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B School
 
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UNIVERSITY OF CHICAGO BOOTH SCHOOL OF BUSINESS
Optimal Mix: Managing a portfolio of supply contracts
The oil and refinery business is complex. Sometimes, companies lose on profit margin and market share if they donít have an idea of managing supply contracts. The right mix of long- and short-term contracts can lead to a bigger profit.
Issue Date - 01/03/2012
 
The study finds that a gasoline supplier is much better off if it adjusts the shares supplied to each channel as market conditions change, rather than adhering to a static policy of keeping the same shares year after year. For instance, if BP decides today that it will satisfy 15% of the branded market and sell five million gallons to the unbranded channel each year, then it could increase its expected profit by 46.3% if it adjusts this share and quantity over time using the studyís forward-looking model. A more aggressive branded market share of 25% also results in substantial gains of between 7.2 and 43.3%, depending on the initial unbranded quantities, if the portfolio of contracts is rebalanced over time.

Both the conservative and aggressive branded marketing strategies result in a much higher expected profit at different levels of unbranded commitments if shares are dynamically adjusted. This is because of the flexibility to reallocate capacity. Allocating too much or too little to the branded market requires a high volume of costly spot trading to get rid of leftover products or to cover unmet obligations. Thus, finding the right mix of branded and unbranded contracts as business conditions change can reduce the companyís reliance on the spot market and increase expected profit.

We developed a retrospective model that BP has recently adopted. The model guides the companyís supply chain optimisation strategy for the entire Midwest. It tells BP what it should have done differently if it could do things over again, by calculating the optimal shares in the past for each channel and city. The results suggest how the company might adjust its market shares in the future.

For example, suppose that Clevelandís branded BP stations got 64% of all the BP gasoline that went to that market during a certain period. The company can run the model to find out whether it actually sold too much or too little. If it turns out that the optimal share for the branded channel in Cleveland was only 43% because profit margins and demand were better elsewhere, then the company knows that it ought to consider shedding some of its exposure to the branded market in order to increase profit. While BP cannot terminate its contracts with branded jobbers any time it wants to, some jobbers may want to defect to other gasoline suppliers, and at that point BP knows that it is in its best interest to let them go.

Companies around the world sell their products through different types of contracts, so the challenge of optimising a portfolio of these contracts in order to sell at capacity and to maximize profit is not unique to BP. However, it is a topic that has not been discussed much in academic studies. This paper brings attention to the fact that we can build models to help firms optimise their contract portfolios.
 

Amir Moin           

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