A supply chain model with direct and retail channels

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Abstract

We study a dual channel supply chain in which a manufacturer sells to a retailer as well as to consumers directly. Consumers choose the purchase channel based on price and service qualities. The manufacturer decides the price of the direct channel and the retailer decides both price and order quantity. We develop conditions under which the manufacturer and the retailer share the market in equilibrium. We show that the difference in marginal costs of the two channels plays an important role in determining the existence of dual channels in equilibrium. We also show that demand variability has a major influence on the equilibrium prices and on the manufacturer’s motivation for opening a direct channel. In the case that the manufacturer and the retailer coordinate and follow a centralized decision maker, we show that adding a direct channel will increase the overall profit. Our numerical results show that an increase in retailer’s service quality may increase the manufacturer’s profit in dual channel and a larger range of consumer service sensitivity may benefit both parties in the dual channel. Our results suggest that the manufacturer is likely to be better off in the dual channel than in the single channel when the retailer’s marginal cost is high and the wholesale price, consumer valuation and the demand variability are low.

Introduction

Internet has become an important retail channel. In 2004, online retail sales comprised of about 5.5% of all retail sales excluding travel (Mangalindan, 2005). Recognizing the great potential of the Internet to reach customers, many brand name manufacturers, including Hewlett-Packard, IBM, Eastman Kodak, Nike, and Apple, have added direct channel operations (Wilder, 1999, Tsay and Agrawal, 2004). More companies are weighing the option to sell directly to consumers. The largest English-language publisher Random House has publicly said that it may sell books directly to readers, putting them in direct competition with Barnes and Noble and Amazon.com (Tranchtenberg, 2004). Meanwhile, traditional online-only companies are expanding their presence at retail stores. Dell has installed kiosks in shopping malls and now sells its computers through Costco (McWilliams and Zimmerman, 2003). Gateway also sells its products at the electronic retailer Best Buy and plans to sign up other retailers, including Wal-Mart and Circuit City, to carry its computers (Palmer, 2004).

Early reports suggested some retailer resistance against their suppliers’ direct channel initiatives (Hanover, 1999). It is doubtful, however, that such resistance is effective and helpful over time. When Levi Strauss decided to sell its jeans to J.C. Penney and Sears, it promoted a boycott from Macy. It took 10 years for Macy to realize the folly of denying its customers a product they wanted and driving its customers elsewhere to buy (Hanover, 1999). Similarly today, as consumers grow accustomed to multiple channels, they expect to have the choice of buying from a store or buying direct. Studies find that more consumers are embracing multiple channels to satisfy their shopping needs (Stringer, 2004). Therefore, supply chains must react in order to meet this consumer expectation rather than to resist it. Examples of dual channels, cited above, in various industries suggest that many retailers and manufacturers have already learnt this lesson. The evidence suggests that dual channel supply chains already exist. Given such a supply chain, our focus in this paper is on analyzing its performance in equilibrium.

Dual channels could mean more shopping choices and price savings to customers. To traditional retailers and manufacturers, however, the implications for their strategic and operational decisions are not all that clear. How should they make the pricing and quantity decisions and what will be the outcome in equilibrium? As a manufacturer is both a supplier of and competitor with a retailer, traditional supply chain models are not sufficient for developing insights into the equilibrium performance of such supply chains. In this paper, we develop a model to answer the above questions.

Mangalindan (2005) observes that consumers are more likely to purchase certain product categories via direct channel. We also observe that some industries have seen a faster growth in dual channel supply chains than others. Such observations suggest that difference in product/cost characteristics of the two channels as well as consumer preference for different channels deeply influence the performance of such supply chains. Our objective is to incorporate product/cost characteristics and consumer preference into our model and develop managerial insights into their influence. We analyze how such factors that are important in shaping consumer behavior and determining channel efficiency affect the model. Specifically, we examine the effects of service quality, consumer sensitivity to service, cost, and wholesale price on pricing and equilibrium outcomes. In addition, we investigate how demand uncertainty affects the equilibrium and what the effect of coordination will be on the channel structure.

