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Journal of Retailing 84 (3, 2008) 325333

Optimal Guaranteed Profit Margins for Both Vendors


and Retailers in the Fashion Apparel Industry
Chang Hwan Lee a , Byong-Duk Rhee b,
a Department of Operations Management, School of Business Administration, Ajou University, Suwon, Republic of Korea
b Marketing Department, Whitman School of Management, Syracuse University, Syracuse, NY 13244, USA

Abstract
Guaranteed profit margin (GPM) is one of the chargebacks that retailers frequently employ in the fashion industry. With this stipulation, the
store demands a vendors guarantee of its target mark-up rate, even in a markdown operation. This makes the retailer order too much and later
liquidate a greater amount of leftovers. We propose a new GPM scheme for supply chain coordination. Specifically, if the retailer compensates the
vendor for the same fraction of the joint costs as the guaranteed mark-up rate, the retailers quantity choice results in profit maximization for the
entire supply chain. Thus, the supply chain becomes fully coordinated and provides winwin outcomes for both retailer and vendor.
2008 New York University. Published by Elsevier Inc. All rights reserved.

Keywords: Guaranteed profit margin; Fashion apparel industry; Supply chain coordination

Introduction allowance or markdown money, have been around for at least


four decades (Womens Wear Daily, June 7, 2005). The practice
We have recently observed numerous vendors in the fash- became widespread under the tutelage of Wal-Marts Sam Wal-
ion apparel industry filing lawsuits against their retail partners ton, who took an early lead in pushing costs onto his suppliers,
over unauthorized chargebacks. Onward Kashiyama claimed and has been the norm in retailing for at least 10 years (Zieger
$9.3 million in damages against Saks for excessive chargebacks. 2003). With slim retail profits, many other stores have quickly
International Design Concepts also sued Saks over more than adopted this practice by recognizing that getting the right sup-
$31 million in unauthorized chargebacks (CNN Money, May plies in the right condition could lower inventory costs and speed
18, 2005). A group of bankrupt vendors filed a class-action law- up the flow of goods.
suit against Federated Department Stores over alleged improper Chargebacks were intended to offer a positive mechanism
chargebacks (Rozhon 2005b). SDG, an apparel wholesaler, through which retailers and vendors could share in shipping
claimed $440,000 in damages against May over unjustifiable and merchandizing mistakes. For instance, if a vendor fails to
chargebacks, and Ben Elias, a family-owned clothing maker comply with a retailers requirements, chargebacks relieve the
in New York, filed a lawsuit against Dillards over excessive retailer from responsibility for its order by requiring the ven-
chargebacks. There were at least two dozen lawsuits pending dor to indemnify sell-throughs. Such positive sharing faded
against major department stores over chargebacks in the middle away a long time ago, and over the past decade, chargebacks
of 2005 (Rozhon 2005a). have become a contentious issue between retailers and vendors
Retailer chargebacks are fees charged to vendors for every- (Casabona 2005). Many retailers have abused chargebacks and
thing from incomplete orders and problematic deliveries to turned them into a built-in profit center (Womens Wear Daily,
customer returns and goods that the store marks down because June 7, 2005). The retailers use their dominant positions in sup-
of slow sales (Casabona 2005). Though it is unclear who ply chains and bolster their gross margins easily by making their
first started using them, chargebacks, also known as vendor vendors subsidize their bottom lines of profit.
Unauthorized chargebacks are a problem hardly unique to
a specific industry. They have been pervasive throughout any
Corresponding author. Tel.: +1 315 443 1874; fax: +1 315 443 5457.
supply chain. According to the Credit Research Foundation, a
E-mail addresses: chlee@ajou.ac.kr (C.H. Lee), brhee@syr.edu financial industry group that tracks credit issues, 510 percent of
(B.-D. Rhee). all invoices are affected by chargeback deductions, amounting

0022-4359/$ see front matter 2008 New York University. Published by Elsevier Inc. All rights reserved.
doi:10.1016/j.jretai.2008.07.002
326 C.H. Lee, B.-D. Rhee / Journal of Retailing 84 (3, 2008) 325333

