10. ENTERPRISE NETWORKING & THE INTERNET
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Transcript 10. ENTERPRISE NETWORKING & THE INTERNET
Chapter 14: Supply Chain
Contracting
Topics to Cover
The Bullwhip Effect
Supply Chain Design Strategy
Suboptimal supply chain performance due to
incentive conflicts
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
First noticed regarding Pampers
Retailer
Customer
Bullwhip effect in the US PC supply chain
Changes in
demand
80%
60%
Semiconductor
Equipment
40%
20%
PC
0%
-20%
Semiconductor
-40%
1995
1996
1997
1998
1999
2000
2001
Annual percentage changes in demand (in $s) at three levels of the semiconductor
supply chain: personal computers, semiconductors and semiconductor manufacturing
equipment.
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.
Causes of the bullwhip effect
Order synchronization
Order batching
Trade promotions and forward buying
Reactive and over-reactive ordering
Shortage gaming
Order synchronization
70
Customers order on the same
order cycle, e.g., first of the
month, every Monday, etc.
50
40
Units
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.
60
30
20
10
0
T im e (e a c h p e rio d e q u a ls o n e d a y )
Order batching
70
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.
60
50
Units
Retailers may be required to
order in integer multiples of
some batch size, e.g., case
quantities, pallet quantities,
full truck load, etc.
40
30
20
10
0
T im e (e a c h p e rio d e q u a ls o n e d a y )
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
7000
6000
S hipm e nts
Cases
Cases
5000
4000
3000
C ons um ption
2000
1000
Nov
Oct
Sep
Aug
Jul
Jun
Apr
Mar
Feb
May
T im e (w e e ks )
Jan
Dec
0
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.
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.
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.
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
Supply-Chain Strategy
Efficient
Supply Chain
Responsive
Supply Chain
Functional Products
Match
Standard picture frames
Standard eyeglass
frames
Sub shop
Innovative Products
Custom made clothes
Gourmet food
Liberal arts education
Low-cal breakfast cereal
Match
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: Cu 115 75 40 Co 75 25 50 Cu / Co Cu 0.4444
Supply chain’s critical ratio: Cu 115 35 80 Co 35 25 10
Cu / Co Cu 0.8889
The difference in the critical ratio leads to poor performance:
Decentralized supply chain
Optimized supply chain
% change
Order Zamatia's
quantity
profit UV's profit Total profit
234
9360
5580
14940
404
16160
1670
17830
42%
-234%
16%
Aligning incentives…
Marginal cost pricing:
Zamatia charges $35 per sunglass, then UV’s critical ratio equals the supply
chain’s critical ratio.
But Zamatia makes zero profit.
What they need is a method to share inventory risk so that the supply chain’s
profit is maximized (coordinated) and both firms are better off.
Buy-back contract:
Zamatia buys back left over inventory at the end of the season.
Coordinates the supply chain and can yield any split of the profit…everyone
can be better off.
Wholesale price ($)
Buy back price ($)
35
45
55
65
75
85
95
105
26.50 37.75 49.00 60.25 71.50 82.75 94.00 105.25
Expected profits:
Umbra
Zamatia
Supply chain
17830 15601 13373 11144
4458
2229
8915 11144 13373
15601
17830 17830 17830 17830 17830 17830 17830
17830
0
2229
4458
6686
8915
6686
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 …
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.
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, …
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.