Session 3-Supply Contracts

Debriefing

Supply Contracts

2
 Why supply contracts?
• Increasing trend of outsourcing to focus on core
competency
• Increase in reliance on outsourcing bring its own
challenges to manage suppliers
• Appropriate contracts and supply strategies can help
meeting these challenges
• Depends on nature of products: Strategic, non-strategic
and commodity

3
 Strategic components
• Strategic parts or products
• Few specialized suppliers available
• need critical procurement function
• Close collaboration with suppliers

Non-Strategic
components
• Highly standard products
• Exist variety of suppliers
• Emphasize on flexible market conditions
than permanent relationship with
suppliers
• Example: Commodity products;
4 electricity, steel, oil, grains
Components of Supply Contracts

• Pricing – structures including volume

discounts.
• Minimum and maximum purchase
quantities.
• Delivery lead times.
• Product or material quality.
• Product return policies.

5
 Strategic components
• Strategic parts or products
• Few specialized suppliers available
• need critical procurement function
• Close collaboration with suppliers

6
 Why contracts between supply chain entities?
Sequential supply chain

SUPPLIER BUYER
Generate a forecast

Reacts to the Determines the order

order placed quantity which
maximizes/optimizes
his/her own expected
profits
Supplier has a
make-to- Places an order to the
order(MTO) supplier
supply chain Purchasing items prior
to knowing the actual
customer demand(buyer
has make to stock
supply chain MTS)
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 Insights
SUPPLIER BUYER
Generate a forecast
• Each Individual in a supply chain tries to
optimize his/her own profits
Reacts
• Notto considering
the Determines
the impact on total supply the order
order placed quantity which
chain performance
• Buyer MTS is taking risk of havingmaximizes/optimizes
more
his/her own expected
inventory than sales
profits
• Supplier MTO carries no risk, but would like to
get big order
Places an order to the
Implication: Buyer tends to order
supplier
limited order quantity, which
significantly increase the likelihood
of out of stock
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 Risk sharing among supply chain entities with MTO
supplier
Supplier Your company/ Buyer End Customer

Customer demand.

Buyer must forecast demand

Supplier assumes Buyer must purchase safety stock to limit Customer may experience stock
Scenario 1 no risk back-orders to meet service level shortages and must back-order
expectations.

You will aim to purchase minimum safety

stock

Supplier willing to
share some risk
provided buyer Buyer is encouraged to purchase more Customer less-likely to experience stock
Scenario 2 increases order stock overall since risk is shared shortages
quantity

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 Supply contracts
MTO-supplier sharing risk

• Buyback contracts

• Revenue sharing contracts

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Sequential supply chain(no supply contract, swimsuit
example)

Fixed Production Cost =$100,000

Variable Production Cost=$35

Wholesale Price =$80

Selling Price=$125
Salvage Value=$20

Manufacturer Manufacturer DC Retail DC

Who takes the risk?

Stores

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 Demand Scenarios

Demand Scenarios

30%
Probability 25%
20%
15%
10%
5%
0%

Sales
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 Retailer Expected Profit

Expected Profit

500000

400000

300000

200000

100000

0
6000 8000 10000 12000 14000 16000 18000 20000
Order Quantity

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 Sequential (cont.)
• Retailer optimal order quantity is 12,000 units
• Retailer expected profit is $470,000
• Manufacturer profit is $440,000
• Supply Chain Profit is $910,000

 Is there anything that the distributor and

manufacturer can do to increase the profit
of both?

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 Buy-Back Contracts

Fixed Production Cost =$100,000

Variable Production Cost=$35

Wholesale Price =$80

Selling Price=$125
Salvage Value=$20

Manufacturer Manufacturer DC Retail DC

Buy back price=$55

Stores

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 Retailer Profit
(Buy Back=$55)
600,000
$513,800
500,000
Retailer Profit 400,000

300,000
200,000

100,000

000 000 000 000 000 000 000 000 000 000 000 000 000
6 7 8 9 10 11 12 13 14 15 16 17 18
Order Quantity

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 Manufacturer Profit
(Buy Back=$55)

600,000
$471,900

Manufacturer Profit
500,000
400,000
300,000
200,000

100,000
0

Production Quantity

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 Revenue Sharing Contact

Fixed Production Cost =$100,000

Variable Production Cost=$35

Wholesale Price =$??