to 410 percent of all open items on account receivable (Zieger high or low, the vendor becomes better off, due to the increase
2003). National Chargebacks Management Group of Charlotte, in order quantity with GPM. Therefore, a GPM stipulation may
N.C., reports that chargebacks typically shave off 210 percent lead to winwin outcomes for both retailer and vendor.
of a vendors overall revenue (Zieger 2003). It is not rare to This paper presents an optimal channel coordination scheme
hear of chargebacks of as much as 35 percent of wholesale price with a GPM provision, which makes both the retailer and the
(Moin and Young 2005). vendor better off by maximizing joint supply chain profits.
The fashion apparel industry is especially vulnerable to This study differs from Mantrala, Basuroy, and Gajanan (2005),
excessive chargebacks (Givhan 2005). Many design houses are which examines the two channel partners independent deci-
relatively small and have difficulty securing floor space in pres- sions under the assumption of guaranteed retail mark-up. We
tigious department stores. Furthermore, the fashion business is employ the Newsboy framework and explicitly assume that mar-
particularly volatile because consumer tastes are fast-changing. ket uncertainty exists regardless of its demand level. We show
It is very difficult to measure and to reflect them in a design. that the conventional GPM does not coordinate the supply chain.
Customer purchases are also affected by their moods and whims. It makes the retailer order too much and later liquidate a greater
Unexpected weather, or too much of a single color or a particu- amount of leftover stock in a markdown operation. This lowers
lar style may also quickly bore customers (Givhan 2005). Given not only the vendors profit, but the joint profits in the entire sup-
their weak bargaining power in the supply chain and the high ply chain as well. However, if a GPM contract is designed to link
level of market uncertainty, vendors in the fashion industry find guaranteed retail margins to joint profit margins, the retailers
themselves easily promising to pay excessive chargebacks in optimal quantity choice leads to profit maximization for the
order to place their creative works on store shelves. entire supply chain. Specifically, we prescribe that the retailer
One of the chargebacks frequently asked by fashion retailers, compensates the vendor for the same fraction of the joint costs
especially department stores, is the one involving markdowns as its guaranteed retail mark-up rate.
(Edelson 2005). Specifically, when a retail store does not reach We also examine a similar contract that some cosmetics pro-
its expected profit margins, because the goods either fail to catch ducers, such as LOreal, Este Lauder, and Chanel, employ in
on with consumers or sell at deeply discounted prices, the store business with department stores (Heckman 2004). The cosmet-
returns to its vendors and asks them to make up the difference ics producers guarantee a fixed retail mark-up rate during regular
on a line that did not sell at full price (Bird and Bounds 1997). sales. Instead of guaranteeing the same mark-up rate in a dis-
This is known as guaranteed profit margin (GPM), under which count sale as in a GPM contract, these firms keep the retail stores
a vendor guarantees the retailers target mark-up rate even in from markdown operations and buy back any unsold units from
the case of markdown sales.1 Large stores use their retail power the stores. These vendors are accused in a class-action law-
and threaten to pull a vendors products from their shelves if suit of conspiring to set artificially high prices on prestige
the vendor refuses to provide GPM (Krishnan and Soni 1997). beauty products, using a hybrid contract of GPM and buybacks
Many legal experts see requiring this type of chargeback as (Heckman 2004). This paper shows that price-fixing may not
improper and frequently take the cases to court (Dahl 2006; be a main motivation of this hybrid GPM contract. We show
Ethics Newsline, May 16, 2005). that the contract enables the producers to coordinate their supply
GPM may help a new designer get floor space in an influential chains.
fashion retail store. It may also encourage a retailer to order more The rest of the paper is organized as follows. Section The
and try new designs for customers. Thus, the vendor can reach model presents a model that captures the conflict between a
more consumers and build its brand equity in the retail market. vendor and its exclusive retailer under the provision of GPM.
On the other hand, with a GPM stipulation, the retail store may We describe the assumptions of their sequential strategic deci-
order too much and take a markdown from the initial price to sions and market demand. Section Chargebacks for joint profit
sell out the ordered quantity without sufficient merchandising maximization examines a benchmark case of integrated supply
efforts. The retailer then turns over all the losses arising from chain first, and then derives the optimal channel coordination
the markdowns to the vendor. scheme with a GPM stipulation. Section Numerical simula-
Mantrala, Basuroy, and Gajanan (2005) examine this issue tions presents numerical simulations to clarify our findings.
in a sequential game of single vendor and single retailer, and The last section draws a conclusion.
show that GPM induces a larger order quantity. The retailer
always makes a higher profit with GPM than without it. As The model
demand uncertainty increases, the retailer is increasingly better
off by forcing the vendor to take the market risk under the GPM We simulate conflicts between vendors and retailers by
provision. Conversely, the vendor becomes worse off with GPM. assuming a single vendor and its exclusive retailer in a bilat-
However, when demand becomes clear and turns out to be either eral relationship. Specifically, the vendor is a sole producer and
sells its products only through the retailer. The product is not
available for sale elsewhere. We assume risk-neutral channel
1 Two different types of chargebacks have been frequently employed regarding members, that is, the vendor and retailer, which maximize their
markdowns in the fashion apparel industry: (a) guaranteed profit margins and (b)
markdown allowance. Markdown allowance is a subsidy that a vendor gives to its
own profits independently. We further assume complete infor-
retailer in order to share the loss from salvaging leftovers. See Tsay (2001) for a mation in order to eliminate information asymmetry as a source
detailed discussion of the supply chain coordination with markdown allowance. of channel power. If either a vendor or retailer has an informa-
C.H. Lee, B.-D. Rhee / Journal of Retailing 84 (3, 2008) 325333 327

