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 Equipment Tier 1 Supplier Factory Distributor Retailer Customer 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: Campbell’s Chicken Noodle Soup over a one year period: Total shipments and consumption One retailer’s buy

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, P&G/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 chain’s 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. • UV’s critical ratio: • Supply chain’s critical ratio: • The difference in the critical ratio leads to poor performance:

16. Aligning incentives… • Marginal cost pricing: • Zamatia charges $35 per sunglass, then UV’s critical ratio equals the supply chain’s critical ratio. • But Zamatia makes zero profit. • What they need is a method to share inventory risk so that the supply chain’s 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 profit…everyone can be better off.

17. More on buy-back contracts • How do they improve supply chain performance? • The retailer’s 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 supplier’s 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 firm’s incentive to choose optimal actions.