3.1 Coordination by Contracts Flashcards
Definition of Supply Chain Coordination
▪ All stages of the supply chain take actions that are aligned and increase supply chain profits.
▪ Create incentives such that locally optimal decisions correspond to globally optimal decisions for the complete supply chain
Obstacles to Coordination
▪ Local optimization of decisions regarding pricing and ordering at every stage of the supply chain (double marginalization).
▪ Information is distorted or delayed as it moves between different stages of the supply chain (information asymmetry).
Impacts of Obstacles to Coordination
▪ Lower order quantities and lower product availability due to double marginalization.
▪ Global supply chain optimum cannot be achieved.
▪ Bullwhip effect: Increasing variability of orders and inventory along the value chain.
Contract Theory
Contracts set incentives for the different stages of the supply chain to behave in an overall optimal way, despite their different objectives.
→ Align local plans with goals of the full supply chain.
→ One party proposes a contract (e.g., the manufacturer), the other party (e.g., the retailer) reacts (Stackelberg situation).
Contract Procedure
- Classification of the Decision Situation
- Designing a Contract
- Evaluating the Efficiency
- Parametrization and Implementation
Classification of the Decision Situation
▪ Demand situation:
− Deterministic
− Deterministic & price sensitive
− Uncertain (stochastic)
▪ Information (a)symmetry:
Different knowledge of supply chain actors regarding important parameters, especially regarding PoS data and self-inflicted fluctuations in demand (e.g., due to promotions)
Fig. Models
Designing a Contract - Overview
- Defining decision competencies
- Setting the contract parameters
▪ Pricing/discounts
▪ Order quantities
▪ Other requirements (e.g., supply lead time or quality
- Defining Decision Competencies
▪ Target:
Controlling downstream stages of the supply chain by shifting decision making competencies, e.g. manufacturer wants to (partly) control retail processes
▪ Examples for practical implementations:
− Resale Price Maintenance:
Manufacturer dictates retailer’s selling price
− Quantity Fixing:
Manufacturer controls delivery quantity
− Vendor Managed Inventory:
Manufacturer manages the retailer’s inventory (e.g., Procter & Gamble at Walmart)
- Setting the Contract Parameters – Pricing / Discounts - Overview
▪ Lot-size based discounts
− All-Unit Quantity Discounts
− Marginal-Unit Quantity Discounts
▪ Order-size based discounts
− Volume-Based Quantity Discount
− Two-Part Tariffs
▪ Revenue sharing agreements
→ Target: Improve coordination to increase total supply chain profits and extract surplus from retailer through price discrimination
Lot-Size based discounts – All-Unit Quantity Discount
If a certain break-point for order quantity is reached, the discount applies to the complete order quantity (if the selected lot size is between qi ≤ Q < qi+1 , every unit causes costs of Ci).
→ Unit costs decrease with increasing lot size (C0 ≥ C1 ≥ … ≥ Cr).
Lot-size based discounts – Marginal-Unit Quantity Discount
If the lot size exceeds a certain break point (q1,…, qr), a discount is granted for quantity of Qi – qi units (given a lot size between q1 ≤ Q < q2, the costs are C0* q1 + C1* (Q – q1)).
→ Marginal unit costs decrease at specified break points.
Order-quantity based discounts – Volume-Based Quantity Discount
▪ If the total order quantity exceeds a certain threshold within a fixed time horizon, a discount is granted (orders are aggregated).
▪ Be Careful: There is an incentive to place high orders towards the end of the time horizon to reach the discount level (→ Hockey Stick Phenomena).
→ Use of rolling horizon planning to cope with hockey stick phenomena.
Order-quantity based discounts – Two-Part Tariffs
▪ Manufacturer charges an up-front fixed payment from the retailer.
▪ In turn, the manufacturer offers the retailer a lower unit price (can even be as low as the manufacturer’s production costs).
▪ The manufacturer realizes all its profit over the fixed payment (Franchise Fee).
▪ The retailer selects an order quantity considering the given fixed/variable costs.
▪ Owing to the franchise fee, this type of “discount” is only realized once the order quantity exceeds a certain threshold.
Revenue Sharing Agreement
▪ The retailer pays a share of the revenue of every sold unit to the manufacturer.
▪ The manufacturer charges the retailer a lower price per unit.
→ Overstocking costs decrease → retailer increases product availability → increase in total supply chain profits.
▪ Requirement: Manufacturer has to implement control mechanisms for retailer sales (e.g., using IT).
Setting the Contract Parameters – Order Quantities Overview
▪ Setting minimum order quantities
▪ Quantity flexibility agreement
▪ Buyback and return agreements
▪ Rationing schemes
Minimum Order Quantity
▪ Retailer is forced to purchase a minimum quantity per order or period from the manufacturer.
▪ For smaller orders, higher prices or penalties could be part of negotiations.
→Target: Reducing variability for the manufacturer (bullwhip effect).
Quantity flexibility
▪ Manufacturer allows a certain deviation from order forecasts (quantity flexibility).