tion advantage regarding consumer demand, its superior position


may enable the firm to exploit the less informed channel partner
for extra profits.
We limit the scope of research to the fashion apparel indus-
try, in which products have a short life cycle due to the seasonal
and perishable nature of fashion goods. Stochasticity prevails
in the demand of a fashion item due to fast-changing consumer
tastes and numerous unobservable influences. Price is usually
set before the sales under the high degree of uncertainty and
remains constant because stores often do not have enough time
to reflect the actual demand into price during the short life cycle.
Procurement is usually done before the sales and additional pro-
curement in the middle of the season is not easy in the fashion Fig. 1. Interactions between the vendor and retailer.
apparel industry.
This study employs a standard approach in the Newsboy
The retailer liquidates the retained leftovers in a markdown
framework as in Pasternack (1985) and Tsay (2001), since the
salvage operation and also collects chargebacks from the vendor.
industry characteristics resemble the modeling structure in the
First, we consider the conventional case of GPM stipulation.
framework.2 Specifically, we assume that the retail price is
The retailer requests the vendors guarantee of a retail mark-up
exogenously given at p during the short sales period. Consumer
rate even when the retailer takes a markdown from the initial
demand is stochastic given retail price p. In other words, con-
retail price to clear the leftovers (Krishnan and Soni 1997). If
sumers of higher reservation prices than p will consider the
the vendor accepts the retailers request, the retailers guaran-
purchase of the product. Actual demand, y, follows continuous
teed unit margins are p and v in the regular and clearance
distribution F(y) with density f(y). If there is leftover stock at the
sales, respectively, where is the retailers target mark-up rate:
end of the regular sales period, the retailer salvages the leftovers
0 1 (Mantrala, Basuroy, and Gajanan, 2005). The retailer
by selling them at bargain price v(< p) in a markdown clear-
earns profit margin p w cr from selling one unit of the prod-
ance sale. Without loss of generality, we assume that the vendor
uct at p in the regular sales period. Hence, the vendors wholesale
incurs constant marginal cost cv in production. The retailer also
price should be w = p(1 ) cr for the guaranteed unit mar-
incurs constant marginal cost cr in procurement including logis-
gin p: that is, p w cr = p. On the other hand, the retailer
tics costs, in addition to the payment to the vendor for a unit
obtains chargebacks b and margin v w cr from selling one
of the product, w. Let c = cv + cr , which represents the joint
unit at v in the clearance sale. Thus, the vendors chargeback rate
marginal costs in the entire supply chain. We omit the long-run
should be b = (p v)(1 ) for the guaranteed unit margin v:
impact of poor product availability on revenue (such as loss in
that is, b + v w cr = v.3 Therefore, we obtain
goodwill) as in Pasternack (1985) and Cachon and Lariviere
(2005). We also do not consider fixed costs. w = p(1 ) cr and b = (p v)(1 ) (2)
Fig. 1 describes interactions between the vendor and retailer.
The vendor sets wholesale price w and chargeback rate b, first. The conventional GPM provision is a special case of the gen-
The retailer then places an order of quantity q given the agree- eral model, in which the vendor guarantees target mark-up rate
ment with the vendor on w and b, and offers the product to for the retailer while the retailer compensates the vendor for por-
consumers. The market reveals demand y in the regular sales tion of joint cost c, where 0 1. becomes zero when the
period, which determines the leftover inventory, max [0, q y], retailer offers no compensation to the vendor as in the conven-
at the end of the period. Hence, the expected sales in the regular tional GPM. If the vendor and retailer agree on this general case
sales period are of GPM stipulation, the retailer is guaranteed to earn p c
from selling one unit of the product in the regular sales, and
q  q v c in the mark-down sales. Using the same procedure as
S(q) = y f (y) dy + q f (y) dy = q F (y) dy. (1) in the above, we obtain
0 q 0 wg = p(1 ) cr + c and bg = (p v)(1 ). (3)
Note that the wholesale price increases by c because the
2 There is another stream of research on channel coordination, which orig- retailer compensates the vendor for that much of the joint
inates from Jeuland and Shugan (1983). It focuses on the vendors non-linear marginal costs. Nevertheless, chargeback rate b is invariant. If
pricing, such as quantity discounts and two-part tariffs, for channel coordination.
Assuming deterministic demand that varies with retail price and no constraint
on production and procurement, this stream shows that the vendor coordinates 3 If the vendor has greater channel power, it determines w and b for its own

