Chapter 14: Supply Chain
Contracting
Topics to Cover
 The Bullwhip Effect
 Supply Chain Design Strategy
 Suboptimal supply chain performance due to
incentive conflicts
What is the bullwhip effect?
 Demand variability increases as you move up the supply chain
from customers towards supply
Equipment Tier 1 Supplier
Factory
Distributor
First noticed regarding Pampers
Retailer
Customer
Bullwhip effect in the US PC supply chain
Changes in
demand
80%
60%
Semiconductor
Equipment
40%
20%
PC
0%
-20%
Semiconductor
-40%
1995
1996
1997
1998
1999
2000
2001
Annual percentage changes in demand (in $s) at three levels of the semiconductor
supply chain: personal computers, semiconductors and semiconductor manufacturing
equipment.
Consequences of the bullwhip effect
 Inefficient production or excessive inventory.
 Low utilization of the distribution channel.
 Necessity to have capacity far exceeding average
demand.
 High transportation costs.
 Poor customer service due to stockouts.
Causes of the bullwhip effect
 Order synchronization
 Order batching
 Trade promotions and forward buying
 Reactive and over-reactive ordering
 Shortage gaming
Order synchronization
70
 Customers order on the same
order cycle, e.g., first of the
month, every Monday, etc.
50
40
Units
 The graph shows simulated
daily consumer demand (solid
line) and supplier demand
(squares) when retailers order
weekly: 9 retailers order on
Monday, 5 on Tuesday, 1 on
Wednesday, 2 or Thursday
and 3 on Friday.
60
30
20
10
0
T im e (e a c h p e rio d e q u a ls o n e d a y )
Order batching
70
 The graph shows simulated
daily consumer demand (solid
line) and supplier demand
(squares) when retailers order
in batches of 15 units, i.e.,
every 15th demand a retailer
orders one batch from the
supplier that contains 15
units.
60
50
Units
 Retailers may be required to
order in integer multiples of
some batch size, e.g., case
quantities, pallet quantities,
full truck load, etc.
40
30
20
10
0
T im e (e a c h p e rio d e q u a ls o n e d a y )
Trade promotions and forward buying
 Supplier gives retailer a temporary discount, called a trade promotion.
 Retailer purchases enough to satisfy demand until the next trade promotion.
 Example: Campbell’s Chicken Noodle Soup over a one year period:
Total shipments and consumption
One retailer’s buy
7000
6000
S hipm e nts
Cases
Cases
5000
4000
3000
C ons um ption
2000
1000
Nov
Oct
Sep
Aug
Jul
Jun
Apr
Mar
Feb
May
T im e (w e e ks )
Jan
Dec
0
Reactive and over-reactive ordering
 Each location forecasts demand to determine shifts in the demand process.
 How should a firm respond to a “high” demand observation?
 Is this a signal of higher future demand or just random variation in current
demand?
 Hedge by assuming this signals higher future demand, i.e. order more than
usual.
 Rational reactions at one level propagate up the supply chain.
 Unfortunately, it is human to over react, thereby further increasing the
bullwhip effect.
Shortage gaming
 Setting:
 Retailers submit orders for delivery in a future period.
 Supplier produces.
 If supplier production is less than orders, orders are rationed, i.e., retailers
are “put on allocation”.
 … to secure a better allocation, the retailers inflate their orders, i.e., order
more than they need…
 … So retailer orders do not convey good information about true demand …
 This can be a big problem for the supplier, especially if retailers are later able
to cancel a portion of the order:
 Orders that have been submitted that are likely be canceled are called
phantom orders.
Strategies to combat the bullwhip effect
 Information sharing:
 Collaborative Planning, Forecasting and Replenishment (CPFR)
 Smooth the flow of products
 Coordinate with retailers to spread deliveries evenly.
 Reduce minimum batch sizes.
 Smaller and more frequent replenishments (EDI).
 Eliminate pathological incentives
 Every day low price
 Restrict returns and order cancellations
 Order allocation based on past sales in case of shortages
 Vendor Managed Inventory (VMI): delegation of stocking decisions
 Used by Barilla, P&G/Wal-Mart and others.
