Supply Contracts

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Supply Contracts
Yossi Sheffi Mass Inst of Tech Cambridge, MA
MIT Executive Course January 6th, 2003
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Outline

• Supply contracts
• Wholesale contracts
• Buyback contracts
• Revenue sharing contracts
• Option contracts

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The Scenario
Supplier
Retailer

• Contract is negotiated
• Retailer places order (a single period)
• Supplier makes and sends the stuff
• The selling season takes place
• Accounting (sales, salvage, etc.)

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Consumer Demand
Average 811.54 Std Dev 154.23
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Demand Distribution
Average 811.54 Std Dev 154.23
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Notations
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Supply Contracts

• Prices and costs
• Supplier has a cost to make/purchase (C50)
• Supplier is selling and retail is buying at a
  wholesale price (W135)
• Retailer is selling for a retail price (R200)
• Retailer can salvage (S10)

• Retailer is facing a Newsboy problem and
  suppliers profit is trivial

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Wholesale Price Contract
R200 W135 C50 S10
800 ordered and 600 demanded Profit600?(200-135
) (800-600)?(10-135)14,000
800 ordered and 1000 demanded Profit800?(200-13
5)52,000
800 ordered Profit800?(135-50)68,000
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Wholesale Price Contract Expected Profits
R200 W135 C50 S10
Optimal Retailer order
Optimal channel order
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Wholesale Price ContractExp Profits (Normal
Approx)
R200 W135 C50 S10
Retail Order 749 Retailer Profit
41,988 Supplier Profit 63,649 Total Profit
105,637
Optimal Order 936 Retailer Profit
33,745 Supplier Profit 79,528 Total Profit
113,273
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Effects of Wholesale Price on Profits
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Optimal Retail Order as a Function of the
Wholesale Price
Order 936 items
Manufacturing costs50
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Wholesale Price ContractCoordination the Channel
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Buyback Contract

• The problem how can the supplier convince the
  retailer to move towards the optimal order size?
• The supplier offer to the retailer to buy back
  all unsold items (B/item).
• For the retailer this is like a higher salvage
  value, so he will order more.
• The supplier now shares in the overage risk (he
  can still salvage, though, at the same price).
• Note supplier may simply pay (B-S) rather than
  actually buy back (unless he has a better use for
  it)

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Buyback Contract Calculations
R200 W135 C50 S10 B80
800 ordered and 600 demanded Profit600?(200-135
) (800-600)?(80-135)28,000
800 ordered and 1000 demanded Profit800?(200-13
5)52,000
800 ordered and 600 demanded Profit600?(135-50)
(800-600)?(80-10)54,000
800 ordered 1000 demanded Profit800?(135-50)6
8,000
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Channel profit with Buyback
R200 W135 C50 S10 B80
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Optimal Buyback and Wholesale price

• Higher wholesale price requires a higher buyback
  rate
• As the wholesale price (and the buyback rate)
  grows the suppliers share of the profit
  increases
• Wholesale price ranges from 50 (suppliers cost)
  to 200 (retail price)
• Buyback rate ranges from 10 (salvage value) to
  200.

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Expected Profits with Buyback Contract
R200 W135 C50 S10 B80
Retail Order 828 Retailer Profit
45,407 Supplier Profit 65,457 Total Profit
110,273
Retail Order 749 Retailer Profit
41,988 Supplier Profit 63,649 Total Profit
105,637
Optimal Order 936 Retailer Profit
43,718 Supplier Profit 69,555 Total Profit
113,273
Optimal Order 936 Retailer Profit
33,745 Supplier Profit 79,528 Total Profit
113,273
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Optimal Buyback Price
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Channel Coordination with Buyback
R200 W135 C50 S10 B80
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Expected Profit with Coordinating Buyback Rate
R200 W135 C50 S10 B118
Optimal Order 936 Retailer Profit
49,086 Supplier Profit 64,188 Total Profit
113,273
Optimal Order 936 Retailer Profit
33,745 Supplier Profit 79,528 Total Profit
113,273
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Buyback Contracts in Practice

• Book publishing
• Periodicals/newspapers
• Price support in consumer electronics

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Revenue Sharing

• Supplier still needs to get the retailer to order
  more
• Another risk-sharing scheme supplier lowers the
  wholesale price but takes a percentage (1-p) of
  the revenue
• Question how to choose W and p so the retailer
  will order the optimal amount
• Note wholesale price has to be lower than the
  suppliers cost.

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The Players
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(No Transcript)
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Revenue Sharing
R 200 W 40 C 50 S 10 p 0.40
800 ordered and 600 demanded Profit600?200?0.4-6
00?40 (800-600)?(10-40)18,000
800 ordered and 1000 demanded Profit800?200?0.4-
800? 4052,000
800 ordered and 600 demanded Profit800?(40-50)
600?200?0.664,000
800 ordered 1000 demanded Profit800?(40-50)
800?200?0.688,000
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Expected Profit with Revenue Sharing
R 200 W 40 C 50 S 10 p 0.40
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Optimal Revenue Share
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Coordination with Rev. Sharing
Retail Price 200 Supplier Costs
50 Salvage value 10
Wholesale price 40 Retail Rev Share 76
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Revenue Sharing (Normal Approx)
R 200 W 40 C 50 S 10 p 0.76
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Real Options

• The retailer buys Q call options at a price w.
• The supplier makes Q items.
• Each option can be exercised at a unit price E.
• As demand materializes the retailer can take
  deliveries at a price E.
• No more than Q items can be bought from the
  supplier

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Real Options
R 200 W 20 C 50 S 10 E 60
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Coordination with Real Options
Retailers optimal order
Comparing to a single channel
Where
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Coordination with Real Options
R 200 C 50 S 10 W 25 E 81
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Expected Profits with Options
R 200 C 50 S 10 W 25 E 81
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Summary

• Wholesale contracts give too much risk and not
  enough expected reward to the retailer
• To make the retailer order more (and increase the
  channels profit) the supplier has to take on
  part of the risk
• Risk sharing mechanisms covered include
• Buybacks revenue sharing, option contract
• Other mechanisms
• Quantity-flexibility (refund on a portion of the
  unsold units)
• Sales-rebate (rebate on unsold units above a
  threshold)
• There are many other mechanisms
• Each mechanism can coordinate the channel with
  various allocations of the profit between the
  retailer and the supplier.

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Any Questions?
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Yossi Sheffi sheffi_at_mit.edu