Options contract theory and real-world supply chains: Key Conceptual Problems The previous section provided insights into the operations of selected perishable (fruit)

supply chains focused on a major supermarket’s retail outlets. This section, reporting on the stated research objective two, questions the validity of the assumptions which underlie option contracts theory in the light of our detailed analysis.

The theory of option contracts is based upon a set of fundamental assumptions. The first assumption is that an option contract must be applied in a retailer-led supply chain in order to achieve the required level of coordination. The second assumption is that the supply chain must be characterised by high demand uncertainty. The third assumption is in respect of the option contract terms - fixed time, fixed price, specific time, and premium payment. As noted earlier, our literature review suggested that studies assumed that perishable food supply chains met these assumptions. The following paragraphs question the validity of these three key assumptions for the supermarket-oriented perishable food chains examined in this study.

Chapter Eight Are supermarkets perishable fruit chains retailer-led supply chains? The assumption that the perishable food supply chains examined in this study are operating as retailer-led chains was investigated by detailed application of the Cox framework (see Chapters 2 and 7). Cox’s power matrix was applied to reveal supplier/buyer relationships in the chain and underlying patterns of dominance. The power relationships were investigated in both single dyad and double dyad supply chains by using four criteria – the number of buyers and suppliers in the market; the level of dependency among them; search and switching costs; and information asymmetry advantage or disadvantage.

The analysis of power between the direct grower and the supermarket in a single dyad supply chain suggested that there are few buyers and few suppliers; that the supermarket has a relatively high % share of the total market for direct growers; that the direct grower is highly dependent on the supermarket for revenue and has few alternatives; supermarket switching costs to new suppliers are high; that the supermarket account is attractive to the direct grower and direct grower offerings are not commoditised and customised; that supermarket search costs are high, importantly, the direct grower has moderate information asymmetry advantage over supermarket. Therefore, the dyadic power between the direct grower and the supermarket reflects an interdependent (A=B) relationship.

The investigation of power balances in the double dyad supply chain required exploration of the power relationships between two dyads in the supply chain. The first exchange relationship is between the indirect grower and the marketer, the second dyad is between the marketer and the supermarket.

In the marketer/indirect grower relationship, the marketer plays the role of buyer (B) and the indirect grower (A) is considered as the supplier. The attributes of this dyadic relationship suggest that there are few marketers and many indirect growers; the marketer has a high % share of total market for grower; that the indirect grower is highly dependent on the marketer for revenue and has limited alternatives; that the indirect grower switching

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power relationship between the marketer and the grower is one of buyer dominance (B>A), with the marketer as the powerful member.

In the supermarket/marketer relationship, the marketer (B) plays the role of supplier and the supermarket is the buyer (C). The attributes of dyadic relationships between them suggest that there are few buyers/few suppliers; the supermarket has a relatively high % share of the total market for the marketer; the marketer is highly dependent on the supermarket for revenue with few alternatives; the supermarket switching costs are high and the supermarket account is attractive to marketer; the marketer offerings are not commoditised and customised and the supermarket search costs are high; and the marketer has moderate information advantage over the supermarket. The power relationship between marketer and supermarket is thus one of interdependence (B=C). The marketer is dependent to the supermarket to be able to market the produce; the supermarket is dependent to the marketer to be able to provide high quality produce at the store shelves.

Based on the above findings, it is clear that these particular chains indicate upstream interdependence. The marketers and direct growers are as powerful as the supermarket and influence order quantities and prices. The supermarket has to share the power with the suppliers in order to be able to respond to the consumers’ expectations, which is fresh quality fruit. It is clear that collaboration delivers advantage to both suppliers and an obviously powerful retailer.

Are perishable fruit chains characterised by demand uncertainty? As noted, demand uncertainty is a ley assumption in option contracts theory. The research suggests that consumer demand has increased year on year reflecting population growth; but long term demand is reasonably predictable. Short term, within season, demand on the other hand is almost invariably uncertain and in some seasons may be exceptionally volatile and adds uncertainty into the decision making process. Competition between fruits, promotions, cross advertising, reality TV shows and prices underline short term demand fluctuations; but a key factor impacting demand fluctuations during the season is the price of produce. Fruit price is supply rather than demand sensitive - the more supply available in the market the lower the price and, predictably, with lower prices the demand increases. This

Chapter Eight predictable increase in demand cannot be considered as uncertainty in the supply chain and in any case the increase in demand while the supply increases favours both growers and the supermarket.

