Vertical cost information sharing in a supply chain with value-adding retailers

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<ul><li><p>Omega 36 (2008) 838851www.elsevier.com/locate/omega</p><p>Vertical cost information sharing in a supply chain withvalue-adding retailers</p><p>Dong-Qing Yaoa,, Xiaohang Yueb, John LiucaDepartment of Management, College of Business and Economics, Towson University, MD 21252, USA</p><p>bSchool of Business Administration, University of Wisconsin-Milwaukee, WI 53201, USAcDepartment of Logistics, Hong Kong Polytechnic University, Hung Hom, Kowloon, China</p><p>Received 12 August 2005; accepted 19 April 2006Available online 9 June 2006</p><p>Abstract</p><p>We consider a supply chain consisting of one supplier and two value-adding heterogeneous retailers. Each retailer has fullknowledge about his own value-added cost structure that is unknown to the supplier and the other retailer. Assuming there is nohorizontal information sharing between two retailers, we model the supply chain with a three-stage game-theoretic framework. Inthe rst stage each retailer decides if he is willing to vertically disclose his private cost information to the supplier. In the secondstage, given the information he has about the retailers, the supplier announces the wholesale price to the retailers. In response to thewholesale price, in the third stage, the retailers optimize their own retail prices and the values added to the product, respectively.Under certain conditions, we prove the existence of equilibrium prices and added values. Furthermore, we obtain the condition underwhich both retailers are unwilling to vertically share their private information with the supplier, as well as the conditions underwhich both retailers have incentives to reveal their cost information to the supplier, thus leading to a winwin situation for the wholesupply chain. 2006 Elsevier Ltd. All rights reserved.</p><p>Keywords: Value-added; Supply chain; Information sharing; Distribution channel; Game theory</p><p>1. Introduction</p><p>The concept of value-added, the idea of adding service or components to a product to increase its value or price[1], has been a buzzword in recent years. In order not to be disintermediated in this competitive E-business era, eachstage in a supply chain needs to add appropriate value to a product. There are numerous ways to add value to a product.A retailer can bundle the product with value-added service/delivery or provide desirable value-added packaging [2].In the IT industry, value can be added through services, free software, technical training or maintenance. For example,software companies (e.g., Systemax) may bundle the PC with a package of free internet access such as basic AOLservice [3]. In hi-tech industries (e.g., electronics industry), value can be added through simple components labelingand kitting to complex supply chain management service [4].</p><p> This manuscript was processed by Associated Editor Richard Metters. Corresponding author. Tel.: +1 410 704 6185; fax: +1 410 704 3236.E-mail addresses: dyao@towson.edu (D.-Q. Yao), xyue@uwm.edu (X. Yue), lgtjliu@polyu.edu.hk (J. Liu).</p><p>0305-0483/$ - see front matter 2006 Elsevier Ltd. All rights reserved.doi:10.1016/j.omega.2006.04.003</p></li><li><p>D.-Q. Yao et al. /Omega 36 (2008) 838851 839</p><p>Since there are always operating costs incurred related to corresponding value-added service, one natural researchquestion arises: how much value should be added, especially under a competitive market structure? In this paper, wewill examine a distribution channel in a supply chain made up of one supplier and two heterogeneous value-addingretailers/distributors. Both retailers order generic products from a supplier, and add certain value to the product, thensell the product to customers. We are interested in studying how much appropriate value should be added to the genericproduct by each retailer.</p><p>Many business practices around such types of distribution channels can be found in real life. For example, ITsolution providers may order white box PCs from suppliers, then add appropriate value (e.g. offer antivirus software,technical training, provide extended warranty). Actually, CRN research showed that white boxes are their best-sellingdesktops, compared to branded name PCs [5]. In the electronics industry, distributors may offer value-added servicessuch as connector and cable assemblies, customized integration, supply chain management services such as a vendormanaged inventory (VMI) program, or even design service [6]. In the franchising industry, each franchisee acquiresthe franchisors generic product (the rights to use franchisors names, trademarks, etc.), then adds value and sells to thecustomers [7]. In the retailing industry, retailers may add value to electronic products by providing an extendedwarrantyor offering lenient returns policy. For example, Best Buys warranty policy would cover defects the manufacturer doesnot cover, while Wal-Marts warranty policy begins after the manufacturers policy expires [8].