Shared-Savings Contracts Benefit the Environment and the Bottom Line

Shared-Savings Contracts Benefit the Environment and the Bottom Line

Research shows that shared-savings contracts between suppliers and buyers can help the environment and drive higher profitability.
Tirath Sandhu August 29, 2010

Save on indirect materials. Split cost savings with supplier.

Firms producing indirect materials (such as solvents for manufacturing) can seemingly improve their bottom line only by selling more of their products. However, using less indirect material is in the best of interests of both the buying firm and the environment.

Research by Charles J. Corbett and Gregory DeCroix investigates supply chain contracts from the perspective of both the bottom line and the environment. In particular, the researchers examine the case of indirect materials and the conflict between the desire of suppliers to sell more product and the environmental harm resulting from the product’s use. They find shared-savings contracts between suppliers and buyers achieve higher supply chain profitability than traditional contracts.

Sharing the Cost Saving

Shared-savings contracts – where the benefit a buyer obtains from consuming less indirect material can be reallocated to help the supplier as well – may help profitability and the environment under certain conditions. In shared savings contracts, cost savings resulting from lower volumes of indirect materials are shared between the buyers and suppliers.

Shared-Savings Contracts vs. Traditional Contracts

In numerical experiments, shared-savings contracts between suppliers and buyers close 73 percent of the profit gap between the traditional contract and the overall profit maximizing solution. Traditional contracts are contracts in which a supplier receives a fixed price per unit of indirect material sold.

Shared-savings contracts work in practice too. Such arrangements have been discussed in practitioner channels (e.g. Chemical Strategies Partnership, Fortune magazine), and a shared-savings contract exists between the Ford Chicago assembly plant and PPG’s Chemfil division.

A decrease in either the supplier’s manufacturing cost or the customer’s cost of waste disposal can lead to decreased profits, unless the decreases in costs are shared between both parties.

Implications for Managers

Explore opportunities for shared-savings contracts within your manufacturing supply chain. Renegotiate these contracts so that both parties agree on a unit price for the materials that will result in profits for both parties.

Numerous contract models exist and can be tailored for your situation: e.g. a flat fee for services, reimbursement for amount of material used, and sharing of any efficiency gains.

Implications for Researchers

Shared-savings contracts are usually very complex; diverse features of these contracts have not been captured in this research. Future research could examine the role of other contract parameters and take a closer look at savings through cost reduction from order consolidation and consumption reduction.

Methods

The research developed a basic model for contracts between suppliers and buyers and then built on this model to examine the equilibrium behaviour under various contract types using game theory. A numerical experiment used 864 scenarios and varying contract parameters.
Corbett, Charles J. and DeCroix, Gregory A.(2001). Shared-Savings Contracts for Indirect Materials in Supply Chains: Channel Profits and Environmental Impacts. Management Science, Vol. 47, No. 7, pp. 881-893.

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