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Strategies to Reduce Product Waste in the

Consumer Packaged Goods Industry


by
Arzum Akkas
M.Eng., Massachusetts Institute of Technology (2004)
B.S., Istanbul Technical University (2000)

Submitted to the Institute for Data, Systems, and Society


in partial fulfillment of the requirements for the degree of

Doctor of Philosophy in Engineering Systems

at the

MASSACHUSETTS INSTITUTE OF TECHNOLOGY

September 2015


c Massachusetts Institute of Technology 2015. All rights reserved.

Author . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Arzum Akkas
Institute for Data, Systems, and Society
August 31, 2015
Certified by . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
David Simchi-Levi
Professor of Engineering Systems and Civil and Environmental Engineering
Thesis Supervisor
Certified by . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Vishal Gaur
Professor of Samuel Curtis Johnson Graduate School of Management
Associate Dean for MBA Programs, Cornell University
Committee Member
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Roy Welsch
Professor of Engineering Systems and Sloan School of Management
Committee Member
Accepted by . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Munther A. Dahleh
William A. Coolidge Professor of Electrical Engineering and Computer Science
Director of Institute for Data, Systems, and Society
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Strategies to Reduce Product Waste in the Consumer
Packaged Goods Industry
by
Arzum Akkas

Submitted to the Institute for Data, Systems, and Society


on August 31, 2015, in partial fulfillment of the
requirements for the degree of
Doctor of Philosophy in Engineering Systems

Abstract
The cost of waste for products such as soft drinks, shelf stable dry food, and dairy in
the consumer packaged goods industry is massive, about $15 billion annually in the
U.S.A.
This thesis focuses on waste associated with product expiration since this type of
waste involves both manufacturers and retailers as well as different functional areas
such as production, warehousing, sales, procurement, and store operations. As a
result, the industry has not made much progress in reducing this type of waste.
We study three problems related to product expiration. Chapter 2 presents a
descriptive study examining the root causes of product expiration and their impact on
expiration. Using econometrics and our collaborator’s data, we find that the amount
of expiration can be reduced considerably via a case size reduction. We identify the
next important opportunities in the areas of inventory aging in the manufacturer’s
supply chain and sales incentives, and thus the remainder of this thesis focuses on
these two areas.
Chapter 3 examines the manufacturer’s sell-or-dispose decision for aged inventory.
We develop an optimization model to find the minimum remaining shelf life below
which the manufacturer does not sell the product since the cost of expiration is more
than the sunk cost of production. We use machine learning to approximate optimum
values which can be used as a low cost alternative method. If supply chain managers
are held accountable for the cost of disposed items, they will have an incentive to
better manage inventory. As a result, expiration will be reduced.
Chapter 4 analyses sales-force compensation schemes from the perspective of prod-
uct expiration caused by overselling. We develop a game theoretic model of the deci-
sion process of the manufacturer and the sales representative. We find a compensation
scheme that aligns the interests of the manufacturer and the sales representative pre-
venting overselling while achieving full profit potential for the manufacturer.

Thesis Supervisor: David Simchi-Levi


Title: Professor of Engineering Systems and Civil and Environmental Engineering

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4
Acknowledgments

First and most importantly, I would like to thank my advisor David Simchi-Levi.
David has been a valuable source of support. He provided me with opportunities to
develop and excel in research and teaching. Next, I would like to extend my thanks
to the other members of my committee. Throughout the short period in which I
had the great chance to work with him, I learned a lot from Vishal Gaur at Cornell
University. Aside from being a great teacher and mentor to me, he has always been
very kind, caring, and encouraging. I have endless respect for him as a person and as
a scholar. Roy Welsch at MIT provided valuable expertise in statistics and machine
learning. He was always available when I needed help and advice. I enjoyed his warm
and friendly personality and always looked forward to our meetings.

I am extremely grateful to my industry partner. My work would not have been


possible without their support. Through my discussions with Paul Hamilton, I found
my research topic. Paul introduced me to the right people in the company, so I could
get a better understanding of the problem. Brian Spearman accepted my research
proposal and provided me with data, financial support, and resources within his
organization. Thank you for your trust, generosity, and kindness. Lisa Sarneso and
Mark Howl, it was truly a great pleasure to work with you and thank you for all your
help and patience.

I am also very grateful to the members of the joint industry unsaleables committee,
in particular to Ted Lechner, Gary Regina, and George Thrower. Thank you for
supporting me, educating me, welcoming me in your committee meetings, and giving
me tours of your facilities. Your passion, dedication, and good heart inspired me.

Moreover, invaluable in this journey were the following students of Engineering


Systems Division, Operations Research Center, and Sloan School of Management:
Alexandre Jacquillat, Vivek Sakhrani, Ross Collins, Erica Gralla, Jesse Sowell, Tom
Heaps-Nelson, Nataly Youssef, Chaithanya Bandi, Gerardo Pelayo, Cecilia Zenteno,
Ozge Karanfil, and Gokce Basbug. Thank you for providing feedback on my ideas
and my research presentations. Above all, thank you for being good friends.

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I am also very grateful to the faculty, researchers, students, and staff at the MIT
Center for Transportation and Logistics (CTL). Even though it has been eleven years
since I graduated from the CTL master’s program in Supply Chain Management, you
still made me feel part of the CTL family throughout my doctoral years. Thank you
for letting me attend CTL’s research seminars and awarding me a fellowship.
My family and friends at MIT, in Boston, in Turkey, or elsewhere, thank you for
your love, support, and all the good times: Hasan Arslan, Yasemin Dalgali, Edan
Bashan, Adil Akbay, Michael Lester, Michel Alexandre-Cardin, Aziz Abdellahi, Firat
Guder, Claudia Octaviano, Goksin Kavlak, Burcu Balcik, Fusun Demirci, Ece Sancak,
Jale Boyacioglu, Zeynep Kirmizigul, Namik Kemal Caliskan, and Safiye Erdemir.
Finally, I would like to thank my father, Yuksel Akkas, for my inheritance which
made it possible for me to complete my education without financial stress. Thank
you and rest in peace.

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Contents

1 Introduction 17
1.1 General background . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
1.2 Financial and environmental impact . . . . . . . . . . . . . . . . . . . 21
1.3 Industry efforts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
1.4 Research questions and thesis outline . . . . . . . . . . . . . . . . . . 29
1.5 Industry collaborator . . . . . . . . . . . . . . . . . . . . . . . . . . 31

2 Drivers of product expiration in retail supply chains 35


2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.2 Literature review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
2.3 Research context and hypotheses . . . . . . . . . . . . . . . . . . . . 42
2.3.1 Unsaleables cost and reduction efforts at AlphaCo . . . . . . . 42
2.3.2 Simulation benchmark . . . . . . . . . . . . . . . . . . . . . . 43
2.3.3 Drivers of expiration . . . . . . . . . . . . . . . . . . . . . . . 44
2.4 Data description and estimation model . . . . . . . . . . . . . . . . . 49
2.4.1 Data description . . . . . . . . . . . . . . . . . . . . . . . . . 49
2.4.2 Zero-inflated negative binomial regression model . . . . . . . 54
2.5 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
2.5.1 Estimation results . . . . . . . . . . . . . . . . . . . . . . . . . 58
2.5.2 Effect of sales incentives . . . . . . . . . . . . . . . . . . . . . 61
2.5.3 Endogeneity between supply chain aging and expiration . . . . 62
2.5.4 Counterfactual analysis . . . . . . . . . . . . . . . . . . . . . . 63
2.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

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Appendix A: Calculation of rotation measure . . . . . . . . . . . . . . . . 70
Appendix B: Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

3 Shipment Policies in Two-tier Supply Chains For Perishable Prod-


ucts 81
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
3.2 Literature review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
3.3 The remaining shelf-life problem . . . . . . . . . . . . . . . . . . . . 85
3.3.1 Impact of manufacturer’s operations on perishability at the re-
tailer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
3.3.2 Supply chain cost dynamics and incentives . . . . . . . . . . . 87
3.3.3 Shipment policies in practice . . . . . . . . . . . . . . . . . . . 90
3.4 Problem definition and data description . . . . . . . . . . . . . . . . . 93
3.5 Determining targets for the remaining shelf life . . . . . . . . . . . . . 97
3.5.1 Solution approach and results . . . . . . . . . . . . . . . . . . 97
3.5.2 Sensitivity analysis . . . . . . . . . . . . . . . . . . . . . . . . 102
3.5.3 Machine learning approximation . . . . . . . . . . . . . . . . . 110
3.6 Comparison with current practice . . . . . . . . . . . . . . . . . . . . 118
3.6.1 Existing practice at AlphaCo . . . . . . . . . . . . . . . . . . 118
3.6.2 Optimization versus existing practice . . . . . . . . . . . . . . 119
3.6.3 Machine learning approximation versus existing practice . . . 123
3.7 Conclusion and future research . . . . . . . . . . . . . . . . . . . . . 125

4 Design of Sales-force Compensation Schemes Considering Product


Expiration 131
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
4.2 Literature review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
4.3 Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
4.4 Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
4.5 Conclusion and future research . . . . . . . . . . . . . . . . . . . . . 151

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5 Concluding Remarks 155

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10
List of Figures

1-1 Distribution of unsaleables cost across product categories . . . . . . . 18


1-2 Unsaleales types by channel . . . . . . . . . . . . . . . . . . . . . . . 19
1-3 Disposition methods of unsaleables . . . . . . . . . . . . . . . . . . . 20
1-4 Impact of unsaleables on company profits . . . . . . . . . . . . . . . . 22
1-5 Unbalanced incentives with existing unsaleables policies. . . . . . . . 24
1-6 AlphaCo’s outbound supply chain. . . . . . . . . . . . . . . . . . . . 32

2-1 Root causes of expiration based on AlphaCo’s internal audit study. . 43


2-2 Simulated versus actual expiration for a sample of 40 SKUs. . . . . . 44
2-3 Occurrence of different case sizes at AlphaCo. . . . . . . . . . . . . . 50
2-4 Coefficient estimates of store type indicators. . . . . . . . . . . . . . . 60
2-5 Histogram of supply chain age measure. . . . . . . . . . . . . . . . . . 65
2-6 Impact of addressing order inflation due to minimum order rule. . . . 66

3-1 Impact of inventory on remaining shelf life. . . . . . . . . . . . . . . . 86


3-2 Impact of an unsynchronized product introduction on remaining shelf
life. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
3-3 Circumstances under which manufacturer is responsible for expiration
cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
3-4 Profit implications of sales and disposal decisions when remaining shelf
life is very short. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
3-5 Types of shipment policies in practice. . . . . . . . . . . . . . . . . . 91
3-6 Impact of demand rate on expiration with regards to remaining shelf
life. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92

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3-7 Net profit from sales and disposal for one SKU as remaining shelf life
changes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
3-8 Histograms of algorithm’s output. . . . . . . . . . . . . . . . . . . . . 101
3-9 Sensitivity of no-shipment threshold to variation in demand. Square
(in red), diamond (in blue), and triangle (in green) points represent the
results with the decreased, baseline, and increased demand scenarios,
respectively. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
3-10 Histogram of store counts by SKU. . . . . . . . . . . . . . . . . . . . 105
3-11 Variation in no-shipment thresholds across SKUs with different store
samples. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
3-12 Variation in no-shipment thresholds across SKUs based on different
rotation assumptions. . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
3-13 Examples of SKUs where rotation has no impact (first graph) and
rotation has an impact (second graph) on the no-shipment threshold. 109
3-14 Approximation of optimum values with machine learning. . . . . . . . 112
3-15 Prediction process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
3-16 Performance of regression methods in prediction of no-shipment thresh-
old. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
3-17 Performance of regression methods in prediction of profitability threshold.117
3-18 Existing shipment policies at AlphaCo. . . . . . . . . . . . . . . . . . 119
3-19 Existing versus optimum minimum remaining shelf life. . . . . . . . . 120
3-20 Existing versus optimum target remaining shelf life. . . . . . . . . . . 121
3-21 Dependence of simulation approach on optimum and existing minimum
shelf life. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
3-22 Impact of optimization on profits. . . . . . . . . . . . . . . . . . . . . 123
3-23 Simulation interval in comparison of three policies: existing, optimum,
and approximation based. . . . . . . . . . . . . . . . . . . . . . . . . 124
3-24 Impact of machine learning approximation on profits. . . . . . . . . . 125

4-1 Sequence of events. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

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4-2 Assumed functions of order quantity, 𝑄(𝑒), and effort cost, 𝐶(𝑒). . . . 142
4-3 Global optimization versus two-stage problem. In the example, 𝑝 = 1,
𝑐 = 4, 𝑥 = 2, and 𝑟𝑎 = 0.45. . . . . . . . . . . . . . . . . . . . . . . . 146
4-4 Relationship between coordinating commission rate and penalty fee for
𝑝 − 𝐹 (𝑄(𝑒* ))𝑐 > 0. In the example, 𝑝 = 1 and 𝑐 = 2. . . . . . . . . . 148
4-5 Relationship between optimum commission rate and penalty fee when
𝑝 − 𝐹 (𝑄(𝑒* ))𝑐 < 0. In the example, 𝑝 = 1 and 𝑐 = 10. . . . . . . . . . 149

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List of Tables

1.1 Examples of industry case studies. . . . . . . . . . . . . . . . . . . . . 26

2.1 Estimation results for the logistics regression model. . . . . . . . . . . 72


2.2 Characteristics of the sales incentives included in the models. . . . . . 73
2.3 Summary statistics of the variables included in the model. . . . . . . 74
2.4 Estimation results for the ZINB model specified in Section 2.4.2. . . . 75
2.5 Parameter estimates of alternative models . . . . . . . . . . . . . . . 76
2.6 Results of the analysis of interaction between demand, sales incentives,
and expiration. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
2.7 Results of the Hausman test for endogeneity. . . . . . . . . . . . . . . 79

3.1 Distribution of difference in no-shipment threshold with varying demand.103


3.2 Distribution of difference in no-shipment threshold with varying as-
sumption on rotation. . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
3.3 Features used in prediction of no-shipment and profitability thresholds 113

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Chapter 1

Introduction

1.1. General background


The cost of consumer packaged goods products, such as soft drinks, shelf-stable dry
food, and health and beauty aids, that turn into waste at retail stores is estimated to
be $15 billion in 2008 which represents 1 to 2% of retail gross sales in the USA [30].
The consumer packaged goods (CPG) industry usually uses the term unsaleables to
refer to certain categories of product waste. Traditionally, unsaleables are defined as
products that are removed from a primary distribution channel, e.g. supermarkets,
mass merchants, pharmacies, for reasons such as damage, discontinuation, or expira-
tion [30]. This definition excludes product recalls, regular returns, or products that
are damaged or expired at secondary markets, as those items are managed outside of
unsaleables policies. A typical unsaleables policy defines the reverse logistics processes
for returning items as well as the terms of the reimbursement that the manufacturer
provides the retailer. The term unsaleables usually does not apply to produce and
fresh meat categories, since manufacturers typically do not reimburse retailers for un-
sold products in these categories. Figure 1-1 provides the distribution of unsaleables
cost across different product categories based on a recent industry survey [30]. Both
for manufacturers and retailers, the majority of the unsaleables cost (51% and 37%,
respectively) is coming from the edible shelf-stable dry category which includes prod-
ucts such as pasta, cereal, and canned food. The second largest category is refrigerated

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grocery (e.g., dairy) which generates 16% and 24% of the total cost for manufacturers
and retailers, respectively. The third largest category is health & beauty aids (e.g.,
shampoos, cosmetics, vitamins and supplements, etc.). Health & beauty aids make up
17% of the unsaleables cost for manufacturers and 16% for retailers. Frozen grocery
is the fourth largest category generating 4% and 11% of the cost for manufacturers
and retailers, respectively. Finally, non-edible shelf-stable (e.g., paper towels, laundry
detergents, dog food, etc.) and general merchandise (e.g., clothing, light bulbs, etc.)
are the smallest categories each making up approximately 6% of the total unsaleables
cost. Observe that a difference exists between manufacturers and retailers since the
numbers are based on survey data from a sample of firms.

60%
Percent of total unsaleables cost by category

50%
51%$

40% Manufacturer cost


37%$ Retailer cost
30%

20% 24%$

16%$ 17%$16%$
10%
11%$
7%$ 6%$ 4%$ 5%$ 6%$
0%
Edible shelf Non-edible Refrigerated Frozen grocery General Health &
stable dry shelf stable grocery (dairy) merchandise beauty aids

Figure 1-1: Distribution of unsaleables cost across product categories

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Types of unsaleables
Generally, unsaleables span three different types: damage, expiration and product
discontinuation. Each type has different sources of root causes. For instance, damages
typically occur due to weak packaging or poor handling practices, whereas reasons of
expiration include poor inventory management or forecasting, aging of products at
the warehouses, or lack of shelf rotation1 . Product discontinuation decisions are made
either by the manufacturer or the retailer, typically to make space for new products, at
the times of planogram2 resets, or as part of an SKU rationalization process. Figure 1-
2 provides the breakdown of different types of unsaleables by channel based on a 2008
industry study [30]. Accordingly, damage type constitutes the majority of unsaleables,
consistent across different channels (grocery stores, drug stores, wholesalers, and mass
merchants). However, as we will discuss later, the composition has been changing over
the years, with the damage portion declining and expiration growing.

100% 4% 4% 8% 10%
19% 20%
22% 34% 17%
80%

21% 12% 5%
60% 25%
45% 58%
56% 21%
40% 48%
40%
31%
20%

0%
Grocery Drug Wholesaler Mass All retailers
Damaged Discontinued/Seasonal Expired Unknown/Other

Figure 1-2: Unsaleales types by channel

1
Shelf rotation is the practice of first-in-first-out inventory management at retail shelves. In other
words, rotation activity involves stocking the newer products to the back of the shelf while pulling
the older ones to the front.
2
Planograms are layouts of shelf configuration.

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Reverse logistics
Reverse logistics of unsaleables can be very expensive. In forward logistics, prod-
ucts are handled in bulk either in pallets or cases. In reverse logistics, products are
handled in units resulting in high labor cost. The CPG company we have been col-
laborating with found that the reverse logistics cost of a product is as large as its
cost of goods sold plus the cost of transporting it to the store. Unlike durable goods
products, such as printers or appliances, product recovery or recycling is typically
not cost effective for unsaleables. Salvageable unsaleables, usually all categories ex-
cept dairy and frozen, are picked from retail stores and are forwarded to dedicated
warehouses called reclamation centers or return centers which are run either by third
party logistics companies or by retailers. At these centers, they are sorted based on
each product’s method of disposal, according to its unsaleables policy. From here,
the majority of them are donated to food banks (35%), some are sold to secondary
markets (26%), and a sizable portion of them are disposed of in landfills (17%). Fig-
ure 1-3 provides distribution of the common disposition methods of unsaleables [30].

1% 2%

Salvage
19% 26%
Donation
Destroyed (landfill)
17% Return to vendor
Recycle
35%
Unknown

Figure 1-3: Disposition methods of unsaleables

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1.2. Financial and environmental impact

Unsaleables is an important issue in industry due to its financial and environmental


implications. As mentioned earlier, the total cost of unsaleables is estimated to be
1 to 2 percent of retail gross sales. These are significant numbers considering the
tight profit margins in the CPG industry. For example, for a retailer with 2% profit
margin -typical for successful retailers- 1 to 2% of gross sales would be equivalent to
50% to 100% of its profit. In practice, retailers are reimbursed by manufacturers for
this cost in the USA via unsaleables policies; therefore, in reality the impact on the
retailer is not as dramatic. However, it still can be significant because manufacturers
do not always fully reimburse retailers. For instance, if a retailer were to be paid
back 80% of the cost, the remaining cost would be equivalent to 10 to 20% of its
profit. To illustrate this, consider a mid-size regional retailer such as Giant Eagle
with $9B annual revenue. In this case, the retailer’s remaining cost corresponds to
$18M to $36M annually. On the other hand, for a national retailer such as Kroger with
$80B revenue, this number equals $160M to $320M. These are remarkable numbers.
Furthermore, our informal conversations with retailers reveal that for some of them
the cost of unsaleables exceeds their annual profit. Perhaps those are retailers with
profit margins less than 2%, which is not uncommon.
The impact of the cost of product waste is equally noteworthy for manufactur-
ers. Consider a manufacturer with about 10% profit margin, which is typical for
CPG manufacturers. For an 80% reimbursement level paid by the manufacturer to
the retailer, 1 to 2% of retail gross sales could be equivalent to 11 to 21.3% of the
manufacturer’s profit3 .
Figure 1-4 illustrates the impact of the cost of unsalables on the retailer and
manufacturer’s profits as a function of the reimbursement percentage provided by
the manufacturer. The x-axis represents the percentage of the unsaleables cost that
is reimbursed by the manufacturer; the y-axis represents the impact of observed

3
Cost of Goods Sold (COGS) at retailers’ income statement usually corresponds to how much
they pay manufacturers for the goods they purchase. COGS/Revenue ratio is typically 0.75 and
accordingly, we assume that manufacturer’s wholesale price is 75% of retail price.

