Sourcing and Contracts Chapter 14

1. Sourcing and ContractsChapter 14

2. Outline • The Role of Sourcing in a Supply Chain • Supplier Scoring and Assessment • Supplier Selection and Contracts • Design Collaboration • The Procurement Process • Sourcing Planning and Analysis • Making Sourcing Decisions in Practice • Summary of Learning Objectives

3. The Role of Sourcing in a Supply Chain • Sourcing is the set of business processes required to purchase goods and services • Sourcing processes include: • Supplier scoring and assessment • Supplier selection and contract negotiation • Design collaboration • Procurement • Sourcing planning and analysis

4. Benefits of Effective Sourcing Decisions • Better economies of scale can be achieved if orders are aggregated • Eliminate some suppliers. Keep strategic dual sourcing. • DineEquity Inc., Glendale, CA, parent company of IHOP and Applebee's restaurants, is consolidating the vendors the two restaurant chains use -- and, in the process, is getting a discount by buying more from the vendors it does keep. DineEquity purchased Applebee's in 2007 and found that there was 75% overlap among IHOP's and Applebee's vendors. • More efficient procurement transactions can significantly reduce the overall cost of purchasing • Buying commodities from commodity exchanges / internet sites • Firms can achieve a lower purchase price by increasing competition through the use of auctions • Design collaboration can result in products that are easier to manufacture and distribute, resulting in lower overall costs • Ford sends its own engineers to its suppliers • Appropriate supplier contracts can allow for the sharing of risk • Buyback contract redistributes the risk of overstocking

5. Supplier Scoring and Assessment • Supplier performance should be compared on the basis of the supplier’s impact on total cost • There are several other factors besides purchase price that influence total cost • Replenishment Lead Time • On-Time Performance • Supply Flexibility • Delivery Frequency / Minimum Lot Size • Supply Quality • Inbound Transportation Cost • Pricing Terms • Information Coordination Capability • Design Collaboration Capability • Exchange Rates, Taxes, Duties • Supplier Viability

6. Example of Supplier Assessment • I am currently sourcing out a multi-carrier shipping system for my company. Since I'll be locked into whatever choice I make for the next 4-5 years, I want to make sure I choose wisely. Do you have any comments on the following: Clippership, Pitney Bowes, NextShip, Logicor, Pfastship, or any others that you may currently be using? By the way, over 80% of our shipping is small carrier (UPS, FedEx, USPS), and the remainder is LTL. I am interested in your comments concerning reliability, tech support, and customer support. • Steve Bachman. April 29, 2006 e-mailed toSupplyChainManagement@yahoogroups.com

7. Example of Transporter Assessments • Hello friends, My project tile is "Transporter rating system“ under this project I have to the parameters for rating [transporters].- Rahul Gaikwad. April 28, 2007 e-mailed to SupplyChainManagement@yahoogroups.com • You can measure transporter performance in the following ways: 1) Cost effectiveness (Affordability) 2) Delivery speed 3) Damage rate (%) 4) Quantity flexibility 5) Time flexibility  ( based on your need transport availability) 6)Assurity (how safe & secure your goods is reaching to the destination) - Austin Lowrie. April 29, 2007 e-mailed to SupplyChainManagement@yahoogroups.com

8. Example: UTD Procurement – DepartmentBidding requirements as of Nov 14, 2008 • UTD is a State of Texas agency and required by state law to bid out orders and give opportunities to companies and HUBS (Historically Underutilized Business) whenever possible.  If you have an expensive or technical purchase please contact us at the beginning of the process if the cost exceeds $10,000. • We can write an RFP (Request for Proposal) and send out a BID for your [UTD personnel] product and service now, allowing you [UTD personnel] to evaluate and discuss the proposals legally with the vendors. As a team we will pick the “Best Value” solution. • If you do this with out our involvement and then send us a purchase requisition we may have to formally bid out your order, delaying your project. Only a state certified buyer can legally “bid” on behalf of the University. http://www.utsystem.edu/policy/policies/uts156.html • Federal Funds:  http://www.whitehouse.gov/omb/circulars/index-education.html  Positive efforts shall be made by [fund] recipients to utilize small businesses, minority-owned firms, and women's business enterprises, whenever possible. Recipients shall, on request, make available for the Federal awarding agency, pre-award review and procurement documents, such as request for proposals or invitations for bids, independent cost estimates, etc., when any of the following conditions apply. • A recipient's procurement procedures or operation fails to comply with the procurement standards in the Federal awarding agency's implementation of this Circular. • The procurement is expected to exceed the small purchase threshold fixed at 41 U.S.C. 403 (11) (currently $25,000) and is to be awarded without competition or only one bid or offer is received in response to a solicitation. • The procurement, which is expected to exceed the small purchase threshold, specifies a "brand name" product.

