1. Sourcing and Contracts Chapter 14

2. Outline The Role of Sourcing in a Supply Chain
Supplier Scoring and Assessment
Supplier Selection and Contracts
Design Collaboration
The Procurement Process
Sourcing Planning and Analysis
Making Sourcing Decisions in Practice
Summary of Learning Objectives

3. The Role of Sourcing in a Supply Chain
Sourcing is the set of business processes required to purchase goods and services
Sourcing processes include:
Supplier scoring and assessment
Supplier selection and contract negotiation
Design collaboration
Procurement
Sourcing planning and analysis

4. Benefits of Effective Sourcing Decisions
Better economies of scale can be achieved if orders are aggregated
Eliminate some suppliers. Keep strategic dual sourcing.
DineEquity Inc., Glendale, CA, parent company of IHOP and Applebee's restaurants, is consolidating the vendors the two restaurant chains use -- and, in the process, is getting a discount by buying more from the vendors it does keep. DineEquity purchased Applebee's in 2007 and found that there was 75% overlap among IHOP's and Applebee's vendors.
More efficient procurement transactions can significantly reduce the overall cost of purchasing
Buying commodities from commodity exchanges / internet sites
Firms can achieve a lower purchase price by increasing competition through the use of auctions
Design collaboration can result in products that are easier to manufacture and distribute, resulting in lower overall costs
Ford sends its own engineers to its suppliers
Appropriate supplier contracts can allow for the sharing of risk
Buyback contract redistributes the risk of overstocking

5. Supplier Scoring and Assessment
Supplier performance should be compared on the basis of the supplier’s impact on total cost
There are several other factors besides purchase price that influence total cost
Replenishment Lead Time
On-Time Performance
Supply Flexibility
Delivery Frequency / Minimum Lot Size
Supply Quality
Inbound Transportation Cost
Pricing Terms
Information Coordination Capability
Design Collaboration Capability
Exchange Rates, Taxes, Duties
Supplier Viability

6. Example of Supplier Assessment
I am currently sourcing out a multi-carrier shipping system for my company. Since I'll be locked into whatever choice I make for the next 4-5 years, I want to make sure I choose wisely. Do you have any comments on the following: Clippership, Pitney Bowes, NextShip, Logicor, Pfastship, or any others that you may currently be using? By the way, over 80% of our shipping is small carrier (UPS, FedEx, USPS), and the remainder is LTL. I am interested in your comments concerning reliability, tech support, and customer support.
Steve Bachman. April 29, ed to

7. Example of Transporter Assessments
Hello friends,
My project tile is "Transporter rating system“ under this project I have to the parameters for rating [transporters] Rahul Gaikwad. April 28, ed to
You can measure transporter performance in the following ways:
1) Cost effectiveness (Affordability)
2) Delivery speed
3) Damage rate (%)
4) Quantity flexibility
5) Time flexibility  ( based on your need transport availability)
6)Assurity (how safe & secure your goods is reaching to the destination)
- Austin Lowrie. April 29, ed to

8. Example: UTD Procurement – Department Bidding requirements as of Nov 14, 2008
UTD is a State of Texas agency and required by state law to bid out orders and give opportunities to companies and HUBS (Historically Underutilized Business) whenever possible.  If you have an expensive or technical purchase please contact us at the beginning of the process if the cost exceeds $10,000.
We can write an RFP (Request for Proposal) and send out a BID for your [UTD personnel] product and service now, allowing you [UTD personnel] to evaluate and discuss the proposals legally with the vendors. As a team we will pick the “Best Value” solution.
If you do this with out our involvement and then send us a purchase requisition we may have to formally bid out your order, delaying your project. Only a state certified buyer can legally “bid” on behalf of the University.
Federal Funds:  Positive efforts shall be made by [fund] recipients to utilize small businesses, minority-owned firms, and women's business enterprises, whenever possible. Recipients shall, on request, make available for the Federal awarding agency, pre-award review and procurement documents, such as request for proposals or invitations for bids, independent cost estimates, etc., when any of the following conditions apply.
A recipient's procurement procedures or operation fails to comply with the procurement standards in the Federal awarding agency's implementation of this Circular.
The procurement is expected to exceed the small purchase threshold fixed at 41 U.S.C. 403 (11) (currently $25,000) and is to be awarded without competition or only one bid or offer is received in response to a solicitation.
The procurement, which is expected to exceed the small purchase threshold, specifies a "brand name" product.

