Smart Contract Leverage Blockchain to Streamline Processes

Supply (physical) Contracts

https://www.capgemini.com/2019/01/will-blockchain-enable-lead-to-digital-nirvana-for-financial-supply-chain-management/
 Needs for such contracts?

• Significant level of outsourcing

• More outsourcing has meant

– Search for lower cost manufacturers

– Development of design and manufacturing expertise by

suppliers

– Procurement function is also being outsourced

• OEMs have to get into contracts with suppliers

– For both strategic and non-strategic components
 The Pie

• How is the pie allocated?

 Supply Contracts Elements

• Pricing and volume discounts.

• Minimum and maximum purchase quantities.

• Delivery lead times.

• Product or material quality.

• Product return policies.

2-Stage Sequential Supply Chain

A buyer and a supplier.

• Buyer’s activities:

– generating a forecast

– determining how many units to order from the supplier

– placing an order to the supplier so as to optimize his own profit

– Purchase based on forecast of customer demand

• Supplier’s activities:

– reacting to the order placed by the buyer.

– Make-To-Order (MTO) policy / Make-To-Stock Policy

 Contracts for
Make-to-Order Supply Chains
 Costs involved in 2 stage SC

• Manufacturer sells price per unit (C): $80 = Input cost to retailer

• Selling price per unit (S) by retailer: $125

• Salvage value per unit (V): $20

• Fixed production cost (F): $100,000

• Q is production quantity, D: demand

• Profit = Revenue - Variable Cost - Fixed Cost + Salvage

 Supply Contracts

Fixed Production Cost =$100,000

Variable Production Cost=$35

Manufacturer sells at =$80

Selling Price=$125
Salvage Value=$20

Manufacturer Distributor Retail DC

Who takes the risk?

Stores
What would the manufacturer like?
 Consider the following case

• A company designs, produces, and sells summer fashion

items such as swimsuits.
• The company has to commit itself six months before summer
to specific production quantities for all its products
– predicting demand for each product.
• The trade-offs are clear: overestimating customer demand
will result in unsold inventory while underestimating
customer demand will lead to inventory stockouts and
loss of potential customers.
 Demand forecast

nThe30%
marketing department28% uses historical data from the last
five years,
25% current economic conditions, and other factors to
construct a probabilistic forecast of22%
the demand.
20% 18%
15%
11% 11% 10%
10%

5%

0%
8000 10000 12000 14000 16000 18000
Unit sales

forecast averages about 13,100

Scenario of excess inventory and stock out

• Scenario One: (assuming no opportunity cost lost)

– Suppose you make 12,000 jackets and demand ends up
being 13,000 jackets.
– Profit = 125(12,000) - 80(12,000) - 100,000 = $440,000

• Scenario Two:
– Suppose you make 12,000 jackets and demand ends up
being 11,000 jackets.
– Profit = 125(11,000) - 80(12,000) - 100,000 + 20(1000) =
$ 335,000
 Questions to respond?

• Find order quantity that maximizes

weighted average profit?

• Will this quantity be less than, equal to, or

greater than average demand?
 How much to Make?

• Should I consider Marginal cost or marginal profit

– if stock out (under estimate demand) then loss
incurred is 125-80 = 45
– if over stock (over estimate demand) cost is 80-20
= 60

• So we will make less than average

 Distributor Expected Profit
(in single period)
Expected Profit

$400,000
$300,000
Profit

$200,000
$100,000
$0
8000 12000 16000 20000
Order Quantity

If Quantity ordered is 12000

Profit = (0.78)*12000*125+ 0.11*8000*125+ 0.11*10000*125-80*12000-100000+4000*0.11*20+2000*0.11*20
= 370700

Note: Opportunity cost of loosing customer not captured

 Distributor Expected Profit
(in long run)
Expected Profit

500000

400000

300000

200000

100000

0
6000 8000 10000 12000 14000 16000 18000 20000
Order Quantity

If Quantity ordered is 12000

Profit = (0.78)*12000*125+ 0.11*8000*125+ 0.11*10000*125-80*12000+4000*0.11*20+2000*0.11*20
= 470700
 Important Observations

• Tradeoff between ordering enough to meet demand

and ordering too much
• Several quantities have the same average profit
• Average profit does not tell the whole story
• 9000 and 16000 units lead to about the same average
profit, so which do we prefer?
Can such scenarios be possible?

Expected Profit

$400,000
$300,000
Profit

$200,000
$100,000
$0
8000 12000 16000 20000
Order Quantity

• How much should I make?

• How to decide?
 What should we do?

