Chapter 5

SUPPLY CONTRACTS

Reference: Chapter 4, Simchi-Levi, D., Kaminsky, P., and Simchi-

Levi, E. (2008). Designing and Managing the Supply Chain:
Concepts, Strategies and Case Studies. Boston: McGraw-Hill/ Irwin.
 CONTENTS
1. Introduction.
2. Types of supply contract for strategic components.
3. Contracts for MTS/MTO supply chains.
4. Contracts with asymmetric information
5. Types of supply contract for nonstrategic
components.
 1. Introduction
¨ Significant increase in the level of outsourcing ~
procurement function becomes critical

¨ Strategic components/products => need to have close

relationships with the suppliers => effective supply
contract
¨ Lower risk of supply
¨ More profit of supply chain: both supplier and buyer

¨ Nontrategic components => can purchase from a

variety suppliers => flexibility to market conditions is
more important
 2. Types of supply contract for strategic components.

¨To ensure adequate supply and demand for goods

¨In a typical supply contract, the buyer and the supplier
will agree on:
 Pricing and volume discounts
 Minimum or maximum purchase quantities
 Delivery lead times
 Product or material quality
 Product return policies
2. Types of supply contract for strategic components.

¨2-stage supply chain:

Optimize
profit
3. Place an order 1. Generate
forecast
2. Determine
order quantity
4.React to the order
Buyer
 2. Types of supply contract for strategic components.

Example During summer season

F = $100,000 Demand Probability
c = $35
8,000 11%
w = $80 p = $125 10,000 11%
Manufacturer Retailer s = $20 End user
12,000 28%
Order : multiples of 1,000 units
quantity
14,000 22%
Retailer’s marginal profit = Manufacturer’s marginal profit =
$45 16,000 18%
Retailer’s marginal loss = $60
18,000 10%
 2. Types of supply contract for strategic components.

Example
500
Þ Retailer’s optimal
450
400
policy is to order
12,000 units ~
Profit (in thousands)

350
300 gain avg profit of
250 $470,700
200
150
4000 6000 8000 10000 12000 14000
Þ Manufacturer’s
16000

Order quantity (number of units) profit = 12,000*(80

- 35) -100,000 =
• The SC total profit = $910,700. 440,000
 2. Types of supply contract for strategic components.

Limit order quantity Probability of

Risk of buyer?
out – of – stock

Would like the buyer to order as much

Risk of supplier?
as possible

Increase profits for

both supply entities
 2. Types of supply contract for strategic
components.

2.1. Buy – back contracts: The seller agrees to buy back unsold
goods from the buyer for some agree – upon price higher than the
salvage value.
Þ Give the buyer incentive to order more units => decrease in the
likelihood of out – of – stock.
Þ The seller can increase their profit since order quantity increases.
 2. Types of supply contract for strategic
components.

2.1. Buy – back contracts

Example
F = $100,000
c = $35

w = $80 p = $125
Manufacturer Retailer s = $20 End user
b = $55
Retailer’s marginal profit = Manufacturer’s marginal profit = $45
Retailer’s marginal loss = $80 - $55 = $25
 2.1. Buy – back contracts

Example 550 Þ Retailer has

500
450
incentive to
Profit (in thousands) 400 increase its
350
300
order quantity to
250 14,000 ~ profit of
200
150 $513,800
100
4000 6000 8000 10000 12000 14000 16000
Þ Manufacturer’s
Quantity profit increases
R's profit M' s profit = $471,900

• The SC total profit = $985,700.