the channel with a non-linear wholesale price schedule that makes the retailers profit maximization anticipating the retailers profit maximization with q as in
marginal cost equal to the entire channels total marginal cost. The wholesale Pasternack (1985). Then, we can derive the optimal w and b employing backward
price then induces the retailer to set a retail price for joint channel profits. This induction. However, retailers have greater channel power in the fashion apparel
type of model works well in the industry where the product has been sold for a industry and frequently demand GPM from design houses for floor space in the
long period of time without much change in design. retail stores.
328 C.H. Lee, B.-D. Rhee / Journal of Retailing 84 (3, 2008) 325333

= 0, we have the wholesale price and chargebacks given in Eq. r (q, b, w ) = (q), v (q, b, w ) = (q) r (q, b, w ) =
(2). (1 )(q).
At any w, b, and q, the retailer has the following expected
Proposition 1 shows that the supply chain achieves full coor-
profit under the assumption of constant marginal cost cr ,
dination at w . Wholesale price w and chargeback rate b are
r (q, b, w) = pS(q) + (b + v)(q S(q)) (cr + w)q. (4) transfer prices in the centralized system and do not change
the joint supply chain profit (q), but determine each channel
Note that the first term in the equation represents the revenue partners share of the joint profit. At w , the retailers and ven-
from the regular sales, whereas the second term shows the rev- dors profits become affine transformations of the joint profit:
enue from the mark-down sales including chargebacks from the that is, r (q, b, w ) = (q) and v (q, b, w ) = (1 )(q),
vendor. The last term shows the retailers total costs, that is, total respectively. Subsequently, the optimal order quantity, qc , for
procurement costs and the payment to the vendor. On the other the joint supply chain profit (q) also maximizes both the
hand, the vendor has the following expected profit, retailers and vendors individual profits, (q) and (1 )(q).
In other words, if a chargeback contract between vendor and
v (q, b, w) = wq b(q S(q)) cv q. (5) retailer is designed for w = w in a decentralized system,
The first term shows the gross revenue from selling the the retailers independent strategic choice of order quantity
ordered quantity to the retailer, whereas the second term shows replicates the optimal choice qc for the entire supply chain
the total chargebacks paid to the retailer. The last term repre- . Hence, the supply chain becomes fully coordinated at w .
sents the total production costs. Therefore, the joint profits in We derive the chargeback rate
the entire supply chain are (w cv )(p v) b(p c)
b= from w = cv + .
(p c) (p v)
(q) = v (q, b, w) + r (q, b, w) = (p v)S(q) (c v)q.
Note that the chargeback rate b is identical to the optimal
(6) buyback rate for supply chain coordination in a return policy
(Pasternack 1985) and also the optimal revenue sharing contract
for channel coordination proposed in Koulamas (2006).4
We now examine whether the conventional GPM leads to the
Chargebacks for joint prot maximization
optimal wholesale price w for supply chain coordination; and,
if not, under what conditions a GPM provision achieves supply
Supply chain coordination is setting all the vendors and
chain coordination. Consider the general model of GPM shown
retailers decisions at the level of maximizing the joint channel
in Eq. (3). GPM stipulation requires wg = p(1 ) cr + c
profits (Jeuland and Shugan 1983). We first examine the case of
and bg = (p v)(1 ) if the vendor accepts the retailers
the centralized system in which both the vendors and retailers
request of guaranteed retail mark-up rate with cost compensa-
decisions can be fully coordinated under the central control. This
tion . The retailer then makes profit r (q) = (q) cq( )
is a benchmark case with which we compare a decentralized sys-
at wg and bg .5 Recall that = 0 describes the case of the conven-
tem of independent vendor and retailer. In full coordination, each
tional GPM. We have the following proposition.
agents decisions such as wholesale price and chargebacks are
aligned for the maximization of the entire supply chain profit. Proposition 2. r (q) has a unique maximum at q* > 0 satis-
Assume that both vendor and retailer are in a centralized fying F (q ) = (p (c/))/(p v) when p > c/. Thus, the
supply chain system. Since any transaction is internalized within retailers order quantity q* increases as / decreases. Fur-
the centralized system, the vendor and retailer can completely thermore, wg = p(1 ) cr + c under the GPM provision
coordinate their decisions for joint profit maximization. Note becomes identical to the optimal wholesale price, w = cv +
that the integrated supply chain earns joint profit (q) in Eq. (6) (b(p c)/(p v)), for supply chain coordination if and only if
at any w, b, and q. Let qc denotes the optimal order quantity = .
that maximizes the profit (q): that is, qc > 0 satisfies F (qc ) =
(p c)/(p v), which is derived from the first order condition, 4 This paper assumes that the vendor provides the retailer with chargebacks
(q)/q = 0.
for the units that the retailer liquidates at a discount price. We derive chargeback
Proposition 1. The retailers and vendors prots, r (q, b, w) rate b from the optimal wholesale price w for supply chain coordination. In
contrast, the vendor buy all the unsold units back from the retailer at a pre-
and v (q, b, w), become (q) and (1 )(q), respectively, at determined rate in a buyback contract (Pasternack 1985). In a revenue sharing
wholesale price w = cv + (b(p c)/(p v)). Hence, the opti- contract, the vendor sets a wholesale price for the units ordered by the retailer
mal order quantity, qc , for the joint prot (q) also maximizes and earns a portion of the revenue from the units sold by the retailer (Cachon
both the retailers and vendors prots, (q) and (1 )(q), 2003). Even though these contracts suggest different benefit transfer schemes,
at w* . they produce the same amount of the transferred benefit between the vendor and
retailer when the supply chain is fully coordinated.
Proof. By substituting w in r (q, b, w) at Eq. (4) with w = 5 At w = p(1 ) c + c and b = (p v)(1 ), (q, b , w ) =
g r g  r g g