9. Example: UTD Procurement • All procurement transactions shall be conducted in a manner to provide, to the maximum extent practical, open and free competition. • < $10,000: we can purchase with one or more quotes at Purchasing’s discretion. • >10,000 and < $25,000: we require at least 3 informal bids, with two HUB Historically Underutilized Businesses, from the CMBL bidders list run by the State of Texas  www2.cpa.state.tx.us/cmbl/cmblhub.html • > $25,000: we require formal sealed written bids, including at least 2 HUB vendors, usually posted on http://esbd.cpa.state.tx.us/ unless available under a government contract, or a sole source or emergency purchase. • Individual departments can purchase • < $500: using a pre-printed “SOS” small dollar purchase order system form • < $1000: using a UTD Purchasing Master card • > $1000: go to Procurement.  • Only the UTD Procurement Department can sign contracts, issue Purchase Orders or conduct formal BIDS. Pricing or quotes for departments are not legal bids and may have to be bid out by Procurement. Verbal orders from UTD Departments may be the personal obligation of that individual and not the University.

10. Example: UTD Procurement – Internet Sources • UTD Procurement Management www.utdallas.edu/utdgeneral/business/procure/ • The University of Texas System www.utsystem.edu/ • Bids over $25,000 posted at the Electronic State Business Daily http://esbd.cpa.state.tx.us/ • U.T. System Historically Underutilized Business (HUB) Program www.utsystem.edu/hub/ • UT System Policy Library www.utsystem.edu/policy/lib_main.html • SBA US Small Business Administration www.sba.gov/aboutsba/sbaprograms/sdb/index.html • State Law for University Purchasing: An institution of higher education may acquire goods or services by the method that provides the best value to the institution. http://tlo2.tlc.state.tx.us/statutes/docs/ED/content/htm/ed.003.00.000051.00.htm#51.9335.00 • Texas Procurement and Support Services (TPASS) www.window.state.tx.us/procurement/ • Historically Underutilized Business (HUB) www.window.state.tx.us/procurement/prog/hub/

11. Supplier Selection and Contracts • UTD contract example • Contracts for Product Availability and Supply Chain Profits • Buyback Contracts • Revenue-Sharing Contracts • Quantity Flexibility Contracts • These contracts coordinate Supply Chains • Contracts to Increase Agent Effort • Contracts to Induce Performance Improvement

12. Example: UTD Gas Suppliers as of June 26, 2008 • After careful review by Procurement Management of the three main companies supplying scientific gases and services Airgas-Southwest, Matheson Tri-Gas, and Air Liquide, Procurement Management has negotiated an agreement using an existing UTSW contract with Airgas-Southwest for scientific and medical bottled gases as our most advantageous contract. The advantages are: • Extremely competitive pricing • Online ordering • Each cylinder will have a tag identifying the ordering person, department, Lab room, and fund number. • Invoices and cylinder inventories can be managed online • Payment can be made by using Procurement cards or invoice • Cylinders can be returned using online system • Lower deliver charges • Faster turnaround on specialty gas orders • Please contact our Airgas-Southwest representative, J??? W???, to set up an account. He can be contacted by email at J???.W???@airgas.com, or by phone at 817-7??-7???. • You may still use any of these companies for your requirements; however they are listed in order of best value to UTD. • Airgas-Southwest. Contact: J??? W???. 910 W. Kerney; Mesquite, TX 75149.www.airgas.com • Matheson Tri-Gas. Contact: R?? E????. 2306 N. Beckley Avenue; Dallas, TX 75208.www.mathesontrigas.com • Air Liquide. Contact: M?? D?????. 801 N. West Carrier Parkway; Grand Prairie, TX 75050.www.airliquide.com

