Terry A. Taylor

Supply Chain Coordination Under Channel Rebates with Sales Effort Effects

A channel rebate is a payment from a manufacturer to a retailer based on retailer sales to end consumers. Two common forms of channel rebates are linear rebates, in which the rebate is paid for each unit sold, and target rebates, in which the rebate is paid for each unit sold beyond a specified target level. When demand is not influenced by sales effort, a properly designed target rebate achieves channel coordination and a win-win outcome. Coordination cannot be achieved by a linear rebate in a way that is implementable. When demand is influenced by retailer sales effort, a properly designed target rebate and returns contract achieves coordination and a win-win outcome. Other contracts, such as linear rebate and returns or target rebate alone, cannot achieve coordination in a way that is implementable. Contrary to the view expressed in the literature that accepting returns weakens incentives for retailer sales effort, we find that the provision of returns strengthens incentives for effort.

Sell the Plant? The Impact of Contract Manufacturing on Innovation, Capacity, and Profitability

In the electronics industry and others, original equipment manufacturers (OEMs) are selling their production facilities to contract manufacturers (CMs). The CMs achieve high capacity utilization through pooling (supplying many different OEMs). Meanwhile, the OEMs focus on innovation: research and development, product design, and marketing. We examine how this change in industry structure affects investment in innovation and capacity, and thus profitability. In particular, innovation is noncontractible, so OEMs will invest less in innovation than is ideal for the industry as a whole. Hence, although contract manufacturing improves capacity utilization, it may reduce the profitability of the industry as a whole by weakening the incentives for innovation. Contract manufacturing is not the only means to achieve capacity pooling. Alternatively, the OEMs can pool capacity with one another through supply contracts or a joint venture. This may result in underinvestment or overinvestment in innovation and capacity, but always increases profitability. We find that the sale of production facilities to a CM improves profitability for the industry as a whole if and only if OEMs are subsequently in a strong bargaining position vis-A -vis the CM. If the OEMs are indeed very strong, the gain from pooling capacity via contract manufacturing is maximized in industries with moderate cost of capacity.

Supply Chain Relationships and Contracts: The Impact of Repeated Interaction on Capacity Investment and Procurement

Consider a firm developing an innovative product. Due to market pressures, production must begin soon after the product development effort is complete, which requires that an upstream supplier invests in capacity while the design of the product and production process are in flux. Because the product is ill-defined at this point in time, the firms are unable to write court-enforceable contracts that specify the terms of trade or the suppliers capacity investment. However, the firms can adopt an informal agreement (relational contract) regarding the terms of trade and capacity investment. The potential for future business provides incentive for the firms to adhere to the relational contract. We show that the optimal relational contract may be complex, requiring the buyer to order more than her demand to indirectly monitor the suppliers capacity investment. We propose a simpler relational contract and show that it performs very well for a broad range of parameters. Finally, we identify characteristics of the business environment that make relational contracting particularly valuable.

Channel Coordination Under Price Protection, Midlife Returns, and End-of-Life Returns in Dynamic Markets

This paper examines three channel policies that are used in declining price environments: Price protection (P) is a mechanism under which the manufacturer pays the retailer a credit applying to the retailers unsold inventory when thewholesale price drops during the life cycle; midlife returns (M) allow the retailer to return units partway through the life cycle at some rebate; and end-of-life returns (E) allow the retailer to return unsold units at the end of the life cycle. Under decliningretail prices, if the wholesale prices and the return rebates are set properly, then EM (i.e., midlife and end-of-life returns) achieves channel coordination. However, such a policy may not be implementable because it may require the manufacturer to be worse off as a result of coordination. If P is used in addition to EM and the terms are set properly, then PEM guarantees both coordination and a win-win outcome. If theretail price is constant over time, then EM is sufficient to guarantee both coordination and a win-win outcome.

Sale Timing in a Supply Chain: When to Sell to the Retailer

A fundamental decision for any manufacturer is when to sell to a downstream retailer. A manufacturer can sell either early, i.e., well in advance of the selling season, or late, i.e., close to the selling season. This paper examines the impact of information asymmetry, retailer sales effort, and contract type on the manufacturers sale-timing decision. We find that if information is symmetric, demand is not influenced by sales effort, and the contract specifies that the price paid is linear in the order quantity, the manufacturer prefers to sell late. This result extends to the case where the retailer exerts sales effort during the selling season. However, if the retailer exerts sales effort prior to the selling season or has superior information about market demand, the manufacturer may prefer to sell early. We characterize the manufacturers sale-timing preference in these settings, providing clear conditions under which the manufacturer prefers to sell either early or late. We show that the retailer, manufacturer, and total system may be hurt by the retailers having higher-quality information.

