Chapter- 5

Supply Chain Contracts and

Coordination
 Introduction
§ Among coordination mechanisms, contracts are valuable
tools used in both theory and practice to coordinate
various supply chains

§ The four coordination mechanisms are: contracts,

information technology, information sharing and joint
decision making
§ the supply chain contract is a coordination mechanism
that provides incentives to all of its members
§ By specifying contract parameters such as quantity,
price, quality and deadlines, contracts are designed to
improve supplier-buyer relationship
§ A supply contract specifies parameters governing the
buyer-supplier relationship

§ In addition to making the terms of the buyer-supplier

relationship explicit, contracts have significant impact on
the behavior and performance of all stages in a supply
chain

§ Contracts should be designed to facilitate desirable SC

outcomes by growing the SC surplus and minimizing
actions that hurt performance
§ The manager should ask the following three questions
when designing a SC contracts:

§ How will the contract affect the firm’s profits and total SC
profits?

§ Will the incentives in the contract introduce any

information distortion?

§ How will the contract influence supplier performance

along key performance measures?
Contracts for product availability and SC profits
Ø Independent actions taken by two parties in a SC often
result in profits that are lower than these that could be
achieved if the SC were to coordinate its actions with a
common objective of maximizing SC profits
Ø To improve the overall profits, the supplier must design a
contract that encourages the buyer to purchase more
and increase the level of product availability.
Ø This requires the supplier to share in some of the buyer’s
demand uncertainty
• The objectives of these coordinating contracts are
(Arshinder et al. 2008):

• Optimization of the total supply chain profit

• Minimization of inventory related costs of salvage

(overstock) and goodwill (shortage)

• Fair risk sharing between the parties

 Centralized vs. decentralized supply chains
What is a centralized supply chain?

Ø It is the traditional SC model, featuring a central

headquarters and warehouse based in a single location

Ø It is typically managed at the headquarters – which

handles all up and downstream decisions

Ø This HQ will feature procurement, distribution and other

logistics officers who handle the work of the entire
network
Advantages of a centralized supply chain
1. Limited operational costs
2. Easier to standardise
3. Easier to make improvement
4. High availability of products
5. Decisions made centrally
6. Potential for lower shipping costs upstream
Disadvantages of a centralized supply chain
1. Potential for higher shipping costs downstream
2. Limited flexibility to move into new markets
3. Limited disaster planning
What is a decentralized supply chain?
Ø operations are spread out over a series of nodes in a
network

Ø Often these nodes are small offices and warehouses,

designed to be situated closer to the organization's end
customer

Ø Decisions in a decentralized SC can still be made centrally

and rolled out across the network, but often the nodes
are given a degree of autonomy to be able to manage
their own unique business requirements
Advantages of a decentralized supply chain
1. Potential for lower costs at the local level
2. Increased flexibility
3. Better customer service
4. Test new products at a smaller scale
5. Ability to stock greater inventory amounts
6. Reduced disaster risk
Disadvantages of a decentralized supply chain
1. Increased operational costs
2. Potential to increase inbound costs
3. Potentially less control
So what’s better: Centralized or decentralized supply
chain operations?
 Supply chain coordination with contracts
Why coordination?
each player (company) in the SC has different and
often time conflicting objectives

These individual objectives are usually not in line with

that of the SC

An incentive structure (contract) is needed to align

the optimization action of each individual player for
the interest of SC (contract design)
Contract Design and Evaluation
• For a given SC structure, which contracts coordinate the
SC?

• How does the contract allocate profit among the players

of the SC?

• Efficiency Vs. Administrative cost for a given contract

 Types of contracts
v Some contracts that increase overall profits by making the
supplier share some of the buyer’s demand uncertainty are:
Ø Wholesale price contracts
§ the retailer purchases the product at a wholesale price from the
manufacturer and then sells it to end consumers at a retail price
Ø Buyback contracts
§ Supplier agrees to buy back all unsold goods for some agreed-
upon price
§ Buyer has incentives to order more
§ Supplier’s risk clearly increases
§ Increase in buyer’s order quantity
o Decreases the likelihood of out of out of stock
o Compensates the supplier for the higher risk
Ø Revenue sharing contracts
§ Buyer shares some of its revenue with the supplier
§ A buyer transfers a portion of the revenue from each unit sold
back to the supplier
§ Seller agrees to reduce the wholesale price and shares a fraction
% of the revenue
Ø Quantity flexibility contracts
§ Retailor can change order quantity after observing demand
§ supplier provides full refund for returned (unsold) items
§ As long as the number of returns is no larger than a certain
quantity
Ø Sales Rebate contracts
§ Provides a direct incentive to the retailor to increase sales by
means of a rebate paid by the supplier for any item sold above a
certain quantity
Thank You!