Sourcing and Contracts

Chapter 13

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 Outline

The Role of Sourcing in a Supply Chain

Supplier Scoring and Assessment

Supplier Selection and Contracts

Design Collaboration

The Procurement Process

Sourcing Planning and Analysis

Making Sourcing Decisions in Practice

Summary of Learning Objectives

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 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

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 Benefits of Effective Sourcing Decisions

Better economies of scale can be achieved if orders are
aggregated
– Eliminate some suppliers. Keep strategic dual sourcing.

More efficient procurement transactions can significantly
reduce the overall cost of purchasing
– Buying from commodities from commodity exchanges / internet sites

Design collaboration can result in products that are easier to
manufacture and distribute, resulting in lower overall costs
– Ford sends its own engineers to its suppliers

Good procurement processes can facilitate coordination with
suppliers

Appropriate supplier contracts can allow for the sharing of risk
– Buyback contract redistributes the risk of overstocking

Firms can achieve a lower purchase price by increasing
competition through the use of auctions 4
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 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

Replenishment Lead Time
Pricing Terms

On-Time Performance
Information Coordination

Supply Flexibility Capability

Delivery Frequency / Minimum
Design Collaboration
Lot Size Capability

Supply Quality
Exchange Rates, Taxes, Duties

Inbound Transportation Cost
Supplier Viability

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 Supplier Selection and Contracts

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

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 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

Recall Chapter 10: double marginalization results in
suboptimal order quantity

An approach to dealing with this problem is to design a
contract that encourages a buyer (retailer) to purchase more and
increase the level of product availability

The supplier must share in some of the buyer’s demand
uncertainty

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 Contracts

A contract is an agreement between two parties.

Pricing contract types
– Fixed price
– Dependent price
» Capturable uncertainty
» Third party measures, indicators as surrogates
– Alterable price
» Uncapturable uncertainty
» Renegotiation necessary

Same classification for quantity contracts

Cost+fee contracts as opposed to price contracts
– Car repair: Spark plug cost + labor fee 8
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 Sourcing Planning and Analysis

A firm should periodically analyze its procurement
spending and supplier performance and use this
analysis as an input for future sourcing decisions

Procurement spending should be analyzed by part and
supplier to ensure appropriate economies of scale

Supplier performance analysis should be used to build
a portfolio of suppliers with complementary strengths
– Cheaper but lower performing suppliers should be used to
supply base demand
– Higher performing but more expensive suppliers should be
used to buffer against variation in demand and supply from
the other source
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 Contracts Advantages & Disadvantages

Advantages
– Uncertainty reduction
– Relationship leveraging

Disadvantages for supplier
– Being blocked from selling to other retailers
– Harsh retailers: GM and its suppliers

Disadvantages for retailer
– Being blocked from buying from other suppliers
– Retailer complacency – lack of incentives for improvement

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 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 for the supplier that must be disposed of, which
increases supply chain costs

Misleading for the supply chain as it reacts to (inflated)
retail orders, not actual customer demand
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 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

Misleading for the supply chain as it reacts to
(inflated) retail orders, not actual customer demand

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 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 misleading demand information than
either buyback contracts or revenue sharing contracts

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 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 misleading demand
information because of order batching
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 Contracts to Increase Agent Effort

There are many instances in a supply chain where an
agent acts on the behalf of a principal and the agent’s
actions affect the reward for the principal
– A car dealer who sells the cars of a manufacturer, as well as
those of other manufacturers
– A doctor who treats patients for an HMO
– Sales force working on a commission

Examples of contracts to increase agent effort include
two-part tariffs and threshold contracts

Threshold contracts increase information distortion,
however
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Contracts to Induce Performance Improvement

A buyer may want performance improvement from a supplier
who otherwise would have little incentive to do so

A shared savings contract provides the supplier with
a fraction of the savings that result from the performance
improvement

Particularly effective where the benefit from improvement
accrues primarily to the buyer, but where the effort for the
improvement comes primarily from the supplier
– GM and its suppliers

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 Design Collaboration

50-70 percent of spending at a manufacturer is through
procurement

80 percent of the cost of a purchased part is fixed in the design
phase

Design collaboration with suppliers can result in reduced cost,
improved quality, and decreased time to market

Important to employ design for logistics, design for
manufacturability

Manufacturers must become effective design coordinators
throughout the supply chain
– Ford designs with its suppliers

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 The Procurement Process

The process in which the supplier sends product in response to
orders placed by the buyer

Goal is to enable orders to be placed and delivered on schedule
at the lowest possible overall cost

Two main categories of purchased goods:
– Direct materials: components used to make finished goods
– Indirect materials: goods used to support the operations of a firm
– Differences between direct and indirect materials listed in Table 13.2

Focus for direct materials should be on improving coordination
and visibility with supplier

Focus for indirect materials should be on decreasing the
transaction cost for each order

Procurement for both should consolidate orders where possible
to take advantage of economies of scale and quantity discounts
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 Product Categorization by Value and
Criticality (Figure 13.2)
High
Strategic Items
Critical Items
Ensure long term
Criticality

Ensure availability relationship

Bulk Purchase
General Items Items
Low Ensure low cost Ensure low cost

Low High
Value/Cost
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 Impact of SC Contracts on Profitability:
Buyback Contracts

Buybacks by publishers
– Practice: Custom books are not bought back!

