Production, Manufacturing and Logistics
Contract design for risk sharing partnerships in manufacturing

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Abstract

The development of extensive partnerships with suppliers has become a characteristic of manufacturing, particularly in the aircraft and automobile industries. This paper considers the development of appropriate contracts that enable market risks to be shared between the lead manufacturer and the partners. It is shown that it is usually appropriate to have threshold contracts, i.e., contracts where a partner only shares in profits if sales exceed a value determined by risk tolerance and target return. The value of having financial partners as well as manufacturing partners is demonstrated, although it is also shown that financial partner contributions to the project should be limited. We also consider the situation where partners have pre-existing commitments to other projects, perhaps with competitors. The producers sales may be correlated with the partners profits on pre-existing commitments so the impact on contract structure is explored. It is shown that even if a partner had preexisting commitments whose profit is positively correlated with product sales then it is often beneficial to use such a partner.

Highlights

► We look at contracts between an aircraft manufacturer and its suppliers/partners. ► Contracts are used to share risks by appropriate payment structure. ► In optimal contracts a partner shares profits only when sales exceed a target (threshold contracts). ► Rather than a straight loan, financial partners using threshold contracts would be preferable. ► When profitability of preexisting contracts is correlated simple threshold contracts may not be optimal.

Introduction

Much manufacturing has now come to be based on the organizational structure of having a lead manufacturer (usually the manufacturer responsible for final assembly of the finished product) and a group of partners who produce components and sub assemblies. The lead manufacturer is responsible for overall product design and marketing, while the partners are responsible for the detailed design of the components and sub assemblies which they produce. This structure has become prevalent in a wide variety of industries making complex products such as aircraft, automobiles and computers. The aircraft industry in particular has evolved rapidly towards this structure in recent years. Airbus has sold off a number of its factories to partners, while Boeing in its Dreamliner production relies very heavily on partners (Bernstein, 2006). There are a variety of reasons for this evolution in structure. One is the sheer managerial complexity of one company running all the sub assembly and parts producers. Another reason is that it is easier to sell aircraft to an airline if manufacturers in the home country of the airline receive contracts to make parts or sub assemblies for the aircraft (offsetting agreements). But another reason, shown in GM’s spin off of its parts producer Delphi, and in the Airbus sell off, is that the spun off businesses are more readily able to take on subcontracts or partnerships with competitors of the lead manufacturer. In the aircraft business where the partners are often located in other countries, there may be better access to government support for businesses that create high tech jobs and skills. Being a partner for a major US or European high tech manufacturer is also a means of creating expertise that can be used as the basis for developing the ability to eventually become a competitor, indeed Boeing has been criticized for enabling Japanese partners to develop the competence to eventually produce aircraft on their own (McPherson and Pritchard, 2007). Embraer developed its ERJ-170/190 family of aircraft using risk sharing partnerships as an integral aspect of the project. Figueiredo et al. (2008) provide a detailed description of Embraer’s use of risk sharing partnerships.

Johnson and Houston (2000) proposed three reasons for firms to seek joint ventures or partnerships. The first is to avoid the possibility of “hold-up”, that is, either the buyer or seller make asset-specific investments and the other party then demands concessions on price, delivery or quality. The potential for hold-up is greatest when there is uncertainty over demand or technology and there are significant up front unique investment costs. The second reason is that partnerships enable financing of investments with less uncertainty. The buyer may have better information about final demand and its uncertainty than a third party capital provider, so can offer better terms if the supplier needs capital to develop design and manufacturing capability. The final reason is that partnerships enable risk sharing. On the other hand, the reasons why buyers do not merge with suppliers are bureaucracy, lack-of-focus and cross-subsidization. There are also incentive problems because the managers of the supplier unit in the merged organization may not necessarily earn higher rewards if they improve costs and delivery. The benefits go elsewhere in the organization.

McPherson and Pritchard (2007) clearly believe that Boeing’s reliance on Japanese manufacturers for the fuselage of the 787 has exposed it to excessive risk of hold-up. The Japanese manufacturers will have developed all the skills to make a composite fuselage, while Boeing will not have this skill in house or with another North American supplier. Boeing (Avery, 2006) justifies moving to “risk-sharing” by asserting that its partnerships with suppliers enable significant benefits in development through early exchange of ideas between partners. Also, it reduces the funds that Boeing has to find in order to develop the aircraft.

Partnerships have become so important in manufacturing because industry views them as a means of sharing risks. For a supplier who partners with multiple customers in the same industry, partnerships with customers give the supplier the ability to trade off the risks with one partner against the risks with another partner. This type of risk-sharing, risk-sharing through diversity, has been studied in many contexts, particularly in portfolio selection and insurance. However, it is also possible to share the risk of uncertain demand between a manufacturer and a supplier through another approach, risk-sharing by payment structure. That is, the contract between a supplier and the manufacturer which specifies the payment made for each aircraft sold has a structure that enables the risk of uncertain demand to be shared. At one extreme, if the contract specified that the supplier would receive a fixed sum, irrespective of the number of aircraft sold, then the manufacturer would be taking on all the risk while the supplier takes on none. At the other extreme, if the contract specified that the supplier would receive nothing until some large number of planes are sold, then the manufacturer would be transferring a great deal of demand risk to the supplier.

Typical contracts that we have seen in the aircraft industry have a two part structure. First of all, there is an up front payment made at the time of signing the contract or when the investment in manufacturing capability is made. This up-front payment can be in either direction. Sometimes it is from the partner to the manufacturer, other times it can be from the manufacturer to the partner. Sometimes the payment is not in cash, but in the form of “free” tooling or manufacturing equipment specific to the project (Lynch, 2005). The second part of the contract payments is a payment from the manufacturer to the partner made when each aircraft is sold. This component is not necessarily a constant. Sometimes it increases with the cumulative number of aircraft sold. It can be of a threshold structure, that is, initially low, then beyond a specified threshold increasing to a higher level.

