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Sourcing and Contracts
Chapter 14
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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

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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
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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
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Supplier Scoring and Assessment
Supplier performance should be compared on the basis of the suppliers impact
on total cost
There are several other factors besides purchase price that influence total cost
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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
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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 to SupplyChainManagement@yahoogroups.com

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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
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Example: UTD Procurement Department
Bidding 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.
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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 Purchasings 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.
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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#51.93
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Texas Procurement and Support Services (TPASS) www.window.state.tx.us/procurement/
Historically Underutilized Business (HUB) www.window.state.tx.us/procurement/prog/hub/
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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
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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
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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
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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 buyers demand
uncertainty
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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.
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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
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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 buyers EOQ
does not take into account the suppliers 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
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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
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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

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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
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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 agents 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.

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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.
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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
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R&D Contracts
Cost Overruns
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.
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A manufacturer is commissioned
to build a product after some R&D.
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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
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Product Categorization by Value
and Criticality (Figure 13.2)
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Critical Items
Ensure availability
Anti-corrosive
coated fasteners
Strategic Items
Ensure long term
relationship
Jet engines
General Items
Ensure low cost
Fasteners
Bulk Purchase
Items
Ensure low cost
Office supplies
Low
Low
High
High
Value/Cost
C
r
i
t
i
c
a
l
i
t
y

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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?
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TF SA
Cost=$5
Wholesale
Price=$100
~N(1000,300
2
)
Market
Price=$200
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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
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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.
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Profits under centralization
) y ( c/p - 1 or ) y ( c/p or
} {
y quantity order Optimal
0 ) ( } { Profits(y) d Coordinate of Derivative
)] ( }[ { Profits(y) d Coordinate
) ( y probabilit only with it sell can you 1, by inventory Increase : ) ( Sales(y) of Derivative
) ( ) ( ) (
) ( ) ( ) , min( Sales(y)
quantity Order : y price; market : p price; wholesale : w cost; : c
*
C
*
C
1 *
C
0 0
0
0
) , min(
0
0
F F
p
c
F
c y F p
y c y Sales p
y F y F
dD D F dx x F dDdx D f
dD D dxf dD D f D y
y y
y
x x D
D
D y
x
= =
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.
|

\
| > <
= =
>= < =
> < =
=
= = =
= = =

= =

} } } }
} } }
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Separately acting
c/p 1
c w
: b
implies which
b} {p
b w
F
{p}
c
F hen quantity w d centralize orders Retailer
b} {p
b w
F (b) y quantity order optimal s Retailer'
)y b - w ( - )] b}[Sales(y - {p ] p[Sales(y) ) [Sales(y)] - b(y -wy b) | Profit(y Retailer
b))y - (w - (c - ] b[Sales(y) cy - ) [Sales(y)] - b(y wy y) | Profit(b Supplier
price buyback : b
C
1 1
1 *
R

=
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=
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.
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Split of Supply Chain Profits under the Buyback
Contract
Profit(y) d Centralize
c - p
w - p
) b | Profit(y s Retailer'
C
=
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Retailer obtains the big portion of the profits
when the wholesale price is far smaller than the sales price.
c
p w
Suppliers portion Retailers portion
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Buyback Contracts: c=$5; p=$200
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5/200 1
5 120
b ; 105
5/200 1
5 110
b ; 95
5/200 1
5 100
c/p 1
c w
: b
C C C
~


= ~


= ~

=
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Wholesale
Price w
Buy
Back
Price b
Optimal
Order size
for SA
Expected
Profit for
SA
Expected
Returns
to TF
Expected
Profit for
TF(suplr)
Expected
Supply
Chain Profit
$100 $0 1,000 $76,063 120 $90,000 $166,063
$100 $30 1,067 $80,154 156 $91,338 $171,492
$100 $60 1,170 $85,724 223 $91,886 $177,610
$100 $95 1,501 $96,875 506 $86,935
$183,810
$110 $78 1,191 $78,074 239 $100,480 $178,555
$110 $105 1,486 $86,938 493 $96,872
$183,810
$120 $96 1,221 $70,508 261 $109,225 $179,733
$120 $116 1,501 $77,500 506 $106,310
$183,810

What happens to the supplier profit with the buyback contract?
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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


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Usual Manufacturer Retailer Supply Chain
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Manufacturer Manufacturer DC
Retail DC
Stores
Variable Production Cost=c=$40
Selling Price=p=$100
Wholesale Price=w=$70
Selling Price=p=$100
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Revenue Sharing (RS) Contracts
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Production Cost=$40
Wholesale Price=w
rs
=$50
If the manufacturer reduces wholesale price to w
rs
,
the retailer can share a percentage of the revenue p.
1-: Revenue sharing portion 50%
Selling Price=$100
Manufacturer
Retailer
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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 w
rs
.
Studio charges w
rs
=$8 per copy.
In general, the retailer shares (1-) portion of the sales revenue with the supplier.
Blockbuster pays (1-)=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)
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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 w
rs
for each unit purchased from the supplier
pays (1-)p more for each unit sold to the market
The contracts are the same if
w
rs
=w-b for each unit purchased from the supplier
(1-)p=b more for each unit sold to the market
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Quantity Flexibility Contracts
If a retailer orders q units,
the manufacturer commits to supplying up to
(1+o)q the retailer commits to buying (1-|)q
Unfortunately the book denotes (1+o)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
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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+ o), o >=0.
Retailer guarantees to buy q(1- | ), 0<=| <=1.
Supplier produces Q>=q(1+).

3. The demand is realized as D=d and the
retailer buys
Min { Max{q(1- |),d} , q(1+) }
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q(1+) q(1- |)
Min{Max{q(1-|),d},q(1+)}
D
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Quantity Flexibility Contract
Without coordination the supplier produces less than with
coordination.
The contract is advantageous to the retailer only if Q<q(1+ o).
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.
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Quantity Flexibility Contracts
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o | Wholesale
price w
Order
size O
Expected
purchase
by SA
Expected
sale by
SA
Expected
profits
for SA
Expected
profits for
TF(supp)
Expected
supply
chain profit
0.00 0.00 $100 1,000 1,000 880 $76,063 $90,000 $166,063
0.20 0.20 $100 1,050 1,024 968 $91,167 $89,830 $180,997
0.40 0.40 $100 1,070 1,011 994 $97,689 $86,122 $183,811
0.00 0.00 $110 962 962 860 $66,252 $96,200 $162,452
0.15 0.15 $110 1,014 1,009 945 $78,153 $99,282 $177,435
0.42 0.42 $110 1,048 1,007 993 $87,932 $95,879 $183,811
0.00 0.00 $120 924 924 838 $56,819 $101,640 $158,459
0.20 0.20 $120 1,000 1,000 955 $70,933 $108,000 $178,933
0.50 0.50 $120 1,040 1,003 996 $78,874 $104,803 $183,811

Larger values of o and | give more flexibility to the retailer.
Supplier prices for this flexibility via the wholesale price w.
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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
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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?
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