 2.1. Buy – back contracts
Limitations
¨ Supplier needs to have an effective reverse logistics system =>
increase its logistics cost.
¨ When retailers sell competing products, they have an incentive
to push the products which are NOT under buy – back contract
due to higher risk.
=> Used in the book and magazine industries
where retailers do not have an influence on
diverting demand from one product to another,
unsold magazine are destroyed by the retailer
Absorb the return products Should
exp.date
supplier Output Q’ty > MOQ
 2. Types of supply contract for strategic
components.
2.2. Revenue – sharing contracts
• One of the reason for the buyer to order a limited number of units is the high
wholesale price.
Buyer’s order quantity
w
Supplier’s profit if it is unable to sell more units

Share its revenue Transfer a

portion of the
revenue from
Discount on the wholesale price Buyer each unit
sold to the
end user
 2. Types of supply contract for strategic
components.
2.2. Revenue – sharing contracts
Example

F = $100,000
c = $35

w = $60 p = $125
Manufacturer Retailer s = $20 End user
15% of revenue

Retailer’s marginal profit = $125 – $60 = $65

Manufacturer’s marginal profit = $60 - $35 = $25
Retailer’s marginal loss = $60 - $20 = $40
 2.2. Revenue – sharing contracts
Example
600

500
Þ Retailer’s
400
optimal policy is
Profit 300
to order 14,000
200
units ~ gain avg
100
profit of
0
$504,325
4000 6000 8000 10000 12000 14000
Þ Manufacturer’s
16000

profit = $481,375
Quantity
R's profit M's profit
• The SC total profit = $985,700.
• The reduction in the wholesale price coupled with revenue sharing leads to
increased profit for both parties.
 2.2. Revenue – sharing contracts
Limitations

¨ Supplier has to monitor the buyer’s revenue => increase

administrative cost
¨ Information technology is not enough, building trust between the
supplier and the buyer is not only important but also difficult to
achieve.
¨ Retailers have an incentive to push competing products with higher
profit margins since under revenue – sharing contracts, the
retailers’ profit margin is reduced.  transparency process
 2. Types of supply contract for strategic
components.
2.3. Quantity – Flexibility contracts
• Supplier provides full refund for unsold products as long as the number
of returns <= a certain quantity

F = $100,000
c = $35

w = $80 p = $125
Manufacturer Retailer End user
s = $80 for unsold products
with condition # returns <= a fixed number
 2. Types of supply contract for strategic
components.
2.4. Sales Rebate contracts
Provide a direct incentive to the retailer to increase sales by means of
rebate paid by the supplier for any item sold above a certain quantity

Contracts for strategic components

Contract Characteristics
1. Buy – back Partial refund for all unsold goods
2. Revenue - sharing Buyer shares revenue with supplier in return for
discount wholesale price
3. Quantity - flexibility Full refund for a limited number of unsold goods
4. Sales rebate Incentives for meeting target sales (multi-level
discount)
 2. Types of supply contract for strategic
components.
2.5. Global Optimization for (order to stock)
What is the most profit both the supplier and the buyer can hope to achieve?

What if an unbiased decision maker is allowed to identify the best strategy for
the entire supply chain?

Same
organizatio
n

Buyer
Maximize supply chain profit
 2. Types of supply contract for strategic
components.

2.5. Global Optimization (order to stock)

Example

F = $100,000
c = $35
w = $80 p = $125

Manufacturer Retailer s = $20 End user

Supply chain marginal profit = $125 - $35 = $90 > Supply chain marginal loss = $35 -
$20 = $15
Þ The supply chain will produce more than average demand
Þ Both parties are in the same company  big company
 2. Types of supply contract for strategic
components.
2.5. Global Optimization for (order to stock)
Example

1200
Þ The optimal
Profit (in thousands)

1000
production
800
quantity is
600
16,000 units ~
400 gain expected
200 supply chain
0
4000 6000 8000 10000 12000 14000 16000
profit of
$1,014,500
Quantity
 2. Types of supply contract for strategic
components.

