Express Lane

Based on research by Dinah Cohen-Vernik (a former Rice Business professor) and Devarat Purohit

• Manufacturers can’t assume that using the turn-and-earn rule based on retailers’ historical sales is the most profitable choice for the manufacturer.
• Retailers don’t always prefer a fixed allocation rule.
• Examining how multi-product firms get the best return sheds light on the right answer.

If you lived in California and were looking for a new Toyota Prius back in spring of 2008, it was tough going. About 65 retail dealers were jockeying for position with Toyota to get a share of the 400 available Priuses. You think you had problems! Manufacturers can’t always increase the wholesale price or expand production capacity in order to solve the problem. Those are risky propositions in a market where product demand is fickle but manufacturer-retailer relationships are critical to long-term success. So what’s a manufacturer to do when capacity might tighten for a product with unpredictable demand?

Many manufacturers try to optimize profits by using a time-honored tradition: turn-and-earn (T&E). It goes like this: Retailers who turn inventory the fastest, based on past sales, earn the right to a higher allocation of scarce, high-demand products in the future. T&E tends to optimize capacity utilization, sales and profitability as compared to fixed allocation methods that dole out the product based on some pre-determined amount across a retail network.

But should a manufacturer consider their retailers’ sales histories across their entire product line, the product that could be in short supply in the future or other products in their line that have stable demand? This choice matters only when capacity is tight and demand is high. It is then that retailers are incentivized to behave differently — to order more products today — in an attempt to secure a sales leadership role that could earn them a higher allocation of a scarce product in the future, if needed.

It turns out that a T&E rule that is based on retailers’ sales of products with fairly steady demand is always inferior to other types of T&E rules. So Dinah Cohen-Vernik, former assistant professor of marketing at Rice Business, and her co-author focused a study on developing a general allocation rule amongst the other alternatives. To do so, they developed an analytical model set in a two-period world in which a single manufacturer sells a product line consisting of two products that are sold via two retailers that are geographically separated, such that they have monopolies within their respective markets. The products are partial substitutes, but demand for one product is stable while demand for the other is unpredictable and subject to supply constraints when demand for it is high. Consistent with some real world situations, wholesale prices and allocation methods are assumed to be fixed across the consecutive selling periods.

Findings from the study reveal that managers at multi-product manufacturing firms shouldn’t assume that using a T&E rule based on retailers’ sales across the entire product line is always the best choice. If products are highly substitutable, then the ability of manufacturers to set an optimal price makes a T&E rule based on retailers’ sales of just the product with erratic demand the best choice, especially if it’s likely that it will be in high demand and suffer future supply constraints. The logic is straightforward. Because the products are substitutable, retailers will increase orders of the product with an anticipated supply shortage today while simultaneously decreasing orders of the product with stable demand. Knowing this, managers will set prices for the product that will get higher orders today at a level that offsets any loss associated with the decline in orders for the product with stable demand.

The strategy should change, however, when products are less substitutable. Sure, retailers still will place more orders today of the product with an anticipated shortage. However, the quantity ordered of the product with stable demand doesn’t decline. Remember, every retailer wants to become a sales leader via any T&E rule. Some, with deep pockets, will attempt to do so by ordering more of both the stable-demand and unpredictable-demand products. Other, less flexible retailers will make a play for sales leadership by sacrificing orders of the product with stable demand in order to buy more of the product with unpredictable demand. Because it’s hard to predict who will respond in these different ways, the manufacturer’s best bet is to go with a T&E rule based on retailers’ sales across the entire product line.

Cohen-Vernik and her co-author also show that T&E is not always a bad deal for retailers, as suggested by prior researchers. Taking into account a full product line, it is possible for the retailer and manufacturer to prefer a T&E rule to a fixed allocation rule. In fact, it is possible for the retailer and manufacturer to prefer the same T&E allocation rule, which enhances profit for both.

You might be wondering: “Wouldn’t it be best for manufacturers to just forget about these T&E rules and let the free market sort things out by raising wholesale prices when capacity gets tight?”

Actually, according to the findings published by Cohen-Vernik and her co-author, when capacity is extremely tight for products with unpredictable demand, it’s more profitable for managers to use a T&E rule based on retailers’ sales across the product line than to use price as an allocation mechanism. The T&E rule gives retailers incentive to secure sales leadership by at least ordering more of the stable-demand product (since more of the variable-demand product isn’t possible). All said, understanding how to get the most out of T&E policies is critical for manufacturers hoping to optimize performance.

Dinah Cohen-Vernik is a former marketing professor at Jones Graduate School of Business at Rice University.

To learn more, please see: Cohen-Vernik, D., & Purohit, D. (2014). Turn-and-earn incentives with a product line. Management Science, 60(2), 400-414.