Operations Mar 2, 2012

The Trick to Turn-and-Earn

Why the allo­ca­tion mech­a­nism smoothes demand fluctuations

Based on the research of

Lauren Xiaoyuan Lu

Martin Lariviere

An odd thing hap­pened in Kel­logg, Ida­ho, dur­ing the 1990s. Despite the town’s small size — pop­u­la­tion 2,422 — and rel­a­tive iso­la­tion — Spokane, Wash­ing­ton is over an hour away — local car deal­er Dave Smith Motors start­ed sell­ing more Dodge trucks than any­one else in the nation. By 1996, it was push­ing near­ly 4,000 extend­ed-cab Ram pick­up trucks out the door.

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Part of the surge was due to an Inter­net ad tout­ing no-hag­gle pric­ing that attract­ed cus­tomers from around the coun­try. But there was more to Dave Smith Motors’ impres­sive sales than just savvy mar­ket­ing. They also had a GMC deal­er­ship that ran the same way on the Inter­net but was not dom­i­nat­ing the mar­ket the same way,” says Mar­tin Lar­iv­iere, a pro­fes­sor of man­age­r­i­al eco­nom­ics and deci­sion sci­ences at the Kel­logg School of Man­age­ment. The dif­fer­ence between the Dodge and GMC deal­er­ships was not the way the two were run, but the way Dodge and GMC allo­cat­ed trucks to dealers.

Dodge was run­ning strict­ly on a turn-and-earn scheme, and if you moved the met­al, they gave you more,” Lar­iv­iere says, refer­ring to the method com­mon­ly used by the auto­mo­tive indus­try to assign capac­i­ty when man­u­fac­tur­ers can­not keep up with demand. Deal­er allo­ca­tions are based on pre­vi­ous sales, with high-sell­ing deal­er­ships receiv­ing more capac­i­ty in the next round. Because of this, the sales reps at Dave Smith Motors were real­ly clean­ing up on Dodges,” he says.

Need­less to say, this was upset­ting oth­er deal­ers, some as far away as Boise, Ida­ho, and Great Falls, Mon­tana. Not only did they feel they were los­ing poten­tial cus­tomers, some thought they were not get­ting the num­ber of trucks they deserved. Deal­ers are valu­able assets to auto com­pa­nies, and Dave Smith Motors’ exploita­tion of the turn-and-earn sys­tem was mak­ing some of them upset. Giv­en the pit­falls of the scheme, you would be for­giv­en if you thought Dodge quick­ly dropped turn-and-earn when it learned of Dave Smith Motors’ hijinks. It didn’t.

Turn-and-Earn

Dodge clear­ly thought turn-and-earn was an advan­ta­geous scheme, or else it would have allo­cat­ed stock dif­fer­ent­ly. But researchers have had a dif­fi­cult time iden­ti­fy­ing pre­cise­ly why turn-and-earn is an effi­cient way to dole out prod­ucts. One of Lariviere’s ear­li­er papers showed that the scheme can put geo­graph­i­cal­ly sep­a­rat­ed deal­ers into com­pe­ti­tion, like what hap­pened in the case of Dave Smith Motors. But that rea­son alone did not sat­is­fy him. Lar­iv­iere had anoth­er hunch, though. In his new paper, writ­ten along with Lau­ren Xiaoyuan Lu, an assis­tant pro­fes­sor at the Uni­ver­si­ty of North Car­oli­na at Chapel Hill, he shows turn-and-earn can reduce uncer­tain­ties that prop­a­gate up the sup­ply chain, tam­ing the so-called bull­whip effect.

The bull­whip effect can be a night­mare for sup­ply-chain man­agers. The term sup­pos­ed­ly orig­i­nat­ed with Proc­tor & Gam­ble and dia­pers,” Lar­iv­iere says. The end con­sumer, so to speak, uses Pam­pers at a pret­ty con­stant rate, but when P&G looked at the way super­mar­kets were order­ing, they saw big swings, and when they looked upstream at how they were plac­ing orders on their sup­pli­ers, like 3M, they saw even big­ger swings.” Fore­cast­ing mate­r­i­al orders or plan­ning new fac­to­ries requires con­fi­dent esti­mates of future demand, and any­thing that damp­ens the bull­whip effect allows com­pa­nies to bet­ter esti­mate demand and oper­ate more profitably.

Auto man­u­fac­tur­ers in par­tic­u­lar have large incen­tives to keep demand for their prod­ucts smooth. Keep­ing cars and trucks mov­ing to deal­ers keeps cost­ly inven­to­ry lev­els low. Fur­ther­more, adding pro­duc­tion capac­i­ty by build­ing a new fac­to­ry or retool­ing an old one can be pro­hib­i­tive­ly expen­sive and risky. For exam­ple, demand for a new mod­el may evap­o­rate before a retool­ing is completed.

While auto mak­ers are most com­mon­ly asso­ci­at­ed with turn-and-earn, allo­cat­ing capac­i­ty based on past sales also hap­pens else­where, Lar­iv­iere says. A short while back, sup­plies of Eggo waf­fles were con­strained because of the two fac­to­ries that pro­duce them, one was shut down for main­te­nance and the oth­er was flood­ed. Boun­ty paper tow­els were on allo­ca­tion for a peri­od of time, too. Demand spiked when a refor­mu­la­tion of the prod­uct proved pop­u­lar, and Proc­tor & Gamble’s pro­duc­tion capac­i­ty could not keep up. One solu­tion was to build a mul­ti­mil­lion-dol­lar paper mill, a deci­sion that would be prof­itable only if demand remained high, Lar­iv­iere points out. Turn-and-earn bought the com­pa­ny time while it eval­u­at­ed demand.

