Supply Contracts
Yossi Sheffi
Mass Inst of Tech
Cambridge, MA
ESD.260J,15.770J, 1.260J
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Outline
 Supply contracts
 Wholesale contracts
 Buyback contracts
 Revenue sharing contracts
 Option contracts
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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.)
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Consumer Demand
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Demand Distribution
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Notations:
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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=$10)
 Retailer is facing a Newsboy problem and
 supplier’s
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profit is trivial
Excel: Supply Contracts
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Wholesale Price Contract
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Wholesale Price Contract
Expected Profits
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Wholesale Price Contract
Exp Profits (Normal Approx)
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Effects of Wholesale Price on Profits
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Optimal Retail Order as a Function
of the Wholesale Price
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Wholesale Price Contract
Coordination the Channel
W=C
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Buyback Contract
 The problem: how can the supplier convince the
retailer to move towards the optimal order size?
 The supplier offer to the retailer to buy
back all unsold items ($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)
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Buyback Contract Calculations
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Channel profit with Buyback
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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.
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Expected Profits with Buyback
Contract
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Optimal Buyback Price
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Channel Coordination with
Buyback
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At w=$135: B=$118, %retailer = 43%
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Expected Profit with
Coordinating Buyback Rate
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Buyback Contracts in Practice
 Book publishing
 Periodicals/newspapers
 Price support in consumer electronics
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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.
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The Players
Paramount
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Blockbuster
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The Economics of Revenue Sharing
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Revenue Sharing
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Expected Profit with Revenue
Sharing
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Optimal Revenue Share
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Coordination with Rev. Sharing
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Revenue Sharing (Normal
Approx)
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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
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Real Options
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Coordination with Real Options
Retailer’s optimal order:
Comparing to a single channel:
Where:
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The condition below is for p to be positive (so the exercise price plus the option is bigger than the option alone)
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Coordination with Real Options
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Expected Profits with Options
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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.
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Any Questions?
Yossi Sheffi
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