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unsaleables cost on the retailer or manufacturer’s profit due to reimbursement policy.
As evident in this graph, the impact of unsaleables on bottom-lines is not trivial,
both for manufacturers and retailers.
100%

Impact of observed unsaleables cost


90%
80%
70% Manufacturer
60% Retailer
on profit

50%
40%
30%
20%
10%
0%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Percentage of unsaleables cost reimbursed by
manufacturer

Figure 1-4: Impact of unsaleables on company profits

The environmental impact of unsaleables is also tremendous. To illustrate this


impact, consider the large CPG manufacturing company that we collaborated with.
We estimate that this company dump in landfills approximately 500,000 tons4 every
year of waste associated with unsalebales. This is quite substantial since according
to the Environmental Protection Agency, despite all recycling efforts in the US since
1990, the total amount of municipal solid waste going to landfills was reduced by
only 400,000 tons per year [15]. Hence, unsaleables is not an issue that only impacts
corporations’ profits, but also society due to a massive burden on the environment.

1.3. Industry efforts


Given the substantial cost of unsaleables, the industry spends considerable effort for
the problem through annual conferences and research studies. Two industry organiza-
4
The warehouse manager we interviewed revealed that one full truckload of waste is picked up at
his facility every week to be disposed at landfills. Assuming 350 warehouses of this company follow
the same disposal method, the total amount of annual waste would be 350x52=18,200 trailers which
approximately corresponds to 500,000 tons.

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tions, the grocery manufactures association (GMA) and the food marketing institute
(FMI), formed a joint-industry unsaleables committee with representatives from both
manufacturers and retailers. The committee members include national and regional
retailers such as Walmart, Harris Teeter, H-E-B, Winn-Dixie, etc. and manufactur-
ers of varying sizes such as Procter & Gamble, Kellogg and Heinz. The committee
organizes the annual unsaleables conference and determines the research studies.

At the annual unsaleables conference, manufacturers and retailers share best prac-
tices in unsalebles reduction and reverse logistics; also, collaboration awards are given
for successful partnerships between manufacturers and retailers that improve un-
saleables by attacking specific root causes. Further, conferences have been market-
places for secondary market buyers to meet retailers and arrange purchase agree-
ments. Since retailers do not want to cannibalize their own sales, it is common that
a regional retailer sells unsaleables to a secondary market grocery store at a distant
location (e.g., a Texas based retailer sells to discount stores in North Carolina). The
conference also functions as a trade show for third party reverse logistics companies
(e.g., Inmar, Genco, etc.) and packaging suppliers.

Manufacturer-retailer conflict

Generally, a tension exists between manufacturers and retailers arising from bad
practices. This tension is apparent at the annual unsaleables conference, joint in-
dustry meetings, and in overall interactions between manufacturers and retailers in
reverse logistics management. For example, manufacturers object to the practice
where retailers buy products at discount (due to trade promotions) but reclaim the
full price from the manufacturer when the product becomes unsaleable. Retailers
respond by saying that their business systems lack tracing capabilities to associate
an expired item with a historical shipment. Moreover, retailers find it damaging for
the channel that manufacturers sometimes, as a punishment, deduct the cost of un-
saleables (which manufacturers are billed for) from the marketing fund manufacturers
provide to retailers. This fund is normally used for promoting retail sales. In addition
to the mutual discontent about bad business processes, it is typical for manufacturers

23
and retailers to blame each other for the root causes of unsaleables. For example,
according to some manufacturers, expiration occurs since retailers do not rotate the
shelves and damage occurs because retailers do not handle products carefully. Simi-
larly, retailers complain that products have very little shelf life remaining when they
arrive at retailers’ supply chains resulting in expiration; also, manufacturers’ poor
packaging makes products vulnerable to damage.
Another problem, from the perspective of retailers, is the increasing adoption of
an unsaleables policy, called the adjusted-rate-policy (ARP), that favors the manu-
facturers. Historically, manufacturers have reimbursed the retailers for the full cost of
observed unsaleables under the joint-industry-report (JIR) policy. The ARP policy
simply provides a wholesale price discount for the future cost of unsalebales, sup-
posedly based on supply chain audits aimed at determining how much each party
contributed to the problem. Retailers see this policy as manufacturers washing their
hands of the problem. These two policies represent two extreme situations in which
the risk associated with observed unsaleables is allocated among channel partners.
See Figure 1-5.

Incentive to Reduce Unsaleables


0% 100%

JIR policy: Retailer Manufacturer


ARP policy: Manufacturer Retailer

Figure 1-5: Unbalanced incentives with existing unsaleables policies.

Further, audit methodologies usually are not transparent to retailers which raises
suspicion about their efficacy among retailers. Also, some retailers find the newer
unsaleables policy unjust since the policy does not differentiate among channels. For
example, drug stores typically have higher rates of unsaleables compared to the gro-
cery channel but the manufacturer’s policy provides the same discount rate to all
retailers (e.g., 2%). As a result, some retailers shut down their facilities to auditors
refusing to collaborate. Over the years, the representation in the joint-industry un-

24
saleables committee from the retailer side has diminished, perhaps due to discontent,
perceived lack of progress and manufacturer dominance in the issue.

Industry reports and case studies


In addition to the unsaleables conference, industry studies are another source of
effort aimed at alleviating unsaleables. GMA and FMI collaborate with consulting
companies for research studies to understand unsaleables and provide suggestions for
firms to mitigate the problem. Most existing studies use survey methods to collect
data from retailers and manufacturers to show the overall state of unsaleables in the
industry. For example, studies report unsaleables distribution by types (e.g. 50%
damage vs 43% expiration), unsaleable rate by channel (e.g., 1.1% in supermarkets
vs 5.1% at drugstores), and unsaleable rate by product category (e.g., 0.8% non-
refrigerated food vs 1.5% dairy products) [30]. The surveys also collect information on
respondent belief on leading root causes of unsaleables. Of course, survey methods do
not provide objective insights on leading causes of unsaleables. Indeed, manufacturers
and retailers have different views on the leading causes of unsaleables, as we discussed
earlier, with each party associating the main cause of a certain type of unsaleable with
the other party.
Industry reports also include case studies to demonstrate practices that have been
successful at reducing unsaleables [49]. Recent case studies give us a good picture
of where the industry stands at tackling the unsaleables problem. Table 1.1 lists a
sample of case studies from a joint industry project called "Reverse Supply Chain
Improvement" conducted by Raftery Resource Network company in 2011.

25
Table 1.1: Examples of industry case studies.

Case study name Company type Tool Description


Involving sales peo- manufacturer education, incen- Unsaleables reports are reviewed for improvement op-
ple to solve prob- tives portunities at salesforce performance reviews.
lems
Shelf life manage- retailer data reporting By analyzing the return data for one manufacturer,
ment the retailer finds that a high percentage were expired
products. Unsaleables policy is updated to shift more
of the unsaleables cost to the manufacturer.
Sales-potential retailer shelf space man- Shelf space is allocated according to sales potential.
planograms agement Slow-moving products are discontinued. Instead of
filling the shelf space with inventory, space fillers and
product fronting techniques are used to reduce on-
shelf inventory.
Engaging the store retailer incentives All stores receive a standard credit for unsaleables
leaders and are charged for what they return. Stores that
return excessive levels are penalized; below average
stores are rewarded.
Six sigma reclama- retailer business process Instead of shipping discontinued products to reclama-
tion optimization tion centers, the retailer uses markdown management
at stores to reduce reclamation center expenses.
Keeping good prod- manufacturer business process Salespeople call customers after promotions to man-
uct out of reclaim age excess inventory either through markdown funds
or returns.
Partnership studies manufacturer audit Opportunities to reduce damage were identified by
collaborating with retailers. E.g., Reduced case
headspace, which reduced top crushing; A retailer
changed unloading practices, which reduced dock
damage.
Demand sales fore- manufacturer analytics Daily store-level POS data is used to improve fore-
casting casting which resulted in lower inventory at the cus-
tomer warehouse and stores.
Increasing available manufacturer data reporting Reclamation center data is collected to understand
shelf life types of unsaleables. Over 80% of the product was
found to be expired. Research is being conducted to
identify acceptable methods for extending shelf life.

26
Based on the existing case studies, some of which we listed in Table 1.1, we make
the following observations regarding the current state of unsaleables.

∙ The industry is struggling with basic issues such as unsaleables data collection.

∙ The distribution of unsaleables type (e.g, 70% expiration, 20% damage) varies
by the supply chain (i.e., manufacturer-retailer combination). The composition
of different unsaleables types is not known by every firm.

∙ Firms pick one issue and attack the related problem (e.g., forecasting, planograms,
damage, discontinuation, incentives, etc.). The associated project is not nec-
essarily part of a roadmap prioritizing opportunities based on a cost-benefit
rank.

∙ Commonly used tools to understand or alleviate unsaleables are business pro-


cesses, data collection and reporting. Existing analytics is limited with sum-
mary statistics (e.g., volume or percentage of expired/damaged unsaleables by
location/SKU). Use of advanced analytical techniques is not common.

∙ There are many more projects on product discontinuation and damage and
than on expiration. Perhaps, discontinuation and damage are relatively easier
matters to address using simple tools such as business processes, data reporting,
and audits.

∙ Audits are expensive. Usually, large manufacturers can afford audits.

∙ Audits are effective at understanding the root causes of damage. Also, root
causes of damage are relatively straightforward matters (e.g., specific packaging
issues, loading/unloading environment, etc.)

∙ There is no simple recipe for expiration.

∙ There are more examples from retailers than manufacturers leveraging incen-
tives and accountability to reduce unsaleables.

27
∙ Manufacturers see the new unsaleables policy as a tool to reduce expiration
since the policy addresses the retailer’s incentive problem. However, this policy
does create a new incentive problem about the remaining shelf life.

Given the importance of unsaleables for firms’ profitability, ironically, the current
state of unsaleables is rudimentary. For example, firms still struggle with basic issues
such as collecting unsaleables data. There are several impediments to progress. First,
scanning and sorting unsaleables (into categories as damaged, expired, discontinued)
is costly. When the unsaleables policy does not reimburse the retailer for the cost
of observed unsaleables (product cost plus the reverse logistics cost), some retailers
choose to compile different unsaleables types (without sorting) during the disposal
process to save labor cost. As a result of this practice, unsaleables type (i.e., damage,
expiration, discontinuation) data is lost. Since each type of unsaleables occurs due to
completely different dynamics, unavailability of granular unsaleables data makes it a
challenge to take effective actions to reduce unsaleables.
Another obstacle to progress is incentive issues arising from the existing un-
saleables policies. The policy that reimburses the retailer for observed unsaleables
creates a motivation problem for the retailer. For example, the retailer may not care
to handle products cautiously (to prevent damage) or to better manage inventory (to
prevent expiration) when the manufacturer provides full reimbursement. Likewise,
the newer policy reimbursing the retailer for future unsaleables through a wholesale
price discount causes incentive issues for the manufacturer. For example, the man-
ufacturer may not have an interest to use durable packing (to prevent damage) or
to ship fresh products (to prevent expiration). Similar incentive issues exist within
a firm since different functions contribute to the problem while usually one function
absorbs the cost (e.g., logistics, sales, etc.). Perhaps, the reason for such unbalanced
accountability is the lack of understanding about the precise drivers of unsaleables
(i.e., what portion of unsaleables is caused by one particular function or firm versus
the other).
Finally, the unsaleables problem has not been addressed effectively in past because
traditionally reverse logistics has not been considered a C-level subject, and thus un-

28
saleables have not received the attention and support it deserves from top executives.
At some firms, in particular at manufacturers (as we are told by industry leaders dur-
ing informal conversations), unsaleables fall under the responsibility of unpromising
managers suggesting that reverse logistics is not a function that a successful man-
ager aspires to be in. We see a parallel between today’s reverse logistics and the 80s
procurement organization. Before the 80s, procurement was generally seen as an ad-
ministrative function. During the 80s and 90s, procurement gained importance (and
got rebranded as "strategic sourcing") as firms started to realize that improvements
in procurement enable firms to cut costs and increase profits substantially. We hope
to see a similar shift with unsaleables in the future.

1.4. Research questions and thesis outline

In this thesis, we study the unsaleables problem. Specifically, we focus on product


expiration since it is a more pressing issue for the industry compared to the other
two types of unsaleables (i.e., product damage and discontinuation). As evident from
existing industry studies, damage can be reduced either through durable packaging
or careful handling; waste due to product discontinuation can be mitigated by im-
proving business processes and communication between channel partners. Drivers
of product expiration, however, are complex spanning across many functions (man-
ufacturing, warehousing, transportation, forecasting, sales, procurement, and store
operations) which makes it a challenge to determine an efficient strategy to reduce
expiration. Furthermore, perhaps due its complexity, the product expiration cate-
gory of unsaleables has been exhibiting growth over the years and quickly becoming
a larger portion of the problem, while unsaleables rates have stayed steady over the
years [30]. For example, in case of our industry partner, product expiration accounts
for 65% of total unsaleables.
In this thesis, we aim to provide suggestions for practitioners to reduce product
expiration occurring in retail supply chains. Specifically, we address the following
research questions:

29
1) What are the root causes of product expiration and how substantial are they
relative to each other?

2) How can we set up shipment rules for the manufacturer (to control the remain-
ing shelf life of products moving into the retailer’s supply chain) in order to mitigate
the cost of expiration?

3) Is there a sales-force compensation scheme that prevents the manufacturer’s


salespeople from overselling (which results in product expiration at the retailer) while
achieving full profit potential for the manufacturer?

Each of the three questions is addressed in a separate chapter in this thesis. We


start Chapter 2 with a descriptive study analyzing the drivers of product expiration
to get a thorough understanding of the issue. Industry audits have been effective at
understanding damage but not expiration. We use a method that is novel (i.e., econo-
metrics based on historical transaction data) to practitioners to analyze the drivers
of expiration. Our main finding is that expiration can be reduced with reduction
in case sizes. In addition, our framework of analysis provides a roadmap to reduce
expiration based on the impact of each expiration driver on savings. The second and
third research questions arose from our first study. Some of the drivers of expiration
are straightforward to address (e.g., reduce case sizes, reduce store replenishment
frequencies to address minimum order sizes, improve rotation compliance through
regular audits at sample stores). However, other root causes, such as aging of inven-
tory in the manufacturer’s supply chain or sales incentives, are more complex and
cannot be addressed with a simple change in operations. Therefore, the remainder of
this thesis focuses on the latter types of expiration drivers that are complex. Chapter
3 addresses the second research question focusing on the remaining shelf life problem.
Chapter 4 addresses the third research question analyzing sales-force compensation
schemes from the perspective of product expiration. Finally, Chapter 5 completes the
thesis with our concluding remarks.

30
1.5. Industry collaborator
Overview
We collaborate with a large CPG manufacturer, which we will refer to as AlphaCo
in this thesis. AlphaCo is a multi-billion dollar food and beverage company operat-
ing over 50 manufacturing locations and 400 distribution centers in North America.
AlphaCo operates under the direct-store-delivery (DSD) sales & distribution model,
which involves delivering products directly to retail stores bypassing retailers’ distri-
bution centers, as well as managing store inventory. Through DSD, AlphaCo’s over
5,000 sales representatives and 5,000 truck drivers service 200,000 consumer points.

Supply chain operations


AlphaCo has a multi-tier supply network consisting of plant warehouses, satellite
warehouses, and retail outlets. High velocity items are typically produced in all plants,
whereas low velocity items are produced in a subset of plants. Each retail outlet is
supplied by one warehouse. Also, each satellite warehouse is supplied by one plant
warehouse in full truckloads. Plants that produce low velocity products distribute
these items in full truckloads to other plants. Therefore, each satellite warehouse
receives all items from a single source plant location. Plants also serve as warehouses
servicing local markets. Products that AlphaCo does not produce but buys from
contract manufacturers are either shipped to plant warehouses or directly to satellite
warehouses, only if the volume is high enough for a full truckload. Figure 1-6 depicts
AlphaCo’s outbound supply chain.

31
AlphaCo plant
AlphaCo satellite warehouse
Retail store
Contract manufacturer

Figure 1-6: AlphaCo’s outbound supply chain.

Sales and delivery operations


Each AlphaCo sales representative is responsible for a fixed set of stores, called a
route, and makes regular visits to the stores according to a fixed schedule. At each
visit, the sales representative creates a return order for damaged or expired products
and moves them to the back room for pick up, then observes the on-hand inventory
and creates replenishment orders. The sales representative is also responsible for re-
stocking shelves from the back room, rotating the shelf, and setting up promotional
displays. Deliveries are made the following day by a different employee, a truck driver,
who also picks up the returns from the back room. A store always receives all of its
deliveries from one warehouse. Stores are categorized by annual sales volume into
two groups: small format and large format stores. Large format stores typically are
supermarkets and mass merchants. Small format stores are drug stores, convenience
stores, and gas stations.

Collaboration
Our first research study, on the drivers of product expiration (Chapter2), as well
as the second study, about the remaining shelf life problem (Chapter 3), are empirical
analysis primarily based on AlphaCo’s archival data (e.g., shipments, returns, orders,

32
inventory counts, point-of-sale purchases, product cost, and product characteristics).
Our third study, on sales-force compensation schemes (Chapter 4), is a mathematical
modeling analysis; however, the study also uses AlphaCo’s data to test some of the
assumptions we make for our model. Overall, through all three studies, we develop
strategies to reduce expiration for AlphaCo as well as for the CPG industry.

33
34
Chapter 2

Drivers of product expiration in retail


supply chains

2.1. Introduction

Product expiration is an important problem in the consumer packaged goods (CPG)


industry costing retailers and manufacturers approximately $6 billion annually1 . This
cost impacts firms’ profits substantially since the industry operates with tight profit
margins (retailers typically have 1-2% gross margin and manufacturers 10%). Chapter
1 provides a detailed discussion on the financial and environmental impact of product
waste (i.e., unsaleables) including the category of expired products.
In this study, we investigate the root causes of product expiration. The CPG
industry typically uses audits and surveys to diagnose the occurrence of unsaleables
[49, 19]. In audit studies, unsaleables are visually inspected at sampled stores or
return centers and a reason code is recorded for each instance of an unsaleable. Such
a visual inspection usually reveals the cause of damage, such as a packing failure
(e.g., weak plastic, case handle, carton burst, nail damage on pallet, etc.). But a
visual inspection of an expired product is not informative. A product can expire

1
Annual cost of unsaleables is $15 billion according to a 2008 industry estimate. Based on industry
surveys, we estimate that about 40% of the total unsaleables volume comes from the expired products
category.

35
on the shelf due to causes that have occurred anywhere during the sojourn of the
product from the factory to the shelf. Batching in production or transportation,
inefficient inventory management at the warehouse, or suboptimal shelf allocation at
the retail store could all cause product expiration. These causes cannot be identified
by examining a product on the shelf after it expires. Thus, audits have been successful
in addressing the causes of damage and product discontinuation, but not expiration.
Surveys, on the other hand, collect information about respondent beliefs on the
causes of unsaleables. Not surprisingly, manufacturers and retailers have different
views on the leading causes of unsaleables [30]. Manufacturers rank rotation prac-
tices at retailers as the major cause of expiration2 , whereas retailers rank code dating3
standards and procedures. Similarly, manufacturers rank product handling as the
leading root cause of damage whereas retailers rank package design. Thus, each asso-
ciates the main cause of certain types of unsaleable with the other. Our interviews at
our collaborator AlphaCo suggest that such differences persist even within the same
company—the sales organization identifies operational practices as the driver of prod-
uct expiration whereas the operations organization argues that sales incentives are the
main reason. Thus, due to dependent events and lack of transparency in the supply
chain, expiration remains an unsolved problem with cost and waste implications for
manufacturers and retailers.
The objective of our study is to propose an econometric model to improve the un-
derstanding of the root causes of expiration in the CPG industry. Unlike the methods
employed by existing studies, our analysis is based on archival data collected from
the entire supply chain to examine the extent to which the occurrence of expiration is
associated with store operations, supply chain performance, and product characteris-
tics. Our primary data source is AlphaCo’s archival system which includes deliveries

2
Rotation refers to the practice of putting the fresher products to the back of the shelf and pulling
the older ones to the front.
3
Manufacturers use either open codes or closed codes on products to assist the store determine
how long to display the product for sale. Open codes are calendar dates that take forms such as
"best buy", "sell by", "use by", etc. whereas a closed code represents a series of numbers. Retailers
contend that it is harder to manage rotation with closed codes. Also, they claim that with the recent
trend to switch from closed code to open code practices, manufacturers have reduced the shelf life
to be more conservative.

36
to and returns from 66,867 retail stores, warehouse inventory counts, product de-
ployment at 449 AlphaCo locations, and shelf life and case size information for 768
products. The data set is from the year 2011.

Is observed product expiration in a CPG business such as AlphaCo natural to


expect due to the randomness of demand, or is there an opportunity to reduce ex-
piration? We first compare observed expiration with a theoretical benchmark con-
structed by simulating a base stock policy on the sample paths of demand observed
in detailed transaction level data for a small subsample of products. We find that
the average actual expiration is 95.83 times the simulated expiration, significantly
different at 𝑝 < 0.01. This result suggests that expiration occurs due to reasons other
than the randomness of demand, and thus, could be reduced by improving operations
at manufacturers and retailers.

