Operations Jul 1, 2007
Supply Chain Coordination with Revenue-Sharing Contracts
A missed opportunity?
gio_banfi via iStock
Coordinating the supply of a product with consumer demand is crucial to the success of any business.
Consider, for example, the plight of a video retailer dealing with a capacity problem. Peak demand for a new rental title lasts only a few weeks, but the cost of a video is relatively high. Before 1998, studios sold videotapes to Blockbuster Inc. and other video retailers for $65 per tape. With retailers collecting $3 per rental, the retailer would break even only after 22 rentals. Hence, retailers could not justify purchasing enough copies to cover the initial peak in demand, and the poor availability of new-release videos was consistently a major customer complaint. To overcome this problem, in 1998 Blockbuster agreed to pay its suppliers a portion of its rental income (probably in the range of 30 percent to 45 percent, based on publicly available information about similar contracts) in exchange for a reduction in the initial price per tape from $65 to $8. The break-even point dropped to about six rentals, allowing Blockbuster to purchase many more tapes and sustain its “Go Home Happy” campaign.
Inspired by Blockbuster’s problem, Martin Lariviere, a professor in the Kellogg School’s Managerial Economics and Decision Sciences Department, and his co-author Gérard Cachon of the University of Pennsylvania have shown that revenue sharing is a very attractive contract. In their 2005 Management Science article “Supply Chain Coordination with Revenue-Sharing Contracts: Strengths and Limitations,” their analysis demonstrates that revenue sharing allows a supplier and a single retailer to coordinate their supply chain effectively; that is, the retailer can choose the optimal actions with respect to quantity and price to maximize profit. The supplier sells at a wholesale price below marginal cost (the cost of production, royalties, transportation, and handling), but sharing the retailer’s revenue more than offsets its loss on sales. This is true whether demand is stochastic or deterministic, whether the product is rented or sold. “With so much going for it,” according to Cachon and Lariviere, it is difficult to see why revenue sharing is “not prevalent in all industries.”
Cachon and Lariviere explore this question starting with a base model in which a supplier sells to a single retailer. The retailer makes two decisions: (1) how many units to purchase from the supplier and (2) retail price. The authors then extend the model to multiple retailers competing on the basis of quantity. After showing how revenue sharing affects the revenue of suppliers and both single and competing retailers, Cachon and Lariviere compare revenue sharing with other types of contracts and point out their limitations.
Revenue sharing allows coordination of a supply chain when the retailer fixes the price of a product, which buy-back contracts do not.
Several types of contracts coordinate a supply chain when the product has a fixed price: buy-back, quantity-flexibility, and sales-rebate. With a buy-back contract, the supplier agrees to buy back unsold stock at a price lower than the original price. Quantity-flexible contracts require the supplier to provide the retailer a full refund up to a certain quantity; and with sales-rebate contracts the supplier gives the retailer a rebate for exceeding a certain number of sales. Cachon and Lariviere show that with a fixed retail price, buy-backs and revenue sharing generate the same cash flow no matter what the demand. This is not true, however, for quantity-flexible and fixed-rebate contracts. And revenue sharing (as well as price discounts) allows coordination of a supply chain when the retailer fixes the price of a product, which buy-back contracts do not.
What, then, are the limitations of revenue sharing? Cachon and Lariviere discuss three potential shortcomings. First, with revenue sharing (in contrast to wholesale price contracts) the supplier must be able to verify the retailer’s revenue, which incurs a cost that reduces the supplier’s profit. Second, revenue sharing does not coordinate the supply chain effectively when several competitors serve the market and the revenues of an individual retailer depend on the actions of all competitors. This situation requires more complex contracts.
Finally, the third limitation is that revenue sharing does not coordinate the supply chain when the retailer’s effort influences the demand and this effort is not contractable (for example, advertising, service quality, and store presentation). When demand is sufficiently influenced by retail effort, revenue-sharing contracts should be avoided, according to Cachon and Lariviere. They make the case that a quantity discount would allow coordination of the supply chain with effort-dependent demand and allocate rents without the use of fixed fees. In quantity-discount contracts, the cost to the retailer is based on the volume purchased, with the price decreasing as more units are purchased. With a quantity-discount contract, the supplier earns the same profit no matter what the demand whereas with revenue sharing the supplier bears some demand risk.
Revenue sharing is a valuable strategy in an industry such as video rentals where administrative costs are low and retail effort does not have much impact on demand. If systems are available to track sales or rentals, it would not be difficult for suppliers to verify revenues. The authors point out that “almost all video stores have systems of computers and bar codes to track each tape rental, so it should not be difficult for the suppliers to monitor and verify revenues.” Also, in a video rental store “the retailer merely displays boxes of available tapes from which customers make their selections. Unlike home appliance or automobile retailing, customers do not make their video selection after substantial consultation with a retail salesperson (which requires effort).” Although there are limits to revenue-sharing contracts, Cachon and Lariviere “suspect that other industries have yet to discover their virtues.”
Cachon, Gérard P. and Martin A. Lariviere (2005). “Supply Chain Coordination with Revenue-Sharing Contracts: Strengths and Limitations,” Management Science, 51(1): 30–44.