OPER312 – Supply Chain Management

Exercise 5: Supply Chain Contracts and Coordination

1) Smith and Jackson Inc. (SJ) sells an outdoor grill to Cusano’s Hardware Store. SJ’s wholesale
price for the grill is $185 (this includes the cost of shipping the grill to Cusano). Cusano sells
the grill for $250 and SJ’s variable cost per grill is $100 (this also includes the cost of
shipping the grill to Cusano). Suppose Cusano’s forecast for season sales can be described
with a Normal distribution with mean 34 and standard deviation 7. Furthermore, Cusano
plans to make only a single grill buy for the season. Grills left over at the end of the season
are sold at a 75% discount.
a) How many grills should Cusano order?
b) What is Cusano’s expected profit given Cusano’s order in part a?
c) What is SJ’s expected profit given Cusano’s order in part a?
d) To maximize the supply chain’s total profit (SJ’s profit plus Cusano’s profit), how many
grills should be shipped to Cusano’s Hardware?
Suppose SJ were to accept unsold grills at the end of the season. Cusano would incur a $15
shipping cost per grill returned to SJ. Among the returned grills, 45% of them are damaged and
SJ cannot resell them, but the remaining 55% can be resold to other clients for a net price of
$185-15=$170 (shipping cost deducted).
e) Given the possibility of returning grills to SJ, how many grills should be sent to Cusano’s
to maximize the supply chain’s total profit?
Suppose SJ gives Cusano 90% credit for each returned grill, that is, SJ pays Cusano $166.50 for
each returned grill. Cusano still incurs a $15 cost to ship each grill back to SJ.
f) How many grills should Cusano order to maximize his profit?
g) What is Cusano’s expected profit given Cusano’s order in part f?
h) What is SJ’s expected profit given Cusano’s order in part f?
i) To maximize the supply chain’s total profit, what should SJ’s credit percentage be?
j) Suppose now that SJ is considering a renewed look at their contract with Cusano. What
range of buyback contract terms (𝑤𝑤 and 𝑏𝑏) would achieve maximum total supply chain
profit? What is the maximum profit SJ can possibly extract?
k) Suppose now that instead of a buyback contract, SJ would like to establish a revenue-
sharing contract to maximize supply chain profits. Identify the range of wholesale price
(𝑤𝑤𝑟𝑟 ) and revenue-share fraction (𝑓𝑓𝑟𝑟 ) values that would achieve this goal.
2) Dan McClure is trying to decide on how many copies of a book to purchase at the start of
the upcoming selling season for his bookstore. The book retails at $28.00. The publisher
sells the book to Dan for $20.00 (wholesale price). Dan can dispose of all of the unsold
copies of the book at 75% off the retail price, at the end of the season. Dan estimates that
demand for this book during the season is normal with a mean of 100 and a standard
deviation of 42.
a) How many books should Dan order to maximize his expected profit?
b) Given the order quantity in part a what is Dan’s expected profit?
c) The publisher’s variable cost per book is $7.50. Given the order quantity in part a, what
is the publisher’s expected profit?
The publisher is thinking of offering the following deal to Dan. At the end of the season, the
publisher will buy back unsold copies at a predetermined price of $15.00. However, Dan would
have to bear the costs of shipping unsold copies back to the publisher at $1.00 per copy.
d) How many books should Dan order to maximize his expected profits given the buyback
offer?
e) Given the order quantity in part d, what is Dan’s expected profit?
f) Assume the publisher is able to earn on average a net $6 on each returned book (some
books are destroyed while others are sold at a discount and others are sold at full price).
Given the order quantity in part d what is the publisher’s expected profit?
g) Suppose the publisher continues to charge $20 per book and Dan still incurs a $1 cost to
ship each book back to the publisher. What price should the publisher pay Dan for
returned books to maximize the total supply chain profit (the sum of the publisher’s
profit and Dan’s profit)?
h) What is the maximum wholesale price the publisher can charge while still being able to
maximize total supply chain profit?
i) Suppose now that instead of a buyback contract, the publisher would like to establish a
revenue-sharing contract to maximize supply chain profits. Identify the range of
wholesale price (𝑤𝑤𝑟𝑟 ) and revenue-share fraction (𝑓𝑓𝑟𝑟 ) values that would achieve this
goal.
3) Handi Inc., a cell phone manufacturer, procures a standard display from LCD Inc. via an
options contract. At the start of quarter 1 (Q1), Handi pays LCD $4.50 per option. At that
time, Handi’s forecast of demand in Q2 is normally distributed with mean 24,000 and
standard deviation 8,000. At the start of Q2, Handi learns exact demand for Q2 and then
exercises options at the fee of $3.50 per option, (for every exercised option, LCD delivers
one display to Handi). Assume Handi starts Q2 with no display inventory and displays
owned at the end of Q2 are worthless. Should Handi’s demand in Q2 be larger than the
number of options held, Handi purchases additional displays on the spot market for $9 per
unit.

