7

Supply Chain Contracts

MGMT566 Global Supply Chain Management
Professor A. David

Learning Objectives

Review newsvendor model

Explore basics of supply chain contracts

Buyback

Revenue-sharing

Lay groundwork for class 9: extension to

exchange rate uncertainty

The Newsvendor Model:

Example
Generate forecast
of demand and
submit an order
to factory

Economics:

Demand is
Spring selling season

uncertain

Nov Dec Jan Feb Mar Apr May Jun

Receive shipment from

factory at the end of the
month

Bet on a single order for

the uncertain demand?

Each suit sells for p = $125

Product. cost c = $50
Discounted suits sell for v =
$25

Jul Aug
Leftover units
are discounted

Deman Likelihoo
d
d
10
0.5%
20
5.4%
30
10.0%
40
19.1%
50
13.7%
60
13.3%
70
13.0%
80
12.0%
90
8.8%
100
4.2%

The Trade-of

The goal is to maximize profit

minimize mismatch cost:

Expected total underage cost + Expected total

overage cost

Underage cost : opportunity cost of unrealized

profits per unit.
Cu = Selling price per unit purchasing cost per
unit = margin

Overage cost: cost of having one unit of

excess inventory
Co = Purchasing cost per unit salvage value per
unit

Back to the Example

Underage cost
Cu = 125-

50=75
Overage
cost

Co = 50-25=25

Critical Ratio?
Cu
Pr( D Q)
75%
Cu C o

Economics:

Each suit sells for p = $125

Product. cost c = $50
Discounted suits sell for v =
$25

Demand Likelihood Cumulativ

e
10
0.5%
20
0.5%
5.4%
30
5.9%
10.0%
40
15.9%
19.1%
35.0%
50
13.7%
60
48.7%
13.3%
70
62.0%
13.0%
75.0%
80
12.0%
90
87.0%
8.8%
100
95.8%
4.2%
100.0%

Optimal Q = 70
See the setup in Excel (L02_Contracts_Base.xls)

Buying from a Supplier?

Wholesale price (price-only) contract

Selling price p =

Deman
$125
d
$50
Suppli Wholesale priceDiscounted price v = 10
$25 Buyer
=
$90
20
er
30
40
50
Buyers order
60
Cu =12570
80
Co = 90=35
90-25 = 65
90
Cu
100

Prod, cost c =

Pr( D Q)

Cu C o

35% Q=40

Likeliho Cumulativ
e
od
0.5%
0.5%
5.9%
5.4%
15.9%
10.0%
35.0%
19.1%
48.7%
13.7%
62.0%
13.3%
75.0%
13.0%
87.0%
12.0%
95.8%
8.8%
100.0%
4.2%

Double Marginalization

Centralized
(Produce inhouse)
Q = 70
Total profit =
3570

>

Decentralized
(Buy from Supplier)
Q =40
Total profit=2777

Why is total profit lower when buying

from an external supplier?
How can we fix this problem?
7

Contract Design to
Coordinate
The goal is to induce the buyer to order Q=70
critical ratio = 75%

Cost-plus contract
Supplier is reimbursed for costs, plus a percentage of
fixed amount.

Buyback contract
Supplier buys back the unsold units after selling season.

Revenue sharing contract

Supplier charges a low per-unit price, but shares a
portion of sales revenue.

Cost-Plus Contract

A per-unit charge (w) + a fixed fee (F)

Prod, cost c =
$50
Suppli
er

Selling price p =
$125
Discounted price v =
A per-unit fee(w)
$25 Buyer

A fixed fee (F)

Cu = 125-w Co = w - 50
Cu
125 w

75% w=50
Coordination
Cu C o
75

Fully compensate production cost

Use fixed fee to allocate profit
9

Cost-Plus Contract

How have we eliminated double

marginalization?

In what situations will this be easy/difficult

to implement?

How is risk shared between the supplier

and buyer?

How does this fall short in practice?

10

Buyback Contract

A per-unit charge (w) + a buy-back refund (b)

Prod, cost c =
$50
Suppli
er

Selling price p =
$125
Discounted price v =
A per-unit fee(w)
$25 Buyer

A buy-back refund
(b)

Cu = 125-w

Co = w - b

Cu
125 w

75
% b=125-(125-w)/75%
Coordination
Cu Co 125 b

b>v=25. The supplier shares the risk of

overage
There can be many pairs (w,b) that
coordinate

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Buyback Contract

Profit allocation and Risk Sharing

(L02_Contracts_Base.xls)

Question: What do you conclude from this sensitivity

analysis?
Per-unit
fee
70
75
80
85
90
95
100

105

Buy-back refund

98.3 105.0

E[Buyer Profit]

51.7

58.3

65.0

71.7

78.3

85.0

91.7

2618 2380 2142 1904 1666 1428 1190

952

110
714

E[Seller Profit]

952 1190 1428 1666 1904 2142 2380 2618 2856

E[SC Profit]
StdDev[Buyer
Profit]
StdDev[Seller
Profit]
StdDev[SC
Profit]

3570 3570 3570 3570 3570 3570 3570 3570 3570

1207 1097
439

548

987

878

768

658

548

439

329

658

768

878

987 1097 1207 1316

1645 1645 1645 1645 1645 1645 1645 1645 1645

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Buyback Contracts

Why does the buyer purchase more?

