Shared-savings contracts for indirect materials in supply chains: Channel profits and environmental impacts

There are many materials for which the quantity needed by a firm is at best indirectly related to the quantity of final product produced by that firm, such as solvents in manufacturing processes or office supplies. For any su ch "indirect" materials, an inescapable incentive conflict exists: The buye r wishes to minimize consumption of these indirect materials, while the sup plier's profits depend on increasing volume. Both buyer and supplier can ex ert effort to reduce consumption, hence making the overall supply chain mor e efficient. However, no supplier will voluntarily participate unless contr act terms are fundamentally revised. This can be done through a variety of "shared-savings" contracts, where both parties profit from a consumption re duction. This paper analyzes several such contracts currently in use for ch emicals purchasing. We show that such contracts can always increase supply- chain profits but need not lead to reduced consumption. We analyze equilibr ium effort levels, consumption, and total profits, and show how these chang e with the contract parameters. We find that the goals of maximizing joint profits and minimizing consumption are generally not aligned. Also, surpris ingly, a decrease in a cost parameter can lead to a decrease in profits; it may be necessary (but is always possible) to renegotiate the shared-saving s contract to reap the benefits of a cost decrease.