Procurement and

Order Fulfilment
Supply Contracts
 Strategic Components
 Effective procurement strategies require the development of relationships with suppliers

 Often, to ensure adequate supplies and timely deliveries, buyers and suppliers typically
agree on …

• Pricing and volume discounts

• Minimum and maximum purchase quantities

• Delivery lead times and schedules

• Product or material quality

• Product return policies

Dr. M S Mahapatra
Importance of Contract
A supply chain consists of a retailer who faces customer demand and a manufacturer who produces
and sells swimsuits to the retailer. Pricing and costing information are as follows:

• During the summer season, a swimsuit is sold to customers at $125 per unit

• The wholesale price the retailer pays to the manufacturer is $80 per unit.

• Any swimsuit not sold during the summer season is sold at a discount store for $20.

For the manufacturer

• Fixed production cost is $100,000.

• The variable production cost per unit equals $35.

Observation: The retailer's marginal profit is the same as the marginal profit of the manufacturer, $45.

Dr. M S Mahapatra
 Importance of Contract
• Retailer's marginal profit for selling a unit during the season is $45, which is smaller than
the marginal loss of $60.
• The optimal order quantity depends on marginal profit and marginal loss but not on the
fixed cost.
• Retailer's optimal policy is to order 12,000 units for an average profit of $470,700. If the
retailer places this order, the manufacturer's profit is 12,000×(80 - 35) -100,000 = $440,000
Retailer’s Expected Profit
$500
Demand Probability

Thousands
$450
8000 11%
$400
10000 11%
$350
12000 28%
$300

Profit
14000 22%
$250
16000 18%
$200
18000 10% 5000 7500 10000
Order Quantity
12500 15000

Dr. M S Mahapatra
 Importance of Contract
Based on this example, we can observe that
• The buyer assumes all the risks of having more inventory than sales, while the
supplier takes no risk.
• Indeed, since the supplier takes no risk, he would like the buyer to order as much
as possible, while the buyer limits his order quantity because of the huge financial
risk.
• Since the buyer limits his order quantity, there is a significant increase in the
likelihood of out-of-stock.

Therefore, sharing of risk is important for increasing supply chain profit.

Dr. M S Mahapatra
 Types of Contracts
Buy-back contracts

Revenue-sharing contracts

Quantity-flexibility contracts

Sales rebate contracts

Dr. M S Mahapatra
 Buy-Back Contracts
• In this contract, the seller agrees to buy back unsold goods from the buyer for
some agreed-upon price higher than the salvage value.

• This contract incentivizes the buyer to order more units since the risk associated
with unsold units decreases.

• The supplier's risk increases.

Dr. M S Mahapatra
 Buy-Back Contracts
Suppose the manufacturer offers to buy unsold swimsuits from the retailer for $55. In
this case, the retailer’s marginal profit, $45, is greater than its marginal loss, $25, thus
motivating the retailer to order more than the average demand
$1,200.00
Thousands

$1,000.00

$800.00
Dist. P
Profit ($)

$600.00
Mfg. P

$400.00 Total P.

$200.00

$0.00
5,000 8,000 Quantity
11,000 14,000 17,000

Dr. M S Mahapatra
 Revenue-Sharing Contracts
• The buyer orders a limited number of units due to the high wholesale price.

• If somehow the buyer can convince the supplier to reduce the wholesale price, then
clearly, the buyer will have the incentive to order more units.

• The buyer shares some of its revenue with the seller in return for a discount on the
wholesale price.

Dr. M S Mahapatra
 Revenue-Sharing Contracts
Suppose the manufacturer agrees to decrease the wholesale price from $80 to $60; the
retailer provides 15 percent of the product revenue to the manufacturer.
Dist. P Mfg. P Total P.
$1,200.00
Thousands

$1,000.00

$800.00
Profit ($)

$600.00

$400.00

$200.00

$0.00
5,000 8,000 11,000 14,000 17,000
Quantity

Dr. M S Mahapatra
 Quantity-Flexibility Contracts
• The supplier provides a full refund for returned (unsold) items as long as the
number of returns is no larger than a certain quantity.

• This contract gives a full refund for a portion of the returned items, whereas a buy-
back contract provides a partial refund for all returned items.

Dr. M S Mahapatra
Sales Rebate Contracts

These contracts provide a direct incentive to the retailer to increase sales through a
rebate paid by the supplier for any item sold above a certain quantity

Dr. M S Mahapatra
 Global Optimization: Which Contracts?
• Now, what is the maximum profit both the supplier and the buyer can hope to
achieve?

• What if an unbiased decision maker is allowed to identify the best strategy for the
entire supply chain

• Effective supply contracts provide incentives for supply chain partners to replace
traditional strategies with global optimization

• The main drawback of global optimization is that it does not provide a mechanism
to allocate supply chain profit between the partners

Dr. M S Mahapatra
 Limitations
• Buy-back contracts require the supplier to have an effective reverse logistics system and
may increase its logistics cost

• When retailers sell competing products, some under buy-back contracts while others are
not; the retailers have the incentive to push the products not under the buy-back contract

• Revenue-sharing contracts require the supplier to monitor the buyer’s revenue and thus
increase the administrative cost.

• In revenue sharing, buyers have the incentive to push competing products with higher
profit margins.

Dr. M S Mahapatra
 Contracts for MTS/MTO Supply Chains
So far, we have assumed that the supplier has a make-to-order supply chain

A variety of supply contracts enable risk sharing, and hence reduce the manufacturer’s risk
and motivate the manufacturer to increase production capacities

Pay-back contracts: In this contract, the buyer agrees to pay some agreed-upon price for any
unit produced by the manufacturer but not purchased by the distributor.

Cost-sharing contract: In this contract, the buyer shares some of the production costs with
the manufacturer in return for a discount on the wholesale price.

One problem with the cost-sharing contract is that it requires the manufacturer to share its
production cost information with the distributor

Dr. M S Mahapatra
 Contracts with Asymmetric Information
We assumed that the buyer and the supplier share the same demand forecast.

However, when the supplier needs to build capacity based on forecasts received from
manufacturers, the buyer has the incentive to inflate its forecast.

The following two contracts achieve credible information sharing…

Capacity reservation contracts: The manufacturer pays to reserve a specific capacity with the
supplier.

Advance purchase contracts: Supplier charges the advance purchase price for firms’ orders
placed before building capacity and a different price for any additional order placed when
demand is realized
Dr. M S Mahapatra
 Contracts for Nonstrategic Components
Traditionally, buyers have focused on long-term contracts

Recently, some companies have started looking at more flexible contracts for nonstrategic components

In this case, products can be purchased from a variety of suppliers.

By selecting multiple supply sources, the buyer can reduce supply costs and be more responsive and
flexible to market conditions.

Risks include…

• Inventory risk due to uncertain demand

• Price, or financial, risk due to volatile market price

• Shortage risk due to limited component availability

Dr. M S Mahapatra
 Types of Contracts for Nonstrategic Components
Long-term contracts: A fixed amount of supply to be delivered at some point in the future; the
supplier and the buyer agree on the price and the quantity to be delivered to the buyer.

Flexible, or option contract: The buyer prepays a relatively small fraction of the product price
upfront in return for a commitment from the supplier to reserve capacity up to a certain level

Spot purchase: Buyers look for additional supply in the open market

Portfolio contract: Buyers sign multiple contracts simultaneously to optimize their expected
profit and reduce risk.

Dr. M S Mahapatra