Supply Contracts and Risk
Management
David Simchi-Levi
Professor of Engineering Systems
Massachusetts Institute of Technology
Tel: 617-253-6160
E-mail: dslevi@mit.edu
Outline
• Supply Chain Strategies
• Supply Contracts
©Copyright 2005 D. Simchi-Levi
Supply Chain Strategies
• Achieving Global Optimization
• Managing Uncertainty
– Risk Pooling
– Risk Sharing
©Copyright 2005 D. Simchi-Levi
Sequential Optimization vs.
Global Optimization
Sequential Optimization
Procurement
Planning
Manufacturing
Planning
Distribution
Planning
Demand
Planning
Global Optimization
Supply Contracts/Collaboration/Integration/DSS
Procurement
Planning
Manufacturing
Planning
Distribution
Planning
Demand
Planning
Source: Duncan McFarlane
©Copyright 2005 D. Simchi-Levi
Supply Contracts
• Fashion items
– short life cycles
– High product variety
– One production opportunity
– Simple supply chain structure
– High demand uncertainty
©Copyright 2005 D. Simchi-Levi
Supply Chain Time Lines
Jan 00
Jan 01
Design
Feb 00
Production
Jan 02
Production
Sep 00
Feb 01
Retailing
Sep 01
©Copyright 2005 D. Simchi-Levi
Supply Contracts
Fixed Production Cost =$100,000
Variable Production Cost=$35
Wholesale Price =$80
Selling Price=$125
Salvage Value=$20
Manufacturer
Manufacturer DC
Retail DC
Stores
©Copyright 2005 D. Simchi-Levi
Demand Scenarios
18
00
0
16
00
0
14
00
0
12
00
0
10
00
0
30%
25%
20%
15%
10%
5%
0%
80
00
Probability
Demand Scenarios
Sales
©Copyright 2005 D. Simchi-Levi
Distributor Expected Profit
Expected Profit
500000
400000
300000
200000
100000
0
6000
8000
10000
12000
14000
16000
18000
20000
Order Quantity
©Copyright 2005 D. Simchi-Levi
Distributor Expected Profit
Expected Profit
500000
400000
300000
200000
100000
0
6000
8000
10000
12000
14000
16000
18000
20000
Order Quantity
©Copyright 2005 D. Simchi-Levi
Supply Contracts (cont.)
• Distributor optimal order quantity is
12,000 units
• Distributor expected profit is $470,000
• Manufacturer profit is $440,000
• Supply Chain Profit is $910,000
–IS there anything that the distributor and
manufacturer can do to increase the profit
of both?
©Copyright 2005 D. Simchi-Levi
Supply Contracts
Fixed Production Cost =$100,000
Variable Production Cost=$35
Wholesale Price =$80
Selling Price=$125
Salvage Value=$20
Manufacturer
Manufacturer DC
Retail DC
Stores
©Copyright 2005 D. Simchi-Levi
Retailer Profit
(Buy Back=$55)
Retailer Profit
600,000
500,000
400,000
300,000
200,000
100,000
0
00 00 00 00
00 00 00 00 00
00 00 00 00
60 70 80 90 100 110 120 130 140 150 160 170 180
Order Quantity
©Copyright 2005 D. Simchi-Levi
Retailer Profit
(Buy Back=$55)
Retailer Profit
600,000
$513,800
500,000
400,000
300,000
200,000
100,000
0
00 00 00 00
00 00 00 00 00
00 00 00 00
60 70 80 90 100 110 120 130 140 150 160 170 180
Order Quantity
©Copyright 2005 D. Simchi-Levi
Manufacturer Profit
(Buy Back=$55)
500,000
400,000
300,000
200,000
100,000
0
60
00
70
00
80
00
90
00
10
00
0
11
00
0
12
00
0
13
00
0
14
00
0
15
00
0
16
00
0
17
00
0
18
00
0
Manufacturer Profit
600,000
Production Quantity
©Copyright 2005 D. Simchi-Levi
Manufacturer Profit
(Buy Back=$55)
500,000
$471,900
400,000
300,000
200,000
100,000
0
60
00
70
00
80
00
90
00
10
00
0
11
00
0
12
00
0
13
00
0
14
00
0
15
00
0
16
00
0
17
00
0
18
00
0
Manufacturer Profit
600,000
Production Quantity
©Copyright 2005 D. Simchi-Levi
Buy Back Contracts: Main
Limitations
• Requires suppliers to have an effective
reverse logistics systems
• Provides retailers with incentives to
push competing products from suppliers
with whom the buyer does not have
buy back agreements
©Copyright 2005 D. Simchi-Levi
Supply Contracts
Fixed Production Cost =$100,000
Variable Production Cost=$35
Wholesale Price =$80
Selling Price=$125
Salvage Value=$20
