Strategic Spot Trading Benefits Supply Chains

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Strategic Spot Trading Benefits Supply Chains

A study helps show how supply chain managers make better decisions.

Supply chains — the string of players involved in making goods from the procurement of raw materials to the consumer end product — have traditionally operated with gross inefficiencies resulting from what they don't know. How can the producer of a computer chip really know how many chips manufacturers will need, particularly when the manufacturers themselves are uncertain? How do manufacturers know how many chips will be on the market when they need them, and whether to take the risk of ordering in advance?

A recent study by two faculty members at Stanford's Graduate School of Business should help supply chain managers make better decisions. The model studied by Haim Mendelson and Tunay Tunca shows that by strategically using both fixed-price contracts and open market trading, supply chain participants can create greater efficiencies. Both consumers and the supply chain as a whole will benefit from these efficiencies, but the companies that make up the supply chain also need to go through a careful analysis to determine whether they will profit.

In industries ranging from agriculture to electronics components, manufacturers and suppliers make long-term purchasing contracts months and sometimes years in advance, long before they know what the end consumers' demand or their own costs will be. Given that availability, costs of raw materials, and consumer tastes fluctuate, both parties sometimes supplement contracts with shorter-term spot trading to take care of these changes. Information technology has reduced the costs of putting together spot markets, which resemble a stock exchange where suppliers and even manufacturers with surpluses trade goods all over the world in a freewheeling, frequently electronic, environment.

"The use of electronic markets for business-to-business trading allows market participants to learn what's going on in the marketplace in terms of supply and demand, even if they don't have that information firsthand," says Mendelson, the Kleiner Perkins Caufield and Byers Professor of Electronic Business and Commerce, and Management at the Graduate School of Business. Just as the stock market summarizes many pieces of information about the performance of a company, business-to-business spot markets can provide up-to-date information about the availability of raw materials, the cost of production, and consumer demand for the end product. Because all of this happens much closer to the time that the end product ships to the consumer, supply chain participants can update their plans to take into account real-time information.

If spot trading provides better information to supply chain players, why not dispense with fixed-price contracts altogether? The researchers found that open markets also have their drawbacks. "The more you trade, the more you drive the price against yourself," says Tunca, assistant professor of operations, information, and technology. A manufacturer may want to buy 10,000 computer chips at $1 per chip. But trying to buy twice that amount may force the manufacturer to pay more per chip, as cheaper supplies will be exhausted. So buying only on-the-spot market raises the risk that you're going to spend more than you would have in a fixed-price contract made six months ago. On the other hand, you have a better idea of actual need, and may end up spending less by not overbuying. Suppliers face similar risks and benefits, and so may also benefit from both early contracts and spot-market trading. What, then, is the best balance between long-term contracting and using the spot market for supply chain players? Mendelson and Tunca argue that the key is determining how liquid the spot market is in any given industry; that is, how freely goods can be traded without driving prices up or down against the players themselves. "You have to carefully assess the liquidity of the market before you jump on the spot-trading bandwagon," Mendelson says.

The researchers have calculated a spot-market liquidity measure that incorporates demand and cost information and helps determine how efficiently the supply chain will function as a whole with spot trading. The study finds that markets tend to be more liquid where consumer demands are more certain, demand forecasts are less noisy, or there are many market players. The high-end computer chip markets tend to be less liquid, for example, because sellers are relatively scarce. Alternately, the large number of buyers and sellers in the oil market make it more liquid. "Where the liquidity measure is very good, the supply chain operates like a well-oiled machine," says Tunca. "It is agile in reacting to new information. A liquid spot market also stimulates production. Where the liquidity measure is bad, there is more friction in the supply chain, information is not used well, and goods are sold almost exclusively through long-term contracts."

In industries with liquid markets, the researchers advise, manufacturers and suppliers should leave more of the purchasing for the open market. In industries with illiquid markets, they should do more of their purchases through fixed-price contracts early on. But in all cases, both are needed: No matter how efficient electronic spot markets can be, there will likely be a role for long-term contracting.

In tying together the effects of information and liquidity on supply chain performance, Mendelson and Tunca have established a novel way of thinking about industrial spot markets. A good spot market, their study reveals, creates efficiencies not only in the spot market itself, but also reaching back to the long-term contract stage.

"Suppliers will anticipate that a well-functioning spot market is coming up — where information about supply and demand is current — and so will price more competitively early on," Mendelson says. This makes the supply chain more efficient and increases the total profit of the businesses that constitute the supply chain. At the same time, consumers also benefit, because a more efficient supply chain translates into lower retail prices.

But the good is not always good for everyone: In some markets, the spot market makes manufacturers better off at the expense of suppliers, whereas in some other markets suppliers gain the upper hand. Supply chain participants have to carefully analyze the impact the spot market will have on their own profit.

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