13. Sourcing Planning and Analysis • A firm should periodically analyze its procurement spending and supplier performance and use this analysis as an input for future sourcing decisions • Procurement spending should be analyzed by part and supplier to ensure appropriate economies of scale • Supplier performance analysis should be used to build a portfolio of suppliers with complementary strengths • Cheaper but lower performing suppliers should be used to supply base demand • Higher performing but more expensive suppliers should be used to buffer against variation in demand and supply from the other source

14. Contracts for Product Availability and Supply Chain Profits • Many shortcomings in supply chain performance occur because the buyer and supplier are separate organizations and each tries to optimize its own profit • Total supply chain profits might therefore be lower than if the supply chain coordinated actions to have a common objective of maximizing total supply chain profits • Recall Chapter 10: double marginalization results in suboptimal order quantity • An approach to dealing with this problem is to design a contract that encourages a buyer (retailer) to purchase more and sell more by • increasing the level of product availability and • decreasing prices, if necessary • The supplier must share in some of the buyer’s demand uncertainty

15. Contracts • A contract is an agreement between two parties. • Pricing contract types • Fixed price • Dependent price • Capturable uncertainty • Third party measures, indicators as surrogates • Alterable price • Uncapturable uncertainty • Renegotiation necessary • Same classification for quantity contracts • Cost+fee contracts as opposed to price contracts • Car repair: Spark plug cost + labor fee. • Sink installation: Drainage assembly + labor at $110/hour for the first hour and $80/hour for the others.

16. Contracts Advantages & Disadvantages • Advantages • Uncertainty reduction • Relationship leveraging • Disadvantages for supplier • Being blocked from selling to other retailers • Harsh retailers: GM and its suppliers • Disadvantages for retailer • Being blocked from buying from other suppliers • Supplier complacency – lack of incentives for improvement

17. Contracts to Coordinate Supply Chain Costs • Differences in costs at the buyer and supplier can lead to decisions that increase total supply chain costs • Ex: Replenishment order size placed by the buyer. The buyer’s EOQ does not take into account the supplier’s costs. • A quantity discount contract may encourage the buyer to purchase a larger quantity (which would be lower costs for the supplier), which would result in lower total supply chain costs • Quantity discounts lead to misleading demand information because of order batching • A contract is said to be coordinating a supply chain if the sum of the profits of various decision makers under the contract is equal to the profit of one decision maker

18. Buyback Contracts • Allows a retailer to return unsold inventory up to a specified amount at an agreed upon price • Increases the optimal order quantity for the retailer, resulting in higher product availability and higher profits for both the retailer and the supplier • Downsides that buyback contract results in • Surplus inventory for the supplier that must be disposed of, which increases supply chain costs • Misleading for the supply chain as it reacts to (inflated) retail orders, not actual customer demand • Most effective for products with low variable cost, such as music, software, books, magazines, and newspapers so that the supplier can keep the surplus

19. Revenue Sharing Contracts • The buyer pays a minimal amount for each unit purchased from the supplier but shares a fraction of the revenue for each unit sold • Decreases the cost per unit charged to the retailer, which effectively decreases the cost of overstocking • Misleading for the supply chain as it reacts to (inflated) retail orders, not actual customer demand

20. Quantity Flexibility Contracts • Allows the buyer to modify the order (within limits) as demand visibility increases closer to the point of sale • Better matching of supply and demand • Increased overall supply chain profits if the supplier has flexible capacity • Lower levels of misleading demand information than either buyback contracts or revenue sharing contracts

21. Contracts to Increase Agent Effort • There are many instances in a supply chain where an agent acts on the behalf of a principal and the agent’s actions affect the reward for the principal. Examples of agents include • A car dealer who sells the cars of a manufacturer, as well as those of other manufacturers • A doctor who treats patients for an HMO • Sales force working on a commission • For more info, see UTD Medical Management master degree • Examples of contracts to increase agent effort include two-part tariffs and threshold contracts • Threshold contract example: • DaimlerChrysler increases the margin for the dealers as the dealers sell more per month. Dealers shift demand from one month to another. • Threshold contracts increase information distortion.

