Koç University
OPSM 305 Supply Chain Management
Class 10:
Incentive issues
Zeynep Aksin
zaksin@ku.edu.tr
1
Hamptonshire Express
 Anna has a degree from journalism & operations
research
 She has started a daily newspaper in her hometown
 She used a leased PC: lease cost $10 per day
 A local printer prints newspapers at 0.20 per copy
 Sales the next day between 6 am and 10 am
 Newsstand rental $30 per day
 Express sold to customers at $1 per copy
 Copies not sold by 10 am are discarded
 Anna estimates daily demand to be distributed
N(500,100)
2
Question 1
 Optimal stocking quantity?
 Profit at this stocking quantity?
3
Ordering Level and Profits in Vertically
Integrated Channel
h=1; Anna sells to market directly:
i* = 584; E[Profit] = $331.33; Fill rate 98%
4
Improving demand through effort
 After 6 weeks of operation, Anna thinks she
can improve demand by adding a profile
section
 Experiments indicate that demand is a function
of time she invests in preparing the section
 She thinks D=500 +50 h
5
Question 2
 How many hours should she invest daily in
the creation of the profile section? Assume
the opportunity cost of her time is $10 per
hour.
 Compare optimal profits to previous
scenario
6
Optimal Level of Effort in Vertically
Integrated Channel
 Demand potential increases by 50 h
 Expected profit increases by 0.8*50 h
h  h+1
0.8 * 50 * ( h  1  h )
01
40
12
16.56
23
12.71
34
10.71
45
i* = 684
E[Profit] =
371.33
7
9.44
Delegating sales to Ralph
 Anna is really busy, so asks Ralph to take-over the
retailing portion of her job.
 Ralph agrees to run the newsstand from 6 AM to 10 AM
and pay the daily rent of $30
 He estimates demand the next day based on viewing a
copy of the paper the previous night at 10 PM
 He buys the papers from Anna at $0.8 per copy
 Ralph is responsible for unsold copies at the end of the
day
8
Question 3
 Assuming h=4 try to determine the optimal stocking
quantity for Ralph?
 Why is this quantity different than the one in Question 2?
 Now vary h in spreadsheet 3c which calculates the
optimal newsboy quantity for the differentiated channel,
i.e. to maximize Ralph’s profit.
 How would changing the transfer price from the current
value of 0.8 impact Ann’s effort level and Ralph’s
stocking decision? (Spreadsheet 3d)
 Compare an integrated (centralized) firm to a
differentiated (decentralized) one.
9
Ordering Level and Profits in
Differentiated Channel
Case 1. h=4; Anna sells to market directly:
i* = 684; E[Profit] = $371.33; Fill rate 98%
Case 2. h=4; Anna sells thru Ralph:
i* = 516; E[Total Profit] = $322
Anna makes $260
Ralph makes $ 62
Fill rate 84%
Why??
10
Effect of Transfer (Wholesale) Price in
Differentiated Channel
Breakdown of total profits (h=4)
400
350
300
250
ralph
$ 200
anna
150
100
50
transfer price
0.
9
0.
8
0.
7
0.
6
0.
5
0.
4
0.
3
0
11
Optimal Effort in Decentralized Channel
Optimal effort level for Anna is h=2 (and not 4).
h=2
h=4
Stocking quantity: $487
$516
Anna’s profit:
$262
$260
Ralph’s profit:
$56
$ 62
Total profit:
$318
$322
Fill rate:
83%
84%
Why??
