OPSM 305 Supply Chain Management Koç 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)

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

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 Expected profit increases by 0.8*50 h  h+1 0  1 40 1  2 16.56 2  3 12.71 3  4 10.71 4  5 9.44 i* = 684 E[Profit] = 371.33

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 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.

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??

Effect of Transfer (Wholesale) Price in Differentiated Channel

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??

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

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

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

Example

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

Costs of Return Policies Extra transportation and handling Extra depreciation Getting the return rate wrong Retailer incentives

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

What’s the problem? Bad forecasting? Inefficient replenishment? 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?

Reduce wholesale price in return for a share of revenues 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

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

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

Quantity Flexibility Contracts 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

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

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

Trust-based solutions Use of intermediaries Reputation Relationship contracts Defining process for renegotiation

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

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