2011 MSOM Annual Conference

Ann Arbor, Michigan, June 26-28, 2011

Buyback versus Revenue-sharing Contracts:

Influence of Loss Aversion and Payment Timing
Karen Donohue

University of Minnesota

Yinghao Zhang

University of Minnesota

Tony Cui

University of Minnesota

Buyback versus Revenue-sharing Contracts:

Influence of Loss Aversion and Payment Timing
Extended Abstract for InForms M&SOM Annual Conference 2011, Ann Arbor, Michigan, USA

Karen Donohue*, Yinghao Zhang**, and Tony Cui+

Carlson School of Management, University of Minnesota
3-150 CSOM, 321 19th Ave S., Minneapolis, MN 55455
*

donoh008@umn.edu, **zhang786@umn.edu, and +tcui@umn.edu

Many operations and supply chain management textbooks advocate flexible supply contracts, such as buyback or
revenue sharing arrangements, as a tool for suppliers to increase their expected profits while offering higher expected
profits for their buyers. This claim is based on years of analytical research outlining how flexible contract parameters
should be set under different supply chain environments to induce channel-optimal ordering decisions by the buyer. These
models often assume the suppliers objective is to coordinate the channel while maximizing her own expected profit level,
subject to an expected reservation profit level for the buyer. In a seminal paper, Cachon and Lariviere (2005) use this
approach to show that revenue sharing and buyback contracts achieve equivalent channel-coordinating solutions in a single
supplier-buyer setting. As such, a supplier should be indifferent between the two contracts. More recent behavioral research
suggests the two contracts perform differently in a laboratory environment with human decision makers taking on the role
of a supplier who sets the contract terms.

Katok and Wu (2009) find that suppliers do not set contract parameters in a

manner that coordinates the channel and suggest that these difference may be due, in part, the framing of losses between the
two contracts.
A quick survey of the type of companies that have adopted each contract provides some insight into what factors may
influence their outcomes. Revenue-sharing has most notably been adopted within the video-rental industry where the lower
initial investment required by a buyer (in this case, a video retailer) allows this level of the supply chain to manage its cash
flow in an effective manner. Under a revenue-sharing contract, the buyer initially pays the supplier a small unit wholesale
price for each item acquired and later pays the supplier a fraction of the revenue earned for each item sold to the final
customer. From the suppliers point of view, the initial wholesale price may not cover her manufacturing cost and so she
maintains a negative cash flow until the buyer sells a sufficient number of items to the final customer. Buyback contracts
have been adopted by a wider range of industries, including publishing, high-tech, and fashion apparel. Under a buyback
contract the buyer also initially pays the supplier a wholesale price for each item acquired. However, rather than providing
the supplier with a second payment stream, the buyer now receives a payment from the supplier for items remaining at the
end of the season. This payment takes the form of a unit buyback price for each unsold item.

Compared with the

revenue-sharing contract, the buyback contract offers the supplier an initial flush of cash but this flush is short lived.
The supplier must be ready to give some money back to buyer at the end of the season.
At a conceptual level, the two contracts are equivalent in terms of their resulting profit realizations, yet the framing
and timing of the financial transactions are quite different. Research in both behavioral economics and psychology has
found that the choices people make are sensitive to the change in frame and that people appear to exhibit loss aversion;
that is, they are more sensitive to changes that are coded as losses than to equal-sized changes that are perceived as gains.
The behavioral economic literature also suggests that when facing intertemporal choices decisions involving trade-offs
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among costs and benefits occurring at different times people tend to care less about a future consequence; in other words,
people tend to place higher weight on recent losses or gains than on future. In the supply chain contract context, buyback
contracts provide more money upfront, which may be more attractive for suppliers who have a tendency to place higher
weight on recent transactions. On the other hand, buyback contracts require suppliers to give back money they have earned,
which may be less attractive for suppliers who exhibit loss aversion. When people exhibit both tendencies, their preferences
of the two contracts are unclear.
The goal of this research is to provide insight into how the framing and timing of financial transactions between
revenue-sharing and buyback contracts impact the suppliers choice of contract parameters and the contracts relative
performance. We begin by developing a series of analytical models that aim to answer the following questions:
1.

If loss aversion exists, what is its potential impact on the way the supplier sets parameters?

2.

Under what conditions or utility profiles are buyback contracts preferred over price-only or
revenue-sharing contracts?

3.

Under what conditions or utility profiles are revenue-sharing contracts preferred over price-only or
buyback contracts?

4.

How does time discounting further influence these decisions?