9. Example: UTD Procurement
All procurement transactions shall be conducted in a manner to provide, to the maximum extent practical, open and free competition.
< $10,000: we can purchase with one or more quotes at Purchasing’s discretion.
>10,000 and < $25,000: we require at least 3 informal bids, with two HUB Historically Underutilized Businesses, from the CMBL bidders list run by the State of Texas  www2.cpa.state.tx.us/cmbl/cmblhub.html          
> $25,000: we require formal sealed written bids, including at least 2 HUB vendors, usually posted on unless available under a government contract, or a sole source or emergency purchase.
Individual departments can purchase
< $500: using a pre-printed “SOS” small dollar purchase order system form
< $1000: using a UTD Purchasing Master card
> $1000: go to Procurement. 
Only the UTD Procurement Department can sign contracts, issue Purchase Orders or conduct formal BIDS. Pricing or quotes for departments are not legal bids and may have to be bid out by Procurement. Verbal orders from UTD Departments may be the personal obligation of that individual and not the University.

10. Example: UTD Procurement – Internet Sources
UTD Procurement Management
The University of Texas System
Bids over $25,000 posted at the Electronic State Business Daily  
U.T. System Historically Underutilized Business (HUB) Program
UT System Policy Library
SBA US Small Business Administration
State Law for University Purchasing: An institution of higher education may acquire goods or services by the method that provides the best value to the institution.
Texas Procurement and Support Services (TPASS)  
Historically Underutilized Business (HUB)

11. Supplier Selection and Contracts
UTD contract example
Contracts for Product Availability and Supply Chain Profits
Buyback Contracts
Revenue-Sharing Contracts
Quantity Flexibility Contracts
These contracts coordinate Supply Chains
Contracts to Increase Agent Effort
Contracts to Induce Performance Improvement

12. Example: UTD Gas Suppliers as of June 26, 2008
After careful review by Procurement Management of the three main companies supplying scientific gases and services Airgas-Southwest, Matheson Tri-Gas, and Air Liquide, Procurement Management has negotiated an agreement using an existing UTSW contract with Airgas-Southwest for scientific and medical bottled gases as our most advantageous contract. The advantages are:
Extremely competitive pricing
Online ordering
Each cylinder will have a tag identifying the ordering person, department, Lab room, and fund number.
Invoices and cylinder inventories can be managed online
Payment can be made by using Procurement cards or invoice
Cylinders can be returned using online system
Lower deliver charges
Faster turnaround on specialty gas orders
Please contact our Airgas-Southwest representative, J??? W???, to set up an account. He can be contacted by at or by phone at 817-7??-7???.
You may still use any of these companies for your requirements; however they are listed in order of best value to UTD.
Airgas-Southwest. Contact: J??? W??? W. Kerney; Mesquite, TX
Matheson Tri-Gas. Contact: R?? E???? N. Beckley Avenue; Dallas, TX
Air Liquide. Contact: M?? D????? N. West Carrier Parkway; Grand Prairie, TX

13. Sourcing Planning and Analysis
A firm should periodically analyze its procurement spending and supplier performance and use this analysis as an input for future sourcing decisions
Procurement spending should be analyzed by part and supplier to ensure appropriate economies of scale
Supplier performance analysis should be used to build a portfolio of suppliers with complementary strengths
Cheaper but lower performing suppliers should be used to supply base demand
Higher performing but more expensive suppliers should be used to buffer against variation in demand and supply from the other source

