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Ko University

OPSM 305 Supply Chain Management

Class 10:
Incentive issues

Zeynep Aksin
zaksin@ku.edu.tr

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?

Ordering Level and Profits in Vertically

Integrated Channel

h=1; Anna sells to market directly:

i* = 584; E[Profit] = \$331.33; Fill rate 98%

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

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

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
01

0.8 * 50 * ( h 1 h )

12

16.56

40

23

12.71

34

10.71

45

9.44

i* = 684
E[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

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 Ralphs profit.
How would changing the transfer price from the current
value of 0.8 impact Anns effort level and Ralphs
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 \$260
Ralph makes \$ 62
Fill rate 84%
Why??

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Effect of Transfer (Wholesale) Price in

Differentiated Channel
Breakdown of total profits (h=4)
400
350
300
250

ralph

\$ 200

anna

150
100
50
0

transfer price

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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
Annas profit:
\$262
\$260
Ralphs 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
w b (retailer
c s cost structure

cost structure)
r b =r supply
s
Supplier can use both w and b
Supplier is bundling insurance with the good

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Example
Breakdown of profits under a
400
350
300
250
\$ 200
150
100
50
0

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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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)

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
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
whats 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
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