cv + (b(p c)/(p v)), we obtain r (q, b, w ) = (1 (b/ pS(q) + (bg + v)(q S(q)) (cr + wg )q = (p v) 1
bg
pv S(q) (cr +
(p v)))[(p v)S(q) (c v)q] = (1 (b/(p v)))(q). wg bg v)q = [(p v)S(q) (c v)q] cq( ) = (q) cq(
Then, r (q, b, w ) = (q), where b = (p v)(1 ). Since ).
C.H. Lee, B.-D. Rhee / Journal of Retailing 84 (3, 2008) 325333 329

Proof. The first order condition of arg maxr (q) pro- makes both the retailer and vendor attain greater profits. They
q
can determine their shares of the gain from the coordination,
vides (p v)[1 F (q )] + v c = 0, which leads to
, through negotiation. Any deviation from = yields a lower
F (q ) = (p (c/)/(p v)). A decrease in / leads to
joint profit and the retailer can improve both partners profits
increasing F(q* ), which implies increasing q* given F(y). Fur-
with supply chain coordination.
thermore, w = cv + (b(p c)/(p v)) = cv + (((p v)(1
If the retailer insists on the conventional GPM of target mark-
)(p c))/(p v)) = p(1 ) + cv c(1 ). Then, w =
up rate , that is, = 0, the retailer and vendor make r (q) =
wg if cv c(1 ) = cr + c, which is = .
[(q) + cq] and v (q) = (1 )(q) cq, respectively, at
If the retailers guaranteed mark-up rate is greater than its w = p(1 )cr and b = (p v)(1 ) as shown in Eq. (2).
cost compensation rate for the vendor, the retailer orders too Hence, we have the following proposition.
much (q* > qc ) and later liquidates a greater amount of leftovers
in a markdown salvage operation. This not only lowers the ven- Proposition 3. r (q) is strictly increasing with respect to
dors profit, but also the entire channels joint profits. On the q. Thus, the retailer orders as much q as possible. On the
other hand, if its cost compensation rate is greater than the other hand, v (q) has a unique maximum at q > 0 satisfying
guaranteed mark-up rate , the retailer orders too small a quan- F (q) = [p (c/(1 ))]/(p v) if p(1 ) > c. Hence, the
tity (q* < qc ), which does not maximize the joint profits in the vendor and retailer most likely agree on the order quantity in
supply chain, either. Proposition 2 shows that a GPM stipulation the neighborhood of q . F (q) F (qc ) if p is sufciently higher
coordinates the supply chain and produces the maximum joint than c, and also F (q) F (qc ) 0 if p approaches c. There-
profits only when the retailer compensates the vendor for the fore, a GPM without cost compensation may lead to joint prot
same fraction of the joint marginal cost c as its guaranteed retail maximization if p is either very high or close to c.
mark-up rate, that is, = . In other words, the retailers optimal Proof. The first derivative of r (q) is r (q)/q = (p
quantity choice leads to profit maximization for the entire supply v)[1 F (q)] + (1 )c + v, which is always positive due
chain only if a GPM contract is designed to link guaranteed retail to 0 1 and p > v. On the other hand, the first deriva-
margins to joint profit margins in the entire supply chain, that tive of v (q) is v (q)/q = (1 )(p v)[1 F (q)] c +
is, p c = (p c) and v c = (v c). Note that since (1 )v. Thus, the first order condition produces F (q) = [p
the guaranteed retail margin is a fraction of the profit margin (c/(1 ))]/(p v). F (q) F (qc ) = (p c)/(p v) if p is
in the entire supply chain, a GPM with = becomes identical either sufficiently higher than c or approaches c so that both
to a revenue sharing contract with wholesale price w = c cr F (q) and F (qc ) converge to zero.
(Cachon 2003; Cachon and Lariviere 2005; Giannoccaro and
Pontrandolfo 2004). Proposition 3 shows results consistent with the findings
A GPM with = is Pareto-optimal. Note that = is a in Mantrala, Basuroy, and Gajanan (2005). A prevailing per-
unique solution even though there are infinitely many values ception of GPM, especially among vendors, is that retailers
of = . Whenever its guaranteed mark-up rate differs from its unfairly exploit vendors using this abusive policy (Young and
 