</p><p>Researchers have examined distribution channels with one player working with two other players. For example, Choi[9] studied price competition in a distribution channel with two suppliers and one retailer. Under a different marketstructure, he analytically obtained channel decisions for three non-cooperative games between the manufacturers andthe retailer. Tsay and Agrawal [10] investigated a supply chain with one supplier supplying a common product totwo retailers, and both retailers competing with each other along both price and service policies. Tsay and Agrawalexamined each partys pricing strategy, total sales, market share and protability.</p><p>However, existing studies of distribution channels assume supplier and retailers compete with complete informa-tion. In other words, the research assumes that information such as production cost, operating cost and other marketparameters about supplier or retailers are common knowledge to all parties in a supply chain. This assumption maynot hold in real life. In practice, each party in a supply chain usually possesses private information that is unknown tooutsiders, and these rms are likely to protect their sales strategies by hiding their private cost or demand information[11], thus leading to a competition under incomplete information. For example, warranty cost is condential informa-tion for retailers such as Best Buy and Circuit City because signicant portions of their operating prots are from thewarranty service [8]. Franchisees also hold their private cost information of sale and decide if they will reveal their costinformation to the franchisor in the contract [7]. Therefore, what information to share and how to share informationbecomes an interesting research issue.</p><p>Some researchers have studied information (e.g., demand, cost, and inventory) sharing/asymmetry in a supply chain.For example, Li [12] studied the incentives a rm would need to share its private information (demand and costs) withits competitors; Gavirneni [13] analyzed a supply chain where inventory information is shared between the supplierand retailer. Cachon and Fisher [14] investigated the sharing of demand and inventory data in a supply chain with onesupplier andmultiple identical retailers. Agrell et al. [15] examined information sharing in telecom supply chains wherea supplier has private cost information and investment opportunities. Corbett et al. [16] analyzed a supply chain withone supplier and one buyer, and studied the value to the supplier of offering more general contracts and acquiring moreaccurate information about the buyers cost structure. Assuming that information asymmetry between a manufacturerand a retailer, i.e., the retailers knowledge of the manufacturers cost is incomplete, Lau et al. [17] also studied how toset up the wholesale price and retail price in a supply chain.</p><p>In this paper, we will examine a supply chain consisting of one supplier and two heterogeneous retailers. There ishorizontal competition between the two retailers, each of whom orders common generic products from the supplier,adds value to the products, then sells to customers. In addition, the supplier has no complete knowledge of the retailerscost structure regarding value-added information. Each retailer needs to decide if he is willing to vertically share hiscost information with the supplier.</p><p>Previously, Li [18] and Zhang [19] studied a vertical information exchange in a supply chain where demand in-formation is uncertain to the supplier. Their focus was on the effects of horizontal information leakage for verticalinformation sharing in a supply chain, i.e., if one retailer vertically discloses his information to the supplier, the latterwill react to the revealed information, and make decisions accordingly. Li and Zhang discovered that the other retailercan infer his competitors private information through the suppliers decision.</p></li><li><p>840 D.-Q. Yao et al. /Omega 36 (2008) 838851</p><p>However, the research assumes that retailers are homogeneous, that is, the retailers sell the same product withoutdifferentiating the product through valued-added practices. Because adding value is crucial in the supply chain practiceas illustrated in previous examples, in this paper we do not explicitly consider horizontal information leakage, butmainly focus on examining the appropriate value to be added to a generic product. We are interested in investigatingthe equilibriums in our supply chain structure with value-adding retailers and under what conditions the retailers haveincentives to share their information vertically with the supplier.</p><p>The main contributions of our research to the extant literature are threefold: rst we nd that equilibrium points existin a supply chain with value-adding (heterogeneous) retailers under certain conditions; second, we show the upstreamplayer always benets from more accurate information about the retailers. Third, we prove information sharing couldbenet both upstream and downstream players, thus leading to a winwin situation for the whole supply chain.