MBA 502 SUPPLY CHAIN

MANAGEMENT
LESSON 3
OGANIVE CHINGAKULE
Supply Contracts INTRODUCTION
Strategic Components

Supply Contract can include the following:

 Pricing and volume discounts.
 Minimum and maximum purchase quantities.
 Delivery lead times.
 Product or material quality.
 Product return policies.
Risk Sharing

 In the sequential supply chain:

 Buyer assumes all of the risk of having more inventory than sales
 Buyer limits his order quantity because of the huge financial risk.
 Supplier takes no risk.
 Supplier would like the buyer to order as much as possible
 Since the buyer limits his order quantity, there is a significant increase in the
likelihood of out of stock.
 If the supplier shares some of the risk with the buyer
 it may be profitable for buyer to order more
 reducing out of stock probability
 increasing profit for both the supplier and the buyer.
 Supply contracts enable this risk sharing
Buy-Back Contract

 Seller agrees to buy back unsold goods from the buyer for some agreed-
upon price.
 Buyer has incentive to order more
 Supplier’s risk clearly increases.
 Increase in buyer’s order quantity
 Decreases the likelihood of out of stock
 Compensates the supplier for the higher risk
 Revenue Sharing Contract

 Buyer shares some of its revenue with the supplier

 in return for a discount on the wholesale price.
 Buyer transfers a portion of the revenue from each unit sold back to the
supplier
 Other Types of Contracts

 Quantity-Flexibility Contracts
 Supplier provides full refund for returned (unsold) items
 As long as the number of returns is no larger than a certain
quantity.
 Sales Rebate Contracts
 Provides a direct incentive to the retailer to increase sales by
means of a rebate paid by the supplier for any item sold above a
certain quantity.
 Implementation Drawbacks of Supply
Contracts

 Buy-back contracts
 Require suppliers to have an effective reverse logistics system and may increase logistics costs.
 Retailers have an incentive to push the products not under the buy back contract.
 Retailer’s risk is much higher for the products not under the buy back contract.

 Revenue sharing contracts

 Require suppliers to monitor the buyer’s revenue and thus increases administrative cost.
 Buyers have an incentive to push competing products with higher profit margins.
 Similar products from competing suppliers with whom the buyer has no revenue sharing agreement.
Question 1

 You are selling badges at a retail price of K100.

 You buy them from sunshine incorporated at K63 each. Your optimum sales quantity is
15,000 units .
 Sunshine inc. has fixed cots of K123,000 and have a variable cost of K33 per badge.
 You dispose of (salvage) badges at a cost of K20 each.
 Sunshine inc. wants you to increase your purchase quantity to 18,000 units. Sunshine inc.
will buy back left over stock at K50 per unit.
Question 1

a) Calculate total profit for both you and Sunshine at 15,000 units.
b) Calculate the total profit for both you and Sunshine. at 20,000 units.
c) Calculate the total loss/profit for you if you sell 6,000 out of the 18,000 units at salvage
value.
d) Calculate the total loss/profit for you if sunshine buys back 6,000 out of 18,000 units.
e) Calculate the total loss/profit for sunshine if they buy back 6,000 out of 18,000 units.
Buy Back (a)

 Retailer
 Total profit = 100 – 63 x 15000 = 555,000
 Supplier
 Total Profit = 63 – 33 x 15000 = 450,000 – 123,000 = 327,000
Buy Back (b)

 Retailer
 Total profit = 100 – 63 x 20000 = 740,000
 Supplier
 Total Profit = 63 – 33 x 20000 = 600,000 – 123,000 = 477,000
Buy Back (c)

 Retailer
 Gross Profit = 100 – 63 x 12000 = 444,000
 Total Loss = 63 – 20 x 6000 = (258,000)
 Total Profit = 444,000 - 258,000 = 186,000
Buy Back (d)

 Retailer
 Gross Profit = 100 – 63 x 12000 = 444,000
 Total Loss = 63 – 50 x 6000 = (78,000)
 Total Profit = 444,000 - 78,000 = 366,000
Buy Back (e)