▪ The retailer’s orders must adhere to the negotiated flexibility range.
▪ Beneficial in combination with postponement or multiple retailers / regions with independent demand.
→ Target: Better capacity planning, risk distribution, and avoiding of exaggerated forecasts.
Buyback and Return Agreements
▪ Manufacturer buys back unsold inventory at an agreed upon buyback price from the retailer.
→ Overstocking costs decrease → product availability increases → total profits increase
▪ Be Careful: Reverse transportation might hurt profit and could have a negative environmental impact.
→ Target: Risk sharing to protect against overly cautious ordering by retailer due to demand variability
Rationing schemes
▪ A manufacturer commits its scarce inventory or capacities to multiple retailers.
▪ Classifying the retailers into customer categories.
▪ Use of queuing systems.
→ Target: Avoiding competition and exaggerated forecasts in the distribution of scarce inventory / capacities.
Supply Lead Time Requirements
▪ Manufacturer offers different (guaranteed) supply lead times at different prices.
▪ Retailer offers a bonus payment if order is on time.
→ Target: Reducing safety inventory.
Quality Requirements
▪ Manufacturer offers warranty and assures a certain quality.
▪ Manufacturer offers several production processes or levels of quality at different prices.
→ Target: Reducing ordering costs.
Evaluation of Efficiency
▪ Impact of contract on total supply chain profits
▪ Impact of contract on individual profits of manufacturer and retailer
Parametrization and Implementation
▪ Negotiating the contractual terms, formulation and execution of the contract
Analyzing the Mechanisms of Contract Design
Analysis based on a supply chain with a manufacturer (M) and a retailer (R), and highly aggregated models for a single time period.
▪ Analysis of decentralized decisions of players (individual point of view)
→ Uncoordinated supply chain
▪ Analysis of centralized decision (supply chain view, complete information)
→ Global optimum for supply chain
▪ Design and implementation of contract coordination mechanisms to incentivize both actors to achieve the total optimum solution despite individual decisions.
→ Contract → “Coordinated” supply chain
Deterministic Demand - Decision Situation
▪ Deterministic demand 𝐷
▪ Retailer makes decision about lot size Q depending on their fixed ordering costs 𝑆𝑅, their holdings costs ℎ𝑅
and the wholesale price 𝑐R
Deterministic Demand - Individual Costs
𝒄𝑴 Production costs per unit
𝑺𝑴 Fixed ordering costs
𝒉 Holding costs
𝒄𝑹 Wholesale price per unit
𝑺𝑹 Fixed costs of retailer
𝒉 Holding costs
𝑫 Deterministic demand
Deterministic Demand – SC-Optimum
▪ The selected lot size selected by the retailer (R) is based on local decisions by the manufacturer and retailer
➢ Double marginalization
▪ Considering the structure of costs of the entire SC, the (globally) optimal lot size of the SC is:
Deterministic Demand - SC-Optimum – Results
▪ Joint optimization of lot size reduces the costs of supply chain.
▪ However: Retailer (R) has no incentive to select a higher lot size.
▪ Such an incentive can be offered by a contract with a specific price structure:
− All-Unit Quantity Discount
Coordination – All-Unit Quantity Discount (All-Unit Discount on Lotsizes)
▪ Deterministic demand 𝐷
▪ Retailer selects the lot size Q (order to manufacturer) based on their fixed ordering costs 𝑆𝑅 , holding costs ℎ𝑅 and wholesale price 𝑐𝑅.
All-unit discount: Manufacturer offers discount if the lot size exceeds a certain threshold
Coordination – All-Unit Quantity Discount (All-Unit Discount on Lotsizes) - Individual Costs
ĉ𝑹 (< 𝒄𝑹) Reduced wholesale
price per unit
Price Sensitive Demand - Decision Situation
▪ Retailer distributes product with price sensitive demand 𝐷 𝑝 = 𝐴 − 𝐵𝑝.
▪ Manufacturer decides about wholesale price 𝑐𝑅.
▪ Based on wholesale price 𝑐𝑅 the retailer choses selling price 𝑝.
▪ Customer demand and order quantity of retailer are based on selling price 𝑝.
Price Sensitive Demand - Individual Profit
𝒄𝑴 Unit production costs
𝑫(𝒑) Price-sensitive demand
𝑫(𝒑) Price-sensitive demand
Price Sensitive Demand – SC-Optimum
▪ The wholesale price selected by the manufacturer
(M) as well as the selling price selected by the
retailer (R) are based on local decisions.
▪ Globally optimal supply chain profit:
𝐺𝑆𝐶(𝑝) = 𝐷(𝑝) * (𝑝 − 𝑐𝑀) = (𝐴 − 𝐵𝑝) * (𝑝 − 𝑐𝑀)
▪ Optimal selling price:
𝑝∗ = (𝐴+𝐵𝑐𝑀) / 2𝐵 (with 𝑐𝑅∗= 𝑐𝑀)
Price Sensitive Demand – SC-Optimum - Conclusion
▪ Setting the optimal price increases the total profit of the supply chain.
