Supply Contracts and Risk Management David Simchi-Levi Professor of Engineering Systems Massachusetts Institute of Technology Tel:

©Copyright 2005 D. Simchi-Levi 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 Procurement Planning Manufacturing Planning Distribution Planning Demand Planning Sequential Optimization Supply Contracts/Collaboration/Integration/DSS Procurement Planning Manufacturing Planning Distribution Planning Demand Planning Global Optimization Sequential Optimization vs. Global Optimization 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 00Jan 01Jan 02 Feb 00 Sep 00Sep 01 DesignProductionRetailing Feb 01 Production

©Copyright 2005 D. Simchi-Levi Manufacturer Manufacturer DC Retail DC Stores Fixed Production Cost =$100,000 Variable Production Cost=$35 Selling Price=$125 Salvage Value=$20 Wholesale Price =$80 Supply Contracts

©Copyright 2005 D. Simchi-Levi Demand Scenarios

©Copyright 2005 D. Simchi-Levi Distributor Expected Profit

©Copyright 2005 D. Simchi-Levi Distributor Expected Profit

©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 Manufacturer Manufacturer DC Retail DC Stores Fixed Production Cost =$100,000 Variable Production Cost=$35 Selling Price=$125 Salvage Value=$20 Wholesale Price =$80 Supply Contracts

©Copyright 2005 D. Simchi-Levi Retailer Profit (Buy Back=$55)

©Copyright 2005 D. Simchi-Levi Retailer Profit (Buy Back=$55) $513,800

©Copyright 2005 D. Simchi-Levi Manufacturer Profit (Buy Back=$55)

©Copyright 2005 D. Simchi-Levi Manufacturer Profit (Buy Back=$55) $471,900

©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 Manufacturer Manufacturer DC Retail DC Stores Fixed Production Cost =$100,000 Variable Production Cost=$35 Selling Price=$125 Salvage Value=$20 Wholesale Price =$80 Supply Contracts

©Copyright 2005 D. Simchi-Levi Retailer Profit (Wholesale Price $70, RS 15%)

©Copyright 2005 D. Simchi-Levi Retailer Profit (Wholesale Price $70, RS 15%) $504,325

©Copyright 2005 D. Simchi-Levi Manufacturer Profit (Wholesale Price $70, RS 15%)

©Copyright 2005 D. Simchi-Levi Manufacturer Profit (Wholesale Price $70, RS 15%) $481,375

©Copyright 2005 D. Simchi-Levi Supply Contracts

©Copyright 2005 D. Simchi-Levi Manufacturer Manufacturer DC Retail DC Stores Fixed Production Cost =$100,000 Variable Production Cost=$35 Selling Price=$125 Salvage Value=$20 Wholesale Price =$80 Supply Contracts

©Copyright 2005 D. Simchi-Levi Supply Chain Profit

©Copyright 2005 D. Simchi-Levi Supply Chain Profit $1,014,500

©Copyright 2005 D. Simchi-Levi Supply Contracts

©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 SM MAKE-TO-ORDER Symmetric Information

©Copyright 2005 D. Simchi-Levi Telecom Supply Chain SM Purchased material (80 to 85 %) Value added Note: Typical ratios for Telecom EMs Operator MTS MTO

©Copyright 2005 D. Simchi-Levi Manufacturer Manufacturer DC Distributor DC Stores Fixed Production Cost =$100,000 Variable Production Cost=$55 Selling Price=$125 Wholesale Price =$80 Salvage Value =$20 Supply Contracts MAKE-TO-STOCK

©Copyright 2005 D. Simchi-Levi Demand Scenarios

©Copyright 2005 D. Simchi-Levi Manufacturer Expected Profit

©Copyright 2005 D. Simchi-Levi Manufacturer Expected Profit

©Copyright 2005 D. Simchi-Levi 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 Manufacturer Manufacturer DC Distributor DC Stores Fixed Production Cost =$100,000 Variable Production Cost=$55 Supply Contracts Selling Price=$125 Wholesale Price =$80 Salvage Value =$20

©Copyright 2005 D. Simchi-Levi Manufacturer Profit (Pay Back=$18)

©Copyright 2005 D. Simchi-Levi Manufacturer Profit (Pay Back=$18) $180,280

©Copyright 2005 D. Simchi-Levi Distributor Profit (Pay Back=$18)

©Copyright 2005 D. Simchi-Levi Distributor Profit (Pay Back=$18) $525,420

©Copyright 2005 D. Simchi-Levi Manufacturer Manufacturer DC Distributor DC Stores Fixed Production Cost =$100,000 Variable Production Cost=$55 Supply Contracts Selling Price=$125 Wholesale Price =$80 Salvage Value =$20 MAKE-TO-STOCK

©Copyright 2005 D. Simchi-Levi Manufacturer Profit (Wholesale Price $62, CS 33%)

©Copyright 2005 D. Simchi-Levi Manufacturer Profit (Wholesale Price $62, CS 33%) $182,380

©Copyright 2005 D. Simchi-Levi Distributor Profit (Wholesale Price $62, CS 33%)

©Copyright 2005 D. Simchi-Levi Distributor Profit (Wholesale Price $62, CS 33%) $523,320

©Copyright 2005 D. Simchi-Levi Supply Contracts

©Copyright 2005 D. Simchi-Levi Manufacturer Manufacturer DC Distributor DC Stores Fixed Production Cost =$100,000 Variable Production Cost=$55 Selling Price=$125 Salvage Value=$20 Wholesale Price =$80 Supply Contracts

©Copyright 2005 D. Simchi-Levi Supply Chain Profit

©Copyright 2005 D. Simchi-Levi Supply Chain Profit $705,700

©Copyright 2005 D. Simchi-Levi Supply Contracts

©Copyright 2005 D. Simchi-Levi “Forecasts by electronics and telecom companies are often inflated.” “Now, Selectron has $4.7 billion in inventory.” Business Week, March 19, 2001 Forecast inflation

©Copyright 2005 D. Simchi-Levi Shared Forecast Evolution Semiconductor Equipment Supply Chain Source: Wharton: Intel Tool Order data over time

©Copyright 2005 D. Simchi-Levi 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

©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 Study used Inventory Analyst™

©Copyright 2005 D. Simchi-Levi From Local to Global Optimization Study used Inventory Analyst™ For a given lead-time, the optimized supply chain provides reduced costs

©Copyright 2005 D. Simchi-Levi From Local to Global Optimization Study used Inventory Analyst™ For a given lead-time, the optimized supply chain provides reduced costs For a given cost, the optimized supply chain provides better lead-times

©Copyright 2005 D. Simchi-Levi Waltham Oil Field Two Companies: –SLNR operates, lift and manage –Subcontractor to build the facility CapacityCost 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

©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 Facility Size 90,000BPD, System NPV = $750B