SUPPLY CHAIN

MANAGEMENT
 SCM IN HC
▪ Healthcare supply chain management is the regulation of the flow of
medical goods and services from manufacturer to patient. SCM
encompasses the planning and management of all activities involved
in sourcing and procurement, conversion and all logistics
management activities. Hence, it greatly help material managers to
manage with continuous improvement efforts, while maintaining
quality of care.
▪ Healthcare supply chain management involves obtaining resources,
managing supplies, and delivering goods and services to providers
and patients. In healthcare, managing the supply chain is typically a
very complex and fragmented process.

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CONTINUED…

3
SUPPLY CHAIN MANAGEMENT
PROCESS

4
IMPORTANCE OF SUPPLY CHAIN
MANAGEMENT
▪ It is well known that supply chain management is an integral part of most businesses and is
essential to company success and customer satisfaction.
▪ 1. Boost Customer Service
▪ Customers expect the correct product assortment and quantity to be delivered on time.
▪ 2. Reduce Operating Costs
▪ Decreases Purchasing Cost – Retailers depend on supply chains to quickly deliver expensive
products to avoid holding costly inventories in stores any longer than necessary.
▪ Decreases Production Cost – Patient treatments depend on supply chains to reliably deliver
medicine or surgical items to hospitals to avoid shortages that would shut down treatment or
recovery.
▪ Decreases Total Supply Chain Cost – Retailers depend on supply chain managers to design
networks that meet patient service goals at the least total cost. Efficient supply chains enable a
firm to be more competitive in the market place.

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CONTINUED..
▪ 3. Improve Financial Position
▪ Increases Profit Leverage– Hospital value supply chain managers because they help control
and reduce supply chain costs. This can result in dramatic increases in hospital profits.
▪ Decreases Fixed Assets– Hospital value supply chain managers because they decrease the use
of large fixed assets.
▪ Increases Cash Flow– Hospital value supply chain managers because they speed up product
flows to patients.

6
FIVE HEALTH CARE SUPPLY
CHAIN MANAGEMENT TRENDS
▪ 1. Web-based tech will push health care supply chain management market past $2.2
billion by 2021
▪ The value of the health care supply chain management market will reach $2.22
billion in four years. Driving market expansion are a number of factors,
including compliance with the Food and Drug Administration’s Unique
Identification Initiative, increasing pressure on hospitals and health systems to
improve operational efficiency and profitability and rising adoption of cloud-
based supply chain management solutions. Web-based models help to reduce
operational and administrative expense, citing that technology as a particular
area of growth for health care organizations.

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CONTINUED…
▪ 2. Use of data and analytics to drive supply chain management performance will increase
▪ The need to reliably forecast supply chain outcomes will drive the increased use of advanced
analytics to improve supply chain management performance.
▪ 3. Push for population health management will reshape health care supply chain
management
▪ Population health management – the art and science of keeping healthy people healthy and
people with chronic medical conditions as healthy as possible – will remake health care supply
chain management.
▪ 4. Risk-based contracting between providers and suppliers will redefine supply chain
relationships
▪ As health care providers assume more clinical and financial risk under value-based
reimbursement contracts with payers, they want to share that risk with their suppliers.

8
CONTINUED..
▪ 5. Health care supply chain leaders will need to upgrade and expand their skill set in the
future
▪ The “ideal” supply chain leader will excel in four competencies: communication, negotiation,
analytics and presentation. They will have experience in health care, supply chain, managing
people, project management and technology. They will have an advanced degree, be certified
in Lean/Six Sigma and have leadership training. Their five desired personal traits are the
ability to see the big picture, be an active listener, be personally effective, be flexible and be
ethical.

9
MARKET DRIVERS FOR SUPPLY
CHAIN MANAGEMENT FOR
HOSPITAL
▪ There has been a seismic shift in the hospital environment such as
▪ increasing competition,
▪ high operational expenditure,
▪ growing fragmentation of the healthcare industry,
▪ shortening product lifecycles,
▪ crumbling of trade barriers, are the market drivers for healthcare
supply chain management.

