Logistics Management

Sourcing
Özgür Kabak, Ph.D.
The Role of Sourcing
in a Supply Chain
 Sourcing is the set of business processes required to
purchase goods and services
 Sourcing processes include:
 Supplier scoring and assessment
 Supplier selection and contract negotiation
 Design collaboration
 Procurement
 Sourcing planning and analysis
Benefits of Effective
Sourcing Decisions
 Better economies of scale can be achieved if orders
are aggregated
 More efficient procurement transactions can
significantly reduce the overall cost of purchasing
 Design collaboration can result in products that are
easier to manufacture and distribute, resulting in
lower overall costs
 Good procurement processes can facilitate
coordination with suppliers
 Appropriate supplier contracts can allow for the
sharing of risk
 Firms can achieve a lower purchase price by
increasing competition through the use of auctions
Supplier Scoring and Assessment
 Supplier performance should be compared on the
basis of the supplier’s impact on total cost
 There are several other factors besides purchase
price that influence total cost
Supplier Assessment Factors
 Replenishment Lead Time  Pricing Terms
 On-Time Performance  Information Coordination
 Supply Flexibility Capability
 Delivery Frequency /  Design Collaboration
Minimum Lot Size Capability
 Supply Quality  Exchange Rates, Taxes,
Duties
 Inbound Transportation
Cost  Supplier Viability
 The impact of Supplier Performance Factors
on Total Cost
Purchase Production
Price of Inventory Transportation Introduction
Component Cycle Safety Cost Time
Replenishment lead time X
On-time performance X
Supply flexibility X
Delivery frequency X X X
Supply quality X X
Inbound transport cost X
Pricing terms X X
Information coordination X X

Design collaboration X X X X X
Exchange rates and taxes X
Supplier viability X X
Comparing suppliers based on total cost
Green thumb purchases bearings from a local supplier.
Weekly demand; mean: 1000, standard deviation 300
Holding cost: 25%
Cycle service level: 95%
 Local Supplier:  New supplier
 Cost: $1.00 per bearing  Cost: $0.97 per bearing
 Average lead time: 2  Average lead time: 6
weaks weaks
 Lead time standard  Lead time standard
deviation: 1 weak deviation: 4 weak
 Lot size: 2000  Lot size: 8000
 Comparing suppliers based on total cost
Current supplier New supplier
Annual material cost 1000x52x1=$52000 1000x52x0.97=$50440
Average cycle inventory 2000/2 = 1000 8000/2=4000
(Q/2)
Annual Cost of holding 1000x1x0.25 = $250 4000x0.97x0.25=$970
cycle inventory
Standard deviation of (2*3002+10002*12)0.5= (6*3002+10002*42)0.5=
demand during lead time 1086.28 4066.94
L = (L*L2+D2*sL2)0.5
Safety inventory required NORMINV(0.95)*1086.28 NORMINV(0.95)*4066.94
ss = Fs-1(CSL) * L = 1.645*1086.28 = 1787 = 6690

Annual cost of holding 1787*1*0.25 = $447 6690*0.97*0.25 = $1622

safety inventory
Annual cost of using 52000+250+447= 50440+970+1622 =
each supplier $52697 $53032
Contracts and Supply Chain Performance
 Contracts for Product Availability and Supply Chain
Profits
 Buyback Contracts
 Revenue-Sharing Contracts
 Quantity Flexibility Contracts
 Contracts to Coordinate Supply Chain Costs
 Contracts to Increase Agent Effort
 Contracts to Induce Performance Improvement
Contracts for Product Availability and
Supply Chain Profits
 Many shortcomings in supply chain performance
occur because the buyer and supplier are separate
organizations and each tries to optimize its own
profit
 Total supply chain profits might therefore be lower
than if the supply chain coordinated actions to have
a common objective of maximizing total supply chain
profits
 An approach to dealing with this problem is to design
a contract that encourages a buyer to purchase
more and increase the level of product availability
 The supplier must share in some of the buyer’s
demand uncertainty, however.
Contracts for Product Availability and
Supply Chain Profits: Buyback Contracts
 Allows a retailer to return unsold inventory up to a
specified amount at an agreed upon price
 Increases the optimal order quantity for the retailer,
resulting in higher product availability and higher
profits for both the retailer and the supplier
 Most effective for products with low variable cost,
such as music, software, books, magazines, and
newspapers
 Downside is that buyback contract results in surplus
inventory that must be disposed of, which increases
supply chain costs
 Can also increase information distortion through the
supply chain because the supply chain reacts to
retail orders, not actual customer demand
Example
 A music store that sells CDs. The supplier manufactures
CDs at $1 per unit and sells them to the music store at $5
per unit. The retailer sells each discs to the end customer
at $10. At this price, market demand is normally
distributed, with a mean of 1000 and standard deviation
of 300.
 The retailer has margin of $5 per disc and potentially lose
$5 for each unsold disc.
 CL: 0.5; O* = 1000 discs
 Retailers expected profit = $3803; suppliers profit = $4000
 For the supply chain, supplier and retailer have a margin
of $9, can lose $1 per unsolved disc.
 CL: 0.9; Stock 1384 discs.
 Expected supply chain profit = $8474
Buyback contracts
 c: whole sale price
 b: buyback price (=sR :salvage value for the retailer)
 sM : salvage value for the manufacturer
 v : unit production cost for the manufacturer
 p: retail price