Supply availability is significantly dependent on weather events which are uncontrolled factors in fruit production. Supply uncertainty is a critical characteristic of fruit supply chains and uncertainty directly impacts on both volume and quality of produce.

Since the level of uncertainty in the supply is higher than the uncertainty of demand, the idea of applying option contracts in fruit supply chains is challenging. Option contracts must be designed to deal with supply uncertainty in the fruit supply chains. It might be defined as the right of the supplier to sell the fruits up to a specified quantity to the supermarket. However, there are still issues with such a definition. The supplier has to pay a premium to the supermarket to receive the right of selling. In an undersupply situation, then, the supplier has the right to sell a lower volume of fruits to the supermarket. The supplier already faces a loss in revenue due to shortage, what would be the benefit of premium payment to receive the right? Since in the current relationship there is no fine and punishments for supplying less fruit to the supermarket, then the use of option contract cannot be beneficial for parties.

Are the contractual terms required by option contracts theory appropriate for perishable fruit supply chains? There are four terms in the option contract definition that need in-depth investigation in order to explore applicability in the fruit supermarket chains. These terms are fixed amount, fixed price, fixed time and premiums.

Setting a fixed volume of fruit to be supplied in the contract prior to the season is especially risky because of the high supply uncertainty involved in the supply chain. The growers are not able to predict the supply volume before the season starts. They can ‘flower count’ the trees and provide estimation of the volume of fruits but the estimate is subject to changes due to weather events. Order quantities are changed even during the season, and the final

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In the current relationship between the suppliers and the supermarket, both parties are allowed to change the order quantity as they get closer to the actual time. The supply chain would not be able to manage the supply uncertainty in the chain without flexibility in ordering. Again, premium payment is not a useful requirement in the contract for the supermarket. The supermarket already has flexibility in the current relationship without extra payment. Therefore, the supermarket is not convinced to enter to a contract that gives the flexibility, which he already has, in return to extra payments.

Time relevant parameters for the production of fruit – such as the start day of the season, duration of the season and time of peak season vary from year to year. This is also due to weather events. Having fixed time requirements in the option contract cannot be applied in the fruit supermarket chains and a flexible time frame for the start of the season would be more compatible with the fruit supply chain characteristics.

Option contracts set fixed prices for both exercising price and wholesale price. These parameters are determined prior to the season. As explored in the objective one, the prices are supply driven and variable throughout the season. Determination of a fixed wholesale price for the entire season prior to the start of the season is not satisfactory for any chain player and would decrease their confidence in the market.

Price fluctuations are the results of supply uncertainty and if the impacts of uncertainty could be reduced then applying fixed prices is applicable in the fruit supply chains. Strawberries can be grown under the cover and reduces the impacts of weather impacts and supply uncertainty. Production under cover is new proceeding through collaboration between the strawberry grower and the supermarket. In this way, the grower believes the cost of production can be determined more precisely according to the supply volume. This grower was willing to enter into a periodic fixed price contract that considers the bell shape pattern for the price - high at the beginning of the season, decreasing in the peak season and increasing by the end of the season. Decreasing the impact of supply uncertainty is not possible for most fruit supply chains. So that entering to contracts with fixed a price is not applicable in these fruit chains.

Chapter Eight As noted previously, premium payments in option contracts are designed to stimulate the contract offeree to accept the contract while there will be an increase in the risk associated in the trade. The premium payment from the retailer (contract offeror) to the supplier (contract offeree) brings the flexibility in ordering to the retailer. In the fruit supply chains, the supermarket (offeror) already has the flexibility in ordering. Therefore, the supermarket is not convinced to pay the premium in the contract.

However, the supermarket is willing to financially assist the direct growers. The purpose of supermarket is assurance on quality fruit supply not the flexibility. The financial

collaboration between the parties strengthens the long term relationship between them.

Our discussion suggest that the three assumptions underlying option contracts theory - retailer-led supply chain, demand uncertainty, and contract terms - are not valid in the fruit supermarket chain. However, modifications and parameter adjustments may be able to customise the contract to be applicable in the fruit supermarket chains. These modifications and adjustments are the purpose of objective three which are investigated in the following subsection.

8.2.3 Applying option contracts in perishable fruit supply chains: adjustments for