</p><p>2. Model framework</p><p>We consider a supply chain consisting of one supplier and two heterogeneous retailers. We assume there is nowholesale price discrimination. The supplier sells a common generic product to two retailers at the same wholesaleprice. Afterwards, the retailers add their own values to the product and decide on the retail prices to the customers.Here each retailer has his own private information about the cost of the value added to the product, which is unknownto the other players. For example, each retailer has his private warranty cost, or each franchisee has his private costinformation of the sale. Considering the retailers are competitors, we assume there is no horizontal information sharingbetween retailers; however, each retailer can make his own decision if he is willing to disclose his cost informationto the supplier vertically. Furthermore we assume each party only takes into account the direct effects of informationsharing between different players. As a result, there is no horizontal information leakage considered in this paper. Infact, in the real situation, one player (i.e., the supplier) makes decision based on many considerations (e.g., forecast,cost structure, market promotional strategy, brand consideration, etc.). Thus, it is very hard for a retailer to infer theother retailers private information based on the suppliers decision.</p><p>We model our supply chain as a three-stage game. The sequences of moves are as follows:</p><p>(1) Each retailer has his own private cost information about value-added service, and decides if he is willing to sharethe cost information with the supplier vertically.</p><p>(2) Informed of the retailers cost information, if any, the supplier announces the wholesale price to optimize his(expected) prot. In this stage, the supplier may have either, both, or neither retailers cost information. Therefore,three different scenarios exist for the wholesale price.</p><p>(3) In response to the wholesale price, two retailers decide on the values added to the product and the retail pricessimultaneously to maximize their own expected prots, respectively.</p><p>Next, we describe three key system components in our supply chain framework: demand functions, value-addedfunctions and payoff functions. Before that, we will summarize our notations as follows:</p><p>w: The suppliers wholesale price to the retailers (decision variable)p1: Retailer 1s retail price to the customers (decision variable)p2: Retailer 2s retail price to the customers (decision variable)v1: Value added to the retailer 1s product (decision variable)v2: Value added to the retailer 2s product (decision variable)d1: Demand via retailer 1s channeld2: Demand via retailer 2s channel</p><p>2.1. Demand functions</p><p>In this paper, we adopt linear demand functions mainly because linear demand functions are widely used in supplychain and marketing literature due to their tractability. Specically we use demand functions similar to those proposedby Tsay and Agrawal [10]. It is worth noting that this kind of linear model structure has been empirically tested byother researchers. For example, Raju et al. [20] employed a similar demand structure to study market characteristicswhen retailers introduced store brands to compete against national brand products. Sayman et al. [21] used the same</p></li><li><p>D.-Q. Yao et al. /Omega 36 (2008) 838851 841</p><p>linear model structure to study the position of store brands against national brands. In essence, the structure of ourdemand function is similar to theirs. For other demand functions, if they can be approximated or locally approximatedby linear functions, our managerial insights still hold.</p><p>For retailer 1:</p><p>d1 = 1 1p1 + 2v1 + 1(p2 p1) + 2(v1 v2). (1)For retailer 2:</p><p>d2 = 2 1p2 + 2v2 + 1(p1 p2) + 2(v2 v1). (2)i (i = 1, 2) are market bases for two retailers. 1 measures the marginal demand change with channel price. 2</p><p>measures the marginal demand change with value-added service. i (i=1, 2) are migration rates for the perceived pricedifference and the perceived service difference, which means if customers perceive there is price difference (value-added service) between two retailers, they will switch to the other retailer at the rate of 1 (2). Therefore, horizontalcompetition exists between the two retailers. We also make the following assumptions about the parameters in thedemand functions:</p><p>(1) Market base i (i = 1, 2) is large enough compared to other market parameters. Typically this assumption holdsfor real life cases.</p><p>(2) We assume i &gt; i (i = 1, 2), which means that the effect of a direct price/value change is greater than the effectof a price/value difference between the two channels (cross-price/value change).</p><p>2.2. Value-added functions</p><p>In practice, we can use a strictly convex service function c(v) to depict the relationship between the added value andits related cost. That is, the cost of value-added service have the properties of dc(v)/dv &gt; 0 and d2c(v)/dv2 &gt; 0. Oneform commonly adopted in previous literature (e.g., [10,22]) is given Eq. (3)</p><p>ci(v) = iv2</p><p>2, i = 1, 2. (3)</p><p>i is the efciency paramet...</p></li></ul>

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