Optimal Contract Selection for the Global Supply and Distribution of Raw Materials Mukta Bansal, ² I. A. Karimi,* ,² and Rajagopalan Srinivasan ²,‡ Department of Chemical and Biomolecular Engineering, National UniVersity of Singapore, 4 Engineering DriVe 4, Singapore 117576, and Process Sciences and Modeling, Institute of Chemical and Engineering Sciences, 1 Pesek Road, Jurong Island, Singapore 627833 A multinational company’s purchases go well beyond basic raw materials; they include catalysts, indirect materials, additives, etc. Strategic sourcing contracts offer several advantages and are common practice in many industries, especially the chemical industry. However, contracts come in various shades of price, commitments, duration, terms, flexibility, lead time, quality, discounts, product bundling, etc. Selecting the best contracts and suppliers for a company’s globally distributed sites in an integrated and global business environment can be nontrivial. In this paper, we propose a relatively comprehensive classification of material supply contracts and propose a multiperiod mathematical programming model that selects optimal contracts for the minimum total procurement cost in the face of several practical considerations such as different contract types, multitier prices and discounts, logistics and inventory costs, quantity/dollar purchase commitments, spot market, product bundling, etc. The model also identifies the optimal distribution of materials from various suppliers to plant sites. Our examples demonstrate substantial savings over ad hoc or heuristic methods. 1. Introduction Raw material purchases comprise a major portion of the total production costs in many companies. Automobile manufacturers spend 60% of their revenues on material purchases, food processors spend 70%, and oil refineries spend 80% (Chaudhry et al.). 1 Purchased materials and services represent up to 80% of total product costs for high technology firms (Burton). 2 Coal purchases for large electric utilities, such as TVA, approach $1 billion annually (Bendor et al.). 3 The percentages of sales revenues spent on materials vary from more than 80% in the petroleum refining industry to only 25% in the pharmaceutical industry (Krajewski and Ritzman). 4 Clearly, it is vital for companies to reduce their material purchase costs. Globalization is offering new opportunities, and global competition is forcing companies to seek ways of reducing purchase costs. Many companies, especially the chemical companies, often prefer long-term contracts with their raw material suppliers. Such a supply contract is an agreement between a buyer (company) and a supplier for a fixed duration, which stipulates certain terms, conditions, and commitments. Negotiating the best supply contracts with each supplier and selecting the right contracts with the right suppliers are crucial tasks. Shah 5 identifies the negotiation of long-term supply contracts as a typical supply chain problem. One motivation for a supply contract is to share the risks arising from various uncertainties in demand, supply, delivery, inventory, price, exchange rate, etc. in the business environment. Contracts often specify fixed amounts of materials that the supplier agrees to deliver at various times in the future at some agreed prices. These prices are not necessarily fixed; for instance, the price of liquefied natural gas (LNG) in most supply contracts is pegged to the price of crude oil. Whether they use fixed or pegged prices, contracts reduce price uncertainty to some extent. In addition, contracts increase supply reliability and may save costs for the buyer. Many contracts stipulate purchase commitments, which guarantee orders for the sup- pliers and reduce demand and inventory uncertainty for the supplier. A company’s goal is to fulfill the demands of raw materials over time at all its plant sites. This can be done in two ways. One is to sign contracts with one or more suppliers. The other is to buy from the spot market. While a long-term contract generally offers reliability, it may also force a price that is higher or lower than that in the open market. Thus, to reduce its costs, a company could use a combination of both ways to fulfill its raw material needs. However, contracts come in various shades of price, reliability, flexibility, duration, lead time, quality, capacity, commitment, discount, terms and conditions, product bundling, etc. Striking an optimum balance among these factors and the option of spot market is not always easy, and hence, selecting the right combination of contracts can often be a challenging problem. Tsay et al. 6 reviewed supply chain contracts and classified the literature in terms of contract clauses such as specification of decision rights, pricing, minimum purchase commitments, quantity flexibility, buyback or return policies, allocation rules, lead times, and quality. Sykuta 7 examined the role of future contracts in the context of a firm’s overall contracting activities and presented alternative forms of contracting. He identified four types of purchasing strategies, namely, spot market, forward contracts, long-term contracts, and future contracts. Both spot purchases and forward contracts are transaction-specific. While the former involves an exchange of goods and payment at present conditions, a forward contract involves a future exchange of goods and payment at the terms set today. Sykuta 7 viewed future contracts as a form of synthetic storage. They lower the cost of contracting for advance supplies by providing the flexibility of a spot contract with the advanced coordination features of a forward contract. A long-term contract, on the other hand, specifies the terms for a series of repeated transactions and involves repeated exchanges of goods and payments over a set contract duration. * Corresponding author. E-mail: cheiak@nus.edu.sg. Tel.: +65 6516-2186. Fax: +65 6779-1936. ² National University of Singapore. ‡ Institute of Chemical and Engineering Sciences. 6522 Ind. Eng. Chem. Res. 2007, 46, 6522-6539 10.1021/ie070395w CCC: $37.00 © 2007 American Chemical Society Published on Web 08/30/2007