cost compensation rate, that is, = / , the retailer can make Zaczkiewicz 2005). Mantrala, Basuroy, and Gajanan (2005)
these two rates equal for supply chain coordination and uses show that, in contrast to the common perception, the provision
a part of the gain from the coordination to entice the vendor of GPM by vendors may result in winwin outcomes when
to participate in the coordinated supply chain. Specifically, the the probability of large demand is either very high or very low. If
retailers profit is r (q) = (q) = cq( ) under a GPM provi- consumer demand is very high, retail price p will be set at a very
sion. Let q* denote the optimal order quantity that the retailer high level. Thus, cost c becomes relatively very low compared
   
chooses for its own profit maximization at and , where = / . to the high value of p. Thus, p (p c), and guaranteed retail
Let qc be the optimal order quantity for the joint supply chain mark-up rate provides a winwin solution for both vendor and
profits. Suppose that the retailer coordinates the supply chain at retailer, that is, F (q) F (qc ). On the other hand, if the demand
= .
We know (qc ) > (q* ) and r (qc ) = (q
c ) as shown in is very low, retail price p will be chosen near the cost c, and order
Proposition 1. Let  denote the gain from the coordination, that quantity will be very small due to the extremely low margin, that
is,  = (qc ) (q* ) > 0. Suppose that the retailer and vendor is, F (q) F (qc ) 0. Hence, the guaranteed retail mark-up also
split this gain  into  and (1 ), respectively, where leads to joint profit maximization. As shown in Proposition 2,
0 1. Then, the retailers profit under the coordination is however, if the consumer demand is neither very large nor very
r (q* ) + , which should be equivalent to (q c ), that is, small, a GPM stipulation with no cost compensation (i.e., = 0)
r (q ) +  = (q c ). Therefore, never coordinates the supply chain.
r (q ) +  r (q ) + [(qc ) (q )] We now examine a similar contract that some upscale cosmet-
= = (7) ics producers such as Chanel, Este Lauder, and LOreal employ
(qc ) (qc )
in business with large department stores such as Macys, Saks
If the vendor takes all the gain from the coordination, Fifth Avenue, Dillards, and Bloomingdales (Heckman 2004).
that is, = 0, 1 = (r (q )/(qc ))(= 1 ). On the other hand, These producers pay for the stores merchandising expenses for
if the retailer takes all the gain, that is, = 1, 2 = ((qc ) their brands and guarantee fixed retail mark-up , 40 percent of
v (q )/(qc ))(= 2 ). Note that 2 1 . Hence, any = in the retail price. In return, the cosmetics producers ask the stores
the interval 1 2 leads to supply chain coordination and to sell their products at the Manufacturers Suggested Retail
330 C.H. Lee, B.-D. Rhee / Journal of Retailing 84 (3, 2008) 325333