Manufacturer
Manufacturer DC
Retail DC
Stores
©Copyright 2005 D. Simchi-Levi
Retailer Profit
(Wholesale Price $70, RS 15%)
500,000
400,000
300,000
200,000
100,000
0
60
00
70
00
80
00
90
00
10
00
0
11
00
0
12
00
0
13
00
0
14
00
0
15
00
0
16
00
0
17
00
0
18
00
0
Retailer Profit
600,000
Order Quantity
©Copyright 2005 D. Simchi-Levi
Retailer Profit
(Wholesale Price $70, RS 15%)
$504,325
500,000
400,000
300,000
200,000
100,000
0
60
00
70
00
80
00
90
00
10
00
0
11
00
0
12
00
0
13
00
0
14
00
0
15
00
0
16
00
0
17
00
0
18
00
0
Retailer Profit
600,000
Order Quantity
©Copyright 2005 D. Simchi-Levi
Manufacturer Profit
(Wholesale Price $70, RS 15%)
600,000
500,000
400,000
300,000
200,000
100,000
0
60
00
70
00
80
00
90
00
10
00
0
11
00
0
12
00
0
13
00
0
14
00
0
15
00
0
16
00
0
17
00
0
18
00
0
Manufacturer Profit
700,000
Production Quantity
©Copyright 2005 D. Simchi-Levi
Manufacturer Profit
(Wholesale Price $70, RS 15%)
600,000
500,000
$481,375
400,000
300,000
200,000
100,000
0
60
00
70
00
80
00
90
00
10
00
0
11
00
0
12
00
0
13
00
0
14
00
0
15
00
0
16
00
0
17
00
0
18
00
0
Manufacturer Profit
700,000
Production Quantity
©Copyright 2005 D. Simchi-Levi
Supply Contracts
Strategy
Sequential Optimization
Buyback
Revenue Sharing
Retailer Manufacturer
470,700
440,000
513,800
471,900
504,325
481,375
©Copyright 2005 D. Simchi-Levi
Total
910,700
985,700
985,700
Supply Contracts
Fixed Production Cost =$100,000
Variable Production Cost=$35
Wholesale Price =$80
Selling Price=$125
Salvage Value=$20
Manufacturer
Manufacturer DC
Retail DC
Stores
©Copyright 2005 D. Simchi-Levi
Supply Chain Profit
1,000,000
800,000
600,000
400,000
200,000
0
60
00
70
00
80
00
90
00
10
00
0
11
00
0
12
00
0
13
00
0
14
00
0
15
00
0
16
00
0
17
00
0
18
00
0
Supply Chain Profit
1,200,000
Production Quantity
©Copyright 2005 D. Simchi-Levi
Supply Chain Profit
$1,014,500
1,000,000
800,000
600,000
400,000
200,000
0
60
00
70
00
80
00
90
00
10
00
0
11
00
0
12
00
0
13
00
0
14
00
0
15
00
0
16
00
0
17
00
0
18
00
0
Supply Chain Profit
1,200,000
Production Quantity
©Copyright 2005 D. Simchi-Levi
Supply Contracts
Strategy
Sequential Optimization
Buyback
Revenue Sharing
Global Optimization
Retailer Manufacturer
470,700
440,000
513,800
471,900
504,325
481,375
Total
910,700
985,700
985,700
1,014,500
©Copyright 2005 D. Simchi-Levi
Supply Contracts: Key Insights
• Effective supply contracts allow supply
chain partners to replace sequential
optimization by global optimization
• Buy Back and Revenue Sharing contracts
achieve this objective through risk
sharing
©Copyright 2005 D. Simchi-Levi
Supply Contracts: Key Insights
• Effective supply contracts allow supply chain
partners to replace sequential optimization
by global optimization
• Buy Back and Revenue Sharing contracts
achieve this objective through risk sharing
• Effective supply contracts are designed so that
no party has an incentive to deviate from
the set of actions defined by the contract
– Unique Nash Equilibrium
©Copyright 2005 D. Simchi-Levi
Supply Contracts: Case Study
• Example: Demand for a movie newly released video
cassette typically starts high and decreases rapidly
– Peak demand last about 10 weeks
• Blockbuster purchases a copy from a studio for $65
and rent for $3
– Hence, 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
©Copyright 2005 D. Simchi-Levi
Supply Contracts: Case Study
• Starting in 1998 Blockbuster entered a revenue sharing
agreement with the major studios
– Studio charges $8 per copy
– Blockbuster pays 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
– Market share increased from 25% to 31% (The 2nd largest
retailer, Hollywood Entertainment Corp has 5% market share)
©Copyright 2005 D. Simchi-Levi
What are the drawbacks of RS?
