How to ensure a long-term contract generates profit instead of loss?

Many organizations prefer to enter long-term contracts.

In addition to providing a guarantee of stable demand for upstream businesses, long-term contracts can secure discounts, predictable pricing, and flexibility for downstream providers or consumers.

This, however, is an idealized scenario. In reality, long-term contracts can also entail considerable losses.

For example, US multinationals Verizon and Apple signed a long-term contract lasting four years. Verizon held $14 billion of Apple products as surplus stock when the agreement expired, which resulted in significant capital loss and inventory pressure.

While some major organizations may be able to absorb losses on such a vast scale, this would represent total calamity for most small and medium-sized businesses.

Merchants should therefore remain alert to the difficulties entailed by drafting, signing, and fulfilling long-term contracts. Since long-term contracts are subject to uncertainty and lack of completeness, eradicating risk is tantamount to playing roulette.

Associate Professor YUAN Quan at Zhejiang University’s School of Management has made a breakthrough while leading a team to study how long-term contracts can obstruct high-quality development in Chinese businesses.

Focus on three major issues and propose a solution

Funded by the National Natural Science Foundation of China, Prof. YUAN’s research project, entitled Formation Mechanism of Total Minimum Commitment Contracts and Joint Dynamic Pricing of Inventory, focused on mechanism design, resource allocation, and dynamic pricing decisions within long-term contracts.

The study concentrated on total minimum commitment contracts (a type of long-term contract). A close analysis of relevant contractual design principles yielded a streamlined problem-solving process for optimal resource allocations. The study’s authors also offer analytical tools to address problems arising from multi-cycle joint production and the fixed costs of carbon emission trading.

Concurrently, the research proposes a novel method for dynamic pricing and yield management while clarifying the critical role of dynamic pricing in long-term contracts. Long-term contracts are ubiquitous throughout the Chinese economy, from the energy sector to the “Dual-Cable” commitment put forward by General Secretary XI Jinping to annual and monthly access schemes within the sharing economy.

Long-term contracts constitute a crucial factor in national economic development and the lives of ordinary people. Accordingly, the research conducted by Prof. YUAN’s team, which has resounding theoretical support alongside considerable application value in the signing, dynamic execution, and pricing of medium- and long-term contracts, is profoundly important.

A few days ago, the research conducted under Prof. YUAN’s leadership was rated as ‘Particularly Outstanding’ in the 2021 Project Performance Evaluation of the National Natural Science Foundation of China’s Management Science Department.

Interview with Professor YUAN Quan

What was the biggest challenge you encountered during this research, and how did you overcome it?

“The greatest challenge is to propose new tools for theoretical analysis that solve difficult problems in light of their distinctive characteristics. These endeavors require a deep understanding of the subject matter, the capacity to make bold assumptions, and a sincere willingness to verify those assumptions carefully. There are often difficulties and setbacks during this process—we need to be ready to step past them, always remembering why we are passionate about our work.”

What does a “good scholar” look like in your mind? What is your research goal?

“As far as I can see, a good scholar needs to combine skill in their field with integrity and a desire to innovate. Management science is a highly practical field that requires a capacity to solve practical problems of the highest order and most relevant to China’s development. International recognition for research outcomes, influence over others in the field, and the caliber of a scholar’s contributions to their discipline’s development are also important characteristics of a good scholar. My research goal is to establish a series of innovative operational theories and methods, gain international recognition, and solve important problems in China’s development practice while exerting a wide influence.”

This is a translation of the article by DUAN Ting published on Mar. 14 on ZJU-SOM WeChat Official Account.

Editor: DUAN Ting, ZHU Yudi

Picture Source:Qianku