Price (MSRP). The producers also do not allow any markdown


operation at the stores. They buy back all the leftovers from the
stores to ensure no discount. Note that, in contrast to the con-
ventional GPM case, the vendors initiate the guaranteed retail
mark-ups in these cases. These producers are accused of con-
spiring to set artificially high prices on their beauty products in
a class-action lawsuit (Heckman 2004).
We can show that the cosmetics producers use this hybrid
contract of GPM and buybacks for supply chain coordination,
not only for price-fixing in the retail market. Specifically, a pro-
ducer guarantees fixed retail margin p by charging wholesale
price w = p(1 ) cr . The producer buys back all of the left- Fig. 2. OQR under the uniform demand density.
overs, q S(q), from the retailer at rate and liquidates them in
a salvage operation at unit price v. Therefore, the producers Numerical simulations
and retailers profits are derived as v (q, , w) = wq (
v)(q S(q)) cv q and r (q, , w) = pS(q) + (q S(q)) This section presents numerical simulations in order to clar-
(cr + w)q, respectively. Note that the joint profit is (q) = ify the findings. We first show that the joint supply chain profit is
v (q, , w) + r (q, , w) = (p v)S(q) (c v)q, which is maximized at = using three commonly adopted demand den-
the same as in Eq. (6). Subsequently, at buyback rate sity functions: (1) the uniform, (2) exponential, and (3) logistic
= (p[p(1 ) + v c]/(p c)), we derive the following distributions. We consider three cases of = 0.35, 0.40, and 0.45
profits6 and change the value of in the neighboring interval around the
value with a grid size of 0.01 while keeping other parame-
 
p p ters constant. We derive the retailers optimal order quantity q*
r (q) = (q) and v (q) = 1 (q), (8)
pc pc in each case and compute the order quantities ratio (OQR) and
percentage increase ratio (PIR),
 
which are affine transformations of the joint profit, (q). Thus, q (qc )
OQR = and PIR = 1 100%,
the producer fully coordinates the supply chain at w and .
qc (q )
The optimal order quantity qc for the joint supply chain profit
where qc is the optimal order quantity for the joint supply chain
also maximizes both the producers and stores individual prof-
profits. A higher value of OQR than 1 represents the retailers
its. It can be easily shown that this hybrid contract yields the
order larger than the optimal quantity for the joint supply chain
same coordinated profits as a GPM with different retail mar-
profits. PIR measures the relative advantage of supply chain
gins in the regular and clearance sales, that is, p in the regular
coordination at a value of .
sales and (p(v c)/(p c)) in the mark-down sales.7 This
Assume that the demand is uniformly distributed with den-
implies that the cosmetics producers can achieve the full coor-
sity f(y) = 1/100. Other parameters take the following values:
dination even without price-fixing in the retail market. Note that
p = $100, c = $70, and v = $50. Figs. 2 and 3 show the val-
condition p(1 ) > c should be satisfied for the vendors non-
ues of OQR and PIR at different levels of , which varies from
negative profit. Therefore, we infer that, given the joint cost
0.10 to + 0.10: that is, the interval 0.25 0.45 in the
c in the supply chain, as the cosmetics producer guarantees a
case of = 0.35, 0.30 0.50 in the case of = 0.40, and
higher retail mark-up rate (i.e., increasing ), the firm should
0.35 0.55 in the case of = 0.45. The dotted line shows
set an increasingly higher MSRP on its prestige beauty prod-
the case of = 0.35, whereas the solid line shows the case of
uct to ensure non-negative profit under supply chain coordi-
= 0.40. The dashed line depicts the case of = 0.45. As shown
nation.
in Proposition 2, the retailers order quantity q* for its own

6 By rearranging the terms, we obtain (q, , w) = (p )S(q) (c + w


r r
)q. When we substitute and w in r (q, , w) with = p[p(1 ) + v
c]/(p c)and w = p(1 ) cr , we derive r (q, ,
w)
= (p/(p c))[(p
v)S(q) (c v)q] = (p/(p c))(q). We also obtain v (q, , w)
= (q)
r (q, ,
w)
= (1 (p/(p c)))(q).
7 Wholesale price w is fixed at w = p(1 ) cr for the guaranteed
retail markup p in the regular sales. If the retailer liquidates leftover
stock at discount price v with chargebacks at b, the retailers unit mar-
gin from the salvage operation including chargebacks is b + v w cr ,
which becomes p(v c)/(p c) at b = [p(1 ) c](p v)/(p c). The
retailers profit r (q, b,
w)
= pS(q) + (b + v)(q S(q)) (cr + w)q
= (p
b v)S(q) (cr + w b v)q. Given w = p(1 ) cr and b = [p(1
) c](p v)/(p c), we derive r (q, b, w)
= p/(p c)[(p v)S(q)
(c v)q] = (p/(p c))(q), which is the same as in Eq. (8). Fig. 3. PIR under the uniform demand density.
C.H. Lee, B.-D. Rhee / Journal of Retailing 84 (3, 2008) 325333 331