▪ However: There is no incentive for the manufacturer to sell goods to the retailer at production cost, as the manufacturer would make no profit.
▪ Such an incentive could be created using a pricing / discount contract:
− Two-part tariffs
− Volume-based quantity discount
Coordination – Two-Part Tariffs
▪ The manufacturer achieves his profit through a fixed payment 𝐹 (franchise fee).
▪ In return the price per unit is reduced 𝑐𝑅 = 𝑐𝑀.
▪ This price per unit results in the total optimum selling price 𝑝∗ for the retailer.
Coordination – Two-Part Tariffs - Individual Profit
Coordination – Volume-Based Quantity Discount
▪ The manufacturer offers a volume-based quantity discount if the order quantity reaches a threshold ( >= optimal demand).
▪ The retailer decides about selling price 𝑝∗.
Coordination – Volume-Based Quantity Discount - Individual Profit
ĉ𝑹 (< 𝒄𝑹) Reduced wholesale
price
Lot-Size Based Quantity Discounts Conclusion
▪ Lead to coordination of the supply chain in case of mass production.
▪ However, there is an increase in lot size and cycle inventory.
▪ If fixed ordering costs are very high, lot-size based discounts achieve better results than volume-based discounts.
Volume-Based Quantity Discounts / Two-Part Tariffs - Conclusion
▪ Generally lead to a better coordination of the supply chain.
▪ However, may lead to an artificial increase in orders at the end of the period to take advantage of discounts.
▪ To cope with this, volume-based quantity discounts can be combined with rolling horizon planning.
Uncertain Demand - Decision Situation
▪ The manufacturer offers a product with uncertain demand. After the sales season, the product expires and only has a salvage value
▪ The retailer orders the product before sales season / before customer demand is known.
▪ The manufacturer produces the exact quantity ordered by the retailer.
Newsvendor Model – Assumptions
▪ Uncertain demand represented by normal distribution 𝑁(𝜇, 𝜎)
▪ Product “expires” after one season
▪ Ordering and delivery before beginning of season
▪ Manufacturer produces the exact order quantity
→ Retailer determines optimal order quantity when demand is uncertain by assessing costs of overstock and understock.
− Costs of overstock (𝐶𝑂 = 𝑐𝑅 − 𝑠)
− Costs of understock (𝐶𝑈 = 𝑝 − 𝑐𝑅)
Newsvendor Model - ▪ Expected profit of retailer for order quantity 𝑸
Newsvendor Model - Optimal Order Quantity 𝑸∗
Newsvendor Model - Profit of retailer for order quantity 𝑸∗
Newsvendor Model - Profit of manufacturer for order quantity 𝑸∗
Uncertain Demand – SC Optimum
▪ The wholesale price selected by the manufacturer (M) and the CSL of the retailer (R), as well as the resulting order quantity are based on local decisions.
▪ The globally optimal CSL and the resulting order quantity is given by:
Uncertain Demand - SC Optimum – Conclusions
▪ Optimal 𝐶𝑆𝐿𝑆𝐶∗ increases the total profit of the supply chain.
▪ However: The manufacturer has no incentive to sell the goods to the retailer for the production cost, as he would make no profit.
▪ In order to set such an incentive, a contract regulating pricing / discounts or order quantities can be used:
− Order quantity: Buyback
− Pricing and discounts: Revenue sharing
Coordination –Buyback Contract
▪ Manufacturer offers retailer to buy back unsold units (buyback price 𝑏).
▪ Requirements: Buyback price 𝑏 is higher than salvage value 𝑠.
▪ Retailer: Costs for overstock decrease → Incentive to place larger order / increase in product availability
Principle:
Coordination –Buyback Contract - Individual Profit
Buyback Contract - Conclusion
▪ Buyback contracts improve product availability, leading to an increase of total supply chain profits.
▪ The higher the costs per unit, the higher the manufacturer can set the buyback price.
▪ However: Buyback contracts are not advisable when return costs are high. In this case, the return process should be adjusted
Coordination – Revenue Sharing
▪ Retailer receives share 𝑢 0 ≤ 𝑢 ≤ 1 of the selling price of every sold unit. Manufacturer receives share (1 − 𝑢).
→ Revenue of retailer per unit sold: 𝑢 ⋅ 𝑝; Revenue of manufacturer: (1 − 𝑢) ⋅ 𝑝
▪ In turn, the manufacturer reduces the wholesale price.
▪ Retailer: Overstock costs decrease → Incentive to order place larger order / improve product availability
Coordination – Revenue Sharing - Individual Profit
Revenue Sharing - Conclusion
▪ Revenue sharing improves product availability and thus total supply chain profits.
▪ Depending on the design the retailer, manufacturer, or both benefit from revenue sharing.
▪ It is not necessary to return products (see buyback contracts).
▪ Information infrastructure is necessary, such that the manufacturer is able to record the retailer’s sales.
▪ Unit profit and overstock costs of the retailer are reduced by revenue sharing.
→ This could lead to a reduced effort of the retailer to sell products.