• Administrative Cost
– Lawsuit brought by three independent video retailers who
complained that they had been excluded from receiving the
benefits of revenue sharing was dismissed (June 2002)
– The Walt Disney Company has sued Blockbuster accusing
them of cheating its video unit of approximately $120 million
under a four year revenue sharing agreement (January 2003)
• Impact on sales effort
– Retailers have incentive to push products with higher profit
margins
– Automotive industry: automobile sales depends on retail effort
©Copyright 2005 D. Simchi-Levi
What are the drawbacks of RS?
• Retailer may carry complementary
products from other suppliers
– One supplier offers revenue sharing while
the other does not
• Retailer may discount the product offered under
revenue sharing to motivate sales of the other
product
©Copyright 2005 D. Simchi-Levi
Other Contracts
• Quantity Flexibility Contracts
– Supplier provides full refund for returned
items as long as the number of returns is
no larger than a certain quantity
• Sales Rebate Contracts
– Supplier provides direct incentive for the
retailer to increase sales by means of a
rebate paid by the supplier for any item
sold above a certain quantity
©Copyright 2005 D. Simchi-Levi
Key Assumptions
Symmetric Information
S
M
MAKE-TO-ORDER
©Copyright 2005 D. Simchi-Levi
Telecom Supply Chain
Value added
S
MTS
Operator
M
MTO
Purchased material
(80 to 85 %)
Note: Typical ratios for Telecom EMs
©Copyright 2005 D. Simchi-Levi
Supply Contracts
Fixed Production Cost =$100,000
Variable Production Cost=$55
Wholesale Price =$80
Salvage Value =$20
Selling Price=$125
Manufacturer
Manufacturer DC
Distributor DC
MAKE-TO-STOCK
Stores
©Copyright 2005 D. Simchi-Levi
Demand Scenarios
18
00
0
16
00
0
14
00
0
12
00
0
10
00
0
30%
25%
20%
15%
10%
5%
0%
80
00
Probability
Demand Scenarios
Sales
©Copyright 2005 D. Simchi-Levi
Manufacturer Expected Profit
Expected Profit
$175,000
$150,000
Profit
$125,000
$100,000
$75,000
$50,000
$25,000
$0
6000
8000
10000
12000
14000
Production Quantity
©Copyright 2005 D. Simchi-Levi
16000
Manufacturer Expected Profit
Expected Profit
$175,000
$150,000
Profit
$125,000
$100,000
$75,000
$50,000
$25,000
$0
6000
8000
10000
12000
14000
Production Quantity
©Copyright 2005 D. Simchi-Levi
16000
Supply Contracts (cont.)
• Manufacturer optimal production
quantity is 12,000 units
• Manufacturer expected profit is
$160,400
• Distributor profit is $510,300
• Supply Chain Profit is $670,700
–IS there anything that the distributor and
manufacturer can do to increase the profit
of both?
