Handi Inc. Options Contract Management

RICHARD T. DOERMER SCHOOL OF BUSINESS

Prof. C.Z. Gurgur

Handi, Inc. Options Supply Contract Management

Before you attempt and work on this scenario, you must have worked on the Flextrola Software Systems Integrator case study where you were introduced to the pertinent concepts and management of an option supply contract. As such, please first refer to the course videos and posted/written solutions for Flextrola. Otherwise, you will have issues in the comprehension of the Handi, Inc. scenario analysis and execution of the full solutions on the provided Excel template comfortably.

Handi Inc., a cell phone manufacturer, procures a standard display from LCD Inc. via “an options type of supply contract”. At the start of quarter 1 (Q1) Handi pays LCD $20 per option. At that time Handi’s forecast of demand in Q2 is normally distributed with mean 20,000 and standard deviation 4000. At the start of Q2 Handi learns exact demand for Q2 and then exercises options at the fee of $50 per option (for every exercised option LCD delivers one display to Handi). Assume Handi starts Q2 with no display inventory and displays owned at the end of Q2 are worthless. Should Handi’s demand in Q2 be larger than the number of options held, Handi purchases additional displays on the spot market for $100 per unit.

a. How many options should Handi purchase from LCD, Inc.? (I.e. the optimum options) to minimize Expected Procurement Cost?

b. Suppose Handi purchases 12,000 options. What is the probability that he will need to do procurement on the spot market?

c. Given that Handi purchases 12,000 options, what is the expected number of displays Handi will buy on the spot market?

d. Given that Handi purchases 12,000 options, what is the expected number of options that Handi will exercise?

e. What is Handi’s expected total procurement cost given that he purchases 12,000 options?

f. What is the fill-rate Handi implies by purchasing 12,000 options?

g. What is Handi’s expected total procurement cost given the number of purchased options from part (a)?

h. Suppose Handi were to procure exclusively from the spot market? What would be his expected procurement cost? What would be his fill-rate in this arrangement? Also, what is the mismatch cost he incurs with this arrangement?

RICHARD T. DOERMER SCHOOL OF BUSINESS

Prof. C.Z. Gurgur

RICHARD T. DOERMER SCHOOL OF BUSINESS

Prof. C.Z. Gurgur

Handi, Inc. Options Contract Management Solutions

a. To find the number of options Handi should purchase from LCD, you must calculate the

critical ratio by using the unit overstocking and understocking cost.

Cu = Cost of buying an option that was needed Cu = Spot Market Cost – (Initial Cost + Exercised Cost) Cu = $100 – ($20 + $50)

Cu = $30

Co = Cost of an option that is not used (Initial Cost)

Co = $20

With the Understocking and Overstocking Cost, we calculate the critical ratio:

Critical Ratio = (Cu) / (Cu + Co) Critical Ratio = $30 / ($30+$20) Critical Ratio = .60

NORMSINV (0.60) returns a z-statistics: 0.25

The optimal number of options =

Expected Demand + (Z-Stat * Std. Dev. of Demand)

The optimal number of options = 20000 + (0.25*4000)

The optimal number of options to sign for = 21013

b. If Handi decided to purchase 12,000 options, the probability he would need to procure

more on the spot market (given the mean and standard deviation) would be as follows:

P(D> 12000) = 1 – NORMDIST (12000, 20000, 4000,1) = 0.98 P(Z> -2.00) = 1 – NORMSDIST (-2.00) = 0.98

RICHARD T. DOERMER SCHOOL OF BUSINESS

Prof. C.Z. Gurgur

c. Had Handi purchased the 12,000 options, the expected number of displays Handi

would buy in the MTO setting would be as follows --- i.e. ON THE SPOT MARKET:

EXPECTED LOST SALES: 4000 * L (-2.00) = 8034

d. With the 20,000 options, the expected number of options that Handi will exercise:

EXPECTED SALES: 20000 – 8034 = 11,966

e. With the 12000 options Handi purchased, the total procurement cost would include

multiple additions, from the original option purchase, the exercising of the options, and

then the emergency procurement cost.

f. The fill rate of 12,000 options would be as follows:

Handi

E (Sales) 11966 = = 59.83%

E (Demand) 20000

g. The expected number of purchases on the spot market is equal to

Expected Lost Sales.

Expected lost sales = Std. Dev. * L (Z-Stat) Expected lost sales = 4,000* L (0.25) = 4000*0.2863 Expected lost sales = 1145

Handi

Option Purchase + Options Exercised + MTO Purchase of

Items = Total Cost

12000($20) 11966($50) + 8034($100)

$ 240,000 $ 598300 + $ 803400 $ 1,641,700

Fill Rate =

RICHARD T. DOERMER SCHOOL OF BUSINESS

Prof. C.Z. Gurgur

Expected sales = Expected demand (mean) – Expected Lost Sales Expected sales = 20000 – 1145 Expected sales = 18855

The cost of buying 21,013 options

Ci*Qi = $20*21013 = $ 420,260

Plus exercising options

Ce*Qe = $50*18855 = $ 942750

Plus purchases on spot market

Total Expected Procurement Cost $ 1,477,510

h. If Handi were to exclusively have an MTO agreement, i.e. purchasing only from the spot

market, then the fill-rate for this would be 100%, as there would be no lost sales.

Expected Sales = Expected Demand.

As such, there is NO mismatch cost. All demand will be met. There is NO mismatch risk, the cu and co are simply equal to zero.

Cs*Qs = $100*1145 = $ 114,500

Handi

Expected

Procurement Cost

= Purchase Cost*E(Demand) =

$100*20000

2,000,000