10
CHALLENGES FOR SUPPLY
CHAIN MANAGEMENT FOR
HOSPITAL
▪ 1. Hidden Costs
▪ Challenge that healthcare providers face is the hidden costs of every
product. Most providers have historically just looked at the product
cost and the shipping cost. But there are additional expenses, such
as inventory holding. Providers need to plan their budget around
total landed supply costs. They need to be aware of the losses they
will incur from the unavoidable aspect of expired products and
excess supplies.

11
2. DRUG SHORTAGES

▪ This can create a mess in the healthcare supply chain. It

forces providers to either purchase alternatives that are
much more expensive or maintain a comprehensive backup
inventory of products that are at risk of being in short
supply, which then leads to the added cost of inventory
management and product expiration.

12
3. DATA SHORTAGE

▪ A lack of actionable data is something that is

endemic among providers. Executives in hospitals
recognize that their decisions are not sufficiently
informed because they do not have access to
advanced modelling systems and real-time reports.

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4. LACK OF INTEGRATION
▪ These supply chains need to be integrated. Purchasing
channels need to be centralized. Facilities need to share
contracts so that they can gain access to higher tier pricing.
Without these adjustments, the supply chain will not be
cost-effective and the processes that it contains will remain
inefficient.

14
5. POOR WORKFLOW
DESIGN
▪ Throughout the healthcare supply chain, many processes
are unnecessarily duplicated. The reason for this is that the
systems and entities that make up the supply chain are
disconnected. Many of the tasks could be automated and
integrated in a way that would allow all participants to
share information more freely.

15
 Introduction
● Outsourcing components have increased
progressively over the years
● Some industries have been outsourcing
for an extended time
● Fashion Industry (Nike) (all manufacturing
outsourced)
● Electronics Industry
● Cisco (major suppliers across the world)
● Apple (over 70% of components outsourced)

1-16
 Outsourcing Benefits and Risks
Benefits
● Economies of scale
● Aggregation of multiple orders reduces costs, both in
purchasing and in manufacturing
● Risk pooling
● Demand uncertainty transferred to the suppliers
● Suppliers reduce uncertainty through the risk-pooling
effect
● Reduce capital investment
● Capital investment transferred to suppliers.
● Suppliers’ higher investment shared between
customers.

1-17
 Outsourcing Benefits
● Focus on core competency
● Buyer can focus on its core strength
● Allows buyer to differentiate from its competitors
● Increased flexibility
● The ability to better react to changes in customer
demand
● The ability to use the supplier’s technical knowledge
to accelerate product development cycle time
● The ability to gain access to new technologies and
innovation.
● Critical in certain industries:
● High tech where technologies change very frequently
● Fashion where products have a short life cycle

1-18
 Outsourcing Risks
Loss of Competitive Knowledge
● Outsourcing critical components to suppliers
may open up opportunities for competitors
● Outsourcing implies that companies lose their
ability to introduce new designs based on their
own agenda rather than the supplier’s agenda
● Outsourcing the manufacturing of various
components to different suppliers may prevent
the development of new insights, innovations,
and solutions that typically require cross-
functional teamwork

1-19
 Outsourcing Risks
Conflicting Objectives
● Demand Issues
● In a good economy
● Demand is high
● Conflict can be addressed by buyers who are willing to
make long-term commitments to purchase minimum
quantities specified by a contract
● In a slow economy
● Significant decline in demand
● Long-term commitments entail huge financial risks for
the buyers
● Product design issues
● Buyers insist on flexibility
● would like to solve design problems as fast as possible
● Suppliers focus on cost reduction
● implies slow responsiveness to design changes.

1-20
 Two Main Reasons for
Outsourcing
● Dependency on capacity
● Firm has the knowledge and the skills
required to produce the component
● For various reasons decides to outsource
● Dependency on knowledge
● Firm does not have the people, skills, and
knowledge required to produce the
component
● Outsources in order to have access to these
capabilities.

1-21
 Outsourcing Decisions at Toyota
● About 30% of components in-sourced
● Engines:
● Company has knowledge and capacity
● 100% of engines are produced internally
● Transmissions
● Company has the knowledge
● Designs all the components
● Depends on its suppliers’ capacities
● 70 % of the components outsourced
● Vehicle electronic systems
● Designed and produced by Toyota’s suppliers.
● Company has dependency on both capacity and
knowledge

1-22
 Outsourcing Decisions at Toyota
● Toyota seems to vary its outsourcing
practice depending on the strategic role of
the components and subsystems
● The more strategically important the
component, the smaller the dependency on
knowledge or capacity.