Supply Chain Design Strategy
Based on concepts developed by
Marshall Fischer at Wharton (Penn)
 Functional Products
 Staples that people buy at retail outlets
 Predictable demand and long life cycles
 Physical costs
 Strategy: Minimize physical costs
 Innovative Products
 Life cycle is just a few months (e.g. fashion clothes
& computers)
 Demand is unpredictable
 Market mediation costs (inventory & stockouts)
 Strategy: Maximize responsiveness & flexibility
Supply-Chain Strategy
Efficient
Supply Chain
Responsive
Supply Chain
Functional Products
Match
Standard picture frames
Standard eyeglass
frames
Sub shop
Innovative Products
Custom made clothes
Gourmet food
Liberal arts education
Low-cal breakfast cereal
Match
Suboptimal supply chain performance due
to incentive conflicts
 Suboptimal supply chain performance occurs because of double
marginalization:
 Each firm makes decisions based on their own margin, not the supply
chain’s margin.
 A sunglass supply chain:
 Zamatia produces sunglasses for $35 each and sells them to Umbra
Visage (UV) for $75, UV retails them for $115 and liquidates them for
$25.
 UV’s critical ratio: Cu  115  75  40 Co  75  25  50 Cu /  Co  Cu   0.4444
 Supply chain’s critical ratio: Cu  115  35  80 Co  35  25  10
Cu /  Co  Cu   0.8889
 The difference in the critical ratio leads to poor performance:
Decentralized supply chain
Optimized supply chain
% change
Order Zamatia's
quantity
profit UV's profit Total profit
234
9360
5580
14940
404
16160
1670
17830
42%
-234%
16%
Aligning incentives…
 Marginal cost pricing:
 Zamatia charges $35 per sunglass, then UV’s critical ratio equals the supply
chain’s critical ratio.
 But Zamatia makes zero profit.
 What they need is a method to share inventory risk so that the supply chain’s
profit is maximized (coordinated) and both firms are better off.
 Buy-back contract:
 Zamatia buys back left over inventory at the end of the season.
 Coordinates the supply chain and can yield any split of the profit…everyone
can be better off.
Wholesale price ($)
Buy back price ($)
35
45
55
65
75
85
95
105
26.50 37.75 49.00 60.25 71.50 82.75 94.00 105.25
Expected profits:
Umbra
Zamatia
Supply chain
17830 15601 13373 11144
4458
2229
8915 11144 13373
15601
17830 17830 17830 17830 17830 17830 17830
17830
0
2229
4458
6686
8915
6686
More on buy-back contracts
 How do they improve supply chain performance?
 The retailer’s overage cost is reduced, so the retailer stocks more.
 With a buy-back the supplier shares with the retailer the risk of left over
inventory.
 Other uses for buy-back contracts:
 Allow for the redistribution of inventory across the supply chain.
 Helps to protect the supplier’s brand image by avoiding markdowns.
 Allows the supplier to signal that significant marketing effort will occur.
 What are the costs of buy-backs?
 Administrative costs plus additional shipping and handling costs.
 Where are they used?
 books, cosmetics, music CDs, agricultural chemicals, electronics …
Other methods to align incentives
 Quantity discounts:
 Used to induce larger downstream order quantities so that downstream
service is improved and/or handling and transportation efficiency is
improved.
 Franchise fees:
 Marginal cost pricing coordinates actions, but leaves the upstream party
with no profit.
 So charge a franchise fee to extra profit from the franchisee.
 Revenue sharing:
 Supplier accepts a low upfront wholesale price in exchange for a share of
the revenue.
 Under appropriately chosen parameters, the retailer has an incentive to
stock more inventory, thereby generating more revenue for the supply chain.
Options contract
 What are they?
 The buyer purchases the option to buy at a future time.
 Each option costs po and it costs pe to exercise each option.
 How can they improve supply chain performance?
 Provides an intermediate level of risk:
 Fixed long term contract requires a commitment at a price
greater than po.
 Procuring on the volatile spot market could lead to a price greater
than po + pe.
 Where are they used?
 Semiconductor industry, energy markets (electric power), commodity
chemicals, metals, plastics, apparel retailing, air cargo, …
Summary
 Coordination failure:
 Supply chain performance may be less than optimal with decentralized
operations (i.e., multiple firms making decisions) even if firms choose
individually optimal actions.
 A reason for coordination failure:
 The terms of trade do not give firms the proper incentive to choose supply
chain optimal actions.
 Why fix coordination failure:
 If total supply chain profit increase, the “pie” increases and everyone can be
given a bigger piece.
 How to align incentives:
 Design terms of trade to restore a firm’s incentive to choose optimal
actions.