Supply Contracts
Forward Auctions
William Vickrey first established the taxonomy of auctions based on the
order in which the auctioneer quotes prices and the bidders tender
their bids.
He established four major auction types:
(1) the ascending-bid (open, oral, or English) auction;
(2) the descending-bid (Dutch) auction;
(3) the first-price, sealed-bid auction; and
(4) the second-price, sealed-bid (Vickrey) auction.
Classifications of Contracts:
Formation
1. Bilateral contract – a promise for a promise
2. Unilateral contract – A promise for an act
3. Express contract – A contract expressed in oral or written words
4. Implied-in-fact contract – A contract inferred from the conduct of
the parties
Classifications of Contracts:
Formation
5. Quasi-contract – A contract implied by law to prevent unjust
enrichment
6. Formal contract – A contract that requires a special form or
method of creation
7. Informal contract – A contract that requires no special form or
mode of creation
Classifications of Contracts:
Enforceability
1. Valid contract – A contract that meets all of the essential elements
to establish a contract
2. Void contract – No contract exists
3. Voidable contract – A party has the option of voiding or enforcing
the contract
4. Unenforceable contract – A contract that cannot be enforced
because of a legal defense
Classifications of Contracts:
Performance
1. Executed contract – A contract that is fully performed on both sides
2. Executory contract – A contract that is not fully performed by one
or both parties
TYPES OF CONTRACTS-Suit Example
• 2 Stages:
• a retailer who faces customer demand
• a manufacturer who produces and sells suits to the retailer.
• Retailer Information:
• Summer season sale price of a suit is $125 per unit.
• Wholesale price paid by retailer to manufacturer is $80 per
unit.
• Salvage value after the summer season is $20 per unit
• Manufacturer information:
• Fixed production cost is $100,000
• Variable production cost is $35 per unit
Case 1-Sequential Supply Chain
• Retailer marginal profit is the same as the marginal profit of the manufacturer,
$45.
• Retailer’s marginal profit for selling a unit during the season, $45, is smaller than
the marginal loss, $60, associated with each unit sold at the end of the season to
discount stores.
• Optimal order quantity depends on marginal profit and marginal loss but not on
the fixed cost.
• Retailer optimal policy is to order 12,000 units for an average profit of $470,700.
• If the retailer places this order, the manufacturer’s profit is 12,000(80 - 35) -
100,000 = $440,000
Sequential Supply Chain
FIGURE: Optimized safety stock
Case 2-Buy-Back Contract
• Seller agrees to buy back unsold goods from the buyer for some
agreed-upon price.
• Buyer has incentive to order more
• Supplier’s risk clearly increases.
• Increase in buyer’s order quantity to 14,000
• Assume the manufacturer offers to buy unsold suits from the retailer
for $55.
Buy-Back Contract- suit Example
FIGURE: Buy-back contract
Implementation Drawbacks of Supply
Contracts
• Buy-back contracts
• Require suppliers to have an effective reverse logistics system
and may increase logistics costs.
• Retailers have an incentive to push the products not under the
buy back contract.
• Retailer’s risk is much higher for the products not under the buy
back contract.
Case 3- Revenue Sharing Contract
• Buyer shares some of its revenue with the supplier
• in return for a discount on the wholesale price.
• Buyer transfers a portion of the revenue from each unit sold back to
the supplier
• Manufacturer agrees to decrease the wholesale price from $80 to $60
• In return, the retailer provides 15 percent of the product revenue to
the manufacturer.
• Retailer has an incentive to increase his order quantity to 14,000
Revenue Sharing Contract- Suit Example
• Manufacturer agrees to decrease the wholesale price from $80 to $60
• In return, the retailer provides 15 percent of the product revenue to
the manufacturer.
• Retailer has an incentive to increase his order quantity to 14,000 for a
profit of $504,325
• This order increase leads to increased manufacturer’s profit of
$481,375
• Supply chain total profit
= $985,700 (= $504,325+$481,375).
Revenue Sharing Contract-Suit Example
FIGURE: Revenue-sharing contract
Implementation Drawbacks of Supply
Contracts
• Revenue sharing contracts
• Require suppliers to monitor the buyer’s revenue and thus
increases administrative cost.
• Buyers have an incentive to push competing products with
higher profit margins.
• Similar products from competing suppliers with whom the buyer
has no revenue sharing agreement.
Cost-Sharing Contract
• Buyer shares some of the production cost with the manufacturer, in
return for a discount on the wholesale price.
• Reduces effective production cost for the manufacturer
• Incentive to produce more units
Implementation Issues
Cost-sharing contract
• Cost-sharing contract requires manufacturer to share production cost
information with distributor
• Agreement between the two parties:
• Distributor purchases one or more components that the manufacturer needs.
• Components remain on the distributor books but are shipped to the
manufacturer facility for the production of the finished good.
Other Types of Contracts
• Quantity-Flexibility Contracts
• Supplier provides full refund for returned (unsold) items
• As long as the number of returns is no larger than a certain quantity.
• Sales Rebate Contracts
• Provides a direct incentive to the retailer to increase sales by means of a rebate paid
by the supplier for any item sold above a certain quantity.
• Capacity Reservation Contract
• Buyer pays to reserve a certain level of capacity at the supplier
• A menu of prices for different capacity reservations provided by supplier
• Buyer signals true forecast by reserving a specific capacity level
• Advance Purchase Contract
• Supplier charges special price before building capacity
• When demand is realized, price charged is different
• Buyer’s commitment to paying the special price reveals the buyer’s true forecast