We identify six potential drivers of product expiration: case size, supply chain ag-
ing, sales incentives, forecasting complexity, minimum order rules, and shelf rotation.
Here, we define supply chain aging as the elapsing of a product’s life in the supply
chain before the product reaches the retail shelf. These variables represent different
aspects of practical supply chains, including store execution, back-end supply chain
operation, and product characteristics. We select these variables based on interviews
with AlphaCo, industry reports, and models of perishable inventory management. In
addition, we control for mean demand rate, store type, and product shelf life in the
analysis. Our estimation method is based on count models because expiration is a
nonnegative integer and is bounded above by the total shipment quantity. Using data
from 870,493 store-product combinations, we evaluate several econometric specifica-
tions: binomial, Poisson, negative binomial, and zero-inflated models. We find that
the zero-inflated negative binomial (ZINB) model yields the best fit and the most
unbiased residuals by addressing two characteristics of our data: probability mass at
zero and overdispersion.

Our main result is that case size, supply chain aging, sales incentives, forecasting
complexity, and minimum order rule are all statistically significant determinants of
product expiration. The control variables, demand rate, shelf life, and store type

37
also affect expiration significantly. These results are robust to different clustered
standard errors. Thus, our study shows that expiration occurring at retail shelves
can be caused by both manufacturers and retailers. To refine our results, we analyze
the interaction of sales incentives with demand rate—sales incentives can increase
demand rate, which can lead to underestimating the effect of sales incentives on
expiration. We also examine a potential inverse relationship between supply chain
aging and expiration, i.e., that more expiration may result in more inventory upstream
in the supply chain, which may increase supply chain aging. The Hausman test does
not reveal any significant evidence of endogeneity.

We present counterfactual analysis to assess the performance improvement that


can be achieved by addressing various types of causes of product expiration. We
find that reducing the case size to 12 units for products that are currently packed
in 24 units yields a 41% decrease in expiration volume and a $7.66M decrease in
expiration cost. This constitutes an opportunity for CPG companies to reduce waste
by reducing case sizes. Reducing the days of supply in the supply chain by one week
corresponds to a 0.98% decrease in expiration volume and a $912.4K decrease in
expiration cost. Relaxing the minimum order rule can reduce expiration volume by
0.87% and expiration cost by $610.7K. Accordingly, visit frequencies can be reduced
at stores that have a high frequency of orders equal to their minimum order sizes.
Last, we find that three sales incentives cost $645K, $2,634K, and $25.7K with more
expiration of 14%, 9%, 7% in volume, respectively.

Our study is the first descriptive study of product expiration in the inventory
management academic literature. While the existing literature on perishables inven-
tory management has focused on inventory policies, our research contributes to the
literature by developing an econometric model of expiration, and providing insights
into its sources beyond demand uncertainty. Our analysis is distinct in combining
sku-level data from stores and supply chain and marketing data from manufacturers.
The results of this analysis can facilitate solutions to the problem of expiration by
improving the understanding of its root causes. Our expiration model identifies the
contribution of different actors to the expiration problem, and presents evidence that

38
expiration can be alleviated with better management at retailers and manufacturers.

2.2. Literature review

Our research is related to the literature in perishable inventory management, retail


operations, and sustainability models.
The management of perishables is an important problem in many industries, such
as blood banks, food, and pharmaceuticals. Seminal research in this area was con-
ducted by Nahmias [47] and Fries [16], who analyze the optimal inventory policy
considering expiration and shortage costs under a cost-minimizing dynamic program
and show that the optimal policy is non-stationary and is dependent on the age dis-
tribution of inventory. Nahmias [48] presents an extensive review of the issuance
and replenishment decision models for perishable inventory. Most of this literature
has focused on single-location models and ignored aging in the supply chain, i.e., a
product is available for its full life upon receipt at the retailer.
Ketzenberg et al. [33] consider a two-stage system with supply chain aging and
order batching in order to evaluate the benefit to the retailer from the availability of
product life information at the supplier. This benefit manifests in the retailer ordering
more product when the supplier has fresher inventory available, and less otherwise.
Through a simulation study, the authors show that sharing product life information
increases the retailer’s profit by an average of 4.4%, increases the average remaining
shelf life of retail inventory at the time of replenishment by 8%, and decreases the
incidence of product expiration by 40%. The retailer benefits the most from infor-
mation sharing when the variability of the demand or the remaining shelf life of the
items is high, product lifetimes are short, and the cost of the product is high.
Ketzenberg and Ferguson [34] focus on slow-moving items that are ordered in
single case pack sizes. For a two-stage supply chain with one supplier and one retailer,
they evaluate the value of two supply chain improvements—sharing of inventory and
replenishment information by both partners in a decentralized supply chain, and
centralized control. Using a numerical study, they find that, compared to the base

39
scenario, the total supply chain expected profit increases by 4.2% with information
sharing and by 5.6% with centralization. Further, the benefits of information sharing
or centralized control are minimal when an optimal case size is chosen.

Our work contributes to the literature on perishable inventory by examining it


in a real-world context, integrating data from the manufacturer and many retailers
to identify the role of each player, and identifying the role of supply chain execu-
tion variables such as rotation compliance, supply chain aging, case size, and sales
incentives. Whereas the literature has developed optimal policies and useful heuris-
tics for inventory management for perishable products, we develop insights into the
relative effects of different supply chain variables that can be managed to reduce the
occurrence of expiration.

The recent literature on retail operations and supply chain execution is also rel-
evant to our research. Several papers in this literature have studied real-world phe-
nomena through empirical research or analytical models. For example, Dehoratius
and Raman [14] identify the sources of inventory record inaccuracy using hierarchical
linear modeling and emphasize the need to incorporate these sources into inventory
planning tools. Kok and Shang [38], Dehoratius [13] and several others have since
developed inventory planning algorithms under inventory data inaccuracy. Gaur et
al. [61] study the ordering behavior in a supermarket chain and show that store
managers deviate predictably from automated replenishment systems due to factors
such as in-store handling cost, case size, demand rate, produce variety, and demand
variability. Accordingly, they devise a method to improve automated replenishment
systems. Kesavan et al. [32] investigate the relationship between flexible labor re-
sources and financial performance. Corstjens and Doyle [11] study optimal shelf space
allocation among multiple products, considering main and cross space elasticities, in
order to minimize procurement, inventory carrying, and out-of-stock costs. Kok and
Fisher [39] study the optimal allocation of shelf space to an assortment of substi-
tutable products in a category.

Our work contributes to this stream of research by studying an important but


unexplored issue in the CPG industry, and identifying its causes, which have only been

40
partially analyzed in theoretical research. We exploit the statistical characteristics of
expiration in practice, i.e., count data with frequent zero observations, to employ zero-
inflated count models for hypothesis testing. Some variables used in our research are
based on the literature. For instance, excess shelf space, whether due to suboptimal
shelf allocation or case size considerations, can lead to excess inventory, which then
can cause product expiration. Thus, our research builds on these topics in retail
operations by showing the waste implications of different aspects of supply chain
execution.
Other aspects of supply chain execution include sales incentives, order batching,
and order inflation. Examples of this work span the literature in operations man-
agement and economics. Chen [8] proposes a salesforce compensation package that
induces a smooth ordering behavior to match the production cycle. He compares this
to a widely used compensation plan based on annual quotas which causes salesper-
sons to concentrate their efforts in the last period. Oyer [50] empirically shows that
salespersons and executives influence the timing of customer purchases, driven by
nonlinear incentive contracts, resulting in business seasonality with high sales at the
end of the fiscal year and low sales at the beginning. Our work adds to this litera-
ture by identifying sales incentives and order batching as factors that cause increased
product expiration.

41
2.3. Research context and hypotheses

2.3.1 Unsaleables cost and reduction efforts at AlphaCo

The cost of unsaleables consists of the procurement cost of the product, sales & de-
livery cost to place it in the store, and reverse logistics cost. An internal unsaleables
study conducted at AlphaCo in 2010 suggested that the reverse logistics cost is ap-
proximately equal to the sum of the other two cost components. Thus, even though
unsaleables make up only 0.87% of the total sales volume at AlphaCo, the total cost
of unsaleables is equivalent to 50% of the net profit (profit margin at AlphaCo is
approximately 3%). Further, unsaleables have indirect costs such as the opportunity
cost of occupying shelf space that would otherwise be used for saleable products and
the cost of lost goodwill due to consumers switching to competing products. As a
result, unsaleables are a matter of great importance. Expiration comprises about 65%
of the unsaleables volume while damage makes up the remaining 35% at AlphaCo.
Discontinued products go through a phase-out process and eventually enter reverse
logistics once they expire.
AlphaCo conducted a comprehensive study of product waste in 2010. It involved
audits at sample stores to document the root cause for each instance of unsaleables.
The study was able to identify the root causes for damaged products. However, the
causes for expired products were not definitively established. Figure 2-1 presents the
causes of expiration as identified in the study. Note that the second most frequently
cited root cause for expiration is unknown. This shows the inability of audits to
diagnose the causes of expiration.

42
40%  
35%  
30%  
25%  
20%  
15%  
10%  
5%  
0%  
Rota-on   Unknown   Over   Other   Ship  to   Retail  price  
issue   ordered   trade  short   point  
coded   increase  

Figure 2-1: Root causes of expiration based on AlphaCo’s internal audit study.

2.3.2 Simulation benchmark

We perform a simulation analysis using point-of-sale data for 40 SKUs of AlphaCo


obtained from one retail store. These products include all items carried at this store
supplied by AlphaCo, i.e., whose UPC codes match AlphaCo inventory IDs. The
products vary in their shelf lives, case sizes, and demand rates. The median, max-
imum, and minimum values of these variables are respectively as follows: shelf life,
14, 104, and 12 weeks; case size, 12, 24, and 1 units; and daily demand rate, 0.12,
0.65, and 0.01 units.
We receive daily point of sale data covering 604 days. Since the store is serviced
once a week by AlphaCo, we aggregate the daily point of sale data by week. 26
out of 40 products had zero sales for some of the weeks, most likely due to product
introductions and discontinuations. To account for such scenarios, we discard obser-
vations prior to the first week of positive sales and after the last week of positive sales.
We construct an empirical demand distribution from the observed sales, and use it to
generate a sample path of 10,000 demand occurrences. Order quantities for each week
are computed based on a heuristic order-up-to inventory replenishment policy with
a 95% in-stock rate. We use a heuristic because the optimal policy for perishables
suffers from the curse of dimensionality and is hard to compute. Each week, an order
equal to the difference between the order-up-to level and the sum of the inventories

43
of different ages is created. We allow single-unit replenishment in the simulation in
order to focus on the amount of expiration due to the randomness of demand; case
size will be included as a variable in the regression model in Section 3.2. We also
assume that inventory is depleted under the FIFO rule.
The average weekly expiration quantity per product in the simulation is 1.9917 × 10−3
units. The actual expired quantity, according to AlphaCo’s product return records, is
1.908 × 10−1 units/week/product, which is 95.83 times the simulated expiration, sig-
nificant at 𝑝 < 0.01 in a one-tailed t-test. Further, only 10/40 products have non-zero
expiration in the simulation result, whereas 23 out of 40 products have expiration in
AlphaCo’s data. Figure 2-2 shows the difference between simulated expiration and
actual expiration for all 40 products. The graph shows that the observed expiration
is substantially larger than the simulated expiration for most of the products. Thus,
demand uncertainty cannot be the only source of expiration at this store.

1.4  
Actual  Expira5on  (average/week)  

1.2  

1  

0.8  

0.6  

0.4  

0.2  

0  
0   0.005   0.01   0.015   0.02   0.025  
Simulated  Expira5on  (average/week)  

Figure 2-2: Simulated versus actual expiration for a sample of 40 SKUs.

2.3.3 Drivers of expiration

To motivate the hypotheses, we consider the inventory replenishment of a single prod-


uct at a retail store. Let 𝑆 denote the shelf life of the product, 𝐷𝑡 denote the random
demand in period 𝑡, and 𝑄 denote the amount of inventory shipped to the store at
the beginning of period 1 with zero starting inventory. Thus, the amount that will

44
eventually expire from this batch of shipment under the FIFO issuing policy will be
𝐸𝑄 = [𝑄 − 𝑆𝑡=1 𝐷𝑡 ]+ , which depends on the demand realization, the shelf life of
∑︀

the product, and the shipment quantity. For the same demand realization, a larger
shipment quantity or a shorter shelf life correspond to a higher amount of expira-
tion. Therefore, we expect practices or circumstances that reduce shelf life or inflate
shipments to cause expiration. We discuss these practices identified through our in-
terviews and industry reports, and set up our hypotheses.

Hypothesis 1: The probability of expiration is positively correlated with


case size.
CPG manufacturers ship items in multiples of case size to stores.
In the simulation study in Section 2.3.2, we find that the target inventory level
calculated based on empirical demand distribution is less than case size for 33/40
products. Thus, stores must round up their shipment quantities to one case. Further,
case size cover (i.e., case size divided by mean demand) is greater than shelf life for
15/40 products. In other words, a case of inventory is expected to last longer than
the shelf life for many products, which would result in expiration. Low demand rates
are not unique to this store. According to an industry study [63], nearly half of the
SKUs at retail stores sell less than one unit a week. For such products, shelf life does
not need to be very short for expiration to occur. For instance, expiration will occur
if case size is 24 units and shelf life is less than 6 months or if case size is 12 units
and shelf life is less than 3 months.
A test of this hypothesis is valuable because higher case sizes need not necessarily
correspond to a higher occurrence of expiration if they are correlated with demand
rate and shelf life. Moreover, manufacturers resist decreasing case size because it
increases handling and packaging costs and may even require upgrading production
lines. Due to these costs, it is important for manufacturers to verify the value of
smaller case size in order to make an informed optimal case size decision.

45
Hypothesis 2: The probability of expiration is positively correlated with
supply chain aging.
The probability of expiration is positively correlated with supply chain aging.
Every product has a fixed shelf life at the time of production. Time spent in the
supply chain erodes this shelf life. We call this supply chain aging. It can occur due to
reasons such as production and transportation batching, high safety stocks, and poor
forecasts. By reducing effective shelf life, supply chain aging can increase expiration
for any given level of demand and supply. Further, the effect of supply chain aging
on expiration can be expected to depend on the demand rate, the case size, and the
shelf life.
We measure supply chain aging for each product-store combination as the cumu-
lative average days of supply of that product in its supply chain. AlphaCo has a
multi-tier supply network consisting of plant warehouses, satellite warehouses, and
retail outlets. High velocity items are typically produced in all plants, whereas low
velocity items are produced in a subset of plants. We map this supply chain for each
product-store combination and compute the total average days of supply of the prod-
uct across the stages of the supply chain.

Hypothesis 3: The probability of expiration is negatively correlated


with rotation.
The probability of expiration is negatively correlated with rotation.
Shelf rotation is the practice of placing fresher products in the back of the shelf
while pulling older ones to the front. Rotation facilitates first-in-first-out issuing of
inventory. Perishable inventory theory on the issuance of inventory in LIFO or FIFO
order suggests that rotation affects the occurrence of expiration [48]. According to
the 2008 Joint Industry Report, CPG manufacturers believe lack of shelf rotation
to be the most common root cause of expiration. An internal study by AlphaCo,
however, found that 63% of the time when an expired product is found on the shelf,
the shelf was in fact rotated. Thus suggests that the impact of rotation may not be
as dramatic as believed in the industry.

46
Hypothesis 4: The probability of expiration is positively correlated with
compliance to minimum order rules.
The probability of expiration is positively correlated with compliance to minimum
order rules.
Inflation of order quantities to reduce transportation cost is a common practice.
AlphaCo imposes minimum order sizes for store replenishment orders in order to
reduce delivery costs. Our field trips reveal that original order quantities can be in-
creased to make the total order size equal to the required minimum. This behavior
inflates store inventory, which can be expected to increase expiration. Sales represen-
tatives are measured on their compliance to this rule, which we use as the measure
to test this hypothesis.

Hypothesis 5: The probability of expiration is positively correlated with


manufacturer’s sales incentives.
The probability of expiration is positively correlated with manufacturer’s sales incen-
tives.
CPG manufactures offer a variety of performance incentives to their sales force
which can increase the chances of product expiration. AlphaCo, for instance, offers
its sales representatives not only a sales commission applicable on the overall sales
volume, but also a second layer of rewards for growing sales volume or building
store displays for specific products. AlphaCo calls these reward programs incentives.
Products for which AlphaCo intends to improve market penetration are typically
selected for incentives. Each incentive is valid during a particular month and focuses
on a group of products.
Two types of incentives are offered. One involves competition for the best looking
in-store displays among sales representatives. Products not returned to the warehouse
at the end of the display period generate over supply of inventory at the stores. The
other incentive type involves a sales growth target by a fixed volume or a percentage
compared to the prior year. Typically, these targets are achieved by gaining additional

47
shelf space or permanent displays, which increases store inventory.
Incentives can inflate store inventory as well as stimulate demand. We test whether
incentives have a positive net effect on expiration. Section 2.5.2 discusses how de-
mand, incentives, and expiration interact with each other in our estimation model.

Hypothesis 6: The probability of expiration is positively correlated with


forecasting complexity.
The probability of expiration is positively correlated with forecasting complexity.
Each AlphaCo route is managed by one sales representative. Routes serve varying
number of stores. For instance, a sales representative assigned to large format stores
such as supermarkets may visit as few as 4 stores a day, whereas one assigned to
small format stores may visit up to 15 stores a day. Sales representatives initiate
replenishment orders at store visits by forecasting the demand up to the next replen-
ishment epoch. This forecasting task inevitably gets more complex with increasing
store-product combinations in the route and so does the likelihood for mismanaging
inventory. Thus, we expect that as the difficulty in forecasting increases, sales rep-
resentative will err on overstocking than understocking, which should increase the
chances of expiration. We measure forecasting complexity as the number of store-
product combinations that a sales representative is in charge of managing.
The above drivers of expiration can be classified through different perspectives.
For example, sources of expiration can be classified as (i) drivers reducing shelf life,
and (ii) drivers increasing shipment quantity. Among the root causes listed, case
size, minimum order rule, sales incentives, and forecasting complexity can raise the
shipment quantity beyond the amount required to match uncertain demand, and
therefore, can be considered as drivers increasing the shipment quantity. Supply chain
aging and non-compliance with shelf rotation on the other hand reduce effective shelf
life. Further, from a channel viewpoint, drivers can be categorized as (i) manufacturer-
related, and (ii) retailer-related drivers. Case size, supply chain aging, and sales
incentives can be categorized as manufacturer-related, whereas minimum order size,
rotation, and forecasting complexity can be considered as retailer-related drivers.

48
This classification is helpful in improving supply chain coordination issues in product
expiration.

2.4. Data description and estimation model

2.4.1 Data description

We obtain delivery, return, supply chain, and marketing data for 768 SKUs and 66,867
stores in the United States for the year 2011. There are 8 store types in our dataset:
supermarkets, convenience stores & gas stations, other grocery (stores bigger than
convenience stores and smaller than supermarkets are categorized as other grocery
at AlphaCo’s business systems), dollar discount stores, drug stores, mass merchants,
club stores, and supercenters. For computational efficiency, we do not estimate our
models on the entire data set. Instead, we draw a random sample of 10,000 stores.
Thus, our final data set consists of 870,493 store-SKU level observations across 768
SKUs and 10,000 stores. We expect results to be generalizable to the full data set
because the sample is fairly large and representative of all store types.
Our data are obtained from three sources: data warehouse, spreadsheets, and
picture files. Different parts of the data have varying levels of aggregation with
respect to time (i.e., day, month, year) and supply chain structure (i.e., warehouse,
route, store). We construct the following variables from these data:
∙ 𝑟𝑒𝑡𝑢𝑟𝑛𝑝𝑠 is an integer-valued variable representing the total number of expired
units for store 𝑠 and product 𝑝 during 2011. 𝑟𝑒𝑡𝑢𝑟𝑛𝑝𝑠 is our dependent variable.
∙ 𝑑𝑒𝑙𝑖𝑣𝑒𝑟𝑦𝑝𝑠 is a discrete variable representing the net amount of product 𝑝 deliv-
ered to store 𝑠. A store receives all its inventory from a single warehouse and a single
route. Our data set includes total deliveries, total saleable returns, and total returns
due to damage aggregated for 2011 by shipping warehouse, route, store, and product.
Saleable returns are unsold display products that are returned to the warehouse at
the end of the display period. We deduct saleable returns and returns due to damage
from the delivery amount to obtain net delivery amount, 𝑑𝑒𝑙𝑖𝑣𝑒𝑟𝑦𝑝𝑠 . We use it to

49
represent the number of Bernoulli trials in our rate (i.e., binomial) model, and as the
exposure variable in our count models (i.e., Poisson and negative binomial).
∙ 𝑐𝑎𝑠𝑒 𝑠𝑖𝑧𝑒𝑝 , the explanatory variable associated with Hypothesis 1, represents
the number of consumer units contained in one case of product 𝑝. It is obtained from
the products table in the data warehouse. Case size varies by product. The case sizes
at AlphaCo are 1, 2, 3, 4, 6, 8, 12, 15, or 24 units of products. Figure 2-3 shows the
frequency distribution of case size across all 768 products in our data set.

