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Supply Contracts

Supply Contracts. Yossi Sheffi Mass Inst of Tech Cambridge, MA. ESD.260J,15.770J, 1.260J. Supply contracts Wholesale contracts Buyback contracts Revenue sharing contracts Option contracts. Outline. The Scenario:. Contract is negotiated Retailer places order (a single period)

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Supply Contracts

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  1. Supply Contracts Yossi Sheffi Mass Inst of Tech Cambridge, MA ESD.260J,15.770J, 1.260J

  2. Supply contracts Wholesale contracts Buyback contracts Revenue sharing contracts Option contracts Outline

  3. The Scenario: • Contract is negotiated • Retailer places order (a single period) • Supplier makes and sends the stuff • The selling season takes place • Accounting (sales, salvage, etc.)

  4. Consumer Demand

  5. Demand Distribution

  6. Notations:

  7. Wholesale Contracts • Prices and costs: • Supplier has a cost to make/purchase (C=$50) • Supplier is selling and retail is buying at a wholesale • price (W=$135) • Retailer is selling for a retail price (R=$200) • Retailer can salvage (S=$10) • Retailer is facing a Newsboy problem and • supplier’s profit is trivial Excel: Supply Contracts

  8. Wholesale Price Contract

  9. Wholesale Price ContractExpected Profits

  10. Wholesale Price ContractExp Profits (Normal Approx)

  11. Effects of Wholesale Price on Profits

  12. Optimal Retail Order as a Functionof the Wholesale Price

  13. Wholesale Price ContractCoordination the Channel W = C

  14. Buyback Contract • The problem: how can the supplier convince the • retailer to move towards the optimal order size? • The supplier offer to the retailer to buy • back all unsold items ($B/item). • For the retailer – this is like a higher salvage value, • so he will order more. • The supplier now shares in the overage risk (he • can still salvage, though, at the same price). • Note: supplier may simply pay ($B-$S) rather than actually buy back • (unless he has a better use for it)

  15. Buyback Contract Calculations

  16. Channel profit with Buyback

  17. Optimal Buyback and Wholesale price • Higher wholesale price requires a • ______ buyback rate • As the wholesale price (and the • buyback rate) grows the supplier’s • share of the profit _______ • Wholesale price ranges from $50 • (supplier’s cost) to $200 (retail price) • Buyback rate ranges from $10 (salvage • value) to $200.

  18. Expected Profits with BuybackContract

  19. Optimal Buyback Price

  20. Channel Coordination withBuyback At w=$135: B=$118, %retailer = 43%

  21. Expected Profit withCoordinating Buyback Rate

  22. Buyback Contracts in Practice • Book publishing • Periodicals/newspapers • Price support in consumer electronics

  23. Revenue Sharing • Supplier still needs to get the retailer • to order more • Another risk-sharing scheme: supplier • lowers the wholesale price but takes • a percentage (1-p) of the revenue • Question: how to choose W and p so • the retailer will order the optimal Amount • Note: wholesale price has to be lower than the • supplier’s cost.

  24. The Players Paramount Blockbuster

  25. The Economics of Revenue Sharing

  26. Revenue Sharing

  27. Expected Profit with RevenueSharing

  28. Optimal Revenue Share

  29. Coordination with Rev. Sharing

  30. Revenue Sharing (NormalApprox)

  31. Real Options • The retailer buys Q call options at a • price w. • The supplier makes Q items. • Each option can be exercised at a • unitprice E. • As demand materializes the retailer • cantake deliveries at a price E. • No more than Q items can be bought • from the supplier

  32. Real Options

  33. Retailer’s optimal order: Comparing to a single channel: Where: Coordination with Real Options The condition below is for p to be positive (so the exercise price plus the option is bigger than the option alone)

  34. Coordination with Real Options

  35. Expected Profits with Options

  36. Summary • Wholesale contracts give too much risk and not enough • expected reward to the retailer • To make the retailer order more (and increase the • channel’s profit) the supplier has to take on part of the risk • Risk sharing mechanisms covered include: • Buybacks; revenue sharing, option contract • Other mechanisms • Quantity-flexibility (refund on a portion of the unsold units) • Sales-rebate (rebate on unsold units above a threshold) • There are many other mechanisms • Each mechanism can coordinate the channel with various • allocations of the profit between the retailer and the supplier.

  37. Any Questions? Yossi Sheffi

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