1-23
 Product Architectures
● Modular product
● Made by combining different components
● Components are independent of each other
● Components are interchangeable
● Standard interfaces are used
● Customer preference determines the product
configuration.
● Integral product
● Made up from components whose functionalities are
tightly related. =
● Not made from off-the-shelf components.
● Designed as a system by taking a top-down design
approach.
● Evaluated on system performance, not on component
performance
● Components perform multiple functions.
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A Framework for Make/Buy Decisions
Product Dependency on Independent for Independent for
knowledge and knowledge, knowledge and
capacity dependent for capacity
capacity
Modular Outsourcing is risky Outsourcing is an Opportunity to reduce
opportunity cost through
outsourcing

Integral Outsourcing is very Outsourcing is an Keep production

risky option internal

1-25
 Hierarchical Model to Decide
Whether to Outsource or Not
● Customer Importance
● How important is the component to the customer?
● What is the impact of the component on customer experience?
● Does the component affect customer choice?
● Component Clockspeed
● How fast does the component’s technology change relative to
other components in the system?
● Competitive Position
● Does the firm have a competitive advantage producing this
component?
● Capable Suppliers
● How many capable suppliers exist?
● Architecture
● How modular or integral is this element to the overall
architecture of the system?
1-26
 Examples of Decisions
Criteria Example 1 Example 2 Example 3 Example 4

Customer Important Not important Important Important

Importance
Clockspeed High Slow High Slow

Competitive Competitive No advantage No advantage No advantage

Position Advantage
Capable X X Key variable to
Suppliers decide
strategy
Architecture X X Key variable to
decide
strategy
DECISION Inhouse Outsource Inhouse, Outsource with
Acquire modular;
supplier, Inhouse or
Partnership joint
development
with integral.

1-27
 Appropriate Strategy
● Depends on:
● type of products the firm is purchasing
● level of risk
● uncertainty involved
● Issues:
● How can the firm develop an effective purchasing
strategy?
● What are the capabilities needed for a successful
procurement function?
● What are the drivers of effective procurement
strategies?
● How can the firm ensure continuous supply of
material without increasing its risks?

1-28
 Kraljic’s Supply Matrix
● Firm’s supply strategy should depend on
two dimensions
● profit impact
● Volume purchased/ percentage of total purchased
cost/ impact on product quality or business growth

● supply risk
● Availability/number of suppliers/competitive
demand/ make-or-buy opportunities/ storage risks/
substitution opportunities

1-29
 Kraljic’s Supply Matrix

FIGURE 9-4: Kraljic’s supply matrix

1-30
 Kraljic’s Supply Matrix
● Top right quadrant:
● Strategic items where supply risk and impact on profit
are high
● Highest impact on customer experience
● Price is a large portion of the system cost
● Typically have a single supplier
● Focus on long-term partnerships with suppliers
● Bottom right quadrant
● Items with high impact on profit
● Low supply risk (leverage items)
● Many suppliers
● Small percentage of cost savings will have a large
impact on bottom line
● Focus on cost reduction by competition between
suppliers

1-31
 Kraljic’s Supply Matrix
● Top left quadrant:
● High supply risk but low profit impact items.
● Bottleneck components
● Do not contribute a large portion of the product cost
● Suppliers have power position
● Ensure continuous supply, even possibly at a
premium cost
● Focus on long-term contracts or by carrying stock
(or both)
● Bottom left quadrant:
● Non-critical items
● Simplify and automate the procurement process as
much as possible
● Use a decentralized procurement policy with no
formal requisition and approval process

1-32
Fisher’s Functional vs. Innovative Products
Functional Products Innovative Products

Product clockspeed Slow Fast

Demand Characteristics Predictable Unpredictable

Profit Margin Low High

Product Variety Low High

Average forecast error at the Low High

time production is committed

Average stockout rate Low High

1-33
 Supply Chain Strategy
● Functional Products
● Diapers, soup, milk, tiers
● Appropriate supply chain strategy for functional
products is push
● Focus: efficiency, cost reduction, and supply chain
planning.
● Innovative products
● Fashion items, cosmetics, or high tech products
● Appropriate supply chain strategy is pull
● Focus: high profit margins, fast clockspeed, and
unpredictable demand, responsiveness, maximizing
service level, order fulfillment