14. Contracts for Product Availability and Supply Chain Profits
Many shortcomings in supply chain performance occur because the buyer and supplier are separate organizations and each tries to optimize its own profit
Total supply chain profits might therefore be lower than if the supply chain coordinated actions to have a common objective of maximizing total supply chain profits
Recall Chapter 10: double marginalization results in suboptimal order quantity
An approach to dealing with this problem is to design a contract that encourages a buyer (retailer) to purchase more and sell more by
increasing the level of product availability and
decreasing prices, if necessary
The supplier must share in some of the buyer’s demand uncertainty

15. Contracts A contract is an agreement between two parties.
Pricing contract types
Fixed price
Dependent price
Capturable uncertainty
Third party measures, indicators as surrogates
Alterable price
Uncapturable uncertainty
Renegotiation necessary
Same classification for quantity contracts
Cost+fee contracts as opposed to price contracts
Car repair: Spark plug cost + labor fee.
Sink installation: Drainage assembly + labor at $110/hour for the first hour and $80/hour for the others.

16. Contracts Advantages & Disadvantages
Uncertainty reduction
Relationship leveraging
Disadvantages for supplier
Being blocked from selling to other retailers
Harsh retailers: GM and its suppliers
Disadvantages for retailer
Being blocked from buying from other suppliers
Supplier complacency – lack of incentives for improvement

17. Contracts to Coordinate Supply Chain Costs
Differences in costs at the buyer and supplier can lead to decisions that increase total supply chain costs
Ex: Replenishment order size placed by the buyer. The buyer’s EOQ does not take into account the supplier’s costs.
A quantity discount contract may encourage the buyer to purchase a larger quantity (which would be lower costs for the supplier), which would result in lower total supply chain costs
Quantity discounts lead to misleading demand information because of order batching
A contract is said to be coordinating a supply chain if the sum of the profits of various decision makers under the contract is equal to the profit of one decision maker

18. Buyback Contracts
Allows a retailer to return unsold inventory up to a specified amount at an agreed upon price
Increases the optimal order quantity for the retailer, resulting in higher product availability and higher profits for both the retailer and the supplier
Downsides that buyback contract results in
Surplus inventory for the supplier that must be disposed of, which increases supply chain costs
Misleading for the supply chain as it reacts to (inflated) retail orders, not actual customer demand
Most effective for products with low variable cost, such as music, software, books, magazines, and newspapers so that the supplier can keep the surplus

19. Revenue Sharing Contracts
The buyer pays a minimal amount for each unit purchased from the supplier but shares a fraction of the revenue for each unit sold
Decreases the cost per unit charged to the retailer, which effectively decreases the cost of overstocking
Misleading for the supply chain as it reacts to (inflated) retail orders, not actual customer demand

20. Quantity Flexibility Contracts
Allows the buyer to modify the order (within limits) as demand visibility increases closer to the point of sale
Better matching of supply and demand
Increased overall supply chain profits if the supplier has flexible capacity
Lower levels of misleading demand information than either buyback contracts or revenue sharing contracts

21. Contracts to Increase Agent Effort
There are many instances in a supply chain where an agent acts on the behalf of a principal and the agent’s actions affect the reward for the principal. Examples of agents include
A car dealer who sells the cars of a manufacturer, as well as those of other manufacturers
A doctor who treats patients for an HMO
Sales force working on a commission
For more info, see UTD Medical Management master degree
Examples of contracts to increase agent effort include two-part tariffs and threshold contracts
Threshold contract example:
DaimlerChrysler increases the margin for the dealers as the dealers sell more per month. Dealers shift demand from one month to another.
Threshold contracts increase information distortion.

22. Contracts to Induce Performance Improvement
A buyer may want performance improvement from a supplier who otherwise would have little incentive to do so
A shared savings contract provides the supplier with a fraction of the savings that result from the performance improvement
Particularly effective where the benefit from improvement helps primarily the buyer, but where the effort for the improvement comes primarily from the supplier
GM and its suppliers
Department of Defense is moving towards performance based contracts from cost+fee contracts. Airlines use performance based contracts.
USAir engines are owned/repaired by General Dynamics in a certain delivery time.