©Copyright 2005 D. Simchi-Levi
Supply Contracts
Fixed Production Cost =$100,000
Variable Production Cost=$55
Wholesale Price =$80
Salvage Value =$20
Selling Price=$125
Manufacturer
Manufacturer DC
Distributor DC
Stores
©Copyright 2005 D. Simchi-Levi
Manufacturer Profit
(Pay Back=$18)
200000
Manufacturer Profit
175000
150000
125000
100000
75000
50000
25000
0
6000
8000
10000
12000
14000
16000
Production Quantity
©Copyright 2005 D. Simchi-Levi
18000
Manufacturer Profit
(Pay Back=$18)
200000
$180,280
Manufacturer Profit
175000
150000
125000
100000
75000
50000
25000
0
6000
8000
10000
12000
14000
16000
Production Quantity
©Copyright 2005 D. Simchi-Levi
18000
Distributor Profit
(Pay Back=$18)
600000
Distributor Profit
500000
400000
300000
200000
100000
0
6000
8000
10000
12000
14000
16000
18000
Order Quantity
©Copyright 2005 D. Simchi-Levi
Distributor Profit
(Pay Back=$18)
600000
$525,420
Distributor Profit
500000
400000
300000
200000
100000
0
6000
8000
10000
12000
14000
16000
18000
Order Quantity
©Copyright 2005 D. Simchi-Levi
Supply Contracts
Fixed Production Cost =$100,000
Variable Production Cost=$55
Wholesale Price =$80
Salvage Value =$20
Selling Price=$125
Manufacturer
Manufacturer DC
Distributor DC
MAKE-TO-STOCK
Stores
©Copyright 2005 D. Simchi-Levi
Manufacturer Profit
(Wholesale Price $62, CS 33%)
$200,000.00
$175,000.00
Manufacturer Profit
$150,000.00
$125,000.00
$100,000.00
$75,000.00
$50,000.00
$25,000.00
$0.00
6000
8000
10000
12000
14000
16000
18000
Production Quantity
©Copyright 2005 D. Simchi-Levi
Manufacturer Profit
(Wholesale Price $62, CS 33%)
$200,000.00
$182,380
$175,000.00
Manufacturer Profit
$150,000.00
$125,000.00
$100,000.00
$75,000.00
$50,000.00
$25,000.00
$0.00
6000
8000
10000
12000
14000
16000
18000
Production Quantity
©Copyright 2005 D. Simchi-Levi
Distributor Profit
(Wholesale Price $62, CS 33%)
$600,000.00
Distributor Profit
$500,000.00
$400,000.00
$300,000.00
$200,000.00
$100,000.00
$0.00
6000
8000
10000
12000
14000
16000
18000
Order Quantity
©Copyright 2005 D. Simchi-Levi
Distributor Profit
(Wholesale Price $62, CS 33%)
$600,000.00
$523,320
Distributor Profit
$500,000.00
$400,000.00
$300,000.00
$200,000.00
$100,000.00
$0.00
6000
8000
10000
12000
14000
16000
18000
Order Quantity
©Copyright 2005 D. Simchi-Levi
Supply Contracts
Sequential Optimization
Payback
Cost Sharing
Distributor Manufacturer Supply Chain
510,300
160,400
670,700
525,420
180,280
705,700
523,320
182,380
705,700
©Copyright 2005 D. Simchi-Levi
Supply Contracts
Fixed Production Cost =$100,000
Variable Production Cost=$55
Wholesale Price =$80
Selling Price=$125
Salvage Value=$20
Manufacturer
Manufacturer DC
Distributor DC
Stores
©Copyright 2005 D. Simchi-Levi
Supply Chain Profit
$800,000.00
System Profit ($)
$700,000.00
$600,000.00
$500,000.00
$400,000.00
$300,000.00
$200,000.00
$100,000.00
$0.00
5,000
8,000
11,000
14,000
17,000
Quantity
©Copyright 2005 D. Simchi-Levi
Supply Chain Profit
$800,000.00
System Profit ($)
$700,000.00
$705,700
$600,000.00
$500,000.00
$400,000.00
$300,000.00
$200,000.00
$100,000.00
$0.00
5,000
8,000
11,000
14,000
17,000
Quantity
©Copyright 2005 D. Simchi-Levi
Supply Contracts
Strategy
Sequential Optimization
Payback
Cost Sharing
Global Optimization
Distributor Manufacturer
510,300
160,400
525,420
180,280
523,320
182,380
©Copyright 2005 D. Simchi-Levi
Total
670,700
705,700
705,700
705,700
Forecast inflation
“Forecasts by electronics and
telecom companies are often
inflated.”
“Now, Selectron has $4.7 billion
in inventory.”
