Video Vault What do customers want from a video store?

• Problem of wholesale price contract

• Availability
– Supply chain performance issues in absence of bullwhip
• Customer service
– Double marginalization
• Convenient location
• Solutions to Supply Chain failure
– Revenue Management • Broad assortment
• Problems of revenue sharing contracts • Low price
– Franchise • Reasonable late fees
– Buyback Contracts
• Clean store
– Options Contracts
• …
– Quantity Discounts

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Video Vault: How many units to buy under

Why is availability difficult? standard wholesale price contract?

• Retailer’s cost per tape = $65; rental revenue per tape = $3

• Uncertain demand • Supplier’s cost per tape = $8
• Demand starts high and decreases rapidly Number of tapes Expected total
Required incremental
purchased number of rentals number of rentals to
• Alternative ways to obtain videos
1 60 justify purchasing an
Best
2 for VV 100 additional tape:
3 120
VV: 65 / 3 = 21.67
4 132
Best SC: 8 / 3 = 2.67
5 137
for SC
6 139 (Or calculate expected
revenues – see Excel)
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What happened ? Another example of double marginalization

• Lack of inventory is not due to poor forecasting or bad
inventory management, it is due to the economics
imposed on the retailer.
• Suboptimal supply chain performance occurs because …
– Each firm makes decisions based on their own margin, not
the supply chain’s margin.
– This is called double marginalization.
• Zamatia makes sunglass at a cost of $35 and sells them to UV for $75.
• UV sells them for $115 and salvages left over inventory for $25 per unit.
• Demand is normal with mean 250 and standard deviation 125.
• UV faces a newsvendor problem:
– Cu = 115 - 75 = 40, Co = 75 - 25 = 50, Critical ratio = 40 / 90 = 0.44
• Supply chain:
– Cu = 115 - 35 = 80, Co = 35 - 25 = 10, Critical ratio = 80 / 90 = 0.89

– Supply chain’s critical ratio is much higher than UV’s critical ratio!
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 Back to Video Vault:
How would we get VV to order more? Blockbuster Independent Store
• Clientele: teenagers • Clientele: older segment of
• Cut the wholesale price:
• No relationship with customer population
– The retailer buys more tapes… but not attractive to the supplier.
• Employees uninformed about • Know customer preferences
• We want an arrangement that …
products and not helpful • Know movies & helpful at
(1) maximizes supply chain profits and
• Carry dozen copies of new recommending alternative titles
(2) allows the firms to divide the “supply chain’s pie” so that they
are both better off. releases, few old movies • Carry older movies, only few
• Customers want to rent the copies of new releases
• Revenue sharing:
movie • Customers want to rent a movie
– Supplier sells tapes at a reduced price, but takes share of retailer’s
revenue, e.g., wholesale price = $4, retailer’s share = 50%.
Need high service level ⇒
– Now the retailer only needs 4 / ( 50% x 3) = 2.67 incremental rentals to Customers willing to switch ⇒
revenue sharing very beneficial
justify ordering a tape. revenue sharing less beneficial
Powerful enough to get favorable
– Various wholesale price – retailer share combinations maximize supply Too small to negotiate very
division of the pie.
chain profits, but result in different divisions of the pie. (See Excel) favorable division of the pie.
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Before and after revenue sharing Some revenue sharing issues

Blockbuster market share • Monitoring costs:

• Before revenue sharing (pre 1998):
– Rentals shrinking, sales declines,
20% of surveyed customers can’t
find what they want.
• After revenue sharing (1998+)
– Blockbuster negotiated revenue
sharing deals with all the studios.
– Begins the “Go home happy”
campaign:
– Total industry profit increased by
about 7% (Mortimer, 2003)
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– Supplier must incur the cost of monitoring the retailer’s revenue.
1997 – Disney sued Blockbuster 2002 for $120 million in damages over rental
25% revenue & discontinued revenue sharing. (Settled for $18M in 2005.)
• Risk: Supplier’s profit becomes more variable and payment is received later.
PLEASE DO NOT TURN SLIDES…
• Diversion:
– Must avoid retailers using the low wholesale price to resell tapes.
– (Restriction on total number of videos bought by retailers – revenue sharing
more a form of subsidization than supply chain coordination???)
1999 • Effort: Retailer’s incentive to exert effort to increase sales is reduced (e.g., why
increase sales if you only keep ½ of the revenue).
38%
• But revenue sharing makes supplier advertising more attractive because demand
can be concentrated around the release date (i.e., there is more inventory to
satisfy the burst of demand created by advertising).
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Other solutions to supply chain Buy-back contracts

coordination failure (also known as returns policies)

• What are they?