 Manufacturer
 Gross Profit = 63 – 33 x 18000 = 540,000 – 123,000 = 417,000
 Total Loss = 50 x 6000 = (300,000)
 Total Profit = 417,000 - 300,000 = 117,000
Question 2

 You are selling Easter eggs for K3,500. Salvage value for your Easter eggs is K425 per
egg and the optimum sales level is 8,000 units. Dairy milk manufactures the eggs at a
cost of K1,500 and a fixed cost of K250,000. They agree to sell the goods at a cost of
K2,000 instead of K2,750 as usual on condition that you give them a revenue share of
15% if you buy at least 15,000 units.
Question 2

a) Calculate total profit for both you and Dairymilk at 8,000 units.
b) Calculate the total profit for both you and dairymilk. at 12,000 units.
c) Calculate the total loss/profit for you if you sell 2,000 out of the 12,000 units at salvage
value.
d) Calculate the total loss/profit for you if dairymilk gives you the discount and you pay
15% of revenue at 12,000 units.
e) Calculate total loss/profit for you if dairymilk gives you a discount and you pay 15%
revenue share and sell 2000 out of 12,000 units at salvage value.
Revenue Sharing(a)

 Retailer
 Total profit = 3500 – 2750 x 8000 = 6,000,000
 Supplier
 Total Profit = 2750 – 1500 x 8000 = 10,000,000 – 250,000 = 9,750,000
Revenue Sharing(b)

 Retailer
 Total profit = 3500 – 2750 x 12000 = 9,000,000
 Supplier
 Total Profit = 2750 – 1500 x 12000 = 15,000,000 – 250,000 = 14,750,000
Revenue Sharing(c)

 Retailer
 Total profit = 3500 – 2750 x 10000 = 7,500,000
 Total Loss = 2750 – 425 x 2000 = 4,450,000
 Total Profit = 7,500,000 – 4,450,000 = 3,050,000
Revenue Sharing(d)

 Retailer
 Total revenue = 3500 x 12000 = 42,000,000
 Total profit = 3500 – 2000 x 12000 = 18,000,000
 Total revenue shared = 15% of 42,000,000= 6,300,000
 Total Profit = 18,000,000 – 6,300,000 = 11,700,000
Revenue Sharing(e)

 Retailer
 Total revenue = 3500 x 10000 = 35,000,000
 Total profit = 3500 – 2000 x 10000 = 15,000,000
 Total revenue shared = 15% of 35,000,000 = 5,250,000
 Total loss = 2000 – 425 x 2000 = 3,150,000
 Total Profit = 15,000,000 – (5,250,000 + 3,150,000) = 6,600,000
 Contracts for Make-to-Stock vs Make-to-Order Supply Chains

 Previous contracts examples were with Make-

to-Order supply chains
 What happens when the supplier has a Make-
to-Stock situation?
 Pay-Back Contract

 Buyer agrees to pay some agreed-upon price for any unit produced by the
manufacturer but not purchased.
 Manufacturer incentive to produce more units
 Buyer’s risk clearly increases.
 Increase in production quantities has to compensate the distributor for the
increase in risk.
Cost-Sharing Contract

 Buyer shares some of the production cost with

the manufacturer, in return for a discount on
the wholesale price.
 Reduces effective production cost for the
manufacturer
 Incentive to produce more units
 Two Possible Contracts

 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
 Buyer’s commitment to paying the special price reveals the
buyer’s true forecast
 Implementation Issues

 Cost-sharing contract requires manufacturer to share production cost

information with distributor
 Agreement between the two parties:
 Distributor purchases one or more components that the manufacturer needs.
 Components remain on the distributor books but are shipped to the manufacturer
facility for the production of the finished good.
Question 3

