1. 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

2. 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

3. 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*=( )/(200-0)=0.5
Orders 1000
Expected profit = $76063
Manufacturer:
Produces and sells 1000 units
Profit = (100-10)*1000 = $90000

4. 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!

5. 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

6. 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

7. 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.

8. 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?

9. 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

10. 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)

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

12. Quantity flexible contracts

13. 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

14. 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