23. Contracts for Design Collaboration
50-70 percent of spending at a manufacturer is through procurement
80 percent of the cost of a purchased part is fixed in the design phase
Design collaboration with suppliers can result in reduced cost, improved quality, and decreased time to market
Important to employ design for logistics, design for manufacturability
Manufacturers must become effective design coordinators throughout the supply chain
Ford designs with its suppliers

24. R&D Contracts Cost Overruns
A manufacturer is commissioned
to build a product after some R&D.
Military commissions ship and aircraft manufacturers; see the aside from NYT April 25, 2008.
Energy companies commission oil field development, alternative energy projects
International Energy Agency estimates that $1 trillion/year investment necessary in energy infrastructure until 2030.
These projects have cost and time overruns:
“Projects overrun because most owner and contractor organizations lack a practical and disciplined approach to strategic risk management.”
- R. Westney, Chairman of Westney Consulting, 2008.
Failing to capture now what can fail later.

25. The Procurement Process
The process in which the supplier sends product in response to orders placed by the buyer
Goal is to enable orders to be placed and delivered on schedule at the lowest possible overall cost
Two main categories of purchased goods:
Direct materials: components used to make finished goods
Indirect materials: goods used to support the operations of a firm
Focus for direct materials should be on improving coordination and visibility with supplier
Focus for indirect materials should be on decreasing the transaction cost for each order
Procurement for both should consolidate orders where possible to take advantage of economies of scale and quantity discounts

26. Product Categorization by Value and Criticality (Figure 13.2)
High
Critical Items
Ensure availability
Anti-corrosive coated fasteners
Strategic Items
Ensure long term relationship
Jet engines
Criticality
Bulk Purchase Items
Ensure low cost
Office supplies
General Items
Ensure low cost
Fasteners
Low
Low
High
Value/Cost

27. Impact of SC Contracts on Profitability: Buyback Contracts
Buybacks by publishers
Practice: Custom books are not bought back!
Unsold regular books are returned to the publishers at a lower price than the bookstores initially pay. All the unsold books are returned back to the publisher.
Buyback by TF
Tech Fiber(TF) produces jacket and sells to Ski Adventure(SA) which sells them in the market. Unsold jackets have no salvage value. Should TF be willing to buy back unsold jackets? Why?
Market
Price=$200
Wholesale
Price=$100
Cost=$5 TF SA
~N(1000,3002)

28. Impact of SC Contracts on Profitability: Buyback Contracts
Buyback by HP
HP manufactures Pavilion laptops, and sell to its retailer BestBuy. Each Pavilion costs $500 to produce, wholesales price is $700 and retail price is $1000. When a newer model is released, HP promises to buy back the left over laptops at $200 and HP can donate their leftover to charity and gain $50 in tax credit. If a=overage cost , b=underage cost for BestBuy, what is (a,b) with and without the contract?
(500, 300) with contract
(700, 300) without contract
Buyback by Panasonic
Panasonic sells a DVD player at $120 to BestBuy. BestBuy sells them at $150 to consumers. Unsold players are sold at discount price of $100 to customers, Panasonic compensates BestBuy for $ =$20 per player. Is this a buyback scheme, if so what is the buyback price?
Hint: Can BestBuy sell all the DVD players at the discount price? Answer: No.

29. Profits under centralization

30. Separately acting

31. Split of Supply Chain Profits under the Buyback Contract
Retailer obtains the big portion of the profits
when the wholesale price is far smaller than the sales price.
Supplier’s portion
Retailer’s portion c
“w” p

32. Buyback Contracts: c=$5; p=$200
What happens to the supplier profit with the buyback contract?

33. Does a buyback contract increase profits?
Which of these are true?
Buyback contract increases
the supply chain profit
the supplier profit
the retailer profit
the sales to the market
the sales to the retailer
the demand

34. Usual Manufacturer – Retailer Supply Chain
Selling Price=p=$100
Manufacturer
Manufacturer DC
Retail DC
Stores
Variable Production Cost=c=$40
Wholesale Price=w=$70
Selling Price=p=$100
What does wholesale price drive?
How can manufacturer benefit from lower price?