 Sunrise Likuni Plc sells Likuni Phala to D4D groceries. D4D wants sunrise to produce at
least 15,000 units. Current optimum levels are 8,000 unts. D4D pays back sunrise K20
per unit for every item not sold. D4D normally purchases the Likuni Phala at K450 per
unit and sells at K750 per unit. Salvage value for sunrise is K50 per unit. The Likuni
production cost per unit is K100 and fixed cost K100,000. D4D agrees to contribute 25%
to the production cost. Salvage cost for D4D is K200 per unit.
Question 3

a) Calculate total profit for both D4D and Sunrise at 8,000 units.
b) Calculate the total profit for both D4D and Sunrise. at 15,000 units.
c) Calculate the total loss/profit for Sunrise if they sell 2,000 out of the 15,000 units at
salvage value.
d) Calculate the total loss/profit for sunrise if D4D pays back on the 2000 out of 15,000
units.
e) Calculate total loss/profit for sunrise if D4D cost shares production at 15,000 units.
f) Calculate total loss/profit for sunrise if D4D cost shares production at 13,000 units and
the extra 2000 units is sold at salvage cost.
Pay Back and Cost Sharing(a)

 D4D
 Total profit = 750 – 450 x 8000 = 2,400,000
 Sunrise
 Total Profit = 450 – 100 x 8000 = 2,800,000 – 100,000 = 2,700,000
Pay Back and Cost Sharing(b)

 D4D
 Total profit = 750 – 450 x 15000 = 4,500,000
 Sunrise
 Total Profit = 450 – 100 x 15000 = 5,250,000 – 100,000 = 5,150,000
Pay Back and Cost Sharing(c)

 Sunrise
 Total profit = 450 – 100 x 13000 = 4,550,000 – 100,000 = 4,450,000
 Total Loss = 100 – 50 x 2000 = 100,000
 Total Profit = 4,450,000 – 100,000 = 4,350,000
Pay Back and Cost Sharing(d)

 Sunrise
 Total profit = 450 – 100 x 13000 = 4,550,000 – 100,000 = 4,450,000
 Total Loss = 100 – 50 – 20 x 2000 = 60,000
 Total Profit = 4,450,000 – 60,000 = 4,390,000
Pay Back and Cost Sharing(e)

 Sunrise
 Total profit = 450 – 100 x 15000 = 5,250,000
 Total cost shared = 25% of 1,600,000 = 400,000
 Total cost = 100 x 15000 + 100,000 = (1,600,000)
 Total Profit = (5,250,000 + 400,000) – 100,000 = 5,550,000
Pay Back and Cost Sharing(f)

 Sunrise
 Total profit = 450 – 100 x 13000 = 4,550,000
 Total cost shared = 25% of 1,600,000= 400,000
 Total cost = 100 x 15000 + 100,000 = (1,600,000)
 Total salvage cost = 100 – 50 x 2000 = (100,000)
 Total Profit = (4,550,000 + 400,000) – 200,000 = 4,750,000
Contracts for Non-Strategic Components

 Variety of suppliers  Long Term Contracts

 Market conditions dictate price  Flexible, or Option Contracts
 Buyers need to be able to choose suppliers  Spot Purchase
and change them as needed  Portfolio Contracts
 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
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.
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.
Flexible or Option Contracts

 Provide buyer with flexibility to adjust order quantities depending on realized demand
 Reduces buyer’s inventory risks.
 Shifts risks from buyer to supplier
 Supplier is now exposed to customer demand uncertainty.
 Flexibility contracts
 Related strategy to share risks between suppliers and buyers
 A fixed amount of supply is determined when the contract is signed
 Amount to be delivered (and paid for) can differ by no more than a given percentage determined
upon signing the contract.
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.
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.
Appropriate Mix of Contracts

 How much to commit to a long-term contract?

 Base commitment level.
 How much capacity to buy from companies selling option contracts?
 Option level.
 How much supply should be left uncommitted?
 Additional supplies in spot market if demand is high
 Hewlett-Packard’s (HP) strategy for electricity or memory products
 About 50% procurement cost invested in long-term contracts
 35% in option contracts
 Remaining is invested in the spot market.