1-34
 Procurement Strategy for the Two
Types
● Functional Products
● Focus should be on minimizing total landed cost
● unit cost
● transportation cost
● inventory holding cost
● handling cost
● duties and taxation
● cost of financing
● Sourcing from low-cost countries, e.g., mainland
China and Taiwan is appropriate
● Innovative Products
● Focus should be on reducing lead times and on
supply flexibility.
● Sourcing close to the market area
● Short lead time may be achieved using air shipments
1-35
 Sourcing Strategy for Components
● Fisher’s framework focuses on finished goods and
demand side
● Kraljic’s framework focuses on supply side
● Combine Fisher’s and Kraljic’s frameworks to derive
sourcing strategy

1-36
SUPPLY CHAIN INTEGRATION
STRATEGIES

37
 PUSH & PULL SUPPLY CHAINSPull Supply Chains
Production and distribution demand driven Firm does not
Push Supply Chains hold any inventory and only responds to specific orders.
Production and distribution decisions based on long-term forecasts. Reduced lead times through the ability to better
Manufacturer demand forecasts based on orders received from the anticipate incoming orders from the retailers.
retailer’s warehouses.
Longer reaction time to changing marketplace: Reduced inventory since inventory levels increase
Excessive inventories due to the need for large safety with lead times
stocks Less variability in the system
Larger and more variable production batches Decreased inventory at the manufacturer due to the
Unacceptable service levels reduction in variability.
Product obsolescence
Often difficult to implement
Not clear how a manufacturer should determine production when lead times are long impractical to react to
capacity? Transportation capacity?
Peak demand? demand information.
Average demand? more difficult to take advantage of economies of scale
Results:
Higher transportation costs
Higher inventory levels and/or higher manufacturing costs
more emergency production changeovers

38
PUSH-PULL SUPPLY CHAIN
Some stages (typically, the initial ones) of the supply chain
operated in a push-based manner Make a part of the product to stock – generic
Remaining stages employ a pull-based strategy. product
Interface between the push-based stages and the pull-based The point where differentiation has to be
stages is the push–pull boundary. introduced is the push-pull boundary
Based on extent of customization, the position
of the boundary on the timeline is decided

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 SC STRATEGY - DEMAND UNCERTAINTY &
ECONOMIES OF SCALE
Demand Uncertainty:

Higher demand uncertainty leads to a preference for pull

strategy.
Lower demand uncertainty leads to an interest in managing the
supply chain based on a long-term forecast: push strategy.

Economies of scale:

The higher the importance of economies of scale in reducing

cost
The greater the value of aggregating demand Achieving the appropriate design depends on:
The greater the importance of managing the supply chain product complexity
based on long-term forecast, a push-based strategy.
Economies of scale are not important manufacturing lead times
Aggregation does not reduce cost supplier–manufacturer relationships.
A pull-based strategy makes more sense. Many ways to implement a push–pull strategy
location of the push–pull boundary is key!

40
 IMPACT OF PUSH-PULL STRATEGY
Push portion Portion Push Pull
Low uncertainty Maximize service
Service level not an issue Objective Minimize cost
level
Long lead times
Focus on cost minimization.
better utilizing resources such as production and Complexity High Low
distribution capacities
minimizing inventory, transportation, and production Resource
Focus allocation
Responsiveness
costs.
Supply Chain Planning processes are applied Lead time Long Short

Supply chain
Pull portion Processes planning
Order fulfillment

High uncertainty
Simple supply chain structure
Short cycle time
Focus on service level.
Flexible and responsive supply chain
Order-fulfillment processes are applied
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PUSH – PULL INTERACTION

Only at the push-pull boundary

Typically through buffer inventory
Different role for the inventory in each portion
In the push portion, buffer inventory is part of the output
generated by the tactical planning process
In the pull system, it represents the input to the fulfillment
process.
Interface is forecast demand
Forecast based on historical data obtained from the pull
portion
Used to drive the supply chain planning process and determine
the buffer inventory.