 O*: optimal order quanity for the retailer

 CSL* = Cu / (Cu + Co ) = (p-c) / (p-sR)
 O* = F-1 (CLS*,,) =NORMINV(CSL*,,)

 Expected Retailer profits

 = (p-sR) NORMDIST((O - )/, 0, 1, 1) – (p-sR) NORMDIST((O- )/, 0, 1, 0)
 – O(c-sR) NORMDIST(O, , , 1) + O (p-c) [1 - NORMDIST(O, , , 1)]

 Expected manufacturer’s profit

 = O*(c-v) – (b-sM)*expected overstock at retailer

 Expected overstock at retailer

 = (O - )NORMDIST((O - )/, 0, 1, 1) +  NORMDIST((O - )/, 0, 1, 0)
Buyback Contracts - Example
 Sales price p = 10
 demand; mean=1000, std=300
Optimal Expected
Order Size Profit Expected Expected Expected
WholeSale Buy-Back for Music for Music Returns Profit Supply Chain
Price c Price b Store Store to Supplier for Supplier Profit
$5 $0 1,000 $3,803 120 $4,000 $7,803
$5 $2 1,096 $4,090 174 $4,035 $8,125
$5 $3 1,170 $4,286 223 $4,009 $8,295
$6 $0 924 $2,841 86 $4,620 $7,461
$6 $2 1,000 $3,043 120 $4,761 $7,804
$6 $4 1,129 $3,346 195 $4,865 $8,211
$7 $0 843 $1,957 57 $5,056 $7,013
$7 $4 1,000 $2,282 120 $5,521 $7,803
$7 $6 1,202 $2,619 247 $5,732 $8,351
Contracts for Product Availability and Supply
Chain Profits: Revenue Sharing Contracts
 The buyer pays a minimal amount for each unit
purchased from the supplier but shares a fraction of
the revenue for each unit sold
 Decreases the cost per unit charged to the retailer,
which effectively decreases the cost of overstocking
 Can result in supply chain information distortion,
however, just as in the case of buyback contracts
Revenue sharing contracts
 c: whole sale price
 f : fraction that manufacturer gets from the retailer’s revenue
 v : unit production cost for the manufacturer
 sR :salvage value for the retailer
 p: retail price

 O*: optimal order quanity for the retailer

 CSL* = Cu / (Cu + Co ) = (1-f)p – c / [(1-f)p-sR)]
 O* = F-1 (CLS*,,) =NORMINV(CSL*,,)

 Expected manufacturer’s profit

 = O*(c-v) + fp(O* – EOR)

 Expected Retailer profits

 = (1-f)p(O*-EOR) + sR x EOR – cO*

 Expected overstock at retailer (EOR)

 = (O - )NORMDIST((O - )/, 0, 1, 1) +  NORMDIST((O - )/, 0, 1, 0)
Revenue Sharing Contracts - Example
 Sales price p = 10
 demand; mean=1000, std=300
Revenue Optimal Expected Expected Expected Expected
WholeSale Sharing Order Size Overstock Profit Profit Supply Chain
Price c Fraction f for Retailer at Retailer for retailer for Supplier Profit
$1 0.30 1,320 342 $5,526 $2,934 $8,460
$1 0.45 1,273 302 $4,064 $4,367 $8,431
$1 0.60 1,202 247 $2,619 $5,732 $8,350
$2 0.30 1,170 223 $4,286 $4,009 $8,395
$2 0.45 1,105 179 $2,881 $5,269 $8,150
$2 0.60 1,000 120 $1,521 $6,282 $7,803
Contracts for Product Availability and Supply
Chain Profits: Quantity Flexibility Contracts
 Allows the buyer to modify the order (within limits) as
demand visibility increases closer to the point of sale
 Better matching of supply and demand
 Increased overall supply chain profits if the supplier
has flexible capacity
 Lower levels of information distortion than either
buyback contracts or revenue sharing contracts
Contracts to Coordinate
Supply Chain Costs
 Differences in costs at the buyer and supplier can
lead to decisions that increase total supply chain
costs
 Example: Replenishment order size placed by the
buyer. The buyer’s EOQ does not take into account
the supplier’s costs.
 A quantity discount contract may encourage the
buyer to purchase a larger quantity (which would be
lower costs for the supplier), which would result in
lower total supply chain costs
 Quantity discounts lead to information distortion
because of order batching
Next Class
 Supplier Selection