22. Contracts to Induce Performance Improvement • A buyer may want performance improvement from a supplier who otherwise would have little incentive to do so • A shared savings contract provides the supplier with a fraction of the savings that result from the performance improvement • Particularly effective where the benefit from improvement helps primarily the buyer, but where the effort for the improvement comes primarily from the supplier • GM and its suppliers • Department of Defense is moving towards performance based contracts from cost+fee contracts. Airlines use performance based contracts. • USAir engines are owned/repaired by General Dynamics in a certain delivery time.

23. Contracts for 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 • Ford designs with its suppliers

24. R&D ContractsCost Overruns A manufacturer is commissioned to build a product after some R&D. • Military commissions ship and aircraft manufacturers; see the aside from NYT April 25, 2008. • Energy companies commission oil field development, alternative energy projects • International Energy Agency estimates that $1 trillion/year investment necessary in energy infrastructure until 2030. • These projects have cost and time overruns: “Projects overrun because most owner and contractor organizations lack a practical and disciplined approach to strategic risk management.” - R. Westney, Chairman of Westney Consulting, 2008. Failing to capture now what can fail later.

25. The Procurement Process • The process in which the supplier sends product in response to orders placed by the buyer • Goal is to enable orders to be placed and delivered on schedule at the lowest possible overall cost • Two main categories of purchased goods: • Direct materials: components used to make finished goods • Indirect materials: goods used to support the operations of a firm • Focus for direct materials should be on improving coordination and visibility with supplier • Focus for indirect materials should be on decreasing the transaction cost for each order • Procurement for both should consolidate orders where possible to take advantage of economies of scale and quantity discounts

26. Product Categorization by Value and Criticality (Figure 13.2) Strategic Items Ensure long term relationship Jet engines High Critical Items Ensure availability Anti-corrosive coated fasteners Criticality Bulk Purchase Items Ensure low cost Office supplies General Items Ensure low cost Fasteners Low Low High Value/Cost

27. Impact of SC Contracts on Profitability: Buyback Contracts • Buybacks by publishers • Practice: Custom books are not bought back! • Unsold regular books are returned to the publishers at a lower price than the bookstores initially pay. All the unsold books are returned back to the publisher. • Buyback by TF • Tech Fiber(TF) produces jacket and sells to Ski Adventure(SA) which sells them in the market. Unsold jackets have no salvage value. Should TF be willing to buy back unsold jackets? Why? Market Price=$200 Wholesale Price=$100 Cost=$5 TF SA ~N(1000,3002)

28. Impact of SC Contracts on Profitability: Buyback Contracts • Buyback by HP • HP manufactures Pavilion laptops, and sell to its retailer BestBuy. Each Pavilion costs $500 to produce, wholesales price is $700 and retail price is $1000. When a newer model is released, HP promises to buy back the left over laptops at $200 and HP can donate their leftover to charity and gain $50 in tax credit. If a=overage cost , b=underage cost for BestBuy, what is (a,b) with and without the contract? • (500, 300) with contract • (700, 300) without contract • Buyback by Panasonic • Panasonic sells a DVD player at $120 to BestBuy. BestBuy sells them at $150 to consumers. Unsold players are sold at discount price of $100 to customers, Panasonic compensates BestBuy for $120-100=$20 per player. Is this a buyback scheme, if so what is the buyback price? • Hint: Can BestBuy sell all the DVD players at the discount price? Answer: No.

