Supply Chain Coordination with Revenue-Sharing Contracts
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Operations Jul 1, 2007

Sup­ply Chain Coor­di­na­tion with Rev­enue-Shar­ing Contracts

A missed opportunity?

Woman chooses from soaps at grocery store

gio_banfi via iStock

Based on the research of

Gérard Cachon

Martin Lariviere

Coor­di­nat­ing the sup­ply of a prod­uct with con­sumer demand is cru­cial to the suc­cess of any business. 

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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.”

Featured Faculty

Martin Lariviere

Professor of Operations, Division Chair of Operations

About the Writer

Bea Weaver, a freelance writer based in Altamonte Springs, Florida.

About the Research

Cachon, Gérard P. and Martin A. Lariviere (2005). “Supply Chain Coordination with Revenue-Sharing Contracts: Strengths and Limitations,” Management Science, 51(1): 30–44.

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