Contracts and Spot Pricing
Konys Inc., as a mobile communication device manufacturer, is in the industry having very short product life cycles and faces uncertain demand which challenges its ability to manage procurement (pricing) to ensure the company’s profitability. The company has experienced unpredicted demand with its previous 19 versions of MC mobile phones and needs a better procurement strategy to better source its MC20 mobile device (better pricing). It has the choices of entering into a long-term contract which requires a commitment to fixed quantities for each quarter in exchange of a lower per-unit price or options contract which requires much less commitment upfront for the flexibility to meet actual demand but has a higher per-unit cost when exercising if combined with a reservation fee. The company can decide to go with either type of contract or a mixture of both. Moreover, it can source itself by supplementing from the spot market if demand goes too high to be satisfied with the planned contract quantity.
Utilizing historical data of quarterly demand for the past 19 versions and the data of past spot prices to generate distributions of quarterly demand and spot price, and further the analysis to forecast expected net profit. This analysis is based on three scenarios: Q3 forecast with a long-term purchase contract, Q3 forecast incorporating options contract, full life cycle (all four quarters) forecast incorporating options contract. After that, their is a further analysis of the result and the use of risk solver to find the optimal combinations of long-term contracts and options contract quantities for each module.
From the analysis, it can be determined that the options contract was beneficial to meet uncertain demand and increase the company’s profitability. Furthermore, the long-term contract was also useful based on a going concern assumption to smooth demand variation by using excess inventory from previous quarters and achieve lower cost. Thus, a trade-off between lower per-unit cost and flexibility of purchase quantity should be made, and a combination of both types of contracts would be the best course of action. Managers should analyze the unique situation to find the optimal mixture to maximize profitability.
Konys traditionally a contract manufacturer grew into an original equipment manufacturer that produced mobile communication devices. Konys, capitalizing on the holiday season, launches its MC mobile phones in the third quarter of the calendar year. The demand for MC mobile devices needs to be predicted in advance to produce the right quantity to avoid lost sales or excessive inventory. They face a general newsvendor problem as on the one hand the parts required in the MC series are expensive and challenging to produce leading to lost sales while on the other hand surplus inventory leads to cash flow problems. One such part is the liquid crystal display (LCD) module which would be the focus of our analysis.
Konys have been purchasing the LCD module for the last ten versions of its MC mobile phones from Paravan systems. The company generally purchases the module through a purchase contract that specifies quantity, per unit price and delivery date for each order. The suppliers in this market prefer long term contracts which ensures consistent sales for them. This also allows the company to negotiate a lower unit price. In the case of low demand, the company ends up salvaging the excess inventory while in case of high demand, they end up buying a module from the spot market, which is highly volatile.
With the intention of avoiding this situation, the company is now looking to enter into an options contract along with the purchase contract from the supplier. The options contract gave the flexibility to the company to buy the module at a future date or not, at the same time giving stability to the suppliers. The company is now considering the options contract for its MC20 mobile device. They want to analyze the options contact quantity and the purchase contract quantity to maximize their expected net profit given the uncertainty in demand and spot prices of the parts.
Pricing and Profit Analysis
To analyze the net profit, first we need to find the distribution of demand and spot prices using historical data. To find the distribution, I’ve used risk solver’s fit function to best forecast the demand. The table below gives the distribution of demand for MC mobile devices in various quarters and the distribution for spot prices of the LCD module.
Analyzing Net Profits
We first started by analyzing the net profit in Q3 2013, the first quarter of MC20 sales. We assumed a purchase contract of 2,150,000 units at $17 per LCD. We also assumed no options contract. Given the variation, in-demand, and spot prices, the expected profit for the quarter is negative as seen below.
Incorporating the option contract model
Now incorporating the option contract in the model. This gives the company the flexibility to purchase options early on and not purchase the material in case of low demand. It also shields the company from volatile spot rates to some extent with some fees in case of high demand. Given the flexibility, it would be safe to assume a positive expected net profit as confirmed below.
Konys should not enter into a purchase contract and instead enter into an options contract with a quantity of 3,500,000 to maximize its expected net profits.
Running the same analysis but extending it for the FY 2014. Also, fixing the purchase contract quantities (Q3: 2,170,000 Q4: 3,700,000 Q1: 2,100,000 Q2: 1,500,000).
A determination can be made for quantity of the options contract which would maximize the expected profit for FY 2014: 350,000.
Given the large quantity purchased in Q4 along with the inventory from Q3, not many sales would be lost during Q4. Also, the spot purchase would be limited in this quarter, thereby the given profit.
Based on this analysis above, it seems that in the short-run, Q3 in this case, profitability will be more related to the company’s ability to leverage options contract and meet the specific demand quantity in that period. So when it comes to the long-run, the company could have the choice to smooth demand variation among quarters by using excess inventory from previous quarters. Thus, it makes more sense, in the long-run, for the company to make a trade-off between the lower unit cost of inventory and flexibility of quantity to order. Moreover, according to the situation described in the case, it makes even more sense for the company to enter into a long-term contract, not only to achieve a better performance of procurement but also to repair its relationship with suppliers.
If we look beyond the case, the same trade-off always bothers managers. As the operation is based on ongoing concern, managers have to mind both short-run and long-run profitability when making decisions. The long-term contract may enable companies to negotiate for a better price, but it lacks the flexibility to meet specific demand quantity. Thus, companies facing stable demand might be seen using such types of contracts more often to lower their costs. Meanwhile, the options contract can fill the gap between long-term and short-term imbalance and enable companies to manage their procurement better. It requires comparably less commitment in exchange for the ability to better manage uncertainty. Moreover, this is also the reason why options contract receives more preference in industries having lots of uncertainties. Also, even if with more stable demand, managers can also choose to leverage options contracts to manage short-term demand fluctuations better.
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