Improving Supply Chain Performance and Managing Risk Under Weather-Related Demand Uncertainty

The demand of many products is connected to the weather patterns during and before the selling season. Ice cream can be best sold during warm summers, of course. But also other food products or clothes exhibit weather dependent demand pattern.

This article by Chen and Yano (2010) has a look at improving contracting between a manufacturer of a product with weather dependent demand and its retailer. One is for sure: uncertain demand causes negative effects for the whole supply chain, and should be handled as such. The full paper can be downloaded here.

Method

The author utilize the classic news vendor setting with one manufacturer (M) and one retailer (R) to focus on the analysis of their relationship.

M is set as the focal company. Due to several reasons (e.g. long lead times, seasonal products) M wants to offer weather related rebates for the retailers.

Model

The sales process is modeled in three steps:

• M designs the contract and offers it to R

• R decides on the ordering quantity

• Depending on the weather and the quantity ordered, payouts are made from M to R

A weather rebate is an alternative to other supply contracts that manufacturers might use to induce retailers not just to order greater […] quantities, but also to order them well in advance of the selling season. Such inducements fall into two broad categories: (1) early-season incentives that reduce the retailer’s financial obligation for any given purchase or commitment level and (2) end-of-season concessions paid by manufacturers when demand is weak.

In this case the authors only have a look at the second type.

Without loss of generality, the authors focus on the temperature as weather index and design the payoff depicted in figure 1, where t is the measured temperature, t* is the “strike”-temperature and K is the payoff.

Figure 1: Suggested Contract for Weather Rebate (Chen and Yano, 2010)

Results

The results show how the effects of the demand risks for the manufacturer can be mitigated in such a setting:

• Choice of strike temperature (t*) and rebate function
  t* has an huge effect on the risk sharing between the two parties. So in combination with adjusting the payoffs K, it is possible to cater to different degrees of risk aversion between the manufacturer and the retailer

• Additionally risks can be hedged by using weather derivatives
  Tapping the growing market of derivative products on weather allows to offset the risks of such a contract by buying a corresponding weather certificate.

Conclusion

The authors suggest a very flexible contracting scheme to optimize the distribution of risks between a manufacturer and retailer.

[The authors also see] very significant side benefits that the weather rebate offers (e.g., no auditing of leftover inventory at the retailer that would be required in the case of buy-back contracts or markdown allowances).

But, on the other hand the authors admit that the difficulty of the negotiation process might be increased since many more parameters (rebate, weather indices,…) have to be agreed upon.