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Yossi Sheffi Mass Inst of Tech Cambridge, MA

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1 Yossi Sheffi Mass Inst of Tech Cambridge, MA
Supply Contracts Yossi Sheffi Mass Inst of Tech Cambridge, MA ESD.260J,15.770J, 1.260J (c) Yossi Sheffi, MIT

2 Outline Supply contracts Wholesale contracts Buyback contracts
Revenue sharing contracts Option contracts (c) Yossi Sheffi, MIT

3 The Scenario: Contract is negotiated
Retailer places order (a single period) Supplier makes and sends the stuff The selling season takes place Accounting (sales, salvage, etc.) (c) Yossi Sheffi, MIT

4 Consumer Demand (c) Yossi Sheffi, MIT

5 Demand Distribution (c) Yossi Sheffi, MIT

6 Notations: (c) Yossi Sheffi, MIT

7 Wholesale Contracts Prices and costs:
Supplier has a cost to make/purchase (C=$50) Supplier is selling and retail is buying at a wholesale price (W=$135) Retailer is selling for a retail price (R=$200) Retailer can salvage (S=$10) Retailer is facing a Newsboy problem and supplier’s profit is trivial (c) Yossi Sheffi, MIT Excel: Supply Contracts

8 Wholesale Price Contract
(c) Yossi Sheffi, MIT

9 Wholesale Price Contract Expected Profits
(c) Yossi Sheffi, MIT

10 Wholesale Price Contract Exp Profits (Normal Approx)
(c) Yossi Sheffi, MIT

11 Effects of Wholesale Price on Profits
(c) Yossi Sheffi, MIT

12 Optimal Retail Order as a Function of the Wholesale Price
(c) Yossi Sheffi, MIT

13 Wholesale Price Contract Coordination the Channel
W = C (c) Yossi Sheffi, MIT

14 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) (c) Yossi Sheffi, MIT

15 Buyback Contract Calculations
(c) Yossi Sheffi, MIT

16 Channel profit with Buyback
(c) Yossi Sheffi, MIT

17 Optimal Buyback and Wholesale price
Higher wholesale price requires a ______ buyback rate As the wholesale price (and the buyback rate) grows the supplier’s share of the profit _______ Wholesale price ranges from $50 (supplier’s cost) to $200 (retail price) Buyback rate ranges from $10 (salvage value) to $200. (c) Yossi Sheffi, MIT

18 Expected Profits with Buyback Contract
(c) Yossi Sheffi, MIT

19 Optimal Buyback Price (c) Yossi Sheffi, MIT

20 Channel Coordination with Buyback
(c) Yossi Sheffi, MIT At w=$135: B=$118, %retailer = 43%

21 Expected Profit with Coordinating Buyback Rate
(c) Yossi Sheffi, MIT

22 Buyback Contracts in Practice
Book publishing Periodicals/newspapers Price support in consumer electronics (c) Yossi Sheffi, MIT

23 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 supplier’s cost. (c) Yossi Sheffi, MIT

24 The Players Paramount Blockbuster (c) Yossi Sheffi, MIT

25 The Economics of Revenue Sharing
(c) Yossi Sheffi, MIT

26 Revenue Sharing (c) Yossi Sheffi, MIT

27 Expected Profit with Revenue Sharing
(c) Yossi Sheffi, MIT

28 Optimal Revenue Share (c) Yossi Sheffi, MIT

29 Coordination with Rev. Sharing
(c) Yossi Sheffi, MIT

30 Revenue Sharing (Normal Approx)
(c) Yossi Sheffi, MIT

31 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 (c) Yossi Sheffi, MIT

32 Real Options (c) Yossi Sheffi, MIT

33 Coordination with Real Options
Retailer’s optimal order: Comparing to a single channel: Where: (c) Yossi Sheffi, MIT The condition below is for p to be positive (so the exercise price plus the option is bigger than the option alone)

34 Coordination with Real Options
(c) Yossi Sheffi, MIT

35 Expected Profits with Options
(c) Yossi Sheffi, MIT

36 Summary Wholesale contracts give too much risk and not enough
expected reward to the retailer To make the retailer order more (and increase the channel’s 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. (c) Yossi Sheffi, MIT

37 Any Questions? Yossi Sheffi (c) Yossi Sheffi, MIT

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