Tam­ing the Bull­whip

Lar­iv­iere and Lu sus­pect­ed turn-and-earn may have some role in reduc­ing the bull­whip effect, so they con­struct­ed a mod­el in which deal­ers are assigned capac­i­ty based on the allo­ca­tion scheme. Unlike pre­vi­ous mod­els which had only two time peri­ods, where capac­i­ty in the sec­ond was allo­cat­ed based on sales in the first, this one ran ad infini­tum. Pre­vi­ous pub­li­ca­tions had to set­tle for two time peri­ods as the math­e­mat­ics proved dif­fi­cult. Extend­ing the model’s hori­zon required Lar­iv­iere and Lu to apply the tools of com­pu­ta­tion­al economics.

High-sales deal­ers not only have a clear advan­tage under turn-and-earn when demand is high — they receive the high­est allo­ca­tion and so can sell more — they will fight hard to keep their lead when demand dips to the medi­um level.

Next, they mim­ic­ked real-world fluc­tu­a­tions in demand by intro­duc­ing three lev­els — low, medi­um, and high — rather than one. Not only did this more faith­ful­ly rep­re­sent the real world, it also allowed them to see under what con­di­tions a deal­er like Dave Smith Motors would fight to retain sales dom­i­nance. Final­ly, Lar­iv­iere and Lu’s new mod­el intro­duced fluc­tu­a­tions in local demand, such as when the road in front of a busi­ness is being repaired.

Lar­iv­iere and Lu found that high-sales deal­ers not only have a clear advan­tage under turn-and-earn when demand is high — they receive the high­est allo­ca­tion and so can sell more — they will fight hard to keep their lead when demand dips to the medi­um lev­el. Lar­iv­iere explains from a dealer’s per­spec­tive: If I’ve got a lead on a com­peti­tor and we get down to that medi­um state, I will sac­ri­fice some­thing so I can clean up when the mar­ket is great.”

In oth­er words, by sub­sti­tut­ing high­er sales for high­er prof­its dur­ing slight sags in demand, deal­ers can guar­an­tee high future allo­ca­tions. When things pick back up, they can recov­er their loss­es through renewed strong, high-prof­it sales. But,” Lar­iv­iere con­tin­ues, if demand gets real­ly soft and the mar­ket is real­ly slow, then I will give up.” When demand drops off a cliff to the low state, Lar­iv­iere and Lu’s mod­el pre­dicts that pre­vi­ous sales lead­ers can­not con­tin­ue to sell at a loss to guar­an­tee future allocation.

Up Side to Down Sales

Low demand is not bad for every­one, though. It can give low-sales deal­er­ships a chance to catch up, Lar­iv­iere and Lu found. The recent reces­sion con­firms their result. Toy­ota has tra­di­tion­al­ly been strong on the coasts, par­tic­u­lar­ly the West Coast” but not in the Mid­west, Lar­iv­iere says. As Amer­i­can car com­pa­nies start­ed to floun­der in the ear­ly 2000s, Toy­ota sales in the Mid­west start­ed to pick up. But Toy­ota ran into a prob­lem, he adds. Because it allo­cates based on turn-and-earn, deal­ers on the coasts con­tin­ued to receive more of the hot sell­ers like the Sien­na mini­van. It was not until sales for the entire indus­try dropped lat­er in the decade that Mid­west deal­ers had a chance to catch up.

Back in 2007 and 2008 as the over­all econ­o­my start­ed to slow down, there were var­i­ous deal­ers in the Mid­west who were being quot­ed in the trade press say­ing, I can final­ly get Sien­nas’,” Lar­iv­iere says. East and West Coast deal­ers sim­ply could not main­tain their high sales and so lost allo­ca­tion. Should the reces­sion end quick­ly, then Mid­west deal­er­ships will like­ly emerge with bet­ter sales allo­ca­tions than before. How­ev­er, Lar­iv­iere cau­tions, if sales are low for an extend­ed peri­od of time, every­one suffers.

Smooth­ing Demand

The dynam­ics are sim­i­lar on the local lev­el. Turn-and-earn can mol­li­fy short-term dis­tur­bances in demand. Let’s say the road in front of a car deal­er is being repaired by the city and cus­tomers are find­ing it a has­sle to turn into the deal­er­ship. The deal­er­ship knows the con­struc­tion will be over in a few months, and rather than reduce orders, they will keep orders high to ensure future allo­ca­tions. They may lose some mon­ey dur­ing con­struc­tion, but would like­ly lose more mon­ey in the future if the man­u­fac­tur­er reduced their allocation.

Turn-and-earn is a way of mit­i­gat­ing vari­abil­i­ty in the sup­ply chain, which is some­thing pre­vi­ous mod­els didn’t actu­al­ly address,” Lar­iv­iere says. By encour­ag­ing deal­ers and retail­ers to absorb local vari­abil­i­ty in demand — reduc­ing the bull­whip effect — man­u­fac­tur­ers allo­cat­ing based on turn-and-earn have an eas­i­er time plan­ning for the future.

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Featured Faculty

Martin Lariviere

Professor of Operations, Division Chair of Operations

About the Writer

Tim De Chant was science writer and editor of Kellogg Insight between 2009 and 2012.

About the Research

Lu, Lauren Xiaoyuan and Martin Lariviere. 2011. “Capacity Allocation over a Long Horizon: The Return on Turn-and-Earn.” Manufacturing & Service Operations Management. DOI: 10.1287/msom.1110.0346.

Read the original

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