Business Week, March 19, 2001
©Copyright 2005 D. Simchi-Levi
Shared Forecast Evolution
Semiconductor Equipment Supply
Chain
1999 Q1
1999 Q2
1999 Q3
1999 Q4
2000 Q1
2000 Q2
2000 Q3
2000 Q4
2001 Q1
Actual
1999 Q1
1999 Q2
1999 Q3
1999 Q4
2000 Q1
2000 Q2
2000 Q3
2000 Q4
2001 Q1
2001 Q2
2001 Q3
Year and Quarter
Source: Wharton: Intel Tool Order data over time
©Copyright 2005 D. Simchi-Levi
2001 Q4
Objective
• Can we design contracts that achieve
credible information sharing?
©Copyright 2005 D. Simchi-Levi
Supply Chain Time Line
• Manufacturer send a forecast to the
supplier
– Forecast maybe inflated
– Difficult for the supplier to verify the
forecast ex-post
• Supplier build capacity
• Manufacturer decides
©Copyright 2005 D. Simchi-Levi
Supply Contracts
• Capacity reservation contracts
– Manufacturer pays to reserve a certain
level of capacity and an additional cost for
executing orders
©Copyright 2005 D. Simchi-Levi
Capacity Reservation Contracts
• Concave capacity reservation contract
• Supplier delegates the decision right to the Manufacturer
55
50
price
45
40
35
30
25
6
11
16
21
capacity
©Copyright 2005 D. Simchi-Levi
Supply Contracts
• Advance purchase contracts:
– Supplier charges the advance purchase
price for orders placed prior to building
capacity and a different price for orders
placed when demand is realized
©Copyright 2005 D. Simchi-Levi
From Local to Global Optimization
Safety Stock Cost vs. Quoted Lead Time
$100,000
Safety Stock Cost ($/year)
$90,000
$80,000
$70,000
$60,000
Local Optimization
Global Optimization
$50,000
$40,000
$30,000
$20,000
$10,000
$0
0
20
40
60
80
100
Lead Time Quoted to Customer (days)
Study used Inventory Analyst™
©Copyright 2005 D. Simchi-Levi
From Local to Global Optimization
Safety Stock Cost vs. Quoted Lead Time
$100,000
For a given lead-time, the
optimized supply chain provides
reduced costs
Safety Stock Cost ($/year)
$90,000
$80,000
$70,000
$60,000
Local Optimization
Global Optimization
$50,000
$40,000
$30,000
$20,000
$10,000
$0
0
20
40
60
80
100
Lead Time Quoted to Customer (days)
Study used Inventory Analyst™
©Copyright 2005 D. Simchi-Levi
From Local to Global Optimization
Safety Stock Cost vs. Quoted Lead Time
$100,000
For a given lead-time, the
optimized supply chain provides
reduced costs
Safety Stock Cost ($/year)
$90,000
$80,000
$70,000
For a given cost, the
optimized supply chain
provides better lead-times
$60,000
$50,000
Local Optimization
Global Optimization
$40,000
$30,000
$20,000
$10,000
$0
0
20
40
60
80
100
Lead Time Quoted to Customer (days)
Study used Inventory Analyst™
©Copyright 2005 D. Simchi-Levi
Waltham Oil Field
• Two Companies:
– SLNR operates, lift and manage
– Subcontractor to build the facility
Capacity
Cost 000s
40,000
$290,000
50,000
$360,000
60,000
$420,000
70,000
$490,000
80,000
$550,000
90,000
$570,000
©Copyright 2005 D. Simchi-Levi
SLNR Facility Cost
• Cost of building the facility
Facility Size
40,000
50,000
60,000
70,000
80,000
90,000
$
$
$
$
$
$
Cost
300,000,000.00
370,000,000.00
440,000,000.00
510,000,000.00
580,000,000.00
650,000,000.00
©Copyright 2005 D. Simchi-Levi
Sequential Optimization
• SLNR to build a facility of size 80,000BPD
– Expected NPV is $700M
• Subcontractor profit is $30M
©Copyright 2005 D. Simchi-Levi
Global Optimization
Expected Profit
$800,000,000
$700,000,000
$600,000,000
$500,000,000
$400,000,000
$300,000,000
$200,000,000
$100,000,000
$0
Expected Profit
40,000
50,000
60,000
70,000
80,000
90,000
Facility Size 90,000BPD, System NPV = $750B
©Copyright 2005 D. Simchi-Levi