160  
140  
120  
Number  of  SKUs  

100  
80  
60  
40  
20  
0  
1   2   3   4   6   8   12   15   24  
Case  Size  

Figure 2-3: Occurrence of different case sizes at AlphaCo.

∙ 𝑠𝑢𝑝𝑝𝑙𝑦 𝑐ℎ𝑎𝑖𝑛 𝑎𝑔𝑒𝑝𝑤 , the explanatory variable associated with Hypothesis 2, de-
notes the average number of days spent by product 𝑝 in the supply chain before
shipment to all stores served from warehouse 𝑤. We utilize several elements of infor-
mation obtained from the data warehouse to construct this measure. They include
shipments among AlphaCo warehouses for each product aggregated for 2011, individ-
ual physical inventory count records per warehouse-product for 2011, deliveries made
to retail stores by warehouse-product aggregated for 2011, and annual production
quantity by product aggregated for 2011. Using inventory count records, outgoing
shipments, and deliveries, we calculate days-of-supply for each product-warehouse
combination. We also derive the supply chain network using production and shipment
data. As discussed in Section 2.3.3, supply chain age is computed as the cumulative
days-of-supply across the supply chain.

50
∙ 𝑟𝑜𝑡𝑎𝑡𝑖𝑜𝑛𝑟 , the explanatory variable associated with Hypothesis 3, represents the
probability of at least one unrotated product on route 𝑟. We measure rotation at
the route level because it depends on process compliance by sales representatives who
manage different routes. Information about rotation is not stored in any business
system and is not collected for all routes. Therefore, we compute an instrument for
rotation utilizing audit data provided to us in spreadsheets. Using a logistic regression
model, we estimate the probability of rotation for 128 routes included in the audit
study. Coefficients from this model are then used to estimate the probability of
rotation for the remaining 2851 routes. Appendix A describes our method to compute
a measure for rotation.

∙ 𝑚𝑖𝑛 𝑜𝑟𝑑𝑒𝑟 𝑟𝑢𝑙𝑒𝑠 , the explanatory variable associated with Hypothesis 4, is de-
fined as the percentage of orders at store 𝑠 whose size is equal to the minimum order
quantity. Our data contain order ID, store ID, and order quantity aggregated by
order ID. We measure 𝑚𝑖𝑛 𝑜𝑟𝑑𝑒𝑟 𝑟𝑢𝑙𝑒𝑠 as the count of orders with quantity equal
to either 15 or 75, the two minimum quantities imposed by AlphaCo on small and
large format stores, respectively, divided by the total count of orders by store. Since
we have a large amount of transaction data, we calculate this measure using detailed
order data for the first quarter of 2011 only, assuming that the distribution of order
sizes remains the same throughout the year.

∙ 𝑠𝑖(𝑗)𝑝 is a binary variable indicating whether sales incentive 𝑗 was applied to


product 𝑝. AlphaCo stores sales incentive data in spreadsheets and picture files.
Spreadsheets contain names of the incentives, their dates of effectiveness, a list of
products or product groups covered, and rewards offered to sales representatives. As-
sociated with each incentive, a picture file illustrates the corresponding information in
a poster. We include nine incentives in our data set. We allow a time lag between the
dates of an incentive and the occurrence of expiration because expiration associated
with an incentive is likely to occur with a delay depending on the shelf life of the
product and on the time required to remove expired product from shelves and return
them to the manufacturer. Thus, we include incentives offered in the last six months
of 2010 and the first six months of 2011 in our data.

51
Table 2.2 provides information about the characteristics of incentives. The incen-
tives differ from each other in the times of the year when they are applied, the type
of growth targets, and the set of products to which they are applied. For instance,
incentive 1 is active in the eighth and ninth months of 2010, focuses on a specific
brand consisting of 15 products with relatively short shelf lives, and has an aggressive
growth target of 20%. The median, maximum, and minimum shelf lives are 13, 14,
and 12 weeks. Since this incentive takes place close to the end of 2010, we expect
most of the returns due to expiration to take place in 2011. Incentive 2 is valid dur-
ing the seventh and eight months of 2010. It has a narrower scope compared to the
other incentives and includes only nine products of a specific brand. Their median,
maximum, and minimum shelf lives are 30, 52, and 26. Due to their long shelf lives,
we expect their associated returns from expiration to occur in 2011. Incentive 2 has a
mild growth target with 5%. Similar details for all nine incentive types are presented
in Table 2.2.
∙ 𝑓 𝑜𝑟𝑒𝑐𝑎𝑠𝑡𝑖𝑛𝑔 𝑐𝑜𝑚𝑝𝑙𝑒𝑥𝑖𝑡𝑦𝑟 is the explanatory variable associated with Hypoth-
esis 6. It represents the complexity of forecasting demand as described in Section
3.2. Using deliveries by route, store and product aggregated for 2011, we measure
𝑓 𝑜𝑟𝑒𝑐𝑎𝑠𝑡𝑖𝑛𝑔 𝑐𝑜𝑚𝑝𝑙𝑒𝑥𝑖𝑡𝑦𝑟 as the count of store-product combinations in route 𝑟.
∙ 𝑑𝑒𝑚𝑎𝑛𝑑𝑝𝑠 is a control variable representing the demand for product 𝑝 at store
𝑠. It is a discrete variable and is calculated as the net deliveries (i.e. deliveries after
saleable and unsaleable returns are deducted) by store-product aggregated for 2011.
∙ 𝑠ℎ𝑒𝑙𝑓 𝑙𝑖𝑓 𝑒𝑝 is a control variable indicating the shelf life of product 𝑝 in weeks.
The data are obtained from the products table in the data warehouse.
∙ 𝑠𝑡(𝑘)𝑠 is a binary control variable indicating whether store 𝑠 is of type 𝑘. There
are eight different store types: supermarkets, convenience stores & gas stations, other
grocery, dollar discount stores, drug stores, mass merchants, club stores, and super-
centers.
∙ 𝑐𝑎𝑠𝑒 𝑠𝑖𝑧𝑒 𝑐𝑜𝑣𝑒𝑟𝑝𝑠 is defined as the ratio of 𝑐𝑎𝑠𝑒 𝑠𝑖𝑧𝑒𝑝 to 𝑑𝑒𝑚𝑎𝑛𝑑𝑝𝑠 . It represents
the expected amount of time to sell one case at the store.
Table 2.3 presents summary statistics of all variables. Gas stations and conve-

52
nience stores make up 46% of the data set, supermarkets 22%, other grocery channel
10%, dollar discount stores 4%, drug stores 11%, mass merchants 4%, super centers
3%, and club stores 0.024%. The annual number of returns due to expiration for a
store-product has an average of 2.86 units and a median of zero. About 80% of the
return data consist of zeroes indicating a large mass at zero. The annual number of
deliveries made per store-product has an average of 384.81 units and a median of 120.
Supply chain age has an average of 28.19 days and a median of 22.79 days. The av-
erage is higher than the median showing positive skewness. Case size ranges between
1 and 24, with an average of 12.6 and a median of 12. Shelf life ranges between 10
and 104 weeks, with an average of 21.6 and median of 27.71 weeks. The measure
for forecasting complexity has an average of 4046.64 and a median of 4463, meaning
that the median sales representative manages 4463 store-product combinations. The
average and median values of the rotation metric are 81% and 91%, respectively. The
average and median number of orders equal to the minimum order size are 4.29% and
0, respectively, with 58% of the stores having no orders equal to minimum order size.
Out of nine sales incentives, incentives 1, 2, 3, 4, 6, and 9 cover 3%, 3%, 4%, 6%,6%,
and 9% of the data points, respectively. Incentives 5, 7, and 8 are more prevalent and
include 22%, 13%, and 23% of the data points. The median case size cover is 0.09,
which implies that a one-case shipment covers 0.09 × 365 = 32.85 days of demand at
the median. On average, this number is 0.37, corresponding to 135 days. This large
gap is due to a skewed distribution of demand rate.

We exclude some of the routes due to data accuracy concerns. Prior to 2011, the
versions of the AlphaCo’s hand held system allows product returns to be recorded
only in full cases and not in units. For example, if there were only two units of
expiration found of a given product that has 12 units/case configuration, the sales
representative waited until there are 12 units (i.e. 1 case) of the same product in the
back room before they are returned to the warehouse. Alternatively, it was common
to combine different flavors of the same item together and record it as one case
return, since store managers usually do not want waste waiting in the back room.
This did not impact the credit given to the customer; since same price items were

53
being combined together, however, return records were not always accurate. In 2011,
AlphaCo upgraded the handheld software to allow single unit returns. We notice that
some sales representatives do not use this new feature. For this reason, we exclude
the routes that do not contain any single unit returns in 2011, which is about 10% of
all routes, from the analysis based on the belief that their return records may not be
reliable.

2.4.2 Zero-inflated negative binomial regression model

We examine different count models to find the most suitable specification for pre-
dicting expiration: binomial, Poisson, negative binomial and their zero-inflated gen-
eralizations, namely, zero-inflated binomial (ZIB), zero-inflated Poisson (ZIP), and
zero-inflated negative binomial (ZINB) models. A linear predictor that is common
across all six models forms the basis for these models. The predictor contains the
variables associated with six hypotheses about case size, supply chain aging, rotation,
minimum order rule, sales incentives, and forecasting complexity, as well as control
variables for demand, shelf life, and store types. Let 𝐵 (𝑖) denote the 𝑖-th row of the
data matrix 𝐵 and 𝛽 denote the vector of coefficients for the explanatory variables.
Then we set up the predictor as follows:

𝐵 (𝑖) 𝛽 = 𝛽𝑘 · 𝑠𝑡(𝑘)(𝑖) (𝑖) (𝑖)


𝑠 + 𝛽1 · log 𝑑𝑒𝑚𝑎𝑛𝑑𝑝𝑠 + 𝛽2 · 𝑠𝑢𝑝𝑝𝑙𝑦 𝑐ℎ𝑎𝑖𝑛 𝑎𝑔𝑒𝑝𝑤

+𝛽3 · 𝑠ℎ𝑒𝑙𝑓 𝑙𝑖𝑓 𝑒𝑝(𝑖) + 𝛽4 · 𝑐𝑎𝑠𝑒 𝑠𝑖𝑧𝑒(𝑖) (𝑖)


𝑝 + 𝛽5 · 𝑓 𝑜𝑟𝑒𝑐𝑎𝑠𝑡𝑖𝑛𝑔 𝑐𝑜𝑚𝑝𝑙𝑒𝑥𝑖𝑡𝑦𝑟

+𝛽6 · 𝑟𝑜𝑡𝑎𝑡𝑖𝑜𝑛(𝑖) (𝑖) (𝑖)


𝑟 + 𝛽7 · 𝑚𝑖𝑛 𝑜𝑟𝑑𝑒𝑟 𝑟𝑢𝑙𝑒𝑠 + 𝛽7+𝑗 · 𝑠𝑖(𝑗)𝑝 . (2.1)

Here, 𝑖 indexes observations in our data set, 𝑘 denotes store types, 𝑝 denotes prod-
ucts, 𝑟 indexes routes, 𝑠 denotes stores, and 𝛽𝑘 are the fixed effects for each store type
𝑘. We use 𝑑𝑒𝑚𝑎𝑛𝑑𝑝𝑠 with a log transformation because it reduces heteroscedasticity
and provides higher log-likelihood values and distribution of residuals for all six mod-
els. The other variables do not have this problem, and thus, we find that different
transformations (e.g., log, exponent, square root, square) do not improve the fit in
the same way as for demand.

54
Ideally, the functional specification of the predictor should be derived from a the-
oretical model of expiration. Unfortunately, this is difficult because of the complexity
of the theoretical model. Thus, we analyze different count models and transforma-
tions to improve the model specification. We start our analysis with the binomial
model. The structure of the binomial model inherently suits the nature of our data
because the estimate of expired volume should be limited by the amount of products
delivered to the store over an extended period. Binomial model fits this requirement
with the number of Bernoulli trials providing an upper bound to the estimate of the
response variable. The delivered volume serves as the number of Bernoulli trials and
the expired volume as the number of successes in the binomial model. Using the logis-
tic function to link the linear predictor to the response variable, we use the following
regression form:

𝐸[𝑟𝑒𝑡𝑢𝑟𝑛(𝑖) (𝑖) (𝑖)


𝑝𝑠 /𝑑𝑒𝑙𝑖𝑣𝑒𝑟𝑦𝑝𝑠 ] = 𝑑𝑒𝑙𝑖𝑣𝑒𝑟𝑦𝑝𝑠 · exp(𝐵
(𝑖)
𝛽)/[1 + exp(𝐵 (𝑖) 𝛽)] (2.2)

To find the maximum likelihood estimates of this model, we use the iteratively
reweighted least squares (IRLS) method under the generalized linear model (GLM)
framework [43]. An analysis of the residuals indicates a negatively skewed distribu-
tion. This leads us to explore alternative models. We test the Poisson model, the
other count model within the GLM family, also using the IRLS algorithm for param-
eter estimation. We utilize an exposure variable to establish an upper bound on the
estimate of the response variable. The exposure variable enters the data matrix as
an offset with a log transformation and its parameter is constrained to one. Using
the exponential link function and 𝑑𝑒𝑙𝑖𝑣𝑒𝑟𝑦𝑝,𝑠 as the exposure variable, the regression
takes the form:
𝐸[𝑟𝑒𝑡𝑢𝑟𝑛(𝑖) (𝑖)
𝑝𝑠 ] = 𝑑𝑒𝑙𝑖𝑣𝑒𝑟𝑦𝑝𝑠 · exp(𝐵
(𝑖)
𝛽) (2.3)

The Poisson model assumes equidispersion. This assumption is known to be vi-


olated with real data [26, 43]. Overdispersion in Poisson models refers to the cases
when the response variance is greater than the mean. A negative binomial model,
which is a gamma-Poisson mixture model, is often used as an alternative to model

55
overdispersed Poisson count data. An ancillary parameter in the model addresses
overdispersion. We test the negative binomial model utilizing the same regression
form as for the Poisson model. To estimate model parameters, we use an iterative
process between the IRLS method and the scoring algorithm.

We find that the negative binomial model performs better than Poisson or bino-
mial, as shown in Section 5. This indicates the presence of overdispersion in our data.
Overdispersion generally occurs due to violations in the distributional assumptions of
the data, excessive zero counts, positive correlations between responses, omitted vari-
ables that are important for the model, or a predictor that needs to be transformed
to another scale. This emphasizes two main issues. First, standard errors need to
consider correlations between responses. Thus, we compute clustered standard errors
using the HuberÐWhite method [42, 45] as presented in Section 5. The second is the
importance of a correct model specification. For this, we experiment with scaling ex-
planatory variables as described earlier and test models with different distributional
assumptions. Since zero counts account for 80% of the observations in our data set,
we expand our analysis to evaluate zero-inflated versions of the binomial, Poisson,
and negative binomial models.

Zero-inflated count models are two-component mixture models combining a point


mass at zero with a count distribution. A zero-inflation component of the model
captures the probability of zero observations from the point mass distribution. Let 𝛾
denote the coefficients’ vector and 𝐺(𝑖) denote the 𝑖-th row of the data matrix 𝐺 for
the ‘inflation model’. We define 𝐺(𝑖) 𝛾 as follows:

𝐺(𝑖) 𝛾 = 𝛾𝑘 ·𝑠𝑡(𝑘)(𝑖) (𝑖) (𝑖) (𝑖)


𝑠 +𝛾1 ·𝑐𝑎𝑠𝑒 𝑠𝑖𝑧𝑒 𝑐𝑜𝑣𝑒𝑟𝑝𝑠 +𝛾2 ·𝑠𝑢𝑝𝑝𝑙𝑦 𝑐ℎ𝑎𝑖𝑛 𝑎𝑔𝑒𝑝𝑤 +𝛾3 ·𝑠ℎ𝑒𝑙𝑓 𝑙𝑖𝑓 𝑒𝑝 .

(2.4)
We include these variables in the inflation model as they are expected to have a direct
effect on the occurrence of zero observations. If case size cover is small, supply chain
aging is small, or shelf life is long, we expect to have a higher probability of zero
expiration. Further, we expect large format store types to have more frequent zero
observations, and thus include the store type variables 𝑠𝑡(𝑘) in the inflation model.

56
We perform robustness tests by adding and subtracting different variables and find
that the specification in (2.4) produces the best fit.

Thus, our model specifications are as follows: we specify the count distribution
(𝑖) (𝑖)
component for the Poisson or negative binomial models as𝐸[𝑟𝑒𝑡𝑢𝑟𝑛𝑝𝑠 ] = 𝑑𝑒𝑙𝑖𝑣𝑒𝑟𝑦𝑝𝑠 ·
(𝑖) (𝑖)
exp (𝐵 (𝑖) 𝛽), the count distribution component for the binomial model as 𝐸(𝑟𝑒𝑡𝑢𝑟𝑛𝑝𝑠 /𝑑𝑒𝑙𝑖𝑣𝑒𝑟𝑦𝑝𝑠 ) =
(𝑖) (𝑖)
𝑑𝑒𝑙𝑖𝑣𝑒𝑟𝑦𝑝𝑠 ·exp(𝐵 (𝑖) 𝛽)/[1+exp(𝐵 (𝑖) 𝛽)], and the inflation component as 𝐸(𝑟𝑒𝑡𝑢𝑟𝑛𝑝𝑠 ) =
0, Probability[point mass distribution]=exp(𝐺(𝑖) 𝛾)/[1 + exp(𝐺(𝑖) 𝛾)].

We use the count model for hypothesis testing and the inflation model to ad-
dress the frequent zero counts in the data. We estimate our models in the statistical
language R version 2.14.2 [54] utilizing packages stats, MASS [62], and pscl [65].
We use the glm function for the binomial and Poisson regressions, glm.nb function
for the negative binomial regression, and zeroinfl function for the ZIP and ZINB
regressions. The zeroinfl function finds maximum likelihood estimates using R’s
optimizer function, optim. Since zeroinfl does not support the zero-inflated bino-
mial model, we develop our own function in R to estimate model parameters for the
ZIB model. Our approach is based on the Expectation-Maximization (EM) algorithm
[23, 40]. We treat the source of each zero observation as missing data. If this infor-
mation were present, the log-likelihood function could be decomposed into a binomial
and a logistic regression model as two distinct parts. Based on the expectation of
missing data, in the maximization step of the EM algorithm, we perform maximum
likelihood estimation using the IRLS method for the binomial and logistic regression
models. Using the parameter estimates from the maximization step, in the expecta-
tion step of the algorithm, we calculate the probability of a zero occurring due to the
zero-mass distribution. The iterations are repeated until convergence. This approach
is practical because it allows us to utilize the existing glm function in R without a
necessity to develop score and information functions for the full model. To calcu-
late the standard errors from this model, we use the hessian and numericGradient
functions in R that are part of the numDeriv and maxLik packages to compute the
variance-covariance matrix and the estimating functions.

