Chapter 14: Supply Chain Contracting

1
Chapter 14 Supply Chain Contracting
2
Topics to Cover

• The Bullwhip Effect
• Supply Chain Design Strategy
• Suboptimal supply chain performance due to
  incentive conflicts

3
What is the bullwhip effect?

• Demand variability increases as you move up the
  supply chain from customers towards supply

Customer
Retailer
Distributor
Factory
Tier 1 Supplier
Equipment
First noticed regarding Pampers
4
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.
5
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.

6
Causes of the bullwhip effect

• Order synchronization
• Order batching
• Trade promotions and forward buying
• Reactive and over-reactive ordering
• Shortage gaming

7
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.

8
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.

9
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 Campbells Chicken Noodle Soup over a
  one year period

One retailers buy
Total shipments and consumption
10
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.

11
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.

12
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, PG/Wal-Mart and others.

13
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

14
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
Supply Chain
Responsive
Match
15
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 chains 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.
• UVs critical ratio
• Supply chains critical ratio
• The difference in the critical ratio leads to
  poor performance

16
Aligning incentives

• Marginal cost pricing
• Zamatia charges 35 per sunglass, then UVs
  critical ratio equals the supply chains critical
  ratio.
• But Zamatia makes zero profit.
• What they need is a method to share inventory
  risk so that the supply chains 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 profiteveryone can be better off.

17
More on buy-back contracts

• How do they improve supply chain performance?
• The retailers 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 suppliers 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

18
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.

19
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,

20
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 firms
  incentive to choose optimal actions.