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 IMPACT OF LEAD TIME
Box A
Items with short lead time and high demand uncertainty
Pull strategy should be applied as much as possible.
Box B
Items with long supply lead time and low uncertainty.
Appropriate supply chain strategy is push.
Box C
Items with short supply lead time and highly predictable demand.
Continuous replenishment strategy Longer the lead time, more important it is
Suppliers receive POS data used to prepare shipments to implement a push based strategy.
pull strategy at the production and distribution stages and push Typically difficult to implement a pull
at the retail outlets. strategy when lead times are so long that it
Box D is hard to react to demand information.

Items with long lead times and unpredictable demand Inventory is

critical in this type of environment
Requires positioning inventory strategically in the supply chain

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SUPPLY CONTRACTS

44
SUPPLY CONTRACTS
More outsourcing has meant Supply Contract can include the following:
▪ Search for lower cost manufacturers ✔Pricing and volume discounts
▪ Development of design and manufacturing ✔Minimum and maximum purchase
expertise by suppliers quantities.
OEMs have to get into contracts with suppliers ✔Delivery lead times.
▪ For both strategic and non-strategic ✔Product or material quality.
components ✔Product return policies

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
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 WHOLESALE PRICE
CONTRACT
▪ 2 Stages:
o a retailer who faces customer demand
o a manufacturer who produces and sells swimsuits to the
retailer.
▪ Retailer Information:
o Summer season sale price of a swimsuit is $125 per
unit.
o Wholesale price paid by retailer to manufacturer is $80
per unit.
o Salvage value after the summer season is $20 per unit
▪ Manufacturer information:
o Fixed production cost is $100,000
o Variable production cost is $35 per unit

46
 WHOLESALE PRICE CONTRACT – OPTIMAL POLICY
▪ 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

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SUPPLY CONTRACTS (MTO) & 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.
▪ 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

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BUYBACK 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

Assume the manufacturer offers to buy unsold swimsuits from the

retailer for $55.
What is the optimal quantity now?

49
BUYBACK CONTRACT
▪ Retailer has an incentive to increase its order quantity to 14,000 units, for a profit of $513,800,
while the manufacturer’s average profit increases to $471,900.
▪ Total average profit for the two parties
= $985,700 (= $513,800 + $471,900)
▪ Compare to sequential supply chain when total profit
= $910,700 (= $470,700 + $440,000)

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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.

What is the optimal quantity now?

51
REVENUE SHARING CONTRACT
▪ 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).

52
OTHER 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.

What is the maximum benefit that can be achieved through supply contracts?

53
GLOBAL OPTIMIZATION
Relevant data
Selling price, $125; Salvage value, $20 ;Variable production costs, $35
Fixed production cost.
Marginal profit, 90 = 125 – 35; Marginal loss, 15 = 35 – 20
Optimal production quantity = 16,000 units
Expected supply chain profit = $1,014,500.

54
IMPLEMENTATION ISSUES
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.

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.

55
SUPPLY CONTRACTS FOR MTS SUPPLY CHAINS
▪ Manufacturer produces ski-jackets prior to receiving distributor orders
The distributor sells ski-jackets to retailers for $125 per unit.
The distributor pays the manufacturer $80 per unit.
For the manufacturer, we have the following information:
• Fixed production cost = $100,000.
• The variable production cost per unit = $55
• Salvage value for any ski-jacket not purchased by the distributors= $20.

Manufacturer optimal policy = 12,000 units

Average profit = $160,400
Distributor average profit = $510,300
Manufacturer assumes all the risk limiting its production quantity
Distributor takes no risk

56
PAYBACK CONTRACT
▪ Buyer(Distributor) agrees to pay some agreed-upon price for any unit produced by the manufacturer but
not purchased.
▪ Manufacture has an incentive to make more
▪ Buyer’s risk clearly increases.
✔Increase in manufacturer’s production quantity
✔Should compensate the distributor for increased risk

Assume the distributor offers to pay $18 to the manufacturer for ski
jackets not purchased.
What is the optimal production quantity now?

57
PAYBACK CONTRACT
▪ Manufacturer has an incentive to increase its production quantity to 14,000 units, for a profit
of $180,280; while the distributor’s average profit increases to $525,420.
▪ Total average profit for the two parties
= $705,400 (= $180,280 + $525,420)
▪ Compare to sequential supply chain when total profit
= $670,000 (= $160,400 + $510,300)

58
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

Manufacturer agrees to decrease the wholesale price from $80 to $62. In

return, distributor pays 33% of the manufacturer production cost

What is the optimal quantity now?

