Supply Chain Contracts and their Impact on Profitability SEG 4610 Supply Chain Management Supply Chain Contracts and their Impact on Profitability Double Marginalisation Supply Chain Co-ordination via Contracts Janny Leung

Supply Chain Contracts Manufacturer Retailer A contract specifies the terms of the orders and deliveries between the buyer and the supplier Quantity, Price, Delivery lead time, Quality Over/under-stocking risks? Fixed quantity, long lead time  buyer bears risk Short lead time  supplier bears risk (buyer can wait until demand known) Each link in the supply chain optimises based on its own profit/cost margins (without considering other links in the supply chain) May reduce profits of the entire supply chain

Double Marginalisation -Example Manufacturer (TechFibre): Production cost v=$10, charges Wholesale price c=$100 Retailer (Ski Adventure): Selling price p=$200, Salvage value s=$0 Demand (at p=$200): Normally distributed ~ N(1000, 3002) Retailer (solves a newsvendor problem): CSL*=(200-100)/(200-0)=0.5 Orders 1000 Expected profit = $76063 Manufacturer: Produces and sells 1000 units Profit = (100-10)*1000 = $90000

Double Marginalisation Example With retailer doing own optimisation, 1000 units produced, and total supply chain profit is $76,063 + $90,000 = $166,063 In fact, for the supply chain (as a whole): Cu =200-10, Co=10 CSL* = 190/200=0.95 Optimal production level = 1493 Total supply chain profit = $183,812 Considering Manufacturer and retailer TOGETHER, the supply chain profit is higher!

Double Marginalisation SEG 4610 Supply Chain Management Double Marginalisation If each party makes decisions considering only a part of the supply chain, the decisions may not maximize profits for the whole supply chain! Janny Leung

Supply Chain Co-ordination SEG 4610 Supply Chain Management Supply Chain Co-ordination Can contracts/incentives be set to increase total supply chain profits? Incentives to retailers to order quantities that increase supply chain profits: Buy-back contracts : A manufacturer specifies a wholesale price and a buyback price at which the retailer can return any unsold items at the end of the season Revenue sharing contracts: The manufacturer charges the retailer a low wholesale price and shares a fraction of the revenue generated by the retailer Quantity flexible contracts: Manufacturer allows retailer to change order quantity after observing demand Janny Leung

Returns Policy: Buy Back contracts Manufacturer specifies wholesale price and a buyback price b at which retailers can return unsold units at end of season Retailer: Salvage value becomes b (so, Co=c-b) Optimal Order y* increases! Manufacturer: Expected profit = y*(c-v) – b(expected overstock) Increases if b not too large.

Buyback contract Both manufacturer and retailer can increase profits Increasing wholesale price (and buyback price by a larger amount) can increase manufacturer’s profit Cost of returning goods?

Revenue Sharing Contracts Manufacturer charges a low wholesale price and shares a fraction (f) of the revenue generated by the retailer Lower wholesale price decreases cost of overstocking, so retailer increases level of product availability => increase profit for BOTH manufacturer and retailer

Revenue Sharing Contracts Retailer: Cu = (1-f)p - c, Co= c - sR CSL* = [(1-f)p-c ]/[(1-f)p-sR] Let ES = Expected Overstock at retailer Expected profit = (1-f)p(Q-ES) + sR(ES) - cQ Manufacturer: Expected profit = (c-v)Q + fp(Q-ES)

Quantity Flexibility contracts Manufacturer allows retailer to adjust quantity ordered after observing demand Retail orders O Manufacturer commits to deliver Q=(1+a)O, 0< a < 1 Retailer commits to buying at least q=(1-b)O, 0< b < 1 Manufacturers share risk with retailers No returns required

Quantity flexible contracts

Vendor Managed Inventory (VMI) Manufacturer controls replenishments decisions Retailers share sales information VMI can mitigate the effects of double marginalisation VMI can improve manufacturer forecasts Retailers stock goods from competitors Confidentiality? Substitutability ignored by BOTH manufacturers -> stock too high for retailers

SEG 4610 Supply Chain Management Summary Newsvendor model Tradeoff cost of over-stock and lost sales Supply chain co-ordination by contracts Buy-back Revenue sharing Quantity-flexible Vendor-managed inventory Incentives? Making supply meet demand! Janny Leung