more. The profit is $150  250 = $37,500.

Hence,

VAC’s profit = 0.05  $10,350 + 0.15  $19,400 + 0.30  $28,450 + 0.50  $37,500
= $30,713.

The overall supply chain profit depends only on the amount ordered; it is $51,000 as we
calculated before. So we can obtain the expected profits for the supplier as

Supplier profit = $51,000 – $30,713 = $20,287.

Notice that with this buyback contract in place, the supply chain is coordinated,
maximizing overall supply chain profits. Moreover, both VAC and its supplier achieve higher
overall profits than in the uncoordinated situation.

Note that if the supplier had offered a buyback price that was too high, this would have
distorted the supply chain decisions in the other direction. (For the VAC example, any price
higher than $119.27 is too high.) If the price is too high, then the supplier is taking more risk,
and VAC has an incentive to increase the ordering quantity to a level above the optimal quantity
for the supply chain as a whole (Q* = 300 units in this case). This implies that the total supply
chain profits would be reduced.

The revenue-sharing contract

Another option for increasing the quantity the retailer purchases from the supplier is to
use a revenue-sharing contract. In a revenue-sharing contract, the supplier charges the retailer a
lower wholesale price and shares a fraction of the revenue generated by the retailer. The lower
wholesale price reduces the cost of overstocking for the retailer. Therefore, the retailer increases
the level of product availability resulting in higher profits for both the supplier and the retailer.
The video rental industry is an example of an industry where revenue-sharing contracts have
 -10- UV6009

been used successfully. Blockbuster Inc., the market leader of the video rental industry in the
United States, was able to increase its market share from 24% in 1997 to 40% in 2002 through
the use of revenue-sharing contracts with its suppliers. 1

We will now illustrate the use of a revenue-sharing contract using the VAC example. We
consider the simplest revenue-sharing contract where the supplier charges the buyer only his
costs but receives in addition a fraction of the buyer’s revenues, f r.

Thus the overstocking cost is now similar to the coordinated case, and c o = $51, while the
understocking cost is equal to the margin lost multiplied by the share of revenues the retailer
keeps, and thus c u = ($450(1 – f r) – $150 – $51) = $450(1 – f r) – $201.

Hence we have our usual critical ratio formula for order quantity (Equation 7):

cu 450(1  f r )  201 450(1  f r )  201

F (Q * )    . (7)
cu  co 450(1  f r )  201  51 450(1  f r )  150

In order to achieve the maximum supply chain profits, we need the optimal ordering quantity to
*
equal that of the centralized case. Thus, we need to have 0.5 < F(Q ) < 0.83, since then we get
*
the optimal ordering quantity, Q = 250, from Table 1. Solving this constraint using (Equation
7), we get that in order to guarantee the optimal centralized order quantity and total supply chain
profits, the revenue share needs to satisfy 0 < f r < 44%.

Consider, for example, the case where the revenue shared is f r = 20%. This implies that
the revenue per unit the retailer keeps is $450  80% = $360, and thus the retailer’s profit
margin, which in this case is equal to his understocking cost, c u = $360 – $201 = $159. Since the
*
order quantity, Q = 250, we can calculate the expected profits for the two supply chain parties.
We start by calculating the profits for the different possible values of demand:

 Demand is 100. VAC makes a profit from sales of $159  100 but loses $51 for each of
150 unused compressors. This gives an overall profit of $8,250.
 Demand is 150. VAC makes a profit from sales of $159  150 but loses $51 for each of
100 unused compressors. This gives an overall profit of $18,750.
 Demand is 200. VAC makes a profit from sales of $159  200 but loses $51 for each of
50 unused compressors. This gives an overall profit of $29,250.
 Demand is 250 or more. The profit is $159  250 = $39,750.

1
G. Cachon and M. Lariviere, “Supply Chain Coordination with Revenue Sharing Contracts: Strengths and
Limitations,” Management Science (2005): 30–44.
 -11- UV6009

Hence,

VAC’s profit = 0.05  $8,250 + 0.15  $18,750 + 0.30  $29,250 + 0.50  $39,750
= $31,875.

The overall supply chain profit depends only on the amount ordered, and since the
fraction shared, f r = 20% (< 44%), we know that this amount is Q* = 250, as in the centralized
case, and thus the total supply chain profits are $51,000. We can therefore obtain the expected
profits for the supplier as:

Supplier profit = $51,000 – $31,875 = $19,125.

Figure 2 presents the profits of VAC and its Chinese supplier as well as the total supply
chain profits as a function of the revenue share set by VAC.