Incentives for Retailer Forecasting: Rebates vs. Returns

This paper studies a manufacturer that sells to a newsvendor retailer who can improve the quality of her demand information by exerting costly forecasting effort. In such a setting, contracts play two roles: providing incentives to influence the retailers forecasting decision and eliciting information obtained by forecasting to inform production decisions. We focus on two forms of contracts that are widely used in such settings and are mirror images of one another: a rebates contract, which compensates the retailer for the units she sells to end consumers, and a returns contract, which compensates the retailer for the units that are unsold. We characterize the optimal rebates contracts and returns contracts. Under rebates, the retailer, manufacturer, and total system may benefit from the retailer having inferior forecasting technology; this never occurs under returns. Although one might conjecture that returns would be inferior because its provision of “insurance” would discourage the retailer from forecasting, we show that returns are superior.

Simple Relational Contracts to Motivate Capacity Investment: Price Only vs. Price and Quantity

Because of long lead times associated with product development and building capacity, a supplier must initiate investment in capacity when the product development effort is ongoing. Because the product is ill defined at this point in time, the buyer is unable to commit to the future terms of trade through a court-enforceable contract. Instead, to provide incentives for capacity investment, the buyer informally promises future terms of trade. The prospect of future interaction creates an incentive for the buyer to pay the supplier as promised. We characterize optimal price-only and price-and-quantity promises and compare their performance. If the production cost is low and either the capacity cost is low or the discount factor is high, then the buyer should promise to purchase a specific quantity rather than simply promise to pay a per unit price; otherwise, the buyer should simply promise to pay a specified unit price.

Does a Manufacturer Benefit from Selling to a Better-Forecasting Retailer?

This paper considers a manufacturer selling to a newsvendor retailer that possesses superior demand-forecast information. We show that the manufacturers expected profit is convex in the retailers forecasting accuracy: The manufacturer benefits from selling to a better-forecasting retailer if and only if the retailer is already a good forecaster. If the retailer has poor forecasting capabilities, then the manufacturer is hurt as the retailers forecasting capability improves. More generally, the manufacturer tends to be hurt (benefit) by improved retailer forecasting capabilities if the product economics are lucrative (poor). Finally, the optimal procurement contract is a quantity discount contract.

Partnership in a Dynamic Production System with Unobservable Actions and Noncontractible Output

This paper considers two firms that engage in joint production. The prospect of repeated interaction introduces dynamics, in that actions that firms take today influence the costliness and effectiveness of actions in the future. Repeated interaction also facilitates the use of informal agreements (relational contracts) that are sustained not by the court system, but by the ongoing value of the relationship. We characterize the optimal relational contract in this dynamic system with double moral hazard. We show that an optimal relational contract has a simple form that does not depend on the past history. The optimal relational contract may require that the firms terminate their relationship with positive probability following poor performance. We show how process visibility, which allows the firms to better assess who is at fault, can substantially improve system performance. The degree to which process visibility eliminates the need for termination depends on the nature of the dynamics: If the buyers action does not influence the dynamics, the need for termination is eliminated; otherwise, termination may be required.

Implications of Breach Remedy and Renegotiation Design for Innovation and Capacity

Amanufacturer writes supply contracts with N buyers. Then, the buyers invest in innovation, and the manufacturer builds capacity. Finally, demand is realized, and the firms renegotiate the supply contracts to achieve an efficient allocation of capacity among the buyers. The court remedy for breach of contract (specific performance versus expectation damages) affects how the firms share the gain from renegotiation, and hence how the firms make investments ex ante. The firms may also engage in renegotiation design, inserting simple clauses into the supply contract to shape the outcome of renegotiation. For example, when a buyer grants a financial “hostage” to the manufacturer or is charged a per diem penalty for delay in bargaining, the manufacturer captures the gain from renegotiation. “Tradable options,” which grant buyers the right to trade capacity without intervention from the manufacturer, return the gain from renegotiation to the buyers. This paper proves that, under surprisingly general conditions, the firms can coordinate their investments with the simplest of supply contracts (fixed-quantity contracts). This may require renegotiation design, and certainly requires that the firms understand the breach remedy and set their contract parameters accordingly.