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OPSM 305 Supply Chain Management

Class 10:

Incentive issues

Koç University

Zeynep Aksinzaksin@ku.edu.tr

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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)

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Question 1

Optimal stocking quantity? Profit at this stocking quantity?

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Ordering Level and Profits in Vertically Integrated Channel

h=1; Anna sells to market directly:i* = 584; E[Profit] = $331.33; Fill rate

98%

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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

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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

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Optimal Level of Effort in Vertically Integrated Channel

Demand potential increases by 50 Expected profit increases by 0.8*50

h

h

h h+1

0 1 40

1 2 16.56

2 3 12.71

3 4 10.71

4 5 9.44

)1(*50*0.8 hh

i* = 684E[Profit] = 371.33

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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

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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.

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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 $260Ralph makes $ 62Fill rate 84%

Why??

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Effect of Transfer (Wholesale) Price in Differentiated Channel

Breakdown of total profits (h=4)

0

50

100

150

200

250

300

350

400

transfer price

$ralph

anna

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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??

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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

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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

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Returns policies

Rationale: set buyback price b so that (retailer cost structure

= supply cost structure)

Supplier can use both w and b Supplier is bundling insurance with the good

sr

sc

br

bw

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Example

Breakdown of profits under a buyback scheme

050

100150200250300350400

buyback price

$ralph

anna

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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

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Costs of Return Policies

Extra transportation and handling Extra depreciation Getting the return rate wrong Retailer incentives

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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

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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?

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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

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Revenue sharing

When does it work?– marginal cost of increasing inventory low– administrative burden low– for price-sensitive products

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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

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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

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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

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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

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Trust-based solutions

Use of intermediaries Reputation Relationship contracts

– Defining process for renegotiation

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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

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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