35. Revenue Sharing (RS) Contracts
If the manufacturer reduces wholesale price to wrs,
the retailer can share a percentage of the revenue p.
Wholesale Price=wrs=$50
Production Cost=$40
Selling Price=$100
What does wholesale price drive?
How can manufacturer benefit from lower price?
Manufacturer
Retailer
1-θ: Revenue sharing portion 50%

36. Blockbuster Case Study
Demand for a movie newly released video cassette typically starts high and decreases rapidly
Peak demand lasts about 10 weeks
Blockbuster purchases a copy from a studio for $65 and rents for $3
Hence, Blockbuster (retailer) must rent the tape at least 22 times before earning profit
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 because the Blockbuster stores did not have that movie.
In 1998, Blockbuster started revenue sharing with the major movie studios
In general, the retailer pays the wholesale price wrs.
Studio charges wrs=$8 per copy.
In general, the retailer shares (1-θ) portion of the sales revenue with the supplier.
Blockbuster pays (1-θ)=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 due to higher video availability
Market share increased from 25% to 31% (The 2nd largest retailer, Hollywood Entertainment Corp has 5% market share)

37. Buyback = Revenue Sharing if …
Buyback contract:
The retailer
pays w for each unit purchased from the supplier
gets b for each unit unsold to the market
Equivalently,
pays w-b for each unit purchased from the supplier
pays b more for each unit sold to the market
Revenue Sharing:
pays wrs for each unit purchased from the supplier
pays (1-θ)p more for each unit sold to the market
The contracts are the same if
wrs=w-b for each unit purchased from the supplier
(1-θ)p=b more for each unit sold to the market

38. Quantity Flexibility Contracts
If a retailer orders q units,
the manufacturer commits to supplying up to (1+)q the retailer commits to buying (1-)q
Unfortunately the book denotes (1+)q by O
How can quantity flexibility contracts help increase profitability?
Uncertainty reduction for
Retailers by avoiding lack of supply availability
Suppliers by avoiding lack of retailer demand

39. Quantity Flexibility Contract
1. Retailer knows the demand distribution F and makes a forecast q for its order size, typically q>E(D).
2. Supplier guarantees to supply q(1+ ),  >=0.
Retailer guarantees to buy q(1-  ), 0<= <=1.
Supplier produces Q>=q(1+α).
3. The demand is realized as D=d and the retailer buys
Min { Max{q(1- ),d} , q(1+α) }
Min{Max{q(1-),d},q(1+α)}
q(1- )
q(1+α) D

40. Quantity Flexibility Contract
Without coordination the supplier produces less than with coordination.
The contract is advantageous to the retailer only if Q<q(1+ ).
Otherwise, the supplier orders more than the contract would have indicated even without the contract. If such a high order is optimal for the supplier without the contract, it should also be optimal with the contract. Then the retailer does not benefit by committing to buy q(1-  ) with the contract.
The supplier can coordinate the chain by setting the wholesale price appropriately.
See notes to find out how the wholesaler price w is computed.

41. Quantity Flexibility Contracts
Larger values of  and  give more flexibility to the retailer.
Supplier prices for this flexibility via the wholesale price w.

42. Making Sourcing Decisions in Practice
Use multifunction teams
Ensure appropriate coordination across regions and business units
Always evaluate the total cost of ownership
Build long-term relationships with key suppliers

43. Summary of Learning Objectives
What is the role of sourcing in a supply chain?
What dimensions of supplier performance affect total cost?
What is the effect of supply contracts on supplier performance and information distortion?
What are different categories of purchased products and services? What is the desired focus for procurement for each of these categories?