• But Need to understand risk associated with certain

decisions.
• A frequency histogram provides information about
potential profit for the two given production
quantities, 9,000 units and 16,000 units. The
possible risk and possible reward increases as we
increase the production size.
 Probability of Outcomes
100% 0.89
Q =9000
90%
80% Q =16000
70%
Probability

60%
50%
40% 0.28 0.28
30% 0.22
20% 0 . 11 0 . 11 0 . 11
10% 0 0 0 0 0 0 0 0 0 0 0 0
0%
-300000

-200000

-100000

100000

200000

300000

400000

500000

600000
Profit
 Key Points/ Learning

• The optimal order quantity is not necessarily equal to

average forecast demand
• As order quantity increases, average profit first increases
and then decreases
• As production quantity increases, risk increases. In other
words, the probability of large gains and of large losses
increases
 Supply Contracts

• Retailer optimal order quantity is 12,000 units

• Retailer expected profit is $470,000

• Manufacturer profit is $440,000

• Supply Chain Profit is $910,000

Is there anything that the retailer & manufacturer

can do to increase the profit of both?

 Supply Contracts
Fixed Production Cost =$100,000

Variable Production Cost=$35

Manufacturer sells at =$80

Selling Price=$125
Salvage Value=$20

Manufacturer Distributor Retail DC

Stores

Here, the retailer takes all the risk and the manufacturer takes zero risk.
Hence, the retailer has to be very conservative with the amount he orders.

If the retailer can transfer some of the risk to the manufacturer, the retailer
may be willing to increase his order quantity and thus increase both his profit
and the manufacturer profit
 Supply Contracts
Fixed Production Cost =$100,000

Variable Production Cost=$35

Manufacturer sells at =$80

Selling Price=$125
Salvage Value=$20

Manufacturer Distributor Retail DC

Here, the retailer takes all the risk and the manufacturer takes zeroStores
risk.
Hence, the retailer has to be very conservative with the amount he orders.

RISK SHARING
If the retailer can transfer some of the risk to the manufacturer, the retailer
may be willing to increase his order quantity and thus increase both his profit
and the manufacturer profit
 Risk Sharing
• In the sequential supply chain:

– Buyer assumes all of the risk of having more inventory than sales

– Buyer limits his order quantity because of the huge financial risk.

– Supplier takes no risk.

– Supplier would like the buyer to order as much as possible

– Since the buyer limits his order quantity, there is a significant increase in the

likelihood of out of stock.

• If the supplier shares some of the risk with the buyer

– it may be profitable for buyer to order more

– reducing out of stock probability

– increasing profit for both the supplier and the buyer.

• Supply contracts enable this risk sharing

 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
– Decreases the likelihood of out of stock
– Compensates the supplier for the higher risk
• Disadvantage:
– buyback contract results in surplus inventory that must be disposed of, which
increases supply chain costs
– Can also increase information distortion through the supply chain because the
supply chain reacts to retail orders, not actual customer demand

Most effective for products with low variable cost such

as music, software, books, magazines, and newspapers
 Retailer Profit
(Buy Back=$55)

600,000
500,000
$513,800
Retailer Profit

400,000

300,000
200,000

100,000

0
00

00

00

00

0
00

00

00

00

00

00

00

00

00
60

80

90
70

11

12

14

15

17
10

13

16

18
Order Quantity
 Manufacturer Profit
(Buy Back=$55)

600,000
$471,900
Manufacturer Profit

500,000

400,000

300,000
200,000

100,000

0
00

00

00

00

0
00

00

00

00

00

00
00

00

00
60

70

80

90

11

12

13

14

15

16

17
10

18
Production Quantity
 Supply Contracts
Fixed Production Cost =$100,000

Variable Production Cost=$35

Manufacturer sells at =????

Selling Price=$125
Salvage Value=$20

Manufacturer Distributor Retail DC

Stores

What does retailer price drive?

How can manufacturer benefit from lower price?
 Revenue Sharing Contract

• Buyer shares some of its revenue with the supplier

– in return for a discount on the wholesale price.

• Decreases the cost per unit charged to the retailer,

which effectively decreases the cost of overstocking

• Can result in supply chain information distortion,

however, just as in the case of buyback contracts

 Retailer Profit
(Distributor Price $70 &15% product revenue to manu.)

600,000
$504,325
500,000
Retailer Profit

400,000
300,000
200,000
100,000
0

0
00

00

00

00

0
00
00

00

00

00

00

00

00

00
60

70

80

90
10

11

12

14

15

16

17

18
13 Order Quantity
 Manufacturer Profit
(Distributor Price $70 &15% product revenue to manu.)

700,000
600,000
Manufacturer Profit

500,000 $481,375
400,000
300,000
200,000
100,000
0 0

0
00

00
00

00
00

00

00

00

00

00

00

00

00
60

70

80

90

11

12

13

14

15

16

18
10

17
Production Quantity
 Supply Contracts

Strategy Retailer Manufacturer Total

Sequential Optimization 470,700 440,000 910,700
Buyback 513,800 471,900 985,700
Revenue Sharing 504,325 481,375 985,700
 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 (even of competitors for
multibrand retailer).
• Retailer’s risk is much higher for the products not under
the buy back contract.
• 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.
 Other Types of Contracts
• Quantity-Flexibility Contracts
– Manufacturer provides full refund for returned (unsold)
items as long as the number of returns is no larger than a
certain quantity.
– Allows the buyer to modify the order (within limits) as
demand visibility increases closer to the point of sale

• 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.