57
2.5. Results

2.5.1 Estimation results

The estimates of the ZINB model shows that Hypotheses 1, 2, 4, 5, and 6 are sup-
ported by our data. We first present the results for these hypotheses, then discuss
Hypothesis 3 which is not supported by our data.
Table 2.4 shows the estimation results of the count and inflation parts of the ZINB
model. It includes the estimates of the coefficients and standard errors, as well as
standard errors clustered at the product, warehouse-product, store, and route levels.
For tests of statistical significance, we use the standard errors of the cluster that
is at the same level as the explanatory variable. For example, since supply chain
age is a warehouse-product level variable, we use standard errors clustered at the
warehouse-product for testing significance. Following this approach, standard errors
that correspond to the explanatory variable are highlighted in Table 2.4.
Case size in the count model has a positive coefficient and 𝑐𝑎𝑠𝑒 𝑠𝑖𝑧𝑒 𝑐𝑜𝑣𝑒𝑟 has a
negative coefficient in the inflation model, both significant at 𝑝 < 0.01, which supports
Hypothesis 1, showing that expiration increases with case size. The coefficient for
𝑠𝑢𝑝𝑝𝑙𝑦 𝑐ℎ𝑎𝑖𝑛 𝑎𝑔𝑒 is positive in the count model and negative in the inflation model,
also both significant at 𝑝 < 0.01. This supports Hypothesis 2 and shows that aging
in the supply chain increases expiration.
Hypothesis 4 is supported because the coefficient of 𝑚𝑖𝑛 𝑜𝑟𝑑𝑒𝑟 𝑟𝑢𝑙𝑒 is positive and
significant at 𝑝 < 0.01 showing that compliance to the minimum order rule increases
the likelihood of expiration. 𝑓 𝑜𝑟𝑒𝑐𝑎𝑠𝑡𝑖𝑛𝑔 𝑐𝑜𝑚𝑝𝑙𝑒𝑥𝑖𝑡𝑦 has a positive coefficient and
is significant at 𝑝 < 0.01 which supports Hypothesis 6. It shows that the chance of
product expiration increases in forecasting complexity.
Among the sales incentive variables, 𝑠𝑖(1), 𝑠𝑖(8), and 𝑠𝑖(9) have positive coeffi-
cients and are statistically significant at 𝑝 < 0.01. Thus, Hypothesis 5 is supported
by three of the nine sales incentives. We observe that these incentives differ from
others in two aspects: they have aggressive growth targets and they promote growth
as opposed to display competition, as illustrated in Table 2.2. Hence, we conclude

58
that whether sales incentives lead to an increase in expiration depends on the type
and the intensity of the incentive.
The coefficient of 𝑟𝑜𝑡𝑎𝑡𝑖𝑜𝑛 has a negative sign, rejecting Hypotheses 3. This could
be because the rotation variable is correlated with store type 𝑠𝑡(𝑘). As discussed in the
Online Appendix, a binary variable representing route type is the biggest predictor
of rotation. Small format routes have higher chances of rotation non-compliance
and mostly include gas stations & convenience stores, dollar discount, other grocery,
and drug stores. Also, according to the ZINB model, these store types exhibit a
higher probability of expiration. There is more likelihood of finding rotation non-
compliance at small format stores, such as gas stations & convenience stores, dollar
discount, other grocery type, and drug stores. Also, the coefficient estimates for
these store types in the ZINB model are higher than other store types, indicating
higher probabilities of expiration. Figure 2-4 depicts these differences. Supercenters,
in particular, have much lower chances of expiration. This can also be explained
by rotation. Supercenters belong to large national retail chains which are important
customers for AlphaCo. It is possible that sales representatives service these stores
with extra care and comply more with rotation guidelines.

59
 1.00    
count  
 0.80    
inflaCon  
 0.60    
Coefficient  esCmates  

 0.40    

 0.20    

 -­‐        
supercenters   convenience   other       dollar   supermarkets   mass   drug  stores   club  stores  
 (0.20)   &  gas   grocery   discount   merchants  

 (0.40)  

 (0.60)  

 (0.80)  
Store  types  

Figure 2-4: Coefficient estimates of store type indicators.


Notes. Coefficient estimates of the inflation model is multiplied with -1 for easier
graphical interpretation.

The fixed effects for store types may be correlated with other factors that are
missing variables in the model. For instance, drug stores are known to exhibit higher
expiration rates [30] for CPG products most likely due to excess shelf space allocated
to food & beverage items. In that case, better allocation of shelf space can help
reduce expiration.
Table 2.5 shows estimation results for the alternative models (i.e., binomial, Pois-
son, negative binomial, ZIB, ZIP, and ZINB models). The ZINB model fits our data
best with the highest log likelihood value of -981,344. We find that zero inflated ver-
sions of all count models perform better: ZIP regression performs better than Poisson
with log likelihood values of -1,746,544 vs. -4,134,935, ZINB regression performs bet-
ter than the negative binomial regression with log likelihood values of -981,344 vs.
-1,035,893, and ZIB performs better than the binomial regression with log likelihood
values of -1,621,489 vs. -4,125,456. This shows that zero-inflated models are effective
in addressing overdispersion caused by excess zero points in our data set. We pick
the ZINB model because it gives us the best log likelihood value and and the most
unbiased distribution of residuals.

60
2.5.2 Effect of sales incentives

In this section, we analyze the interaction of sales incentives, demand, and probability
of expiration. We redefine the notation for clarity of exposition. For product 𝑝 in
store 𝑠, let 𝐵𝑝𝑠 denote the baseline demand in the absence of a sales incentive, 𝑆𝑝
denote the sales incentive indicator, and 𝐷𝑝𝑠 denote the demand in the presence of a
sales incentive.
Sales incentives would stimulate demand but also increase expiration. We repre-
sent the first relationship as
𝐷𝑝𝑠 = 𝐵𝑝𝑠 + 𝑆𝑝 𝜃, (2.5)

where 𝜃 is expected to be positive. Also let 𝐸𝑝𝑠 denote the expiration amount observed
for product 𝑝 at store 𝑠, 𝑋𝑝𝑠 denote the matrix representing the explanatory variables
for expiration excluding the variables for sales incentives and demand, and 𝑓 () denote
the link function used in the regression model. In the absence of sales incentives, the
model of expiration is 𝐸𝑝𝑠 = 𝑓 (𝑋𝑝𝑠 𝛽 + 𝐵𝑝𝑠 𝛼).
Hypothesis 5 proposes that sales incentives impact expiration. Thus, including 𝑆𝑠
in the model for 𝐸𝑝𝑠 yields

𝐸𝑝𝑠 = 𝑓 (𝑋𝑝𝑠 𝛽 + 𝑆𝑠 𝛾 + 𝐵𝑝𝑠 𝛼), (2.6)

where 𝛾 is the coefficient of 𝑆𝑠 and is expected to be positive. Further, replacing 𝐵𝑝𝑠


with the observed demand 𝐷𝑝𝑠 gives us:

𝐸𝑝𝑠 = 𝑓 (𝑋𝑝𝑠 𝛽 + 𝑆𝑠 𝛾 + (𝐷𝑝𝑠 − 𝑆𝑠 𝜃)𝛼) = 𝑓 (𝑋𝑝𝑠 𝛽 + 𝑆𝑠 (𝛾 − 𝜃𝛼) + 𝐷𝑝𝑠 𝛼). (2.7)

Note that 𝛾 and 𝜃 are expected to be positive. Therefore, our estimate for the
coefficient of 𝑆𝑠 presented in Section 2.5.1 reflects the net effect of sales incentives on
expiration as shown in (2.7). In fact, it is likely to understate the effect of incentives
on expiration. To compute the true effect of incentives, we estimate (2.5) and use the
estimates of 𝜃 and 𝛼 to obtain 𝛾. Table 2.6 presents the results of this estimation. We
find that only incentives 4 and 7 increase demand. Further, the true effect of five out

61
of nine incentives, namely 1, 5, 6, 8, and 9, on expiration is positive and significant.
This estimation refines our single equation results on sales incentives shown in Section
5.1, where we found incentives 1, 8, and 9 to have positive and statistically significant
effects.

2.5.3 Endogeneity between supply chain aging and expiration

The relationship between supply chain aging and expiration can be prone to reverse
causality. Expiration could lead to inflated estimates of mean demand at warehouses,
which could lead to higher warehouse inventory levels, and thus higher supply chain
aging. In this section, we examine the relationship between supply chain aging and
expiration, and test whether expiration causes supply chain aging.
There are several variables at the warehouse level that can be expected to be
correlated with supply chain aging but are not functions of product expiration in
retail stores. These variables are candidates to instrument for supply chain aging.
They include:

∙ Forecast errors at warehouses: AlphaCo forecasts shipments from warehouses to


plan supply chain inventory. Safety stock levels at the warehouses are calculated
based on forecast error. Therefore, poor forecasting, through higher safety stock,
can cause excess warehouse inventory; as a result, products, on average, spend
longer time at the warehouse.

∙ Production batch size: Producing in bigger batch sizes lowers unit production
cost, but increases inventory. Such inventory would spend a longer time at
warehouses. We expect this relationship to be stronger for low velocity items.

∙ Full pallet shipments: Transporting products in full pallets from plants to dis-
tribution centers reduces handling costs, but can result in excess inventory at
the distribution centers, particularly for low velocity items.

∙ Unsynchronized product launches: AlphaCo has to receive retailers’ approval


before placing new products in their stores. The timing of approvals by different

62
retailers do not always coincide. Therefore, once a batch is produced, products
from that batch may enter different markets at different times. As a result,
some products wait and age at the warehouses.

We instrument supply chain aging using forecast errors at the warehouse-product


level. We find that the correlation coefficient between warehouse aging and forecast
errors for each warehouse-product is 0.2. Table 2.7 reports the results obtained from
the omitted variable version of the Hausman test [31]. Model 1 in the table is the
baseline ZINB model. Model 2 augments Model 1 by including forecast error as an
additional explanatory variable. We find that including forecast error in the model
does not improve explanatory power because AIC values and coefficient estimates of
both models are near identical. Further, an F-test for 𝛽𝑓 𝑜𝑟𝑒𝑐𝑎𝑠𝑡 𝑒𝑟𝑟𝑜𝑟 = 0 fails to reject
the null hypothesis. As a result, we do not find any evidence of endogeneity.
A potential shortcoming of this analysis is that the theory behind this test is
based on the ordinary least squares model. Extending this theory to generalized
linear models would be a valuable future research area.

2.5.4 Counterfactual analysis

In this section, we utilize the estimation results to examine remedies that AlphaCo
can pursue to reduce expiration. We look at changes in four areas: (1) case size, (2)
supply chain aging, (3) frequency of replenishment, and (4) sales incentives.
To assess the reduction in the amount of expiration associated with a change, we
compare the expected expired volume for two scenarios, before and after the change.
For example, if current expected expired volume is 100 units and expected expired
volume with the change is 70 units, we conclude that the change reduces expiration
by 30%. Let 𝐵 𝑐 and 𝐺𝑐 denote data matrices for the count and inflation components
of the ZINB model associated with scenario 𝑐 and let 𝑖 index the data points that are
impacted by the change. We calculate the expected expired volume as:

∑︁
𝐸[𝑟𝑒𝑡𝑢𝑟𝑛𝑐𝑖 ] = 𝑑𝑒𝑙𝑖𝑣𝑒𝑟𝑦𝑖 · exp (𝐵 𝑐𝑖 𝛽)[1/(1 + exp(𝐺𝑐𝑖 𝛾))]. (2.8)
𝑖

63
To project the reduction in expiration amount onto monetary benefits for Al-
phaCo, we use data from AlphaCo’s 2010 waste study. The study gives us an estimate
of the total cost of unsaleables, including the cost of goods sold, sales & delivery cost,
as well as the reverse logistics cost associated with unsaleables products. In addition,
our data indicate that 65% of unsaleables occur due to expiration and the remaining
35% occur due to product damage. To extrapolate the monetary value of benefits, we
express the reduction in expiration as a proportion of the overall expired volume in
our dataset convert it into a monetary estimate. For instance, if a change corresponds
to a reduction in expired volume of 3,000 cases, and the total number of actual ex-
pired volume is 299,786 cases in our data set, then we multiply 3,000/299,786 with
65% of the total cost of unsaleables to find the monetary benefit of this change.

Case size: We find that reducing case sizes from 24 units to 12 reduces expiration
volume by 41% for products that are currently packed in 24 unit cases. Such prod-
ucts make up 26% of the data points in our data set. This corresponds to a $7.66M
reduction in expiration cost. AlphaCo concludes that this benefit is substantially
higher than the expected increase in product handling cost. Hence, the management
of case sizes is a significant opportunity for AlphaCo to improve its bottom-line. By
quantifying the benefits of smaller case sizes, our analysis provides a basis for a busi-
ness case to pursue changes in manufacturing and business processes. AlphaCo can
consider implementing this change either by reducing case sizes directly or developing
a modular case that can be split in half and also be ordered in half cases at stores
with low demand.

Supply chain aging: Our analysis shows that reducing days of supply in the
supply chain by 1 week corresponds to 0.98% reduction in expiration volume and
$912.4K in expiration cost. In this calculation, we consider no change for the data
points that already have less than one week of aging; such data points constitute
2.7% of the observations in our data set. Figure 2-5 illustrates the distribution of
𝑠𝑢𝑝𝑝𝑙𝑦 𝑐ℎ𝑎𝑖𝑛 𝑎𝑔𝑒 in our data set. The majority of the data points have more than 7
days of aging.

64
150000
100000
Frequency
50000
0

0 20 40 60 80 100 120 140


Supply chain age (in days)

Figure 2-5: Histogram of supply chain age measure.

Manufacturers and retailers often try to reduce inventory, usually under pressure
from their financial controllers, in order to decrease working capital requirements.
Our study suggests that the analysis for these efforts need not be limited to the
opportunity cost of the working capital. It is also important to consider the benefit
of inventory reduction on the occurrence of expiration in order to get a more thorough
picture of the benefits.
Frequency of replenishment: To assess the cost of order inflation that occurs
due to the minimum order rule, we examine the stores that have positive values for
𝑚𝑖𝑛 𝑜𝑟𝑑𝑒𝑟 𝑟𝑢𝑙𝑒, indicating order(s) at the minimum order level. We estimate the
change in expected expiration volume for such stores when 𝑚𝑖𝑛 𝑜𝑟𝑑𝑒𝑟 𝑟𝑢𝑙𝑒𝑠 is set to
zero. These data points make up 41.6% of our data set.
We find that the expected expiration reduces by 0.87% when orders are not inflated
to meet the minimum order rule requirement. Further, this difference corresponds
to a monetary value of $610,769. As a remedy, AlphaCo can identify such stores
using 𝑚𝑖𝑛 𝑜𝑟𝑑𝑒𝑟 𝑟𝑢𝑙𝑒 as a metric on a periodic basis and reduce their visit frequency

65
accordingly. Considering the significant savings opportunity and relatively small effort
this remedy requires, this is a worthwhile initiative to pursue for AlphaCo.
AlphaCo’s sales representative visit stores according to a pre-determined schedule,
such as everyday, twice a week, once a week, once every other week, once a month,
etc. Reducing the visit frequency in certain cases, for instance from once a week to
once every other week, may pose a stockout risk because the available shelf space and
backroom space may not be sufficient to cover extra days of demand, especially in
small stores. Therefore, in pursuing this initiative, it is beneficial to focus on stores
with higher scores of 𝑚𝑖𝑛 𝑜𝑟𝑑𝑒𝑟 𝑟𝑢𝑙𝑒. Figure 2-6 represents the percentage reduction
in expiration at stores with different values of 𝑚𝑖𝑛 𝑜𝑟𝑑𝑒𝑟 𝑟𝑢𝑙𝑒. For example, when
orders are not inflated at stores whose value for 𝑚𝑖𝑛 𝑜𝑟𝑑𝑒𝑟 𝑟𝑢𝑙𝑒 ranges between 80
and 100, expiration is lessened by 14%. As seen on the chart, the saving opportunity
increases with the value of 𝑚𝑖𝑛 𝑜𝑟𝑑𝑒𝑟 𝑟𝑢𝑙𝑒. The saving opportunity at stores whose
values of 𝑚𝑖𝑛 𝑜𝑟𝑑𝑒𝑟 𝑟𝑢𝑙𝑒 ranging between 20 and 100 is $201.1K.

16.0%  
Reduc2on  in  expira2on  volume  

14.0%  
12.0%  
10.0%  
8.0%  
6.0%  
4.0%  
2.0%  
0.0%  
(0,20)   (20,40)   (40,60)   (60,80)   (80,100)  
Interval  of  the  minimum  order  rule  measure  

Figure 2-6: Impact of addressing order inflation due to minimum order rule.

Sales incentives: We consider sales incentives 1, 8, and 9, which were signif-


icantly associated with higher expiration in Section 2.5.1. These incentives affect,
respectively, 2.8%, 22.9%, and 0.43% of the data points. We find that eliminating
these incentives, i.e., setting 𝑠𝑖(𝑗) = 0, results in 14%, 9%, 7% less expiration, and
monetary savings of $645,234, $2,634,663, and $25,715, respectively.
As a remedy, AlphaCo’s marketing organization can consider waste implications

66
in the design of these incentives. For example, sales targets for products with shorter
shelf lives can be selectively set to more moderate levels. For instance, a goal of 10%
increase in sales as opposed to a goal of 20% increase should reduce expiration. In
addition, sales representatives’ can be assisted with the execution of sales incentives.
For example, a decision support tool suggesting the stores that have higher likelihood
of selling the type of products included in the sales incentive can be useful in ensuring
that additional inventory in the market translates to consumer purchases.

2.6. Conclusion

Product expiration is an important problem with implications for retailers, manu-


facturers, and supply chain managers. Using data for a CPG manufacturer and a
network of retail stores, we show that expiration can occur due to various causes
related to the manufacturer or the retail stores, such as case size, supply chain aging,
shelf life of products, sales incentives, rotation compliance, minimum order rules, and
forecasting complexity. The amount of expiration also varies across retail store for-
mats and slow- vs. fast-moving products. Counterfactual analysis presented in our
study shows that a reduction in case size, even at the margin from 24 units to 12 units,
can lead to a substantial reduction in expiration. Other variables examined in the
counterfactual analysis include warehouse inventory, sales incentives, and frequency
of replenishment.
Overall, our research exposes and explains the complexity of expiration observed
in retail supply chains. We show that expiration does not occur solely due to demand
uncertainty, but is also a supply chain coordination problem. It can be reduced by
better management at both manufacturers and retailers. Our study suggests a number
of topics for future research. One topic is to examine perishable inventory from a
multi-location and channel perspective. The existing perishable inventory literature
focuses on optimal inventory policies at a single location. Also, supply chain aging
targets and issuance rules for inventory at upstream levels of supply chains have not
been analyzed in current literature. These are the focus of Chapter 3.

67
A second topic is to incorporate the implications of expiration in retail operations
models, such as the optimization of case sizes and shelf space allocation. The existing
literature studies the shelf space allocation problem considering cross-correlation of
demand and substitution effects. If excess shelf space is allocated to a slow-moving
item or an item with a short shelf-life, then its effect on expiration should be included
in the cost of shelf space allocation.

The study of product expiration can also have impact on the literature in sus-
tainable operations, which has studied topics ranging from green product design to
closed-loop supply chains [37]. Thus far, there have been many advancements in the
management of durable goods, such as modular product design [9, 58], remanufac-
turing [22, 36], and lean manufacturing [55]. These practices are useful for improving
sustainability in discrete manufacturing environments more so than in process manu-
facturing, which is the main manufacturing method in CPG companies. Thus, further
research can examine supply chain challenges related to expiration, such as disposal,
short term production planning, inventory replenishment, and package design.

Firms in the CPG industry can use our analysis as a framework to identify the
drivers of expiration that matter in their supply chain and construct business cases
for initiatives to reduce expiration. Current reimbursement policies practiced in the
industry are two extreme schemes in terms of incentives they offer to reduce un-
saleables. For instance, either the manufacturer does not have an incentive to supply
fresher products to the retailer or the retailer does not have an incentive to manage
store inventory better. This is most likely because poor understanding of the sources
of expiration makes it hard to share the cost of unsaleables in an effective and fair
way. Similar incentive issues exist within the same firm. Either no function is held
accountable for the cost or one function (e.g., sales or logistics) absorbs it regardless
of the source. Then, we see behaviors such as the sales-force flooding the market
with excess inventory or plant managers not having any regard to waste implications
when determining production batch sizes. These behaviors can be altered by design-
ing coordination mechanisms to reduce the occurrence of expiration. Thus, Chapter
4 examines incentive mechanisms focusing on the sales-force aiming to discourage

68
overselling.

69
Appendix A: Calculation of rotation measure

We seek to measure compliance with shelf rotation for all store-SKU combinations at
AlphaCo. However, this compliance is not recorded in a database because it cannot
be continuously monitored without incurring prohibitive cost. Therefore, we leverage
data from an audit study conducted by AlphaCo in 2010 to construct an instrument
for rotation.

The audit involved recording all incidences of unsaleable products in sampled store
visits. When found, auditors recorded a reason code associated with each occurrence
of unsaleables, also indicating whether the shelf or the back room inventory was
rotated. The audit covered 128 out of 2,851 routes in our data set. Stores selected for
the audit are representative of diverse geographies, store types, and warehouses. We
develop a logistic regression model to estimate rotation for the 128 routes examined
in the store audits. We utilize the coefficients from this model to predict rotation
for all 2,851 routes included in the data set. These predicted values constitute our
measure for rotation, and represent the probability of an unrotated store-product(s)
occurring on a route.

We aggregate the audit data at the route level and categorize each route into
two groups considering all store-products audited in the route: (i) routes where no
non-compliance is found; (ii) routes where at least one rotation non-compliance is
found in the shelf or the backroom. This binary measure is the dependent variable
in our logistic regression model. We use two explanatory variables, as follows, based
on interviews and observations from our field trips:

1. Route type: Small format routes are more likely to have rotation issues
compared to large format routes. At small format routes, both sales representatives
and drivers are responsible for shelf rotation, whereas at large format routes rotation
falls under the responsibility of only the sales representatives. This rule reflects the
difference in delivery processes between the two route types. At large format stores,
drivers drop off the pallets in the backroom and shelves are stocked from this inventory
by the sales representative or a merchandiser at a later time. Small format stores do

70
not have sufficient backroom space to accommodate bulk deliveries. Therefore, drivers
of small format stores place the products on the shelf. While doing so, they are also
expected to rotate the shelf.

A delivery supervisor stated that making two people accountable for the same
task reduces compliance because both people expect each other to perform the task.
Audit data support this claim; rotation issues are seen at 92% of the small format
routes and 47% of the large format routes audited. We define a binary variable, large
format route, indicating large format routes in the data set. The average value for
large format route is 0.68.