59
COST SHARING CONTRACT
Manufacturer increases production quantity to 14,000
Manufacturer profit = $182,380; Distributor profit = $523,320
The supply chain total profit = $705,700

60
IMPLEMENTATION ISSUES

Cost sharing contracts

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.

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GLOBAL OPTIMIZATION
Relevant data
Selling price, $125; Salvage value, $20 ;Variable production costs, $55
Fixed production cost.
Marginal profit, 70 = 125 – 55; Marginal loss, 35 = 55 – 20
Optimal production quantity = 14,000 units
Expected supply chain profit = $705,700

62
CONTRACTS – ASYMMETRIC INFORMATION
Implicit assumption so far: Buyer and supplier share the same
forecast
Inflated forecasts from buyers a reality
How to design contracts such that the information shared is
credible?

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

63
 CONTRACTS – NON STRATEGIC Long Term Contracts

COMPONENTS Also called forward or fixed commitment contracts

Specify a fixed amount of supply to be delivered at
Variety of suppliers; Market conditions dictate price some point in the future
Buyers need to be able to choose suppliers and change them as Supplier and buyer agree on both price and quantity
needed; Long-term contracts have been the tradition Buyer bears no financial risk but takes huge
Recent trend towards more flexible contracts inventory risks due to uncertainty in demand &
Offers buyers option of buying later at a different price inability to adjust order
Offers effective hedging strategies against shortages

Options Contracts
Spot Purchase
Buyer pre-pays a small fraction of the product price up-front Buyers look for additional supply in the open market
Supplier commits to reserve capacity up to a certain level. Using the marketplace to find new suppliers
Initial payment is the reservation price or premium. Forcing competition to reduce product price.
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) Quantity Flexibility Contracts
agreed to at the time the contract is signed Fixed quantity of supply is determined when the
Total price (reservation plus execution price) typically higher than contract is signed
the unit price in a long-term contract. Amount to be delivered (and paid for) can differ
by no more than a given percentage

64
 How much to commit to a long-term contract?
PORTFOLIO CONTRACTS & RISK TRADE-OFFS Base commitment level.
How much capacity to buy from companies selling
option contracts?
Option level.
Buyer signs multiple contracts at the same time How much supply should be left uncommitted?
optimize expected profit Additional supplies in spot market if demand is
reduce risk. high
Contracts differ in price and level of flexibility, hedge against Hewlett-Packard’s (HP) strategy for electricity or
inventory, shortage and spot price risk. memory products
About 50% procurement cost invested in long-
Meaningful for commodity products term contracts
a large pool of suppliers 35% in option contracts
each with a different type of contract. Remaining is invested in the spot market.
Buyer can select a trade-off level between price risk, shortage risk, Low High
and inventory risk
Base commitment level
✔ For the same option level, the higher the initial contract
commitment, the smaller the price risk but the higher the Option level High
Inventory risk
N/A*
(supplier)
inventory risk taken by the buyer.
✔ The smaller the level of the base commitment, the higher Price and
Inventory risk
Low shortage risks
the price and shortage risks due to the likelihood of using (buyer)
(buyer)
the spot market. *For a given situation, either the option level or the base
✔ For the same level of base commitment, the higher the commitment level may be high, but not both.
option level, the higher the risk assumed by the supplier
since the buyer may exercise only a small fraction of the
option level. 65
 SHORT TERM DISCOUNTS (TRADE PROMOTIONS) –
FORWARD BUY
Trade promotions are price discounts for a limited period of Forward Buy
time Three assumptions
1. Induce retailers to use price discounts, displays, or 1. The discount is offered once, with no future
advertising to spur sales discounts
2. Shift inventory from the manufacturer to the retailer and 2. The retailer takes no action to influence
the customer customer demand
3. Defend a brand against competition 3. Analyze a period over which the demand is
an integer multiple of Q*
Optimal order quantity

Retailers are often aware of the timing of the next promotion

Q* = 6,325 bottles, C = $3 per bottle

d = $0.15, D = 120,000, h = 0.2
What is the changed optimal order quantity?
66
IMPACT ON LOT SIZE
Cycle inventory at DO = Q*/2 = 6,324/2 = 3,162.50 bottles
Trade promotions lead to a significant
Average flow time= Q*/2D = 6,324/(2D) = 0.3162 months increase in lot size and cycle inventory
because of forward buying by the
retailer.
This generally results in reduced supply
chain profits unless the trade promotion
reduces demand fluctuations.