12
Inefficiencies in a Differentiated Channel
 Supplier chooses w, retailer chooses i*
 Retail ignores +ve effect of stocking one more
unit on supplier
 Supplier ignores +ve effect of cutting
wholesale price/increasing effort on retailer
 Supplier prices above marginal cost/exerts
low effort
 Retailer stocks less
 Supply chain profits shrink
13
Contracts
 Specifies the parameters within which a buyer
places orders and a supplier fulfills them
 Example parameters: quantity, price, time, quality
 Double marginalization: buyer and seller make
decisions acting independently instead of acting
together; both of them make a margin on the
same sale – gap between potential total supply
chain profits and actual supply chain profits
results
 Buyback contracts can be offered that will
increase total supply chain profit
14
Returns policies
 Rationale: set buyback price b so that
(retailer cost structure
wb c s

= supply cost structure)
r b r  s
 Supplier can use both w and b
 Supplier is bundling insurance with the
good
15
Example
Breakdown of profits under a
buyback scheme
8
0.
77
0.
74
0.
71
0.
6
0.
45
0.
3
0.
15
ralph
anna
0.
0
400
350
300
250
$ 200
150
100
50
0
buyback price
16
Reasons for return policies
 Supplier is less risk averse than
retailers
 Supplier has a higher salvage value
 Safeguarding the brand
 Signalling information
 Avoiding brand switching
17
Costs of Return Policies




Extra transportation and handling
Extra depreciation
Getting the return rate wrong
Retailer incentives
18
The case of books
 Returns as in Hamptonshire Express…
 …However publisher has no control of return
quantities
 No control of inventory-shelf arrangements
 No control over private-label
 No control of retail price
 Key difference: power has shifted from publisher
to retailer
19
Video sales
 Hollywood: video rentals and sales
$20B business, and largest source of
revenue
 Rentals slipping
– Competition from direct services
– Customer dissatisfaction (20% cannot rent
video they want on a typical trip)
 What’s the problem? Bad forecasting?
Inefficient replenishment?
20
Revenue Sharing
 Reduce wholesale price in return for a
share of revenues
 Encourages retailers to stock more
 $60 a tape
– $3/rental – rent each tape 20 times to break
even
 $9 a tape, studio receives half revenue
– $3/rental – rent each tape 6 times to break
even
 Retailer stocks more
21
Revenue sharing
 When does it work?
– marginal cost of increasing inventory low
– administrative burden low
– for price-sensitive products
22
The Impact of Revenue Sharing
 Blockbuster Instituted the “Go Home
Happy” marketing initiative
 Results
– Store traffic went up
– Market share 4th quarter 98 = 26%
– Market share 2nd quarter 99 = 31%
– Revenue in 2nd quarter 99: +17% from 98
– Cash flow in 2nd quarter 99: +61% from 98
23
Other Contracts
 Quantity Flexibility Contracts
– Supplier provides full refund for returned
items as long as the number of returns is no
larger than a certain quantity
 Sales Rebate Contracts
– Supplier provides direct incentive for the
retailer to increase sales by means of a
rebate paid by the supplier for any item sold
above a certain quantity
24
Vendor-Managed Inventories (VMI)
 Manufacturer or supplier is responsible for all decisions
regarding inventory at the retailer
 Control of replenishment decisions moves to the
manufacturer
 Requires that the retailer share demand information
with the manufacturer
 Manufacturer can increase its profits and total supply
chain profits by reducing effects of double
marginalization
 Having final customer demand data also helps
manufacturer plan production more effectively
 Potential drawback – when retailers sell products that
are substitutes in customers’ minds
25
Information-based Solutions
 Measure more variables to reduce moral
hazard; e.g. scan-based promotions,
“mystery shoppers”
 Reduce pre-contact private information
– Credit rating companies, personal contacts,
long term contracts
26
Trust-based solutions
 Use of intermediaries
 Reputation
 Relationship contracts
– Defining process for renegotiation
27
On Trust..
 Can only “trust” people/firms to do
what’s in their best interest
Align incentives/procedures so
that agent responses lead to revenue
growth/cost reduction for all
Have mechanism to share
gains
28
Supply Chain Coordination (Source: A. Raman)
 Good supply chain management involves
thinking like an engineer («people are dumb but
honest »)
Streamline processes
Educate employees/partners in benefits
 And like an economist (« people are dishonest
but smart »)
Consider changing incentive structure
29