2- Process compliance: We expect routes managed by compliant sales repre-


sentatives to have fewer rotation issues. As a proxy for process compliance, we use a
metric called Order Quality. AlphaCo provides the sales representatives with a tool
to suggest replenishment orders when they provide a set of information into their
handheld devices such as the retail price, the next delivery date, and the amount
of inventory-on-hand. Order Quality measures the extent to which the required in-
formation is provided to this tool. It, therefore, reflects the degree to which sales
representatives are compliant with AlphaCo’s sales processes. We expect complaint
sales representatives to be more likely to perform rotation. Thus, we include order
quality as an explanatory variable in the logistic regression model. It ranges between
59.3 and 99.5 with mean and median values of 87.9 and 90.25, respectively.

Table 2.1 summarizes the estimation results from the logistic regression. Large
format routes and routes with higher order quality have less incidence of rotation
non-compliance. Store format is statistically significant at 𝑝 < 0.01. Although the
p-value of order quality is 23%, not small enough to be considered significant, we
choose to keep it in the model because it reduces the residual deviance by 1%. The
null deviance and residual deviance for the model are 160.54 and 126.93, respectively,
yielding a pseudo R-squared value of 20%. Considering routes with probabilities
higher than 0.5 as having rotation non-compliance, our model classifies 70% of the
routes correctly. Thus, we use this model to construct an instrument for rotation
non-compliance across all routes in the data set.

71
Table 2.1: Estimation results for the logistics regression model.

mean std. error z-value p-value significance level


intercept 5.5 2.65 2.078 0.0377 *
large format route -2.55 0.53 -4.795 1.63e-06 ***
order quality -0.035 0.029 -1.204 0.23
Notes. The null deviance is 160.54 and the residual deviance is 126.93. *, **, *** Statistically
significant at p=0.10, 0.05, 0.01, respectively.

72
Appendix B: Tables

Table 2.2: Characteristics of the sales incentives included in the models.

si(1) si(2) si(3) si(4) si(5) si(6) si(7) si(8) si(9)


year 2010 2010 2010 2010 2011 2011 2011 2011 2011
month(s) 8,9 7,8 6 5,6 1 2 4 6 3,4,5
products included 15 9 35 24 108 61 82 165 4
median shelf life 13 30 13 78 26 13 13 17 26
maximum shelf life 14 52 39 104 104 36 26 35 26
minimum shelf life 12 26 12 72 12 12 13 12 26
type volume volume volume volume display display volume volume volume
focus brand brand flavor brand-flavor broad flavor brand broad brand
target +20% +5% +15% +5% +5 to 25% fixed target
per brand in cases

73
Table 2.3: Summary statistics of the variables included in the model.

Estimate Std. dev. Median Minimum Maximum % of zero points


delivery (exposure variable) 384.81 1106.96 120 1 102008 -
return (dependent variable) 2.86 10.82 0 0 1408 80%
Main variables of interest:
supply chain age 28.19 18.89 22.79 0.06 247.05 -
case size 12.60 7.80 12 1 24 -
forecasting complexity 4046.64 1932.27 4463 14 9571 -
rotation 0.81 0.20 0.91 0.37 0.98 -
min order rule 4.29 8 0 0 100 58%
si(1) 0.03 0.16 0 0 1 97%
si(2) 0.03 0.16 0 0 1 97%
si(3) 0.04 0.21 0 0 1 96%
si(4) 0.06 0.24 0 0 1 94%
si(5) 0.22 0.42 0 0 1 78%
si(6) 0.06 0.24 0 0 1 94%
si(7) 0.13 0.34 0 0 1 87%
si(8) 0.23 0.42 0 0 1 77%
si(9) 0.004 0.07 0 0 1 99.6%
case size cover 0.37 1.79 0.09 0 24 -
Control variables:
demand 381.96 1106.95 120 0 102008 1.23%
shelf life 27.71 21.60 21 10 104 -
st(supermarket) 0.22 0.42 0 0 1 78%
st(gas station or convenience store) 0.46 0.5 0 0 1 54%
st(other grocery) 0.1 0.3 0 0 1 90%
st(dollar discount) 0.04 0.2 0 0 1 96%
st(drug store) 0.11 0.31 0 0 1 89%
st(mass merchant) 0.04 0.18 0 0 1 96%
st(club store) 0.00024 0.02 0 0 1 99.976%
st(supercenter) 0.03 0.17 0 0 1 97%

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Table 2.4: Estimation results for the ZINB model specified in Section 2.4.2.

Mean Std. Error Std. Error Std. Error Std. Error Std. Error
(Product) (Warehouse-Product) (Store) (Route)
count:
intercept 0.49 0.018 *** 0.061 *** 0.025 *** 0.036 *** 0.046 ***
st(gas station or convenience store) -0.11 0.009 *** 0.022 *** 0.013 *** 0.022 *** 0.026 ***
st(other grocery) -0.11 0.012 *** 0.023 *** 0.015 *** 0.026 *** 0.029 ***
st(dollar discount) -0.06 0.015 *** 0.033 . 0.019 *** 0.030 * 0.034 .
st(drug store) 0.11 0.010 *** 0.029 *** 0.015 *** 0.025 *** 0.029 ***
st(mass merchant) -0.09 0.013 *** 0.023 *** 0.016 *** 0.038 * 0.037 *
st(club store) 0.86 0.105 *** 0.144 *** 0.121 *** 0.155 *** 0.155 ***
st(supercenter) -0.60 0.018 *** 0.042 *** 0.029 *** 0.052 *** 0.050 ***
case size 0.04 0.0003 *** 0.002 *** 0.001 *** 0.001 *** 0.001 ***
supply chain age 0.05 0.008 *** 0.003 * 0.001 *** 0.001 *** 0.002 ***
shelf life -0.01 0.0003 *** 0.001 *** 0.001 *** 0.001 *** 0.001 ***
demand -0.69 0.002 *** 0.011 *** 0.003 *** 0.003 *** 0.004 ***
si(1) 0.13 0.014 *** 0.066 . 0.022 *** 0.014 *** 0.015 ***
si(2) -0.04 0.022 . 0.108 0.027 0.026 0.027
si(3) -0.12 0.012 *** 0.056 * 0.016 *** 0.012 *** 0.013 ***
si(4) 0.16 0.034 *** 0.131 0.054 ** 0.051 ** 0.052 **
si(5) 0.04 0.008 *** 0.048 0.013 ** 0.008 *** 0.009 ***
si(6) -0.00 0.010 0.060 0.017 0.013 0.014
si(7) -0.08 0.008 *** 0.045 . 0.014 *** 0.008 *** 0.009 ***
si(8) 0.09 0.007 *** 0.056 0.014 *** 0.008 *** 0.009 ***
si(9) 0.11 0.031 *** 0.059 . 0.033 ** 0.032 *** 0.033 **
forecasting complexity 0.00001 0.000002*** 0.00001 . 0.000002 *** 0.000003 *** 0.000004 **
rotation -0.10 0.018 *** 0.047 * 0.028 *** 0.052 . 0.062
min order rule 0.002 0.0003 *** 0.0005 *** 0.0003 *** 0.001 ** 0.001 *
inflation:
intercept 0.12 0.009 *** 0.088 0.017 *** 0.027 *** 0.031 ***
st(gas station or convenience store) 0.59 0.008 *** 0.047 *** 0.012 *** 0.029 *** 0.035 ***
st(other grocery) 0.60 0.012 *** 0.040 *** 0.016 *** 0.041 *** 0.053 ***
st(dollar discount) 0.52 0.016 *** 0.061 *** 0.021 *** 0.046 *** 0.057 ***
st(drug store) -0.09 0.010 *** 0.054 0.015 *** 0.036 * 0.041 *
st(mass merchant) 0.01 0.016 0.029 0.018 0.069 0.071
st(club store) -0.86 0.160 *** 0.152 *** 0.160 *** 0.193 *** 0.194 ***
st(supercenter) 0.54 0.020 *** 0.048 *** 0.021 *** 0.069 *** 0.068 ***
supply chain age -0.01 0.009 *** 0.009 0.003 ** 0.003 *** 0.004 *
shelf life 0.05 0.0003 *** 0.003 *** 0.001 *** 0.001 *** 0.001 ***
case size cover -1.29 0.010 *** 0.061 *** 0.014 *** 0.016 *** 0.020 ***
Notes. .,*, **, *** Statistically significant at p=0.10, 0.05, 0.01,0.001 respectively. Dispersion parameter is
estimated as 1.0426.

75
Table 2.5: Parameter estimates of alternative models.

Negative Binomial ZINB Poisson ZIP Binomial ZIB


log likelihood: (1,035,893) (981,344) (4,134,935) (1,746,455) (4,125,456) (1,621,489)
count:
intercept 1.308 0.488 0.937 0.076 3.312 2.798
(0.029)*** (0.018)*** (0.005)*** (0.005)*** (0.006)*** (0.004)***
st(gas station -0.672 -0.114 -0.391 -0.063 -0.535 -0.281
or convenience store) (0.042)*** (0.022)*** (0.038)*** (0.025)* (0.042)*** (0.031)***
st(other grocery) -0.608 -0.11 -0.329 -0.03 -0.538 -0.273
(0.050)*** (0.026)*** (0.045)*** (0.029) (0.052)*** (0.037)***
st(dollar discount) -0.459 -0.062 -0.312 -0.029 -0.491 -0.163
(0.054)*** (0.030)* (0.052)*** (0.035) (0.057)*** (0.041)***
st(drug store) 0.068 0.109 0.106 0.116 0.138 0.028
(0.046) (0.025)*** (0.043)* (0.029)*** (0.049)** (0.037)
st(mass merchant) -0.163 -0.094 -0.107 -0.118 -0.127 -0.124
(0.066)* (0.038)* (0.065). (0.044)** (0.067). (0.045)**
st(club store) 1.55 0.857 1.042 0.64 1.832 1.115
(0.269)*** (0.155)*** (0.220)*** (0.137)*** (0.269)*** (0.226)***
st(supercenter) -0.794 -0.598 -0.806 -0.725 -0.542 -0.299
(0.081)*** (0.052)*** (0.088)*** (0.065)*** (0.088)*** (0.059)***
case size 0.055 0.039 0.031 0.024 0.055 0.047
(0.008)*** (0.002)*** (0.005)*** (0.002)*** (0.008)*** (0.004)***
supply chain age -0.08 0.047 0.221 0.171 0.016 -0.074
(0.004)*** (0.001)*** (0.003)*** (0.002)*** (0.004)*** (0.018)***
shelf life -0.041 -0.015 -0.056 -0.014 -0.069 -0.022
(0.003)*** (0.001)*** (0.006)*** (0.002)*** (0.008)*** (0.004)***
demand -0.998 -0.695 -0.849 -0.608 -1.221 -1.034
(0.003)*** (0.002)*** (0.000)*** (0.000)*** (0.001)*** (0.0004)***
si(1) 0.758 0.127 0.357 0.045 0.327 -0.05
(0.189)*** (0.066). (0.106)*** (0.043) (0.158)* (0.090)
si(2) -0.197 -0.039 -0.215 -0.013 -0.128 -0.119
(0.270) (0.108) (0.214) (0.074) (0.217) (0.090)
si(3) -0.347 -0.123 -0.222 0 -0.36 -0.156
(0.113)** (0.056)* (0.084)** (0.043) (0.103)*** (0.052)**
si(4) -0.103 0.156 0.645 0.038 1.22 0.503
(0.296) (0.131) (0.399) (0.124) (0.496)* (0.229)*
si(5) -0.138 0.038 0.091 0.128 0.024 0.039
(0.118) (0.048) (0.072) (0.035)*** (0.103) (0.047)
si(6) -0.003 0 0.016 0.054 -0.061 -0.042
(0.140) (0.060) (0.111) (0.060) (0.143) (0.099)
si(7) 0.11 -0.079 -0.075 -0.147 -0.037 -0.137
Continued on next page

76
Table 2.5 – continued from previous page
Negative Binomial ZINB Poisson ZIP Binomial ZIB
(0.118) (0.045). (0.076) (0.054)** (0.110) (0.067)*
si(8) 0.528 0.085 0.284 -0.004 0.334 -0.002
(0.147)*** (0.056) (0.091)** (0.035) (0.124)** (0.070)
si(9) 0.227 0.106 0.2 0.093 0.135 0.062
(0.128). (0.059). (0.111). (0.059) (0.137) (0.076)
forecasting complexity 0.000032 0.000013 0.000036 0.000016 0.000028 0.000007
(0.000013)* (0.0000043)** (0.00001)** (0.0000001)*** (0.000014)* (0.000008)
rotation -0.541 -0.095 -0.362 0.137 -0.684 -0.113
(0.114)*** (0.062) (0.106)*** (0.062)* (0.122)*** (0.082)
min order rule 0.002 0.002 0.002 0.002 0.001 0.001
(0.001). (0.001)** (0.001). (0.001)** (0.001) (0.001)
inflation:
intercept NA 0.12 NA 0.226 NA 0.229
(0.009)*** (0.008)*** (0.008)***
st(gas station NA 0.587 NA 0.549 NA 0.54
or convenience store) (0.029)*** (0.028)*** (0.028)***
st(other grocery) NA 0.604 NA 0.58 NA 0.571
(0.041)*** (0.040)*** (0.040)***
st(dollar discount) NA 0.521 NA 0.518 NA 0.513
(0.046)*** (0.044)*** (0.044)***
st(drug store) NA -0.086 NA -0.086 NA -0.09
(0.036)* (0.034)* (0.034)**
st(mass merchant) NA 0.014 NA 0.027 NA 0.035
(0.069) (0.066) (0.066)
st(club store) NA -0.859 NA -0.929 NA -0.943
(0.193)*** (0.180)*** (0.180)***
st(supercenter) NA 0.54 NA 0.555 NA 0.571
(0.069)*** (0.068)*** (0.068)***
supply chain age NA -0.063 NA -0.051 NA -0.062
(0.003)*** (0.003)*** (0.019)***
shelf life NA 0.048 NA 0.05 NA 0.05
(0.003)*** (0.003)*** (0.003)***
case size cover NA -1.289 NA -1.146 NA -1.1
(0.010)*** (0.009)*** (0.009)***

77
Table 2.6: Results of the analysis of interaction between demand, sales incentives,
and expiration.

𝜃 𝛽 𝛼 𝛾
si(1) -0.1016 0.1274 -0.6947 0.1980
(0.0117)*** (0.0659). (0.0017)*** (0.0718)**
si(2) -0.2688 -0.0387 -0.6947 0.1480
(0.0104)*** (0.1083) (0.0017)*** (0.1135)
si(3) -0.0599 -0.1227 -0.6947 -0.0811
(0.0081)*** (0.0557)* (0.0017)*** (0.0605)
si(4) -0.2922 0.1559 -0.6947 -0.0471
(0.0092)*** (0.1309) (0.0017)*** (0.1341)
si(5) -0.4859 0.0381 -0.6947 0.3757
(0.0060)*** (0.0476) (0.0017)*** (0.0504)***
si(6) -0.4479 -0.0002 -0.6947 0.3110
(0.0070)*** (0.0600) (0.0017)*** (0626)***
si(7) 0.5087 -0.0790 -0.6947 -0.4324
(0.0051)*** (0.0451). (0.0017)*** (0.0478)***
si(8) -0.0330 0.0851 -0.6947 0.1080
(0.0050)*** (0.0564) (0.0017)*** (0.0580).
si(9) -0.8946 0.1061 -0.6947 0.7276
(0.0255)*** (0.0586). (0.0017)*** (0.0733)***
Notes. .,*, **, *** Statistically significant at p=0.10, 0.05, 0.01,0.001 respectively.

78
Table 2.7: Results of the Hausman test for endogeneity.

Model 1 Model 2
AIC: 1652049 1652051
count:
intercept 0.44321 0.44239
st(gas station or convenience store) -0.11542 -0.11573
st(other grocery) -0.11070 -0.11098
st(dollar discount) -0.05143 -0.05177
st(drug store) 0.12091 0.12065
st(mass merchant) -0.06833 -0.06840
st(club store) 0.94795 0.94765
st(supercenter) -0.64138 -0.64141
case size 0.03837 0.03837
supply chain age 0.00342 0.00339
shelf life -0.01439 -0.01439
demand -0.70125 -0.70123
si(1) 0.14096 0.14107
si(2) -0.03875 -0.03861
si(3) -0.15007 -0.15015
si(4) 0.13489 0.13494
si(5) 0.04673 0.04663
si(6) -0.07340 -0.07330
si(7) -0.05414 -0.05412
si(8) 0.10848 0.10851
si(9) -0.05169 -0.05228
forecasting complexity 0.00002 0.00002
rotation -0.05374 -0.05254
min order rule 0.00209 0.00209
forecast error 0.00002
(0.0000267)
inflation:
intercept 0.16745 0.16745
st(gas station or convenience store) 0.55990 0.55990
st(other grocery) 0.55934 0.55933
st(dollar discount) 0.42890 0.42889
st(drug store) -0.15336 -0.15336
st(mass merchant) -0.02335 -0.02337
st(club store) -0.89077 -0.89083
st(supercenter) 0.48764 0.48764
supply chain age 0.00121 0.00121
shelf life 0.04570 0.04570
case size cover -1.29043 -1.29044
Notes. The value in parenthesis represent the standard error for forecast error. .,*, **, *** Statisti-
cally significant at p=0.10, 0.05, 0.01,0.001 respectively.
79
80
Chapter 3

Shipment Policies in Two-tier Supply


Chains For Perishable Products

3.1. Introduction

The study of the drivers of product expiration presented in Chapter 2 motivates this
research. The analysis shows evidence that inventory aging in the upstream supply
chain increases the probability of expiration at retail stores, since aging erodes shelf
life. We might conclude that we should reduce the supply chain inventory to reduce
the amount of expiration. However, inventory reduction can lead to stockouts and
lost sales for the manufacturer. Further, it is a complex task to determine how much
inventory to reduce and by what means, since excess inventory is driven by multiple
sources. Examples of these sources include production or transportation batching,
forecasting inaccuracy, unrotated products at distribution centers, and delayed prod-
uct launches.
One way a manufacturer can control the amount of product expiration is through
the choice of its shipment policies. A shipment policy prescribes the minimum re-
maining shelf life below which the product will not be released for shipment to the

81
retailer and will be discarded. Properly determined shipment policies help manufac-
turers reduce cost in two ways: 1) by intelligently making sell versus dispose decisions,
and 2) if coupled with organizational incentives, by providing motives to supply chain
managers to rotate the inventory, better manage batch sizes, or improve forecasting
accuracy. When the disposition cost impacts the profit and loss performance of the
supply chain manager, the shipment policy would provide incentives to better man-
age inventory, which increases the effective shelf life and thus reduces the amount of
expired items. This study aims to alleviate the inventory aging issue by establishing
shipment policies for the manufacturer.
Currently, the remaining shelf life is an area of contention in the consumer pack-
aged goods industry. Retailers express discontent that products coming into their
supply chain have very little shelf life remaining [64]. As a result, manufacturers are
increasingly looking at the area of shelf-life management. Typically, existing rules
either dictate the same number of days across a product category (e.g., 30 days of
minimum remaining shelf life) or express the minimum in terms of a percentage of the
manufactured shelf life (e.g., minimum required shelf life is 70% of the manufactured
shelf life). The problem with existing rules is that they do not consider important
factors such as the demand rate or product cost. Consequently, this research asks the
following question: how should we set up shipment policies?
To answer this question, we develop an optimization model which minimizes the
remaining shelf life for a given product with respect to the constraint that the net
profit from sales exceeds the loss from disposition (i.e., disposing of inventory through
donation to food banks, landfills, etc.). In the model, the net profit has two compo-
nents: gross profit from sales and cost of expiration, which depends on the remaining
shelf life. We solve this problem using our collaborator AlphaCo’s historical shipment
and product cost data for 2013.
We find that the optimum remaining shelf life ranges between 1 and 26 weeks

82
with a mean value of 5 weeks for the products included in our dataset. These findings
contrast with our collaborator’s existing shipment policy, which requires a uniform
minimum remaining shelf life of 5 or 6 weeks across products. Comparing our opti-
mum policy with the existing shipment policy, we find that optimization increases the
net profits by 41% in scenarios where products are shipped to retailers’ supply chains
with the required minimum remaining shelf life. This significant increase shows that
a homogenous shipment policy is ineffective; manufacturers can improve profits with
an optimization-based shipment policy that is customized to the product’s profit, ex-
piration cost, and sales rate. Furthermore, our analysis has implications for supply
chain management. Products that require a high degree of freshness (indicated by a
high optimum remaining shelf life) can be considered for discontinuation unless fre-
quent production or distribution in small batch sizes is feasible. Regarding warehouse
management, products requiring high freshness can be rotated more frequently or can
be positioned on the warehouse floor in a way to facilitate rotation.
Simulation based optimization can be costly in practice due to multiple dimensions
(time, retail stores, inventory age). For this reason, we evaluate several regression
techniques, including machine learning tools, to approximate the optimum remaining
shelf life. Approximation of optimal values provides a 14% improvement in net profits
compared to the existing shipment policy at our collaborator. This improvement ac-
counts for 28% of the savings that optimization provides. Consequently, we conclude
that machine learning tools, such as the random forest algorithm, can be used as a
low-cost alternative to optimization.
With this study, we provide a framework (an optimization method and machine
learning approximation of optimal values) to solve a complex problem; such a frame-
work is valuable in practice. Currently, the industry lacks standards on shipment
policies. Further, alignment problems exist due to discordant shipment rules across
manufacturers and mismatched expectations among retailers. Our framework can ad-

83
dress this alignment problem by providing a quantitative-based method to establish
shipment policies.