With trade promotion:

Counter measures
Cycle inventory at DO = Qd/2 = 38,236/2 = 19,118 ✔ EDLP (every day low pricing)
bottles ✔ Discount applies to items sold to
Average flow time = Qd/2D = 38,236/(20,000) customers (sell-through) not the
= 1.9118 months quantity purchased by the retailer
(sell-in)
Forward buy = Qd – Q* = 38,236 – 6,325 = 31,911 bottles ✔ Scan based promotions

67
INFORMATION IN THE
SUPPLY CHAIN

68
 VARIABILITY IN THE SUPPLY CHAIN

The ordering patterns share

a common recurring theme;
the variabilities of the
upstream site are always
greater than those of the
downstream site

69
CAUSES OF THE BULLWHIP EFFECT (BWE)
▪ Demand forecast updating

▪ Order batching

▪ Price fluctuation

▪ Rationing and shortage gaming

70
DEMAND FORECAST UPDATING

▪ Forecasting often based on the order history

from the company’s immediate customers
▪ Role of forecasting method – For e.g.
exponential smoothing
▪ Impact across multiple supply chain stages

▪ Because the safety stock contributes to the

BWE, when the lead times between resupply
are longer, the fluctuations are even more
significant

71
ORDER BATCHING
▪ Demand depletes (continuously), but orders are places immediately. Often, order are batched – Periodic
ordering & Push ordering
▪ Periodic ordering – Often the order processing costs are substantial
▪ E.g., in the case of slow moving items
▪ The suppliers a faces a highly erratic stream of orders
▪ Economics of transportation also plays a role – leads to long order cycles!

▪ Push ordering – Need to fill sales quotas, leading to hockey stick effect
▪ Periodic execution of MRP results in order overlap

72
PRICE FLUCTUATIONS
▪ When ‘high-low’ pricing occurs, forward
buying may be a rational decision
▪ When facing wide swings – Run facility
overtime or build up inventory, premium
freight charges; handling damages increase!
▪ Trade promotions have been called “the
dumbest marketing ploy ever”

73
RATIONING & SHORTAGE GAMING
▪ When product demand exceeds supply, a manufacturer often rations its product to customers

▪ Various allocation schemes are available – e.g., in proportion to the amount ordered

▪ In such instances, customers often exaggerate their needs

▪ Later when demand cools, orders disappear and cancellations start taking place

▪ Often orders are placed with multiple suppliers

▪ Ultimately, customers orders provide very little information on the products’ real demand

74
COUNTERACTING
THE BWE

75
 WHOSE, WHERE & HOW OF INVENTORY
Whose Where
No. How (Control) Descriptor Example
(Ownership) (Location)

1 Buyer Buyer Buyer Traditional -

2 Supplier Buyer Buyer Consignment Pepsi, VW

3 Buyer Buyer Supplier VMI Saturn

4 Supplier Supplier Buyer Supplier Hubs Amazon

5 Supplier Buyer Supplier VMI with C Nokia

6 Buyer Supplier Buyer Pre-Positioning Seagate

7 Buyer Supplier Supplier Forward Buy Cisco

8 Supplier Third Party Supplier (5) + 3P Hub Apple

9 Third Party Supplier Supplier (4) + Financing Circuit City

76
Source: Lee and Whang (2008)
VENDOR MANAGED INVENTORY (VMI)

▪ “VMI is a collaborative strategy between a customer and supplier to optimize the availability of

products at minimal cost to the two companies. The supplier takes responsibility for the operational

management of the inventory within a mutually agreed framework of performance targets which are

constantly monitored and updated to create an environment of continuous improvement.”

(Hines et al., 2000)

77
VMI
AGREEMENT

Source: Zammori et al. (2009)

78
VMI
FRAMEWORK

Source: Elvander et al. (2007) 79