Several studies have examined dual channel supply chains. Rhee and Park (2000) study a hybrid channel design problem, assuming that there are two consumer segments: a price sensitive segment and a service sensitive segment. Chiang et al. (2003) examine a price-competition game in a dual channel supply chain. Their results show that a direct channel strategy makes the manufacturer more profitable by posing a viable threat to draw customers away from the retailer, even though the equilibrium sales volume in the direct channel is zero. Their results depend on the assumption that customer’s acceptance of online channel is homogeneous. Boyaci (2004) studies stocking decisions for both the manufacturer and retailer and assumes that all the prices are exogenous and demand is stochastic. Tsay and Agrawal (2004) provide an excellent review of recent work in the area and examine different ways to adjust the manufacturer–reseller relationship. In a similar setting, Cattani et al. (2006) study pricing strategies of both the manufacturer and the retailer. Viswanathan (2005) studies the competition across online, traditional and hybrid channels using a variant of circular city model. His focus is on understanding the impact of differences in channel flexibility, network externalities, and switching costs. Our model differs from prior studies in the following areas: (i) The demand functions in this study are derived by modeling consumers’ choice between direct and retail channels based on both price and service quality, and we assume than consumer’s sensitivity to service quality is heterogeneous. (ii) The manufacturer and the retailer make simultaneous decisions; the manufacturer decides the direct price and the retailer makes both price and stocking decisions. (iii) We assume demand is stochastic and analyze the effects of demand uncertainty on the equilibrium results. Incorporation of these new features in our model allows us to focus on the questions we posed earlier about the effect of product characteristics and consumer preference in our model. Other details of our single-period model include an assemble-to-order manufacturer, standard inventory costs at the retailer, and different selling costs in the two channels.

Unlike other studies, our model leads to outcomes where both channels are active in the market. Analysis of each party’s problem shows that the retailer’s optimal price and stocking level increase in the manufacturer’s price and the manufacturer’s optimal price increases in the retailer’s price. We then establish conditions under which both the manufacturer direct channel and the retail channel co-exist in the Nash equilibrium under a single period game. That is, the retailer chooses the retail price and order quantity and the manufacturer chooses the direct channel price. At the equilibrium, given the other party’s decisions, each party makes optimal decisions. We refer to these decisions as equilibrium quantity and prices. We show that a product characteristic like demand variability strongly influences the outcome; an increase in variability results in a decrease in equilibrium prices. We show that the difference in marginal costs of the two channels is a major factor determining the existence of dual channel supply chains. In addition, industries with lower demand variability are more likely to see a dual channel supply chain structure.

Our numerical results show that an increase in retailer’s service quality may increase the manufacturer’s profit in dual channel. A larger range of consumer service sensitivity may benefit both parties in the dual channel. We show that dual channel equilibrium may exist in both cases: fixed exogenous wholesale price and manufacturer-set wholesale price. In addition, the manufacturer is likely to be better off in the dual channel than in the single channel when the retailer’s marginal cost is high and the wholesale price, consumer valuation and the demand variability are low. In the case where the manufacturer and the retailer coordinate and follow a centralized decision maker, we show that adding a direct channel will increase the total profit. We believe that these new insights will be useful for retailers and manufacturers in such supply chains.

The rest of the paper is organized as follows: Section 2 sets up the decentralized dual channel supply chain model. We examine the equilibrium results of our model in Section 3. Section 4 presents the numerical results. We conclude and outline the future research in Section 5.

Section snippets

The model

We consider a single period, single product model with a manufacturer and a retailer. The manufacturer sells to the retailer as well as to the consumers directly. Consumers may choose the retailer (retail channel) or the manufacturer (direct channel) to obtain the good. We begin with describing the consumer choice process.

Empirical studies have shown that transaction costs (Liang and Huang, 1998) and service qualities (Devaraj et al., 2002, Rohm and Swaminathan, 2004) are the major determinants

Analysis of the dual channel model

In this section, we analyze the case where the manufacturer and the retailer simultaneously make their decisions. We begin with determining each party’s optimal decisions.

Numerical results

Our objective in this section is to draw managerial insights based on a numerical analysis of our model. We consider several scenarios related to different parties in our model. First, we consider the effect of changes in service qualities offered by the parties. Second, we focus on the difference in the two parties’ costs of selling. Third, we focus on the consumer and consider the effect of the service sensitivity. We also revisit the influence of demand variability on the equilibrium.

Conclusions and future research

We study a dual channel supply chain where a manufacturer sells the same good to a retailer as well as directly to consumers and consumers choose a channel to buy the good accordingly. Based on examples in business press, we suggest that such supply chains already exist in many industries. We build a model to capture the major features of such supply chains. Our objective is to use the model to understand how different product, cost or service characteristics influence the equilibrium behavior

Acknowledgement

We are grateful for the helpful comments of the reviewers and editors that led to many improvements in the paper.

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