3.2. Literature review

In this research, we examine the rules of the manufacturer with regard to the shipment
of perishable products to the retailers. Thus, this study is related to the operations
literature that focuses on two-tier supply chains for perishable products. Related
research studies a range of topics but overlooks the management of effective shelf
lives in the manufacturer’s supply chain.
Goh et al. [20] study two-stage perishable inventory models for blood banks. Two
stages in the supply chain represent fresh and older blood units with separate sources
of demand. When time passes, units are transferred from the first stage to the second.
The analysis is concerned with whether the second-stage demand should be served by
the first stage when the second stage has no inventory. Their study is different from
this thesis in two major aspects. First, in this thesis, the sources of demand for the
manufacturer and the retailer are not independent; the retailer is the sole source of
demand for the manufacturer. Second, the time after which items pass from the first
stage to the second is an input in their study, whereas it is a decision variable in this
thesis.
Fujiwara et al. [17] establish an optimal ordering policy for a two-stage inventory
system for perishable products. In their setting, both stages belong to the retailer.
The retailer is concerned with finding an order-up-to policy and emergency shipment
rules in case of stock-outs for multiple products. In this thesis, orders from the retailer
are an input, not a decision variable.
Ketzenberg et al. [35] are concerned with the value of information sharing in
a two-tier supply chain. In the setting they study, the ages of perishable products

84
that the manufacturer ships to the retailer varies, as in this thesis. However, while
this thesis establishes rules about minimum ages, they compare two scenarios: 1) age
information is shared with the retailer, and 2) age information is not shared with the
retailer. They focus on the impact of these scenarios on the retailer’s profit.
Blackburn and Scudder [6] develop supply chain strategies for fresh produce. With
fresh produce, shelf life varies depending on the picking rate at the harvest stage and
batch size at the cooling stage of the supply chain. The authors find optimum picking
rate of the grower and optimum batch size of the distributer to minimize the total
cost. Although this thesis is concerned with fixed product life times, as with consumer
packaged products, it is similar to their research, since both studies are concerned
with finding suitable product aging levels as products move in the supply chain.
As we can see, the focus of the existing research studying the two-tier supply chain
for perishable products differs from this thesis. This study builds on the operations
literature by introducing and analyzing the following shipment problem of the manu-
facturer: the minimum remaining shelf life below which it is not cost-effective for the
manufacturer to release the inventory for sale to the retailer.

3.3. The remaining shelf-life problem

3.3.1 Impact of manufacturer’s operations on perishability at

the retailer

Certain supply chain activities of the manufacturer erode the product shelf life, in-
creasing the chances of product expiration at the retailer. Three main sources for
shelf-life erosion are the following: 1) high inventory, 2) neglect of product rotation,
and 3) delayed and unsynchronized product introductions.
1- High inventory: Consider two opposite scenarios. In the first scenario, the man-
ufacturer holds an inventory of 10 days-of-supply at its distribution center. Assume

85
that the product’s manufactured shelf life is 45 days. In this case, the product may
have 35 days of remaining shelf life when it reaches the retailer. In contrast, in the
second scenario the manufacturer has an inventory of 30 days-of-supply. Then, a
product can have as little as 15 days remaining shelf life when it arrives at the re-
tailer. For the same demand rate, we expect to see a higher probability of expiration
in the second scenario. See Figure 3-1.

Figure 3-1: Impact of inventory on remaining shelf life.

Usually, high inventory is driven by batching in production or transportation and


by forecast inaccuracy. Big production batches reduce the unit production cost by
minimizing costly changeovers. Similarly, bulk shipments in pallets reduce the han-
dling cost. Clearly, batching is advantageous. However, it erodes the product shelf
life, leaving less time for the retailer to sell through the inventory.
2- Neglect of product rotation: Rotating the products at the manufacturer’s
warehouse to ensure first-in-first-out issuing of inventory reduces the variation in the
remaining shelf life. When products are not rotated, we see instances with very fresh
or very old inventory in shipments to the retailers. Obviously, older inventory has
higher chances of expiration. Further, when rotation is neglected, the product can
even expire on the manufacturer’s warehouse floor. Automated warehousing systems
can perform rotation; however, they require high capital investment. Also, manual

86
rotation takes effort increasing the labor cost, in particular, if the warehouse space is
tight.
3- Delayed and unsynchronized product introductions: For new products,
the manufacturer typically produces one big batch to satisfy the demand of the in-
troductory weeks to prevent stock-outs and/or costly emergency interventions to the
production plan. In the absence of a solid sales and operations process, the new
product can be introduced to different retailers at sparse time intervals. Imagine that
the first batch of production is made on February 1st. Further, the product is intro-
duced to Walmart stores on February 10th, to Walgreens stores on March 1st, and
to 7-Eleven stores on March 15th. If the product has a total of 3 months of shelf life,
there will be only one and a half months remaining time for the 7-Eleven stores to
sell through the first shipment. See Figure 3-2. Synchronized product introductions
avoid this problem.

Figure 3-2: Impact of an unsynchronized product introduction on remaining shelf life.

3.3.2 Supply chain cost dynamics and incentives

The extent to which the manufacturer is impacted by the cost of expiration occurring
at the retailer depends on two factors. The first is the sales and distribution model
of the manufacturer. The second is the unsaleables policy.
Consumer packaged products are distributed to retail stores through two types
of sales and distribution models: 1) the direct-store-delivery (DSD) model, and 2)

87
the traditional model. With DSD, the manufacturer delivers the product directly to
the retail store, skipping the retailer’s distribution center, and also generates replen-
ishment orders for the store. Since the manufacturer manages the store inventory,
when an item expires, the retailer is given full credit for the wholesale price. The
manufacturer also bears the reverse logistics costs. With the traditional model, the
unsaleables policy determines the rules of the reimbursement for the cost of expired
items.
Three unsaleables policies are practiced in the industry: 1) the swell policy, 2) the
adjusted-rate policy (ARP), and 3) the joint-industry-report policy (JIR). The swell
policy provides a wholesale price discount (e.g., 1-2%) as a compensation for future
expiration. The ARP policy provides a similar discount; however, the rate changes
every year based on annual audits in the supply chain. These audits aim to find
how much the manufacturer has contributed to the problem. In contrast, the JIR
policy provides full reimbursement to the retailer for the ex-post cost of expiration,
which comprises the wholesale price as well as the cost of reverse logistics. Figure 3-3
summarizes the situations in which the manufacturer is directly responsible for the
cost of expiration.

88
Examples of manufacturers:

Direct-store-delivery channel

Manufacturer A

Retailer’s DC Retail store


Examples of
manufacturers:

Manufacturer B Traditional channel


(with joint-industry-report unsaleables policy)

Figure 3-3: Circumstances under which manufacturer is responsible for expiration


cost.

Retailers argue that manufacturers lack incentives to ship fresh products under
the swell or ARP policies. Possibly in an attempt to address this issue, some retailers
impose minimum shelf life requirements and have rejection policies refusing shipments
that do not meet the requirement. These rejection policies are not executed strictly
due to the cost or to avoid conflict in the relationship. However, retailers expect that
rejection policies encourage manufacturers to improve the remaining shelf life.
With the DSD model and the JIR policy, the manufacturer has an incentive to
provide fresh products. However, intracompany dynamics of the manufacturer can
counter this incentive. For example, if the plant manager’s cost center is not charged
for the cost of expiration, he/she will have no incentive to produce in smaller batches.
Therefore, in order for different functions to serve the interests of the firm, appropriate
incentive mechanisms need to be in place within the manufacturer’s organization.
Under the DSD model and the JIR policy, product disposition cost of the unsold
product is less than the expiration cost of the sold product for the manufacturer.
Let us consider a case in which it costs $2 to produce an item and transfer it to
a distribution center. When the manufacturer discards this item, the company will

89
lose $2 due to the sunk cost of production and, suppose, $0.10 due to the cost of
reverse logistics. Now, let us imagine the manufacturer sells this product to the
retailer for $2.20, making a gross profit of $0.20, and the product expires on the retail
shelf. Then, the manufacturer will pay the retailer $2.20 and incur a reverse logistics
cost of, perhaps, $1. Notice that the cost of reverse logistics is higher from retailer
stores than it is from distribution centers. In summary, the manufacturer loses $3 if
it sells a product that can expire. However, the loss from disposition will be $2.10
if the product is not sold. Figure 3-4 shows these two scenarios for the sell and
dispose decisions of the manufacturer. Thus, when the remaining shelf life is short,
discarding the product can be a better decision for the manufacturer than selling it
to the retailer.

Cost-of-goods-sold: $2
Wholesale price: $2.20
Gross profit:
sales
$0.20

$2.20
Manufacturer Retailer
disposal expiration

Reverse logistics cost: $0.10 Reverse logistics cost: $1

NET PROFIT FROM DISPOSAL: NET PROFIT FROM SALES:


- $2.10 = - $2 - $0.1 - $3 = $2.2 - $2 - $2.2 - $1
gross profit reimbursement
from sales

Figure 3-4: Profit implications of sales and disposal decisions when remaining shelf
life is very short.

3.3.3 Shipment policies in practice

According to our informal discussions with retailers, it is not uncommon that a prod-
uct with nearly a year long manufactured shelf life arrives at the retailer with only a
few months remaining. Manufacturers acknowledge this issue and pledge to improve
the situation [64]. Industry reports also emphasize the importance of remaining shelf

90
life to alleviate product expiration [64, 49, 30]. These reports recommend that man-
ufacturers set up policies to prevent shipments containing products with little shelf
life left. Two types of practices prevail in the industry. These are based on 1) a fixed
number of days and 2) a percent of manufactured shelf life as shown in Figure 3-5.

Figure 3-5: Types of shipment policies in practice.

With the first policy type, the manufacturer determines a fixed time as the min-
imum remaining shelf life across different products, usually per product category.
Suppose this time is 60 days; then, products with a remaining life of less than 60 days
are not sent to the retailer. With the second policy type, the minimum remaining
shelf life varies with the manufactured shelf life. During an informal conversation, a
retailer stated that their requirement is 80% for perimeter products and 70% for aisle
products. Consider two perimeter products with 30 and 60 days of manufactured shelf
life. Then, this retailer will refuse shipments that contain items with less than 24 and
48 days of remaining shelf life for the first and the second product, respectively.
The main challenge with current practices is that requirements of retailers and
policies of manufacturers are often not aligned. It is a problem for manufacturers that
retailers impose different requirements for the same product, since most warehouse
management systems are not capable of handling different rules for different customers
[25]. It can also be confusing for a retailer when, for the same type of product, policies
of different manufacturers vary. Then, understandably, the retailer may doubt the

91
efficacy of the policies of some manufacturers.
The other key issue with existing policies is that they fail to account for the de-
mand rate and other relevant factors impacting profits (e.g., expiration cost, profit
margin). Imagine two products in the same product category with the same man-
ufactured shelf life. However, their demand rates differ. For the first product, it
takes one month for the retailer to sell through a pallet of inventory. In contrast, the
second product is a slower moving item that takes 4 months for the retailer to sell
through the same amount of inventory. Suppose the manufactured shelf life for both
products is 5 months and we apply the same shipment policy requiring 3.5 months
(70% of manufactured shelf life) of minimum remaining shelf life. In this case, we
could see expiration with the second product, but not with the first product. This
comparison suggests that it is prudent to consider the demand rate in determining
shipment policies.

inventory

1 pallet
product 1
product 2

expiration
amount
time
1 month 4 months
3.5 months
remaining shelf life

Figure 3-6: Impact of demand rate on expiration with regards to remaining shelf life.

Next, we consider a different scenario in which most attributes of the two products
are the same, including the demand rate, shipment size, shipment policy (e.g., 30 days
of minimum remaining shelf life), probability of expiration at the retailer (e.g., 0.01%),
and gross margin (e.g., $1). However, the cost of expiration of these products differs.
Suppose the cost of expiration for the first product is $4, while it is $2 for the second

92
product. In this case, it may not be reasonable to have the same shipment policy for
both of them. To reduce the probability of expiration for the first product, we can
consider changing its shipment policy to a more conservative one such as a 60 day
minimum remaining shelf life.
In conclusion, existing practices overlook relevant factors, such as the demand
rate and expiration cost. The industry seems to lack appropriate methods to establish
shipment policies. Thus, it is not surprising that a disconnect occurs between retailers
and manufacturers resulting from mismatched expectations. Currently, no framework
exists to set up standards that would align retailers and manufacturers.

3.4. Problem definition and data description

As discussed in Section 3.3.2, manufacturers reimburse retailers for the cost of ex-
piration in most situations. Accordingly, we propose that when the remaining shelf
life is short, it may be less costly for the manufacturer to dispose of the product
at its distribution center as opposed to selling it to the retailer. Consequently, the
manufacturer faces the following problem: for a given remaining shelf life, should the
inventory at the distribution center be disposed of or be sold to the retailer?
If the inventory is disposed of, the manufacturer incurs a disposal cost per unit
which we denote by 𝑑. The disposal cost consists of the cost-of-goods-sold of the
product and the reverse logistics cost. If the inventory is used to fulfill a retailer order,
the manufacturer earns a profit of 𝑝, which is the difference between the product’s
wholesale price and cost-of-goods-sold. When this inventory expires on the retailer’s
shelf, the manufacturer incurs an expiration cost of 𝑐. This cost includes the credit
given to the store for the wholesale price and the cost of reverse logistics. Therefore
𝑐 > 𝑝, since wholesale price + reverse logistics cost > wholesale price - cost-of-goods-
sold. This relationship suggests that sales would not be profitable if the product

93
expires. In this situation, the manufacturer is interested in finding the minimum
remaining shelf life when it is economical to sell the product as opposed to disposing
of it from its distribution center over an extended horizon time.
We formulate this problem as follows:

max 𝑎
𝑎
∑︁ ∑︁ ∑︁
s.t. 𝑝 𝑄𝑠 − 𝑐 𝐸𝑠 (𝑎, 𝑓 (𝐷𝑠 ), 𝑄𝑠 ) ≥ −𝑑 𝑄𝑠 (3.1)
𝑠 𝑠 𝑠

0 < 𝑎 ≤ 𝑠ℎ𝑒𝑙𝑓 𝑙𝑖𝑓 𝑒

In this model, 𝑎 denotes the threshold of remaining shelf life at which the manufacturer
stops selling the inventory to the retailer. 𝑄𝑠 denotes the long-run average shipment
quantity, 𝑓 (𝐷𝑠 ) denotes the demand distribution, and 𝐸𝑠 denotes the long-run average
expiration quantity at store 𝑠. Further, 𝐸𝑠 depends on 𝑎, 𝑓 (𝐷𝑠 ), and 𝑄𝑠 and is
nondecreasing in 𝑎1 . In practice, replenishment orders and corresponding shipments
are determined independent of the shelf life of inventory at the distribution center
(𝑄𝑠 is the solution to the multi-period inventory problem ignoring the shelf life).
Therefore, in our model, shipments are treated as external, while expiration quantity
depends on the remaining shelf life of the shipment and the consumer demand at the
retail store. The left-hand side of the inequality in (3.1) represents the net profit from
selling, while the right-hand side represents the net profit from not selling. Essentially,
optimum 𝑎 is a threshold for the remaining shelf life below which the manufacturer
loses more money from selling than from not selling. We refer to this threshold as
the no-shipment threshold.
1
𝑄𝑡 and 𝐷𝑡 denote the order quantity and demand, respectively, at time period 𝑡 for a given store.
Let us assume zero store inventory at 𝑡 = 0. First, consider the case of first-in-first-out inventory
issuing policy at the store. For the shelf life of 𝑎 = 1, 𝑎 = 2, and 𝑎 = 3, the expiration quantity at
the end of the shelf life will be [𝑄1 − 𝐷1 ]+ , [[𝑄1 − 𝐷1 ]+ − 𝐷2 ]+ , and [[[𝑄1 − 𝐷1 ]+ − 𝐷2 ]+ − 𝐷3 ]+ ,
respectively. Notice that 𝐸𝑥𝑝𝑖𝑟𝑎𝑡𝑖𝑜𝑛(𝑎 = 1) ≥ 𝐸𝑥𝑝𝑖𝑟𝑎𝑡𝑖𝑜𝑛(𝑎 = 2) ≥ 𝐸𝑥𝑝𝑖𝑟𝑎𝑡𝑖𝑜𝑛(𝑎 = 3).
Next, consider the case of last-in-first-out inventory issuing policy. The corresponding expiration
quantities are [𝑄1 − 𝐷1 ]+ , [[𝑄1 − 𝐷1 ]+ − [𝐷2 − 𝑄2 ]+ ]+ , and [[[𝑄1 − 𝐷1 ]+ − [𝐷2 − 𝑄2 ]+ ]+ − [[𝐷3 −
𝑄3 ]+ − [𝑄2 − 𝐷2 ]+ ]+ ]+ . Similarly, 𝐸𝑥𝑝𝑖𝑟𝑎𝑡𝑖𝑜𝑛(𝑎 = 1) ≥ 𝐸𝑥𝑝𝑖𝑟𝑎𝑡𝑖𝑜𝑛(𝑎 = 2) ≥ 𝐸𝑥𝑝𝑖𝑟𝑎𝑡𝑖𝑜𝑛(𝑎 = 3).

94
The following modified version of the problem gives us the minimum remaining
shelf life at which the manufacturer achieves a positive profit from sales.

max 𝑎
𝑎
∑︁ ∑︁
s.t. 𝑝 𝑄𝑠 − 𝑐 𝐸𝑠 (𝑎, 𝑓 (𝐷𝑠 ), 𝑄𝑠 ) ≥ 0 (3.2)
𝑠 𝑠

0 < 𝑎 ≤ 𝑠ℎ𝑒𝑙𝑓 𝑙𝑖𝑓 𝑒

In this model, we refer to the optimum 𝑎 as the profitability threshold. Ideally,


products leave the manufacturer’s distribution center with a minimum shelf life that
is equal to the profitability threshold. In a shipment policy, the profitability threshold
can be thought of as the target remaining shelf life, while the no-shipment threshold
can establish the sell-versus-dispose rule.
The extent to which 𝑎 impacts 𝐸𝑠 depends on the rotation practices at the store.
If the inventory is rotated on the shelf during replenishment and the consumer chooses
the outermost product on the shelf, we can assume that the inventory is issued ac-
cording to the first-in-first-out (FIFO) policy. If the product is front-loaded to the
shelf without rotation and the consumer still selects the outermost product, the last-
in-first-out (LIFO) policy can be assumed. It is reasonable to expect that rotation
is not performed at all times. As a result, products can be sorted with varying ages
on the shelf. Therefore, we can consider three cases with regards to shelf rotation:
1) FIFO, 2) LIFO, and 3) mixed issuing policy. In our main analysis, we assume
the mixed policy in which the inventory on the shelf is issued based on the uniform
distribution, where the consumer selects a product among different ages of inventory
with equal probability.
We solve this problem using data obtained from our industry collaborator Al-
phaCo. AlphaCo provided us three datasets:
1) Daily shipment and return data for 603 SKUs and 3,025 stores from one distribu-

95
tion center over a one year period.
2) Wholesale price and cost-of-goods-sold data for 1,094 SKUs.
3) Shelf life and case size data for 8,278 SKUs.
We connected these datasets using the identification numbers of SKUs. Further, we
eliminated SKUs that contain a negative cost or a negative wholesale price. As a
result, our final dataset contains 219 SKUs and 2,670 stores, in which a store carries
an average of 27 SKUs and a median of 15 SKUs.
To calculate 𝑝, 𝑐, and 𝑑, we leverage estimates of the following two costs: the cost
of sales and distribution to retail stores and the cost of reverse logistics from retail
stores.
Calculation of 𝑝: AlphaCo approximates a single number as the sales and distribu-
tion cost per case, identical across SKUs. If we suppose this number is $1, we arrive
at 𝑝 by deducting $1 and SKU’s cost-of-goods-sold from its wholesale price.
Calculation of 𝑐: AlphaCo estimates that the cost of reverse logistics at retail stores
is as high as the product’s cost-of-goods-sold, driven by costly handling in units at
stores as opposed to cases or pallets. Accordingly, we compute a uniform number
for the reverse logistics cost as the average of the cost-of-goods-sold across all SKUs.
Imagine that this number is $8. Then, to calculate 𝑐, we add $8 and the wholesale
price of the SKU.
Calculation of 𝑑: We stated that 𝑑 consists of the cost-of-goods-sold and the re-
verse logistics cost at the distribution center. We let the cost-of-goods-sold represent
𝑑, since the reverse logistics cost at distribution centers is negligible at AlphaCo.