The objective of this paper is to develop an understanding of this risk-sharing by payment structure. We seek to understand the structure of contract payments that effectively share the risk of uncertain demand between a manufacturer and a partner and how the contract payments are affected by various parameters.

In order to model the behavior of partners confronted with risk, we assume that each partner uses an expected utility criterion in order to evaluate the consequences of their decisions. Using expected utility as the decision criteria has the advantage of mathematical convenience in obtaining useful results that provide valuable insight. However, we recognize that expected utility is not an approach likely to meet with much application by real world companies and managers, so we focus on insights.

While there is a large literature on contracting within supply chains (see Cachon (2003) for a review), there are relatively few papers about contracting between risk averse supply chain members. Most of this literature focuses on sharing the risks associated with holding inventory between a manufacturer and retailers, for an early paper on this see Spulber (1985). Often the retailer faces a newsvendor type decision (see Agrawal and Sheshadri (2000), Tsay (2002)). Although these papers contain some more general results, most of their results assume that the manufacturer and retailer have mean variance type utility functions. Buzacott et al. (2011) illustrate the use of mean variance objectives in a supply chain which uses take or pay type contracts. Chen et al. (2005) used a Conditional Value at Risk objective function to determine optimal risk sharing contracts for a single retailer and multiple suppliers.

The most relevant paper to the analysis in this paper is Gan et al. (2004). They consider coordination of supply chains with risk-averse agents and in Section 5 of their paper they consider a supply chain consisting of two parties each with exponential utilities. They derive a number of results for Pareto-optimal sharing rules, showing that supply chain profit will be shared according to the degree of risk averseness of the parties together with a side payment independent of the realized profit.

While the structure of the supply chain in our paper can be regarded as similar to that with one retailer (the aircraft manufacturer) with multiple suppliers, no inventory is kept and all production is make to order. Fixed costs are large so partners may be encouraged to contribute to the project more initial capital than that necessary to pay for their own fixed costs. Partners want to get a sufficient return on their capital to justify participating in the project. So the details of the problem formulation differ substantially from the literature related to inventory risk sharing.

One of the key insights of our paper is that it is useful to introduce financial partners as well as manufacturing partners. The manufacturing partners supply components and sub assemblies for the aircraft. Financial partners supply up-front cash to the project and get paid an amount that depends on aircraft sales. Such financial partners can play a valuable role in sharing the risks of the project.

The paper is organized as follows. After developing formal mathematical description of the problem a basic model of Pareto-optimal decision making is developed. This enables us to show some basic features of contracts, in particular that threshold contracts are optimal. We then look at the contract design problem from the point of view of the manufacturer with partners requiring the satisfaction of a participation constraint. We further look at what happens when the manufacturer can determine the capital contribution of each partner. This enables us to look at the role of financial partners. In the next section we consider the case where partners have existing contracts with other manufacturers and the sales of the different manufacturers are correlated. Even with positive correlation it is still appropriate for partners to take on contracts with our lead manufacturer. Then in Section 5 we discuss the implications of our results and suggest how our analysis could be adapted for real world firms who use a mean variance risk criteria.

Section snippets

Basic model

Our basic model was motivated by the situation of a major aircraft manufacturer. The manufacturer does the final assembly of the aircraft, however, it only produces about 20% of the sub assemblies itself. The remaining 80% of the sub assemblies are produced by project partners, independent suppliers located either locally or in other countries. A major task of the aircraft manufacturer is to develop and negotiate contracts with the project partners who will be responsible for producing all the

Pareto-optimal approach

One approach is to compute the set of Pareto-optimal payments by introducing weights related to relative bargaining powers of the manufacturer and the partners (Raiffa, 1968) and then maximizing the weighted sum of the utilities of all participants. Define a(j) as the relative bargaining power of partner j, j = 0, 1,  , t, such that j=1ta(j)+a(0)=1. Then we formulate the Pareto-optimal problem as that of determining the X0j, j = 0,  , t, and the X1j(m),m=0,,x¯;j=0,,t, which minimizem=0x¯f(m)j=0ta(j)c

Preexisting commitments

Usually partners would have other commitments with uncertain profitability. The profitability of these commitments may be correlated with the sales of the new aircraft and so the partner would take this into account in deciding on their participation in the new aircraft project.

Suppose that partner j has existing commitments that will result in the realization at time 1 of a profit of Pj, a random variable with a known probability distribution g(P). In reality, the profit distribution

Practical application

While the utility approach enables mathematical analysis and the derivation of useful insights, it is not really a practical approach for use by industry. It is too difficult to arrive at a meaningful value of the risk tolerance coefficients. Also there may be other constraints on resource availability than may need to be taken into account.

When we looked at the problem that motivated this paper, designing contracts between an aircraft manufacturer and its partners, our basic formulation was as

Conclusions

This paper was motivated by our desire to develop an understanding of contracts that share risk by the structure of sales dependent payments to partners. What insights about contract design did we gain from the analysis described in this paper?

  • Risk sharing by payment structure is valuable in a situation such as aircraft manufacture where risk sharing by supplier diversity is inappropriate because it would add too much to overheads and reduce scale economies.

  • Contracts are normally threshold

Acknowledgments

The authors wish to acknowledge the very valuable contribution of a referee and the editor to the improvement of the paper.

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