Fig. 4. OQR under the exponential demand density. Fig. 6. OQR under the logistic demand density.

profit maximization increases as / decreases. If is lower


than , the retailer orders too much (q* > qc ) and later salvages
a greater amount of leftovers at a markdown price. Thus, chan-
nel coordination can improve the joint profit by reducing the
amount of leftovers. On the other hand, if is greater than ,
the retailer orders too small a quantity (q* < qc ). Supply chain
coordination can also improve the joint profit by making the
retailer order more. At = , the retailers optimal order quan-
tity q* becomes identical to the optimal quantity for the entire
supply chain, qc . Subsequently, the supply chain is fully coordi-
nated and achieves the highest joint profits. PIR then becomes
zero. Fig. 7. PIR under the logistic demand density.
We now assume that consumer demand follows the exponen-
tial distribution with density f(y) = exp[y/50]/50. Figs. 4 and 5
case of = 0.35, 0.31 0.51 in the case of = 0.40, and
show the values of OQR and PIR at different levels of ,
0.36 0.56 in the case of = 0.45.
which varies from 0.07 to + 0.13: that is, the interval
Fig. 8 shows each channel members profit at different val-
0.28 0.48 in the case of = 0.35, 0.33 0.53 in the
ues of in the interval 0.36 0.48, given = 0.40, when
case of = 0.40, and 0.38 0.58 in the case of = 0.45.
the demand follows the exponential distribution with density
The findings are fundamentally consistent with what we observe
f(y) = exp[y/50]/50. The solid lines show the retailers and ven-
with the uniform demand: q* increases as / decreases. PIR
dors profits at q* , r (q* ) and v (q ), respectively. The dotted
increases as / moves away from 1.
lines describe the retailers and vendors profits when they agree
We also obtain the same results with the logistic demand
on supply chain coordination with = 0.2, which implies that
distribution,
the retailer gets 20 percent of the gain from the coordination,
4 [(4/ 2)(x )/] whereas the vendor gets the remaining 80 percent. On the other
f (y) = exp 2
, hand, the dashed lines represent the retailers and vendors prof-
2 {1 + exp[(4/ 2)(x )/]}
its when they agree on channel coordination with = 0.8, that is,
where = 50 and = 16. Figs. 6 and 7 show the same patterns the retailer gets 80 percent of the gain from the coordination.
of OQR and PIR at differing values of , which varies from OQR in the previous figures shows that q* decreases as
0.09 to + 0.11: that is, the interval 0.26 0.46 in the / increases. Thus, the retailers profit r (q* ) decreases as

Fig. 5. PIR under the exponential demand density. Fig. 8. Gains from supply chain coordination.
332 C.H. Lee, B.-D. Rhee / Journal of Retailing 84 (3, 2008) 325333

rate, guaranteed retail margins are linked to joint profit margins


in the entire supply chain. Therefore, the retailers optimal quan-
tity decisions will result in profit maximization for the entire
supply chain. Hence, the supply chain becomes fully coordi-
nated and provides winwin outcomes for both the retailer and
the vendor by choosing a proper mark-up rate for profit-sharing.

Acknowledgements

The authors thank the associate editor and the three anony-
mous reviewers for their valuable suggestions to improve the
Fig. 9. GPM for supply chain coordination.
quality of the paper. Special thanks should be extended to Scott
Webster for helpful discussions, and to the editor, James R.
increases under a GPM of = 0.40. The vendors profit Brown, for encouraging this research. The authors also grate-
v (q ) initially increases with as the fraction of leftover stock fully acknowledge funding from Ajou University and from the
decreases. However, it decreases later as q* decreases too much. vice president, Research and Computing, Syracuse University,
Both the retailer and vendor improve their profits if the retailer through a research grant awarded to the second author.
coordinates the supply chain by sharing the gain from the coor-
dination with the vendor. As shown in Fig. 8, the retailer gains
more at = 0.8, whereas the vendor gains more at = 0.2. At References
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