2.5. Global Optimization

• Difficulty: Firms have to surrender decision making power to an
unbiased decision maker normal practice: same company
• It does not provide a mechanism to allocate supply chain profit
between partners
Þ Supply contracts help firms achieve global optimization without
the need for an unbiased decision maker, by allowing buyers and
suppliers to share the risks and the potential benefits + allocate
the profit among supply chain members.
Þ Carefully designed supply contracts achieve the exact same
profit as global optimization
3. Contracts for MTS/MTO supply chains.
¨MTO supply chain: buyers take all risks, suppliers
take no risk.
¨MTS supply chain:

Order q’ty?
MTO
MTS

Supplier
Buyer

Prod. Q’ty?
 MTS supply chains
F = $100,000
c = $55
s = $20
w = $80 p = $125
Manufacturer Distributor Retailer
 Contracts for MTS supply chains.

Building more
capacity than Limit its production
sales quantity
Manufacturer

Would like the manufacturer to build

as much capacity as possible
Distributor How?

- Reduce manufacturer’s risk

- Motivate manufacturer to increase
production capacities
- Increase profits for both supply entities
 EXAMPLE

Selling season from Sept to Dec

F = $100,000
c = $55
Start producing s = $20
3 months w = $80 p = $125
before selling
Manufacturer Distributor
season, before
distributors
Production 1.5 months after the
place any
quantity beginning of production
orders.

Manufacturer’s marginal profit = $80 - $55 = $25

Manufacturer’s marginal loss = $80 - $20 = $60
Distributor’s marginal profit = $125 - $80 = $45
 EXAMPLE

200
180 Þ Manufacturer’s
160
140 optimal policy is
Profit (in thousand) 120
100
to produce
80 12,000 units ~
60
40 gain avg profit of
20
0
$143,900
Þ Distributor’s
4000 6000 8000 10000 12000 14000 16000 18000

profit = $510,300
Production quantity

The total SC profit = $143,900 + $510,300 = $654,200

 PAY – BACK CONTRACTS

¨ The buyer agrees to pay some agreed – upon price for any
unit produced by manufacturer but not purchased by the
distributor.
Þ The manufacturer have incentive to produce more units since
the risk associated with unused capacity is decreased.
Þ The distributor’s risk increases.
 PAY – BACK CONTRACTS

Example
F = $100,000
c = $55

w = $80 p = $125
s = $20 Retailer
Manufacturer Distributor

v = $18 for a non-purchased good For promotion

Manufacturer’s marginal profit = $80 - $55 = $25
Manufacturer’s marginal loss = $55 - $20 - $18 = $17
Distributor’s marginal profit = $125 - $80 = $45
 PAY – BACK CONTRACTS
Example
Manufacturer's average profit
Þ Manufacturer has
Profit (in thousand)
220
170
incentive to increase
120
70 its production
20
4000 6000 8000 10000 12000 14000 16000 18000
quantity to 14,000
Production quantity units ~ gain avg
Distributor’s avg profit profit of $180,280
600 Þ Distributor’s profit
Profit (in thousand)

500 increases to
400
300 $525,420
200
4000 6000 8000 10000 12000 14000 16000 18000
Order quantity

The total SC profit = $705,700

 COST – SHARING CONTRACTS
¨ One important reason why the manufacturer does not
produce enough is the high production cost.
¨ If the manufacturer can convince the distributor to
share some of the production cost => the manufacturer
will produce more.
¨ Paying part of the production cost => decrease the
distributor’s profit if it is unable to sell more units.

Share some of production cost

Discount on the wholesale price Distributor

Manufacturer
 COST – SHARING CONTRACTS
Example

F = $100,000
c = $55

w = $62 p = $125
s = $20 Retailer
Manufacturer Distributor

Pay 33% of the manufacturer’s

production cost
Manufacturer’s marginal profit = $62 - $55 = $7
Manufacturer’s marginal loss = $55 - $20 = $35
Distributor’s marginal profit = $125 - $62 = $63
COST – SHARING CONTRACTS
Example Manufacturer's average profit
220 Þ Manufacturer has

Profit (in thousand)

170
120
incentive to increase
70 its production
20
00 00 00 000 000 000 000 00
quantity to 14,000
0 0 0 0
4 6 8 10 12 14 16 18 units ~ gain avg
Production quantity profit of $182,380
Distributor’s average profit
600 Þ Distributor’s profit
500
increases to
Profit (in thousand)