Figure 2: Supply chain profits as a function of the revenue share, f r

$60,000

$50,000

$40,000

Supply $30,000
chain Retail profit
profits Supply chain profit
$20,000 Total profit

$10,000

$0
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
r
Revenue share f
Source: Created by case writer.

As can be seen in the figure, as long as the fraction of revenue shared, f r, is between 0 and
44%, the total supply chain profits are equal to those of the centralized case, and thus the revenue
share is primarily used to divide the supply chain profits among the two parties. When the
revenue share is higher than 44%, the retailer is no longer choosing to order 250 units, and thus
the supply chain as a whole cannot do as well as the centralized case (Figure 2 illustrates this
jump down in total profits).

This document is authorized for educator review use only by Mahvesh Mahmud, University of Cambridge until September 2018. Copying or posting is an infringement of copyright.
Permissions@hbsp.harvard.edu or 617.783.7860
 -12- UV6009

There are, however, additional restrictions on the choice of revenue share. For this
contract to be better for both sides, they will both have to make higher profits than the base case
where the supplier charges the retailer $150 per unit for the compressor. In this base case, the
supplier makes $19,800. Thus we need to guarantee that the supplier will make at least this
amount under the revenue-sharing contract. As can be seen in Figure 2, this is achieved when f r
= 20.71%. Similarly, the retailer needs to do as well as in the base case (make at least $26,250),
which by Figure 3 is achieved when f r = 25.88%.

The optimal solution for the entire supply chain can be achieved in a revenue-sharing
contract with:

 a wholesale price of $50

min max min
 a fraction of revenue, f r , shared with the supplier such that f r < f r <fr (where f r =
max
20.71% and f r = 25.88%)
 Q* = 250

The profit-sharing contract

The last option for increasing the quantity the retailer purchases from the supplier is to
use a profit-sharing contract. Similar to the revenue-sharing contract, in the profit-sharing
contract, the supplier charges the retailer a lower wholesale price and shares a fraction of the
profit generated by the retailer. The lower wholesale price reduces the cost of overstocking for
the retailer. Therefore, the retailer increases the level of product availability resulting in higher
profits for both the supplier and the retailer.

We will now illustrate the use of a profit-sharing contract using the VAC example. We
consider the simplest profit-sharing contract where the supplier charges the buyer only his costs
but receives in addition a share of the buyer’s profits.

In this case, the retailer receives a fixed proportion of the supply chain profits, and hence
the retailer’s best choice of order is the one that maximizes supply chain profits. Remember that
when the two parties work in coordination, the optimal ordering quantity is 250, and the total
supply chain profits are $51,000. Thus, whatever the fraction of profits passed over to the
retailer, this will be the choice of order size for the retailer.
Still, similar to the revenue-sharing contract, there are restrictions on the choice of profit
share. For this contract to be better for both sides, they will each have to make higher profits than
the base case where the supplier charges the retailer $150 per unit for the compressor. In this
base case, the supplier makes $19,800. Under the profit-sharing contract, the profit to the
supplier is given by the fraction f p of the total supply chain profit $51,000. Thus, the minimal
min
fraction, f p , satisfies Equations 8 and 9:
min
fp  $51,000 = $19,800. (8)
 -13- UV6009

Hence,
$19,800
f pmin   38.82%. (9)
$51,000

The amount retained by the retailer will be (100% – f p)  $51,000. The maximum value
of f p that we can consider makes this equal to the profit earned by VAC previously, which is
$26,250. Therefore, (Equation 10):

$26,250
f pmax  1   48.53%. (10)
$51,000

The optimal solution for the entire supply chain can be achieved in a profit-sharing
contract with:

 wholesale price of $51

min max min
 fraction of profit, f p , shared with the supplier such that f p < f p < fp (where f p
max
= 38.82% and f p = 48.53%)
*
 Q = 250
 retailer profits of (1 – f p)  $51,000
 supplier profits of f p  $51,000

The revenue-sharing and profit-sharing contracts illustrate the benefit of supply chain
relationships that are based on cooperation and alliances. They demonstrate that by working
together and sharing risks and profits, supply chain partners can increase their own value and the
total value for the whole supply chain. Comparing the two contracts, it is not surprising that the
fractions shared in the profit-sharing contract are higher than in the revenue-sharing one. This is
based on the fact that in the profit-sharing contract, the supplier also shares the retailer’s other
costs, which is quite problematic and one of the main reasons why profit sharing is much harder
to implement in practice. First, it means that the supplier’s profit depend on the retailer’s other
costs, which he has no control over. In addition, while revenue sharing requires the retailer to
share only its sales information (for example POS data) with its supplier, a profit-sharing
contract requires sharing both sales data and costs the retailer faces.