Coordinating Contracts for Decentralized Supply Chains with Retailer Promotional Effort

Vol. 50, No. 1, January 2004, pp. 48–63 issn 0025-1909 eissn 1526-5501 04 5001 0048

MANAGEMENT SCIENCE

informs

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doi 10.1287/mnsc.1030.0154 © 2004 INFORMS

Coordinating Contracts for Decentralized Supply Chains with Retailer Promotional Effort

Sauder School of Business, University of British Columbia, Vancouver, British Columbia, Canada V6T 1Z2, harish.krishnan@sauder.ubc.ca University of Michigan Business School, Ann Arbor, Michigan 48109, kapuscin@umich.edu University of Michigan Medical School, Ann Arbor, Michigan 48109, dabutz@umich.edu

Harish Krishnan

Roman Kapuscinski David A. Butz

I

n this paper, a risk-neutral manufacturer sells a single product to a risk-neutral retailer. The retailer chooses inventories ex ante and promotional effort ex post. If the wholesale price exceeds marginal production cost, the retailer orders fewer than the joint profit-maximizing inventories. If the manufacturer attempts to coordinate inventories by buying back unsold units, then the retailer’s promotional incentives are dulled. Under very general assumptions on the form of the effort function, we show that buy-backs adversely affect supply chain profits, and higher buy-back prices imply lower profits. Also, while a buy-back alone cannot coordinate the channel, coupling buy-backs with promotional cost-sharing agreements (if effort cost is observable), offering unilateral markdown allowances ex post (if demand is observable but not verifiable), or placing additional constraints on the buy-back (if demand is observable and verifiable) does result in coordination. This problem is not limited to returns policies but is shown to hold for a much larger set of contracts. The results are quite robust (e.g., when the retailer chooses effort before observing demand), but coordinating contracts become more problematic if, for example, the retailer also stocks substitutes for the manufacturer’s product. Other model extensions are also discussed. Key words: supply chain...