1. OPSM 305 Supply Chain Management
Koç University
OPSM 305 Supply Chain Management
Class 10:
Incentive issues
Zeynep Aksin

2. 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)

3. Question 1
Optimal stocking quantity?
Profit at this stocking quantity?

4. Ordering Level and Profits in Vertically Integrated Channel
h=1; Anna sells to market directly:
i* = 584; E[Profit] = $331.33; Fill rate 98%

5. 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=

6. 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

7. 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

8. 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

9. 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.

10. 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??

11. Effect of Transfer (Wholesale) Price in Differentiated Channel

12. 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??

13. 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

14. 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

15. 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

16. Example

17. 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

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

19. 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

20. 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?

21. 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

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

23. 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

24. 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

25. 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

26. 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

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

28. 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

29. 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