What implementation concerns exist?

Where are they used?

What other advantages or disadvantages

exist?

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Revenue-Sharing Contract

A per-unit charge (w) + a revenue-sharing %(a)

Prod, cost c =
$50
Suppli
er

Selling price p =
$125
Discounted price v =
A per-unit fee(w)
$25 Buyer

A rev-sharing %(a)

Cu = 125(1-a)-w

Co = w - v

Cu
125(1 a ) w

75%
Coordination
a=1- (4w-75)/125
Cu Co 125(1 a ) 25

The supplier shares a part of the buyers revenue

and in turn ofers a low per-unit charge
There can be many pairs of (w, a) that coordinate
the SC

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Revenue-Sharing Contract

Profit allocation and Risk Sharing

(L02_Contracts_Base.xls)

Question: What do you conclude from this sensitivity

analysis?
Per-unit
fee
30
31
32
33
34
35
36

37

38

Revenue Sharing
%
64.0% 60.8% 57.6% 54.4% 51.2% 48.0% 44.8% 41.6% 38.4%
E[Buyer Profit]

714

857

1000

1142

1285

1428

1571

1714

1856

E[Seller Profit]

2856

2713

2570

2428

2285

2142

1999

1856

1714

E[SC Profit]
StdDev[Buyer
Profit]
StdDev[Seller
Profit]
StdDev[SC
Profit]

3570 3570 3570 3570 3570 3570 3570 3570 3570

329

395

461

527

592

658

724

790

856

1316

1251

1185

1119

1053

987

921

856

790

1645 1645 1645 1645 1645 1645 1645 1645 1645

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Revenue Sharing

Where are these contracts used?

Why are they comparatively rare in

practice?

What other advantages or disadvantages

exist?

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Revenue-Sharing: Example

Demand for a movie newly released video

cassette typically starts high and decreases
rapidly
Peak demand last about 10 weeks
In 1990s, Blockbuster purchases a copy from a
studio for $65 and rent for $3
Hence, retailer must rent the tape at least 22
times before earning profit (breakeven)
Retailers cannot justify purchasing enough to
cover the peak demand
In 1998, 20% of surveyed customers reported
that they could not rent the movie they wanted
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Revenue-Sharing: Example

Starting in 1998 Blockbuster entered a revenue

sharing agreement with the major studios
Studio charges $8 per copy
Blockbuster pays 30-45% of its rental income
Even if Blockbuster keeps only half of the rental
income, the breakeven point is 6 rental per copy
The impact of revenue sharing on Blockbuster
was dramatic
Rentals increased by 75% in test markets
Market share increased from 25% to 31% (The
2nd largest retailer, Hollywood Entertainment
Corp has 5% market share)
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Supply Chain Contracts

Cu
Co
Critical ratio
Order quantity
E[Buyer Profit]
E[Seller Profit]
E[SC Profit]
StdDev[Buyer
Profit]
StdDev[Seller

Fixed
fee

Refund

Rev %

2100

85

48%

Per-unit
fee
90
50
95
35
Centraliz Wholesal Cost
Buy
Revenue
ed
e Price plus
Back Sharing
75
35
75
30
30
25
65
25
10.0
10
75.0%
35.0% 75.0% 75.0%
75.0%
70
40
70
70
70
1177 1470
1428
1428
1600 2100
2142
2142
3570
2777 3570
3570
3570
-

558

1645

658

658
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Other Contracts

Quantity flexibility contract

Sales-rebate contract

The supplier charges the buyer a per-unit price w but gives the buyer a rebate r >
0 per unit sold above a fixed threshold t, and the buyer continues to salvage
leftover units for v per unit.

Franchise contract

The supplier charges a per-unit price w and allows the buyer to change
the quantity ordered (within limits) after observing demand. If a buyer
orders O units, the supplier commits to providing up to Q=(1+a)O units,
whereas the buyer is committed to buying at least q=(1-b)O units. Both a
and b are between 0 and 1.

A franchise contract combines revenue sharing with a two-part tarif: The

supplier charges a fixed fee, a per-unit price, and a revenue share per
transaction, which is usually called a royalty rate.

Quantity-discount contract

The supplier charges the buyer w(q) per unit purchased, where
w(q) is a decreasing function.
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Summary

Structured contracts allocate risk and

profits between buyer and seller.
A variety of parameters can maximize
supply chain performance and exact
values are a function of the relative
negotiating strength of firms.
A number of contracts exist and are
appropriate for diferent settings based on
implementation concerns.

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Next Class

Contracting in international trade

Ways to mitigate exchange risk

Correlation between exchange and demand
risks

Preparation

IH2 due before class via Blackboard.

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