For example, suppose Handi purchases 30,000 options at the start of Q1, but at the start of
Q2 Handi realizes that demand will be 35,000 units. Then Handi exercises all of its options
and purchases 5,000 additional units on the spot market. If, on the other hand, Handi
realizes demand is only 27,000 units, then Handi merely exercises 27,000 options.

a) Suppose Handi purchases 30,000 options. What is the expected number of options that
Handi will exercise?
b) Suppose Handi purchases 30,000 options. What is the expected number of displays
Handi will buy on the spot market?
c) Suppose Handi purchases 30,000 options. What is Handi’s expected total procurement
cost?
d) How many options should Handi purchase from LCD?
e) What is Handi’s expected total procurement cost given the number of purchased
options from part (d)?
4) During the week of the Passover holiday, Jews all over the world eat a special type of bread
called matzah. The small Jewish community in San Jose, Costa Rica, consists of
approximately 1,000 families. There is only one Jewish restaurant in San Jose that is
supplying matzah bread to the entire Jewish community during the week of Passover at a
price of $20 per box of matzah bread. To meet its demand during the week of Passover, the
restaurant orders the matzah bread from a Mexican supplier about two months before the
holiday. The Mexican supplier charges a wholesale price of $11 for one box of matzah
bread, and the restaurant incurs an additional transportation cost of $1 for each box it
receives. The cost to manufacture each box is $5. The owner of the restaurant estimates
that the level of demand for matzah bread during the week of Passover will be normally
distributed with a mean of 6000, and a standard deviation of 1600. The demand for matzah
bread at the end of the week is close to zero, and thus it has no salvage value for the San
Jose restaurant.
a) How many boxes of matzah bread should the restaurant order from its Mexican
supplier? What would the restaurant’s profit from that order be?
b) What is the Mexican supplier's profit for Passover from the Costa Rican market? What
are the total supply chain profits?
c) Suppose that the restaurant owner and the Mexican supplier were working together to
maximize the entire chain's profits, what would be the optimal ordering quantity of
boxes of matzah for the entire supply chain? What would be the total supply chain
profits? What is the supply chain loss currently (the loss in profit because the supply
chain is not coordinated)?
After seeing the results in part (c), the restaurant owner and the supplier would like to
create a contractual agreement that will coordinate the supply chain with respect to the
ordering quantity. The restaurant owner suggests to the supplier that they implement a
buyback contract to reach the supply chain optimum. Instead, the supplier offers to use a
revenue-sharing contract to align the supply chain incentives.
d) In the case of the buyback contract, assume that the wholesale price stays the same.
What would be the buyback price if the buyback contract is implemented as “markdown
money” (which means the restaurant would be reimbursed up to the buyback price
without actually sending them back)? Calculate the resulting expected profits for both
the restaurant and the supplier.
e) In the case of the revenue-sharing contract, assume that both contract parameters
would need to be revised. What should be the maximum fraction of revenue the
restaurant shares with the supplier for the restaurant to prefer this contract to the
buyback contract?