Chapter 4: Supply Contracts4-1
4-1 Chapter 4: Supply Contracts
4.1 IntroductionSignificant level of outsourcingMany leading brandOEMs outsourcecompletemanufacturing and design oftheir productsMore outsourcing has meantSearchforlower cost manufacturersDevelopment of design and manufacturing expertisebysuppliersProcurementfunction inOEMsbecomes veryimportantOEMshavetogetintocontractswithsuppliersForboth strategic and non-strategic components4-2
4-2 4.1 Introduction ⚫ Significant level of outsourcing ⚫ Many leading brand OEMs outsource complete manufacturing and design of their products ⚫ More outsourcing has meant ⚫ Search for lower cost manufacturers ⚫ Development of design and manufacturing expertise by suppliers ⚫ Procurement function in OEMs becomes very important ⚫ OEMs have to get into contracts with suppliers ⚫ For both strategic and non-strategic components
4.2 Strategic ComponentsSupply Contract can include the followingPricingand volumediscountsMinimumandmaximumpurchasequantitiesDeliveryleadtimesProductor material qualityProductreturnpolicies4-3
4-3 4.2 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
2-Stage Sequential Supply ChainA buyer and a supplierBuyer's activities:generating a forecastdetermining howmany units to order from the supplierplacing an order to the supplier soas to optimize hisownprofitPurchasebasedonforecastofcustomerdemandSupplier's activities:reactingtothe orderplaced bythebuyerMake-To-Order(MTO)policy4-4
4-4 2-Stage Sequential Supply Chain ⚫ A buyer and a supplier. ⚫ Buyer’s activities: ⚫ generating a forecast ⚫ determining how many units to order from the supplier ⚫ placing an order to the supplier so as to optimize his own profit ⚫ Purchase based on forecast of customer demand ⚫ Supplier’s activities: ⚫ reacting to the order placed by the buyer. ⚫ Make-To-Order (MTO) policy
SwimsuitExample 2 Stages:a retailer who faces customer demanda manufacturerwho produces andsells swimsuits tothe retailer.RetailerInformationSummerseasonsalepriceofaswimsuitis$125perunit.Wholesaleprice paid by retailer to manufacturer is$80perunit.Salvage value afterthe summerseason is $20 perunitManufacturer information:Fixed production costis $100,000Variable production costis$35perunit4-5
4-5 Swimsuit Example ⚫ 2 Stages: ⚫ a retailer who faces customer demand ⚫ a manufacturer who produces and sells swimsuits to the retailer. ⚫ Retailer Information: ⚫ Summer season sale price of a swimsuit is $125 per unit. ⚫ Wholesale price paid by retailer to manufacturer is $80 per unit. ⚫ Salvage value after the summer season is $20 per unit ⚫ Manufacturer information: ⚫ Fixed production cost is $100,000 ⚫ Variable production cost is $35 per unit
What Is the Optimal Order Quantity?Retailer marginal profit isthe same as the marginal profitofthemanufacturer,$45Retailer's marginal profit for selling a unit during theseason,$45,issmallerthanthemarginalloss,$60associated witheach unit sold at the end of the seasonto discountstores.Optimal order quantity depends on marginal profit andmarginal loss but not on the fixed cost.Retaileroptimal policy isto order 12,000unitsforanaverageprofitof$470,700If the retailer places this order,the manufacturer'sprofitis12.000(80-35)-100.000=$4400004-6
4-6 What Is the Optimal Order Quantity? ⚫ Retailer marginal profit is the same as the marginal profit of the manufacturer, $45. ⚫ Retailer’s marginal profit for selling a unit during the season, $45, is smaller than the marginal loss, $60, associated with each unit sold at the end of the season to discount stores. ⚫ Optimal order quantity depends on marginal profit and marginal loss but not on the fixed cost. ⚫ Retailer optimal policy is to order 12,000 units for an average profit of $470,700. ⚫ If the retailer places this order, the manufacturer’s profit is 12,000(80 - 35) - 100,000 = $440,000
Sequential Supply Chain$500$400(seo)r$300$200$100$OProductionquantity(numberofunits)FIGURE4-1:Optimized safetystock4-7
4-7 Sequential Supply Chain FIGURE 4-1: Optimized safety stock
RiskSharingInthe sequential supply chain:Buyer assumesall of the risk of having more inventorythansalesBuyer limits his order quantity because of the hugefinancialrisk.Suppliertakes no riskSupplier would likethebuyerto orderas muchas possibleSincethe buyer limits his order quantity,there isasignificantincrease inthe likelihood of out of stockIf the supplier shares some of therisk withthebuyeritmaybeprofitableforbuyertoorder morereducing outofstockprobabilityincreasingprofitforboththe supplierand thebuyerSupplycontractsenable this risk sharing4-8
4-8 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 ContractSelleragreestobuybackunsoldgoodsfromthebuyerforsomeagreed-uponprice.BuyerhasincentivetoordermoreSupplier'sriskclearlyincreasesIncreaseinbuyer'sorderquantityDecreasesthelikelihood ofoutofstockCompensates thesupplier forthehigher risk4-9
4-9 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
Buy-Back ContractSwimsuitExampleAssume the manufacturer offers to buy unsoldswimsuitsfromtheretailer for$55Retailer has an incentive to increase its orderquantityto14,000units,foraprofitof$513,800while the manufacturer's average profitincreasesto$471,900Total average profitforthetwo parties=$985,700(=$513.800+$471,900)Compareto sequential supply chain when totalprofit=$910,700(=$470,700+$440,000)4-10
4-10 Buy-Back Contract Swimsuit Example ⚫ Assume the manufacturer offers to buy unsold swimsuits from the retailer for $55. ⚫ Retailer has an incentive to increase its order quantity to 14,000 units, for a profit of $513,800, while the manufacturer’s average profit increases to $471,900. ⚫ Total average profit for the two parties = $985,700 (= $513,800 + $471,900) ⚫ Compare to sequential supply chain when total profit = $910,700 (= $470,700 + $440,000)