29. Profits under centralization

30. Separately acting

31. Split of Supply Chain Profits under the Buyback Contract Retailer obtains the big portion of the profits when the wholesale price is far smaller than the sales price. Supplier’s portion Retailer’s portion c “w” p

32. Buyback Contracts: c=$5; p=$200 What happens to the supplier profit with the buyback contract?

33. Does a buyback contract increase profits? • Which of these are true? • Buyback contract increases • the supply chain profit • the supplier profit • the retailer profit • the sales to the market • the sales to the retailer • the demand

34. Manufacturer DC Manufacturer Retail DC Stores Usual Manufacturer – Retailer Supply Chain Selling Price=p=$100 Variable Production Cost=c=$40 Wholesale Price=w=$70 Selling Price=p=$100

35. Revenue Sharing (RS) Contracts If the manufacturer reduces wholesale price to wrs, the retailer can share a percentage of the revenue p. Wholesale Price=wrs=$50 Production Cost=$40 Selling Price=$100 Manufacturer Retailer 1-θ: Revenue sharing portion 50%

36. Blockbuster Case Study • Demand for a movie newly released video cassette typically starts high and decreases rapidly • Peak demand lasts about 10 weeks • Blockbuster purchases a copy from a studio for $65 and rents for $3 • Hence, Blockbuster (retailer) must rent the tape at least 22 times before earning profit • Retailers cannot justify purchasing enough to cover the peak demand • In 1998, 20% of surveyed customers reported that they could not rent the movie they wanted because the Blockbuster stores did not have that movie. • In 1998, Blockbuster started revenue sharing with the major movie studios • In general, the retailer pays the wholesale price wrs. • Studio charges wrs=$8 per copy. • In general, the retailer shares (1-θ) portion of the sales revenue with the supplier. • Blockbuster pays (1-θ)=30-45% of its rental income. • Even if Blockbuster keeps only half of the rental income, the breakeven point is 6 rental per copy • The impact of revenue sharing on Blockbuster was dramatic • Rentals increased by 75% in test markets due to higher video availability • Market share increased from 25% to 31% (The 2nd largest retailer, Hollywood Entertainment Corp has 5% market share)

37. Buyback = Revenue Sharing if … • Buyback contract: • The retailer • pays w for each unit purchased from the supplier • gets b for each unit unsold to the market • Equivalently, • pays w-b for each unit purchased from the supplier • pays b more for each unit sold to the market • Revenue Sharing: • The retailer • pays wrs for each unit purchased from the supplier • pays (1-θ)p more for each unit sold to the market • The contracts are the same if • wrs=w-b for each unit purchased from the supplier • (1-θ)p=bmore for each unit sold to the market

38. Quantity Flexibility Contracts • If a retailer orders q units, the manufacturer commits to supplying up to (1+)q the retailer commits to buying (1-)q • Unfortunately the book denotes (1+)q by O • How can quantity flexibility contracts help increase profitability? • Uncertainty reduction for • Retailers by avoiding lack of supply availability • Suppliers by avoiding lack of retailer demand

39. Quantity Flexibility Contract 1. Retailer knows the demand distribution F and makes a forecast q for its order size, typically q>E(D). 2. Supplier guarantees to supply q(1+ ), >=0. Retailer guarantees to buy q(1-  ), 0<= <=1. Supplier produces Q>=q(1+α). 3. The demand is realized as D=d and the retailer buys Min { Max{q(1- ),d} , q(1+α) } Min{Max{q(1-),d},q(1+α)} q(1- ) q(1+α) D

40. Quantity Flexibility Contract • Without coordination the supplier produces less than with coordination. • The contract is advantageous to the retailer only if Q<q(1+ ). • Otherwise, the supplier orders more than the contract would have indicated even without the contract. If such a high order is optimal for the supplier without the contract, it should also be optimal with the contract. Then the retailer does not benefit by committing to buy q(1-  ) with the contract. • The supplier can coordinate the chain by setting the wholesale price appropriately. • See notes to find out how the wholesaler price w is computed.

41. Quantity Flexibility Contracts Larger values of  and  give more flexibility to the retailer. Supplier prices for this flexibility via the wholesale price w.

42. Making Sourcing Decisions in Practice • Use multifunction teams • Ensure appropriate coordination across regions and business units • Always evaluate the total cost of ownership • Build long-term relationships with key suppliers

43. Summary of Learning Objectives • What is the role of sourcing in a supply chain? • What dimensions of supplier performance affect total cost? • What is the effect of supply contracts on supplier performance and information distortion? • What are different categories of purchased products and services? What is the desired focus for procurement for each of these categories?