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Supply Contracts - Contracts for nonstrategic components

15 important questions on Supply Contracts - Contracts for nonstrategic components

What strategy is needed for commodity products?

An effective procurement strategy for commodity products has to focus on both driving costs down and reducing risks.

Which risks are included in effective procurement for nonstrategic components?

  • Inventory risk due to uncertain demand
  • Price, or financial, risk due to volatile market price
  • Shortage risk due to limited component availability

Why is it critical to identify effective procurement strategies for commodity products?

Since companies may be completely dependent on them. At the same time, uncertainty in supply and customer demand raises the question of whether to purchase supply now or wait for better market conditions in the future.
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What are long-term contracts?

This is also called forward or fixed contracts, long-term contracts eliminate financial risk. These contracts specify a fixed amount of supply to be delivered at some point in the future; the supplier and the buyer agree on both the price and the quantity to be delivered to the buyer. Thus in this case, the buyer bears no financial risk while taking huge inventory risks due to uncertainty in demand and the inability to adjust order quantities.

What are flexible, or option contracts?

In option contracts prepays the buyer a relatively small fraction of the product price upfront, in return for a commitment from the supplier to reserve capacity up to a certain level. The initial payment is also called the reservation price or premium. The buyer can purchase any amount of supply up to the option level by paying an additional price, agreed to at the time the contract is signed, for each unit purchased. The additional price is also called the execution price or exercise price.

How does the risk shift from long-term contracts to option contracts?

The option contracts provide the buyer with flexibility to adjust order quantities depending on realized demand which increases inventory risk. The risk shifts, thus, from the buyer to the suppliers as the supplier is now exposed to demand uncertainty from the customer.

What are flexibility contracts?

In these contracts, a fixed amount of supply is determined when the contract is signed, but the amount to be delivered (and paid for) can differ by no more than a given percentage determined upon signing the contract.

What are spot purchases?

Buyers look for additional supply in the open market. Firms may use an independent e-market to select suppliers. The focus is on using the marketplace to find new suppliers and forcing competition to reduce product price.

What are portfolio contracts?

In these contracts, buyers sign multiple contracts at the same time in order to optimize their expected profit and reduce their risk. The contracts differ in price and level of flexibility, thus allowing the buyer to hedge against inventory, shortage and spot price risk.

When are portfolio contracts meaningful?

They are particularly meaningful for commodity products since a large pool of suppliers is available, each offering a different type of contract. Thus, the buyer may be interested in selecting several different complementary contracts so as to reduce expected procurement and inventory holding costs.

How can an effective contract be found?

The buyer needs to identify the appropriate mix of low-price yet low-flexibility (long-term) contracts, reasonable price but better flexibility (option) contracts, or unknown price and quantity supply but no commitment (spot market). The buyer must optimize between the different contracts.

What is base commitment level?

How much to commit from the long-term contract?

What is the option level?

How much capacity to buy from companies selling option contracts?

When will the spot market be used?

When demand is high, the buyer will look for additional supply in the spot market. Thus, how much should be uncommitted?

How does the portfolio approach address risk?

The buyer can select a trade-off level between price risk, shortage risk, and inventory risk by carefully selecting the level of long-term commitment and option level.

The question on the page originate from the summary of the following study material:

Designing and Managing the Supply Chain | 9780071270977 | David Simchi Levi

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