• Franchise fees: – Retailer is allowed to return to the supplier goods left over at the end of
– Marginal cost pricing coordinates actions, but leaves the the selling season for a pre-specified price.
upstream party with no profit.
• How do they improve supply chain performance?
– Charge franchise fee to extract profit from the franchisee. – The retailer’s overage cost is reduced (higher salvage value), so the
retailer stocks more.
– Could protect the supplier’s brand image by avoiding markdowns.
• Buy-back contracts… – Allows the supplier to signal that significant marketing effort will occur.

• What are the costs of buy-backs?

• Options contracts… – Administrative costs plus additional shipping and handling costs.

• Where are they used?

– books, cosmetics, music CDs, agricultural chemicals, electronics …

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 Buyback contracts at Zamatia Buyback contracts at Zamatia

Many wholesale price / buy-back price pairs maximize supply chain profits:
• Suppose Zamatia offers to buy-back unsold sunglasses at b per unit:
Wholesale price ($) 35 45 55 65 75 85 95 105
– UV incurs a $1.5 cost to ship sunglasses back. Buy back price ($) 26.50 37.75 49.00 60.25 71.50 82.75 94.00 105.25
– Zamatia salvages sunglasses for $26.50. C u ($) 80 70 60 50 40 30 20 10
C o ($) 10.00 8.75 7.50 6.25 5.00 3.75 2.50 1.25
– b < $75 so that UV doesn’t make money returning merchandise.
Critical ratio 0.8889 0.8889 0.8889 0.8889 0.8889 0.8889 0.8889 0.8889
– b > $26.50 so UV prefers to return rather than salvage. z 1.23 1.23 1.23 1.23 1.23 1.23 1.23 1.23
Q 404 404 404 404 404 404 404 404
• UV’s overage cost, Co =75 – (b – 1.5) > 50, is reduced … Expected sales 243 243 243 243 243 243 243 243
– … so UV’s critical ratio increases! Exp. left over inv. 161 161 161 161 161 161 161 161
Expected profits:
Umbra 17,830 15,601 13,373 11,144 8,915 6,686 4,458 2,229
• Choose b so that ? UV’s critical ratio = SC’s critical ratio (0.8889):
Zamatia 0 2,229 4,458 6,686 8,915 11,144 13,373 15,601
– Recall: Cu = 115 - 75 = 40 Supply chain 17,830 17,830 17,830 17,830 17,830 17,830 17,830 17,830
– Critical ratio = 40 / [(75 – (b – 1.5))+40] = 40/(116.5 – b) = 0.8889 • As buy-back price increases, risk and profits shift from retailer to supplier.
=> b = 116.5 – (40 / 0.8889) = 71.50 • There is a wholesale/buy back price combination that makes both firms better off!
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Options contract example: semiconductors Summary Supply Chain Coordination

• Setting: • Coordination failure:
– Supplier invests in capacity (fabs cost $3Billion+), then …
– Supply chain performance may be less than optimal with decentralized
– Random demand occurs.
operations (i.e., multiple firms making decisions) even if firms choose
• Scenario 1: individually optimal actions.
– Buyer decides how much to buy after observing demand.
– Supplier bears all risk of idle capacity so under invests in capacity … • A reason for coordination failure:
– … buyer can’t get needed product if demand is high – The terms of trade do not give firms the proper incentive to choose supply
chain optimal actions.
• Scenario 2: option contact:
– Buyer purchases options before demand is observed, p0 per option • Why fix coordination failure:
– Buyer pays pe to exercise an option, after observing demand
– If total supply chain profit increase, the “pie” increases and everyone can
– Now risk is shared (supplier gets p0 up front even if demand is low)
be given a bigger piece.
– Supplier builds more capacity because she bears less risk …
– … and more capacity is available to the buyer if demand is high … • How to fix coordination failure:
– … so they both can be better off.
– Design terms of trade to restore a firm’s incentive to choose optimal
• Where else are option contracts used? actions (revenue sharing, buyback contracts, options, quantity discounts).
– Energy markets, commodity chemicals, metals, plastics, air cargo, … – Vendor managed inventory / Just in time distribution
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