Buyback by Panasonic
– Panasonic sells a DVD at $120 to BestBuy. BestBuy sells at $150 to
consumers. Unsold DVD’s are sold at discount price $100 to customers,
Panasonic compensates BestBuy for $120-100=$20. Is this a buyback
scheme, if so what is the buyback price?

Tech Fiber(TF) produces jacket and sells to Ski Adventure(SA)
which sells them in the market. Unsold jackets have no salvage
value. Should TF be willing to buy back unsold jackets? Why?

Wholesale Market
Cost=$10 TF Price=$100 SA Price=$200
~N(1000,3002)
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 Profits under centralization

Sales = ∫ min(y, D) f ( D)dD =∫ F ( D)dD

∞ y

0 0

Coordinated Profits = p[Sales] − cy

Optimalorder quantity = y*C = F −1 (c / p) or c/p = F ( y*C ) or 1 - c/p = F ( y*C )

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 Separately acting

Supplier Profit(b | y) = (w - b)y + b[Sales] - cy = b[Sales] - (c - (w - b))y

Retailer Profit(y | b) = -wy + b(y - [Sales]) + p[Sales] = (p - b)[Sales] - (w - b)y

 w −b
Retailer' s optimal order quantity = y *R (b) = F −1  
 p−b 
c  w −b
Retailer orders centralized quantity when F −1   = F −1   which implies
p  p−b 
w −c
b :=
C

1 − c/p
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 Split of Supply Chain Profits under the
Buyback Contract

p-w
Retailer' s Profit(y | b C ) = Centralized Profit(y)
p-c

Retailer obtains the big portion of the profits when the wholesale
price is far smaller than the sales price.

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 Buyback Contracts
Wholesale Buy Optimal Expected Expected Expected Expected
Price c Back Order size Profit for Returns Profit for Supply
Price b for SA SA to TF TF Chain Profit
$100 $0 1,000 $76,063 120 $90,000 $166,063
$100 $30 1,067 $80,154 156 $91,338 $171,492
$100 $60 1,170 $85,724 223 $91,886 $177,610
$100 $95 1,501 $96,875 506 $86,935 $183,810
$110 $78 1,191 $78,074 239 $100,480 $178,555
$110 $105 1,486 $86,938 493 $96,872 $183,810
$120 $96 1,221 $70,508 261 $109,225 $179,733
$120 $116 1,501 $77,500 506 $106,310 $183,810

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 Quantity Flexibility Contracts

If a retailer order q units the manufacturer commits to
supplying up to (1+α)q and the retailer commits to
buying (1-β)q
– Unfortunately the book denotes (1+α)q by O

How can quantity flexibility contracts help increase
profitability?
– Uncertainty reduction for
» Retailers
» Suppliers

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 Quantity Flexibility Contract
1. Retailer knows the demand
distribution F and makes a forecast q
Min{Max{q(1-beta),d},Q}
for its order size, typically q>E(D).
2. Supplier guarantees to supply
q(1+alpha), alpha >=0.
Retailer guarantees to buy q(1-beta),
0<=beta<=1.
Supplier produces Q>=q(1+alpha).
3. The demand is realized as D=d and
the supplier buys q(1-beta) Q D
Min { Max{q(1-beta),d} , Q }
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 Quantity Flexibility Contract

Without coordination the supplier produces less than
with coordination.

The contract is advantageous to the supplier if
Q=q(1+alpha). Otherwise, the supplier orders more
than the contract would have indicated even without
the contract.

The supplier can coordinate the chain by setting the
wholesale price appropriately.

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 Quantity Flexibility Contracts
α β Wholesale Order Expected Expected Expected Expected Expected
price c size O purchase sale by profits profits for supply
by SA SA for SA, TF chain profit
P(Q*)
0.00 0.00 $100 1,000 1,000 880 $76,063 $90,000 $166,063
0.20 0.20 $100 1,050 1,024 968 $91,167 $89,830 $180,997
0.40 0.40 $100 1,070 1,011 994 $97,689 $86,122 $183,811
0.00 0.00 $110 962 962 860 $66,252 $96,200 $162,452
0.15 0.15 $110 1,014 1,009 945 $78,153 $99,282 $177,435
0.42 0.42 $110 1,048 1,007 993 $87,932 $95,879 $183,811
0.00 0.00 $120 924 924 838 $56,819 $101,640 $158,459
0.2 0.2 $120 1,000 1,000 955 $70,933 $108,000 $178,933
0.5 0.5 $120 1,040 1,003 996 $78,874 $104,803 $183,677

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 Revenue Sharing (RS) Contracts
Manufacturer reduces wholesale price,
Retailer shares a percentage of the revenue

Fixed Production Cost =$100,000

Variable Production Cost=$35

Wholesale Price =$70

Selling Price=$125
Salvage Value=$20

Manufacturer Manufacturer DC Retail DC

RS: 15%
Stores 29
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 Blockbuster Case Study

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

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) 30
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 Making Sourcing Decisions in Practice

Use multifunction teams

Ensure appropriate coordination across regions and
business units

Always evaluate the total cost of ownership

Build long-term relationships with key suppliers

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 Summary of Learning Objectives

What is the role of sourcing in a supply chain?

What dimensions of supplier performance affect
total cost?

What is the effect of supply contracts on supplier
performance and information distortion?

What are different categories of purchased products
and services? What is the desired focus for
procurement for each of these categories?

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