400
300 $523,320
200
00 00 00 00 00 00 00 00
40 60 80 100 120 140 160 180
Production quantity

The total SC profit = $705,700

 COST – SHARING CONTRACTS

¨ Requires the manufacturer to share its production

cost information with the distributor, something
manufacturers are reluctant to do.

is this contract implemented in practice? 

selling more, trust
 GLOBAL OPTIMIZATION FOR MTS
F = $100,000
c = $55

w = $80 p = $125
s = $20
Manufacturer Distributor Retailer

Supply chain’s marginal profit?

Supply chain’s marginal loss?
What is optimal production quantity?
Profit of supply chain subject to the optimal production quantity?
 4. Contracts with asymmetric
information
Build capacity based
on forecast from the
buyer Might inflate its
forecast
Manufacturer Distributor

Þ There is always a positive probability that the forecast is higher than realized
demand
Þ Whether we can design contracts that achieve credible information sharing or not?
 4. Contracts with asymmetric information

• Capacity reservation contracts:

Pays to reserve a certain

level of capacity

Designs the menu of reservation prices to Buyer

Supplier motivate the buyer to reveal its true
forecast
 4. Contracts with asymmetric
information
• Advance purchase contracts:

Have incentive to make order

in advance?

Charges the advance purchase price for Buyer

Supplier
firms’ orders placed prior to building
capacity & different price for additional
order placed when the demand is realized

Get confirmed Get real Share

orders demand inf. information
 5. Contracts for nonstrategic
components
¨ Products can be purchased from a variety of suppliers => Flexibility to market
conditions is perceived as more important than a permanent relationship with
the suppliers.
¨ Commodity products, i.e., electricity, computer memory, steel, oil, grain, cotton,
are typically available from a large number of suppliers & can be purchased in
spot market. Reliable quality
Þ By selecting multiple supply sources, the buyer can reduce supply costs and be
more responsive and flexible to market conditions.
Þ An effective procurement strategy: drive costs down & reduce risks
¨ Risks: + Inventory risk due to uncertain demand
+ Price, or financial, risk due to volatile price
+ Shortage risk due to limited component availability.
 5. Contracts for nonstrategic
components Secure
supply
5.1. Long – term contracts (forward or fixed commitment contracts):
eliminate financial risk.
¨ Specify a fixed amount of supply to be delivered at some point in the
future.
¨ The supplier and the buyer agree on both price and quantity to be
delivered to the buyer
Þ The buyer bears no financial risk, however, takes huge inventory
risks due to uncertainty in demand and the inability to adjust order
quantities.
 5. Contracts for nonstrategic
components risks

5.2. Flexible, or Option contract:

¨ Buyer prepays a relatively small fraction of the product price
upfront ~ Supplier commits to reserve capacity up to a certain
level.
¨ The initial payment is referred as a reservation price or premium.
The initial payment will be lost if the buyer does not exercise the
option.
¨ The buyer pays an additional price (referred as execution price/
exercise price) when he purchases up to the option level (agreed
to at the time the contract is signed)
Þ Flexible to adjust order quantity => reduce inventory risks
 5. Contracts for nonstrategic
components
Emergency buying
5.3. Spot purchase:
¨ Buyers look for additional supply in the open market.
¨ Firms may use an independent e – market or a private e – market
to select suppliers

=> Use the marketplace to find new suppliers and force competition
to reduce product price.
 5. Contracts for nonstrategic
components

5.4. Portfolio contract:

¨ Buyers sign multiple contracts at the same time to optimize their
expected profit and reduce the risk.
¨ Differs in price and level of flexibility => allow the buyer to hedge
against inventory, shortage, and spot price risk.
 5. Contracts for nonstrategic
components
Contract Characteristics
5.1. Long – term Fixed commitment made in advance
5.2. Flexible or option Prepay for the option to purchase
5.3. Spot market Immediate purchase
5.4. Portfolio Combine the first three contract options strategically