We study the problem in a two-echelon supply chain where the supplier acts as Stackelberg leader offering contract
terms to the retailer. In keeping with prior behavioral studies, we assume the market demand follows a uniform distribution.
While our focus is on comparing the performance of buyback and revenue sharing contracts, we also consider the
price-only contract as a default option for the supplier. We introduce a reservation profit for the retailer which equals the
expect profit the retailer would achieve under the suppliers associated optimal price-only contract, to ensure that the
retailer would never become worse under either coordinating contract. To model the influence of loss aversion, we
introduce a coefficient into the suppliers utility function which captures the relative weight the supplier places on losses
versus gains.
In this new model, we first solve for the suppliers optimal contract parameter values under both contracts assuming a
given loss aversion coefficient. We find that only suppliers with a low to medium level of loss aversion will choose optimal
buyback contract parameters with an active buyback term (i.e., buyback price greater than 0). A price-only contract
avoids the possibility of loss, and so is preferred by suppliers with medium to high loss aversion. For suppliers with lower
levels of loss aversion, the potential of higher profit under buyback contract balances out the disutility of a potential loss,
leading them to prefer an active buyback contract. In contrast, we find that the optimal revenue-sharing contract is always
preferred to a price-only contract no matter how high the loss aversion level. However, suppliers characterized by a
moderate to high loss aversion will set their wholesale price equal to production cost in order to avoid an initial loss. Note
that it is never in the suppliers interest to set their wholesale price above production cost since this would decrease her total
profit while providing no benefit in terms of reducing the initial loss.
After establishing the impact of loss aversion on the suppliers contract parameter decisions, we consider the
additional impact of time discounting. We find that time discounting further increases the attractiveness of a buyback
contract over a price-only option for suppliers with a medium loss aversion level. Time discounting reduces the impact of
loss aversion for the supplier during the second (buyback) period. Under a revenue-sharing contract, time discounting
impacts the suppliers preferences in two ways. First, suppliers with a low loss aversion coefficient continue to prefer
revenue-sharing over price-only contracts, but now set the wholesale price equal to the production cost. Second, suppliers
with a high loss aversion coefficient choose to set the revenue sharing term to be inactive (i.e., set the revenue sharing
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parameter to 0), effectively switching to a price-only contract. Because the supplier discounts future incoming cash flows,
the initial cash flow is more salient. As a result, suppliers either set their wholesale price equal to production cost or choose
a price-only contract to avoid any initial loss.
Using these new supplier decision models as input, we next compare the optimal utilities achieved by the two
contracts and determine which contract a given supplier will prefer in different settings. Figure 1 provides an illustration
of the preference regions, which depend on the supply chains ratio of overage and underage costs (i.e., the critical ratio)
and the suppliers individual attributes (i.e., level of loss aversion and time discounting). As is shown on the left panel,
the revenue-sharing contract is more likely to be preferred in supply chain environments characterized by a medium to high
critical ratio with suppliers who have a high level of loss aversion. Buyback is more likely to be preferred in low critical
ratio environments with suppliers having a lower degree of loss aversion. When suppliers exhibit some degree of time
discounting, revenue-sharing contracts become less attractive (as in the right panel). In addition, the price-only contract
emerges as the preferred option in low critical ratio environments for suppliers with a higher degree of loss aversion.
We test the robustness of the theories implied by our analytical results using a controlled laboratory experiment with
human subjects taking on the role of a supplier who chooses between buyback and revenue-sharing contracts under
different conditions. In additional to measuring their preferences, we measure their loss aversion tendencies using a test
suggested by previous literature. We group participants into two categories based on their level of loss aversion. We find
that participants in the moderate to high loss aversion category exhibit preferences consistent with our theory. This holds for
multiple critical ratios. For participants in the low loss aversion category, the choice of preferred contract appears more

Revenuesharing

CriticalRatio

CriticalRatio

random (close to 50%/50%). These choices may be due to random error.

Buyback

Revenuesharing

Buyback
Priceonly
LossAversionCoefficient

LossAversionCoefficient

Figure 1: Suppliers preference with both loss aversion and time discounting
Note:Ontheleft,thesupplierdoesnotexhibittimediscounting.Ontheright,thesupplierexhibitstimediscounting.

References
Cachon, G. and Lariviere, M. (2005), Supply Chain Coordination with Revenue Sharing Contracts, Management Science,
51(1), 30-44.
Katok, E. and Wu, D. (2009), Contracting in Supply Chains: A Laboratory Investigation. Management Science, 55(12),
1953-1968.
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