Contracting in a Supply Chain with Stochastic Demand and Substitute Products

Abstract

Retailers often stock competing products from multiple manufacturers. When the retailer stocks out of a particular item, customers who prefer the item are likely, with some probability, to switch to a substitute product from another manufacturer at the same store. In such an event, a “lost sale” for the manufacturer is not a “lost sale” for the retailer. This exacerbates differences in manufacturer's and retailer's stockout costs for the item. Such differences in stockout cost influence the optimal contract between the manufacturer and the retailer and also impose agency costs on the channel. Such contracts, in turn, determine equilibrium inventory levels and fill rates. We study these issues in a single‐period supply chain, consisting of a manufacturer and a retailer, under three different scenarios (when the two firms are integrated into a single entity, when the retailer makes stocking decisions, and when the manufacturer makes stocking decisions). We compare, and present a methodology for comparing, stocking quantities, manufacturer efforts, and supply chain profits across different scenarios. We find that VMI performs better when manufacturer effort is a substantial driver of consumer demand and when consumers are unlikely to substitute to another brand in case of a stockout. On the other hand, if non‐contractible manufacturer effort is unimportant, or when substitution is significant, VMI can exacerbate, rather than mitigate, channel inefficiencies, and can perform worse than traditional Retailer Managed Inventory.

The newsvendor problem: Review and directions for future research

“…Kraiseburd, Narayanan and Raman [31] studied a model that incorporates such an aspect in the newsvendor scenario. Their setting is as follows.…”

Capacity Coordination Mechanism for Supply Chain under Supply-Demand Uncertainty

“…However, with the importance of service becoming increasingly remarkable, some non-price factors (quality, time, information and client preference) came into the study field of supply chain coordination [6]. Kraiselburd et al (2004) studied the supply chain coordination problem in which one retailer sells replaceable products from two suppliers at the same time and the suppliers' levels of promotion effort have direct effect on its product demand [7]. Liu and Tang (2005) studied the service level decision making under varying lead time.…”

Substitution Effects in Supply Chains with Asymmetric Information Distribution and Upstream Competition

“…Based on these results, recent work has investigated various competitive environments under customer substitution. Mishra and Raghunathan (2004), Kraiselburd et al (2004), and Kim (2008) explore the consequences of introducing Vendor Managed Inventory for the wholesaler's stocking levels and advertisement efforts. Nagarajan and Rajagopalan (2008) embed the substitution framework into a multi-period setting and Jiang et al (2011) provide a robust optimization approach that determines stocking levels by minimizing absolute regret.…”