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 Retailer Customer First noticed regarding Pampers

Bullwhip effect in the US PC supply chain 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 Customers order on the same order cycle, e.g., first of the month, every Monday, etc. 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.

Order batching Retailers may be required to order in integer multiples of some batch size, e.g., case quantities, pallet quantities, full truck load, etc. 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.

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

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. 2

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. 6

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 Functional Products Innovative Products Custom made clothes Gourmet food Liberal arts education Low-cal breakfast cereal Supply Chain Efficient Match Standard picture frames Standard eyeglass frames Sub shop Responsive Supply Chain 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: Supply chain’s critical ratio: The difference in the critical ratio leads to poor performance:

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.

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.