Decentralized Inventory Management under Price Protection in the High-Technology Industry

In high-technology industries, where technological obsolescence is high, price protection has become a standard element of contracts between manufacturers and distributors. Price protection was designed to counteract the high technological obsolescence and provide distributors with incentives to stock sufficient inventory. However, empirical evidence suggests that price protection often leads to over-stocking at the distributors. Motivated by a need to decrease inventory held at the distributors of a large computer manufacturer, we model and analyze price-protection contracts as implemented in practice: full protection for a limited time, L. Formulating such price-protection contracts requires tracking the historical orders of distributors over the period of time that goods are price protected. The critical element of our analysis is a myopic reformulation that makes it easier to analyze the problem and interpret the results, while preserving the dependency of the price protection cost on L. We characterize the behavior of the optimal inventory targets under a distributor managed inventory (DMI) policy as a function of the economic parameters and the length of the price protection period. We also identify conditions that lead to over-stocking under the current system (DMI). Alternative policies that decrease incentive misalignment are then considered, including a vendor managed inventory policy (VMI) and risk sharing. We show that the incentives for "channel stuffing" that usually accompany VMI are decreased or eliminated in a price-protection environment. In a numerical study, we observe that VMI provides superior performance compared to DMI in conditions that routinely characterize the high-technology industry, i.e., high technological obsolescence, higher impact of product shortages on the manufacturer than the distributor, low inventory carrying costs (other than obsolescence costs), and low to moderate profdit margins. VMI also performs well when profit margins increase over time, which often characterizes new product introductions. While risk sharing may be difficult to implement, combining VMI with risk sharing leads to significant improvements.

By: Karthik Sourirajan; Roman Kapuscinski; Markus Ettl

Published in: RC24715 in 2008


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