Lower levels of information distortion than either buyback

contracts or revenue sharing contracts
 Supply Chain Profit
What is the maximum profit that the supply chain can achieve? i.e When we
have global optimization

1,200,000
$1,014,500
Supply Chain Profit

1,000,000
800,000

600,000
400,000

200,000
0
00

00

00

00

0
00

00

00

00

00

00

00

00

00
60

70

80

90
10

11

12

13

14

15

16

17

18
Production Quantity
 Supply Contracts

Strategy Retailer Manufacturer Total

Sequential Optimization 470,700 440,000 910,700
Buyback 513,800 471,900 985,700
Revenue Sharing 504,325 481,375 985,700
Global Optimization 1,014,500
Global Optimization & Supply Contracts
-Reality-
• Carefully designed supply contracts can achieve as much as
global optimization
• Unbiased decision maker unrealistic
– Requires the firm to surrender decision-making power to an
unbiased decision maker
• Global optimization does not provide a mechanism to allocate
supply chain profit between the partners.
– Supply contracts allocate this profit among supply chain members.
 Key Insights

• Effective supply contracts allow supply chain partners to

replace sequential optimization by global

optimization

• Buy Back and Revenue Sharing contracts achieve this

objective through risk sharing

 Contracts for
Make-to-Stock Supply Chains
 Pay-Back Contract
• Retailer / Buyer agrees to pay some agreed-upon price
for any unit produced by the manufacturer but not
purchased.
• Manufacturer incentive to produce more units
• Buyer’s risk clearly increases.
• Increase in production quantities at manufacturer has
to compensate the retailer for the increase in his risk.
 Cost-Sharing Contract

• Retailer / 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 requires manufacturer to

share production cost information with downstream
player
Contracts with Asymmetric Information

• Implicit assumption so far: Buyer and supplier share

the same forecast
– Thus reducing bullwhip Effect

• Inflated forecasts from buyers a reality

• How to design contracts such that the information

shared is credible?
 Two Possible Contracts
• 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
Contracts for Non-Strategic Components

• Variety of suppliers
• Market conditions dictate price
• Buyers need to be able to choose suppliers and
change them as needed
• Recent trend towards more flexible contracts
– Buyers has option of buying later at a different
price than current
 Flexible or Option Contracts
• Buyer pre-pays a relatively small fraction of the
product price up-front
• Supplier commits to reserve capacity up to a certain
level.
• Initial payment is the reservation price or premium.
• If buyer does not exercise option, the initial payment
is lost.
• Buyer can purchase any amount of supply up to the
option level by:
– paying an additional price (execution price or exercise
price)
– agreed to at the time the contract is signed
– Total price (reservation plus execution price) typically
higher than the unit price in a long-term contract.
 Flexible or Option Contracts
• Provide buyer with flexibility to adjust order
quantities depending on realized demand
• Reduces buyer’s inventory risks.
• Shifts risks from buyer to supplier
– Supplier is now exposed to customer demand uncertainty.

• Flexibility contracts
– Related strategy to share risks between suppliers and
buyers
– A fixed amount of supply is determined when the contract is
signed
– Amount to be delivered (and paid for) can differ by no more
than a given percentage determined upon signing the
contract.
 Spot Purchase

• Buyers look for additional supply in the open market.

• May use independent e-markets or private e-markets

to select suppliers.

• Focus:
– Using the marketplace to find new suppliers

– Forcing competition to reduce product price.

 Portfolio Contracts

• Portfolio approach to supply contracts

• Buyer signs multiple contracts at the same time
– optimize expected profit
– reduce risk.

• Contracts
– differ in price and level of flexibility
– hedge against inventory, shortage and spot price risk.

– Meaningful for commodity products

• a large pool of suppliers
• each with a different type of contract.
Risk Trade-Off in Portfolio Contracts
• If demand is much higher than anticipated
– Base commitment level + option level < Demand,
– Firm must use spot market for additional supply.
– Typically the worst time to buy in the spot market
• Prices are high due to shortages.
• Buyer can select a trade-off level between price risk, shortage
risk, and inventory risk by carefully selecting the level of long-
term commitment and the option level.
– For the same option level, the higher the initial contract
commitment, the smaller the price risk but the higher the inventory
risk taken by the buyer.
– The smaller the level of the base commitment, the higher the price
and shortage risks due to the likelihood of using the spot market.
– For the same level of base commitment, the higher the option level,
the higher the risk assumed by the supplier since the buyer may
exercise only a small fraction of the option level.
 Design Collaboration

• 50-70 percent of spending at a manufacturer is through

procurement
• 80 percent of the cost of a purchased part is fixed in the
design phase
• Design collaboration with suppliers can result in reduced
cost, improved quality, and decreased time to market
• Important to employ design for logistics, design for
manufacturability
• Manufacturers must become effective design
coordinators throughout the supply chain
THANYOU