Selling Price=$125
Salvage Value=$20

Manufacturer Manufacturer DC Retail DC

Stores

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 Retailer Profit
(Wholesale Price $70, RS 15%)

600,000
$504,325
500,000
Retailer Profit 400,000
300,000
200,000
100,000
0

Order Quantity

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 Manufacturer Profit
(Wholesale Price $70, RS 15%)

700,000
600,000

Manufacturer Profit
500,000 $481,375
400,000
300,000
200,000
100,000
0

Production Quantity

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 Blockbuster Video: A successful example of revenue
sharing contract

• Until 1998, video rental stores used to purchase copies of newly released movies from the movie
studios for about $65 and rent them to customers tor $3. Because of the high purchase price, rental
stores did not buy enough copies to cover peak demand , which typically occurs during the first 10
weeks after a movie is released on video. The result was low customer service level; in a 1998 survey,
about 20 percent of customers could not get their first choice of movie.
• Then, in 1998, Blockbuster Video entered into a revenue-sharing contract with the movie studios in
which the wholesale price was reduced from $65 to $8 per copy, and, in return, studios were paid about
30-45 percent of the rental price of every rental. This revenue-sharing contract had a huge impact on
Blockbuster revenue and market share. Today, revenue sharing is used by most large video rental
stores.

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 Supply Contracts

Strategy Retailer Manufacturer Total

Sequential Supply Chain 470,700 440,000 910,700
Buyback 513,800 471,900 985,700
Revenue Sharing 504,325 481,375 985,700

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 Global Optimization

Fixed Production Cost =$100,000

Variable Production Cost=$35

Wholesale Price =$80

Selling Price=$125
Salvage Value=$20

Manufacturer Manufacturer DC Retail DC

Stores

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 Supply Chain Profit

1,200,000
$1,014,500
Supply Chain Profit
1,000,000
800,000

600,000
400,000

200,000
0

Production Quantity

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 Supply Contracts

Strategy Retailer Manufacturer Total

Sequential Optimization 470,700 440,000 910,700
Buyback 513,800 471,900 985,700
Revenue Sharing 504,325 481,375 985,700
Global Optimization 1,014,500

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 Supply Contracts: Key Insights
• Effective supply contracts allow supply chain partners to
replace sequential optimization by global optimization

• Buy Back and Revenue Sharing contracts achieve this

objective through risk sharing

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 Limitations of contracts

• Buy-back contracts require the supplier to have an

effective reverse logistics system and, indeed, may
increase its logistics cost.

• Revenue-sharing contracts also have important

limitations. They require the supplier to monitor the
buyer's revenue and thus increase administrative
cost.

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 Non-Strategic components
• Highly standardized products
• Exist variety of suppliers
• Emphasize on flexible market conditions rather
than permanent relationship with suppliers
• Example: Commodity products; electricity,
steel, oil, grains

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 Contracts for Non-Strategic Components
• Variety of suppliers

• Market conditions dictate price

• Buyers need to be able to choose suppliers and change them as needed

• Long-term contracts have been the tradition

• Recent trend towards more flexible contracts

– Offers buyers option of buying later at a different price than current
– Offers effective hedging strategies against shortages

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 Strategies for non-strategic products
• Reduce inventory risk due to uncertain demand
• Price, or financial risk due to volatile market price
• Shortage risk due to limited component availability

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 Contracts: Non strategic contracts
• Long-term contracts
• Flexible or option contracts
• Spot purchase
• Portfolio contracts

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 Long-Term Contracts
• Also called forward or fixed commitment contracts

• Contracts specify a fixed amount of supply to be delivered at some point in the future

• Supplier and buyer agree on both price and quantity

• Buyer bears no financial risk

• Buyer takes huge inventory risks due to:

– uncertainty in demand
– inability to adjust order quantities.

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 Flexible or Option Contracts

• Buyer pre-pays a relatively small fraction of the product price up-

front

• Supplier commits to reserve capacity up to a certain level.

• Initial payment is the reservation price or premium.

• If buyer does not exercise option, the initial payment is lost.

• Buyer can purchase any amount of supply up to the option level by:
– paying an additional price (execution price or exercise price)
– agreed to at the time the contract is signed
– Total price (reservation plus execution price) typically higher than the
unit price in a long-term contract.
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 Spot Purchase
• Buyers look for additional supply in the open market.
• May use independent e-markets or private e-markets to
select suppliers.
• Focus:
– Using the marketplace to find new suppliers
– Forcing competition to reduce product price.

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 Portfolio Contracts
• Portfolio approach to supply contracts
• Buyer signs multiple contracts at the same time
– optimize expected profit
– reduce risk.
• Contracts
– differ in price and level of flexibility
– hedge against inventory, shortage and spot price risk.
– Meaningful for commodity products
• a large pool of suppliers
• each with a different type of contract.

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Activities and Discussions

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Delivery Reliability in Fresh Connection

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Group Work
The Fresh
Connection
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