96
3.5. Determining targets for the remaining shelf life

3.5.1 Solution approach and results

To find the optimum 𝑎 specified in our optimization model, we use a line search
starting from week one. At each iteration, we calculate the net profit from sales. We
∑︀ ∑︀
retain the value of 𝑎 at the iteration where 𝑝 𝑠 𝑄𝑠 − 𝑐 𝑠 𝐸𝑠 (𝑎, 𝑓 (𝐷𝑠 ), 𝑄𝑠 ) exceeds
∑︀ ∑︀
−𝑑 𝑠 𝑄𝑠 . This value is the no-shipment threshold. The value of 𝑎 at which 𝑝 𝑠 𝑄𝑠 −
∑︀
𝑐 𝑠 𝐸𝑠 (𝑎, 𝑓 (𝐷𝑠 ), 𝑄𝑠 ) exceeds 0 is the profitability threshold. The following graph in
Figure 3-7 represents an example for one SKU.

$3.00
sales disposal
$2.00

$1.00
NET PROFIT (per day for 10 stores)

$-
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39
$(1.00)
profitability threshold
$(2.00)

$(3.00)
no-shipment threshold
$(4.00)

$(5.00)

$(6.00)

$(7.00)

$(8.00)
Remaining shelf life (in weeks)

Figure 3-7: Net profit from sales and disposal for one SKU as remaining shelf life
changes.

The manufactured shelf life of this product is 39 weeks. The x-axis in the graph
represents the remaining shelf life, 𝑎, while the y-axis represents the net profit. The
thick black line shows the net profit for the case where the product is not sold to the
retailer, which is represented by the right-hand-side of the inequality in optimization
∑︀
model 3.1, −𝑑 𝑠 𝑄𝑠 . The curved gray line shows the net profit from sales, which is

97
∑︀
represented by the left-hand-side of the inequality in model 3.1 and 3.2: 𝑝 𝑠 𝑄𝑠 −
∑︀
𝑐 𝑠 𝐸𝑠 (𝑎, 𝑓 (𝐷𝑠 ), 𝑄𝑠 ). Notice that the net profit from sales is increasing with the
remaining shelf life. This increase occurs because as the remaining shelf life increases,
the amount of expiration, 𝐸𝑠 , decreases, eventually reaching zero in this example. The
optimum 𝑎 in model 3.1 (no-shipment threshold) is the minimum remaining shelf life
where the net profit from selling exceeds the net profit from not selling, which is
5 weeks here (marked with red color on the graph). In model 3.2, the optimum
𝑎 (profitability threshold) is the minimum remaining shelf life where the new profit
from selling is positive, which is 13 weeks for this product (marked with blue color).
Generally, there is no guarantee that optimum 𝑎 exists either for model 3.1 or 3.2,
since in the extreme case, in which 𝑄𝑠 = 𝐸𝑠 , both 𝑝 − 𝑐 ≥ −𝑑 (model 3.1) and
𝑝 − 𝑐 ≥ 0 (model 3.2) are not true.
In the example in Figure 3-7, when the remaining shelf life is less than 5 weeks, it
is more economical for AlphaCo to dispose of this product at the distribution center as
opposed to selling it to retailers, since the amount of expiration will be very high if it is
sold. Further, when the remaining shelf life is between 5 and 13 weeks, AlphaCo does
not generate a positive profit from sales due to the amount of expiration; however,
it is viable to sell since the loss from selling is less than the loss from not selling.
Finally, a remaining shelf life that is higher than 13 weeks is ideal for AlphaCo, since
in this case sales generate positive profit for this product.
Notice that the shipment policy we establish here, through computation of the
no-shipment threshold, does not vary across stores. It is possible to find a separate
optimum 𝑎 for each SKU-store. This customization simply requires dropping the 𝑠
subscript in the model 3.1. An SKU-store level shipment policy can yield higher prof-
its but is difficult to implement. In this study, we focus on shipment rules established
at the SKU-distribution center level since 1) it is an improvement compared to the
existing rules that are at the SKU level and 2) in practice, most manufacturers (in-

98
cluding AlphaCo) are not capable of handling different rules for different customers
[25].
The following are important elements of the algorithm regarding the time horizon,
consumer demand, and set of retail stores:
Time horizon: First, we replicate the original shipment data to obtain a long
time series of shipments. We replicate as opposed to randomize the orders since in
practice the sequence of orders is not random; orders follow the pre-determined visit
schedule for the store. For each SKU, remaining shelf life, and store combination, the
algorithm stops at the time period at which the average expiration quantity converges.
Through experimentation, we developed the following criteria for convergence: 1) the
number of time periods needs to be 1,000 at the minimum and 4,000 at the maximum
and 2) the average expiration for the last 200 time periods and the previous 200 time
periods needs to be less than 0.001. Once convergence is achieved, long-run average
expiration quantity and shipment quantity are obtained.
Consumer demand: Point-of-sale (POS) data would provide the ideal informa-
tion to understand store demand. However, AlphaCo does not have the POS data
for most customers. For example, convenient stores and gas stations usually lack
the technology to collect or transfer POS. Therefore, in the absence of POS data,
we leverage shipment data. We assume Poisson arrival of consumer purchase based
on literature with similar settings [2, 27]. We calculate the daily demand rate, 𝜆𝑠 ,
as [total shipments-total returns]/365. At each time period during computation, de-
mand is drawn from the Poisson distribution using the demand rate of the associated
SKU-store.
Retail stores: In the dataset, the number of stores that carries a given SKU
ranges between 1 and 1,772 with mean and median values of 271.6 and 163, respec-
tively. Because including the full set of stores increases the run-time substantially,
we chose a random sample of 10 stores for each SKU to speed up the computation.

99
To conclude, the algorithm is the following. In this program, 𝑖, 𝑎, 𝑑, 𝑠, and 𝑡 index
the SKU, remaining shelf life (in weeks), age of inventory (in days), store, and time
(in days), respectively. In addition, 𝐼 denotes the inventory.

for i in 1:219 do
a=1
while 𝑝𝑟𝑜𝑓 𝑖𝑡𝑎,𝑖 < 0 do
daily=7a
for 𝑠 in 1:10 do
t=1
difference=a large number
while (difference>0.01 and 1000<t) or t<4000 do
for d in 1:daily do
capture expired quantity: 𝐸𝑎,𝑖,𝑠,𝑡 = 𝐼𝑖,𝑠,1,𝑡
update inventory from yesterday: 𝐼𝑖,𝑠,𝑑−1,𝑡+1 = 𝐼𝑖,𝑠,𝑑,𝑡
update inventory based on shipment arrival: 𝐼𝑖,𝑠,𝑑,𝑡+1 = 𝑄𝑖,𝑠,𝑡
update inventory based on customer demand, 𝐷𝑖,𝑠,𝑡
end for
1 ∑︁
calculate average expiration until time period t: 𝐸𝑎𝑣𝑔𝑎,𝑖,𝑠,𝑡 = 𝐸𝑎,𝑖,𝑠,𝑡
𝑡 𝑡
𝑡−200 𝑡−400
1 ∑︁ 1 ∑︁
if t>1000 then difference= 𝐸𝑎𝑣𝑔𝑎,𝑖,𝑠,𝑡𝑖𝑚𝑒 − 𝐸𝑎𝑣𝑔𝑎,𝑖,𝑠,𝑡𝑖𝑚𝑒
200 𝑡𝑖𝑚𝑒=𝑡 200 𝑡𝑖𝑚𝑒=𝑡−200
t=t+1
end while
retain expired quantity per store at convergence: 𝐸𝑐𝑜𝑛𝑣𝑎,𝑖,𝑠 = 𝐸𝑎𝑣𝑔𝑎,𝑖,𝑠,𝑡
end for
∑︁ ∑︁ 1 ∑︁
𝑝𝑟𝑜𝑓 𝑖𝑡𝑎,𝑖 = 𝑝𝑖 𝑄𝑖,𝑠,𝑡 − 𝑐𝑖 𝐸𝑐𝑜𝑛𝑣𝑎,𝑖,𝑠
𝑠 𝑡
𝑡 𝑠
a=a+1
end while

100
∑︁ ∑︁ 1
no-shipment threshold(i)= index of a where 𝑝𝑟𝑜𝑓 𝑖𝑡𝑎,𝑖 > −𝑑 𝑄𝑖,𝑠,𝑡
𝑠 𝑡
𝑡
profitability threshold(i)= index of a where 𝑝𝑟𝑜𝑓 𝑖𝑡𝑎,𝑖 > 0
end for

Running this program for 219 SKUs in our dataset, we obtained the following
results. The no-shipment threshold ranges between 1 and 26 weeks with mean and
median values of 7.2 and 5 weeks, respectively. Further, the profitability threshold
ranges between 2 and 52 weeks with mean and median values of 17.6 and 17 weeks,
respectively. The histograms in Figure 3-8 depict the frequency of the results.

60
50

50
40

40
Frequency

Frequency
30

30
20

20
10

10
0

0 5 10 15 20 25 0 10 20 30 40 50
No−shipment threshold Profitability threshold

Figure 3-8: Histograms of algorithm’s output.

Here, we see SKUs with very high thresholds on the right tail of both histograms.
AlphaCo can consider discontinuing these SKUs, since it may not be profitable to
maintain product freshness at these levels (e.g., 30 weeks of remaining shelf life).
In making these decisions, one can take into account the manufacturing cycles. For
example, if a slow moving product is usually produced every 4 weeks and this product
already has a manufactured shelf life of 12 weeks, it may be hard to maintain a

101
freshness level of 10 weeks remaining shelf life. Our results can also be used as a
feedback for the production plan. Products that require high levels of freshness, as
indicated by high thresholds of no-shipment or profitability, can be produced more
often with smaller batch sizes. Furthermore, SKUs that require high freshness levels
could be given more emphasis for warehouse rotation or could be placed at convenient
locations on the warehouse floor to make rotation easier.

3.5.2 Sensitivity analysis

To examine the robustness of our results, we perform sensitivity analysis in three


areas: 1) the demand rate, 2) sampling of stores, and 3) the assumption regarding
shelf rotation.

Change in demand rate


Since we use an estimate of demand, it is useful to look at the sensitivity of results with
varying demand rates. We run our algorithm for two additional demand scenarios:
demand rate that is half a standard deviation less than the baseline rate and demand
rate that is half a standard deviation more than the baseline rate. We obtain the
results in Figure 3-9 for the no-shipment threshold.

102
25
baseline
minus 0.5 standard deviation
20 Example of an SKU sensitive

no-shipment threshold
plus 0.5 standard deviation
to demand variation
15

(in weeks) 10

0
SKUs (50)

Figure 3-9: Sensitivity of no-shipment threshold to variation in demand. Square (in


red), diamond (in blue), and triangle (in green) points represent the results with the
decreased, baseline, and increased demand scenarios, respectively.

As seen in Figure 3-9, some SKUs are sensitive to demand variation (those with
a wider gap between the red, blue, or green points), while others are not. To make
visualization easier, we include only the first 50 SKUs from our list on this graph.
Results for the full dataset (219 SKUs) are summarized in Table 3.1.

Table 3.1: Distribution of difference in no-shipment threshold with varying demand.

Reduced demand rate (𝜆𝑚𝑖𝑛𝑢𝑠0.5𝑠𝑡𝑑 ) Increased demand rate (𝜆𝑝𝑙𝑢𝑠0.5𝑠𝑡𝑑 )

difference # of SKUs % of SKUs difference # of SKUs % of SKUs

none 62 28% none 70 32%


+ 1 week 67 31% - 1 week 87 40%
+ 2 weeks 28 13% - 2 weeks 24 11%
+ 3 weeks 24 11% - 3 weeks 15 7%
+ 4 weeks 9 4% - 4 weeks 17 8%
+ 5 weeks 14 6% - 5 weeks 3 1%
+ > 5 weeks 15 7% - > 5 weeks 3 1%

As Table 3.1 shows, when the demand rate is reduced by half a standard deviation,
the threshold remains the same for 28% of the SKUs. Similarly, the threshold does
not vary for 32% of the SKUs when the demand rate is increased by half a standard

103
deviation. The change is one week for 31% and 40% of the SKUs for the lower and
higher demand scenarios, respectively. Then, for majority of the SKUs, the results
are robust (with either no change or one week of change) to moderate changes in
demand rate.
For 41% of the SKUs with the reduced demand rate scenario and 28% of the
SKUs with the increased demand rate scenario, the threshold changes by more than
2 weeks. The magnitude of the change differs across SKUs. For example, for 7% of
SKUs, the threshold increases by more than 5 weeks with the lower demand scenario.
To understand what drives the sensitivity of results, we evaluate the relationship
between the range of the threshold across two demand scenarios and several prod-
uct attributes. We find that the range is mildly and negatively correlated with the
product’s gross margin, with a correlation coefficient of -0.15. This means that the
no-shipment threshold for products with higher gross profit can be more robust to
variation in demand. This result can be explained such that demand is relatively
less impactful in the optimization model for products with higher gross margin. Fur-
ther, the correlation coefficient between the range and the (baseline) median demand
rate across sampled stores is -0.21. This relationship suggests that the no-shipment
threshold for faster selling products can be less sensitive to demand variation. This
can occur because for SKUs with high demand, moderate perturbations in demand
are less likely to change the optimization result. Similar results hold when we use
coefficient of variation instead of range to measure variation.
We expect demand variations to impact the optimization results. Our analy-
sis shows that we find that some SKUs are more sensitive than others to moderate
changes in demand, while some are robust. To be conservative, we can use the results
of a reduced demand scenario in practice.

104
Variation in store samples
In our dataset, the number of stores that carry a given SKU varies greatly. The store
count per SKU is between 1 and 1772 stores, with median and mean values of 163
and 271.6, respectively. Figure 3-10 shows the frequencies of the number of stores per
SKU.
80
60
Frequency
40
20
0

0 500 1000 1500


Store count

Figure 3-10: Histogram of store counts by SKU.

For our analysis, we select a random sample of 10 stores to speed up the compu-
tation. In this section, we test the sensitivity of results to varying samples. For this
purpose, we run our algorithm using 5 distinct samples, each containing 10 stores.
Then, we exclude the SKUs that are carried at less than 50 stores from our dataset,
which reduces our number of data points from 219 to 181 SKUs.
The following graph shows the results for a selection of SKUs. Each sample is
represented by a different shape and color on the figure. For each SKU, results from
5 samples are sorted to make the interpretation easier.

105
25
2nd lowest value across 5 samples
3rd lowest value across 5 samples
no-shipment threshold 20
4th lowest value across 5 samples SKUs sensitive to
highest value across 5 samples store sample variation
(in weeks)
15
lowest value across 5 samples

10

0
SKUs (50)

Figure 3-11: Variation in no-shipment thresholds across SKUs with different store
samples.

As seen in Figure 3-11, the variation for some SKUs is more than others. To assess
the sensitivity of the optimization outcome to varying store samples, we calculate the
gap between the highest and the lowest no-shipment threshold across 5 samples for
each SKU. We find that the gap is smaller than 2 weeks for 28% of the SKUs, which we
can consider as robust to sample variation. Exactly 34% of the SKUs are moderately
sensitive to variation in store samples, with a gap that is between 3 and 5 weeks. The
remaining of the SKUs (38%) are sensitive to sample variation, with a gap that is
higher than 5 weeks.
The sensitivity may be explained by the small size of the overall pool from which
we select the sample. For example, an SKU that is carried at 1,000 stores could be
less sensitive to sample variation than an SKU that is carried at 60 stores. To test
this hypothesis, we calculate the correlation between the store count per SKU and the
gap between the highest and lowest optimum values across 5 samples. We find that
the correlation coefficient is -0.33, which supports our prior belief that the results are
less sensitive with large representations.
Based on this analysis, during implementation, one can consider two possible

106
strategies to reduce variation due to sampling of stores: 1) increase the sample size
which could depend on the store count, or 2) run the algorithm with more samples,
selecting the median (or mean) value across different runs to establish the shipment
policy.

Impact of shelf rotation


Our initial analysis is based on a mixed inventory issuing policy on shelf rotation,
which assumes that the consumer selects a product among different ages of inventory
with equal probability. This assumption is conservative considering that store em-
ployees are expected to perform rotation each time they place new items on the shelf.
However, from industry reports [30] and based on our conversations with AlphaCo,
we know that neglect of rotation is not uncommon.
In this section, we analyze two extreme scenarios regarding rotation: full rotation
(FIFO) and no rotation (LIFO). After running our algorithm for these two scenarios,
we find that the impact of rotation on the results varies across SKUs. Figure 3-12
displays the results for a sample of SKUs. In the figure, square (in red), diamond (in
blue), and triangle (in green) points represent the results for the LIFO, mixed issuing,
and FIFO scenarios, respectively.

107
25
Mixed issuing
LIFO
20

no-shipment threshold
FIFO
SKUs not impacted
by shelf rotation
15

(in weeks)
10

0
SKUs (50)

Figure 3-12: Variation in no-shipment thresholds across SKUs based on different


rotation assumptions.

The following table summarizes the results for the full dataset of 219 SKUs.

Table 3.2: Distribution of difference in no-shipment threshold with varying assump-


tion on rotation.

# of SKUs % of SKUs

r=m=nr 111 51%


r=m 55 25%
m=nr 19 9%
r<>m<>nr 34 16%

In Table 3.2, r, m , and nr denote the full rotation, mixed issuing, and no rotation
scenarios, respectively. The equality r=m=nr represent the case where results are
identical for all 3 scenarios, which we find in 51% of the SKUs. For 16% of the SKUs,
results vary for all 3 scenarios, denoted by r<>m<>nr in the table. For 25% of
the SKUs, full rotation and mixed issuing yield the same results, shown by r=m.
Also, for 9% of the SKUs, results of the mixed issuing and no rotation scenarios are
identical (m=nr).
It is surprising that for a large portion of the data points (111 SKUs), rotation
does not have an impact. To get a better understanding of how rotation affects opti-
mization results, we select two SKUs. For the first SKU, the no-shipment threshold

108
for all three rotation scenarios is identical, 5 weeks. For the second SKU, there is a
wide gap in the no-shipment threshold (10 weeks) between the no rotation and full
rotation scenarios. Figure 3-13 shows the outcome of the optimization algorithm.

SKU$1$ SKU$2$
$4.00 $10.00

$5.00
$2.00

NET PROFIT (per day for 10 stores)


NET PROFIT (per day for 10 stores)

$-
1 11 21 31 41 51 61 71 81 91 101
$-
$(5.00)
1 4 7 10 13 16 19 22 25 28 31 34 37
$(2.00) $(10.00)
week 20 Sales (LIFO)
$(15.00) Sales (Mixed issuing)
$(4.00) week 14 Sales (FIFO)
$(20.00) Disposal
$(6.00) Sales (LIFO) week 10
$(25.00)
week 5 Sales (Mixed issuing)
$(8.00)
Sales (FIFO) $(30.00)
Disposal
$(35.00)
$(10.00)
$(40.00)

$(12.00) $(45.00)
Remaining shelf life (in weeks) Remaining shelf life (in weeks)

Figure 3-13: Examples of SKUs where rotation has no impact (first graph) and rota-
tion has an impact (second graph) on the no-shipment threshold.

In Figure 3-13, the three curved lines with green, red, and blue colors represent
the net profit from sales for the FIFO (full rotation), mixed issuing (some rotation),
and LIFO (no rotation) scenarios, respectively. The straight line in purple represents
the loss from disposal. As the graph shows, rotation does impact net profits for both
SKUs since three curved lines representing the three rotation scenarios are separate.
Notice that the net profit with full rotation is higher than (or equal to) the net profit
with some rotation; also, net profit with some rotation is higher than (or equal to)
the net profit with no rotation. Thus, rotation impacts profits favorably.
However, the impact of rotation on the no-shipment threshold is inconsistent. For
SKU 1, there is no impact; this means that the net profit associated with each scenario
exceeds the loss from disposal at the same remaining shelf life, which is 5 weeks. This
case occurs because the difference between net profits of the three rotation scenarios
is very narrow at lower values of the remaining shelf life. On the contrary, for SKU 2,

109
net profits for the three rotation scenarios intersect the loss from disposal at different
values of the remaining shelf life (weeks 10, 14, and 20 for the FIFO, mixed issuing,
and LIFO scenarios, respectively), producing different no-shipment thresholds.
We observe that product attributes of these two SKUs differ. For SKU 2, the
gross profit, cost of expiration, and cost of disposal are higher than they are for SKU
1 by a large margin, which explains the narrow difference in net profits across three
rotation scenarios for SKU 1. To see whether this observation is general, we calculate
the correlation between product attributes and the gap in the no-shipment threshold
between the no rotation and full rotation scenarios. We find the correlation coeffi-
cients to be 0.16, 0.48, and 0.26 for the gross margin, cost of expiration, and cost
of disposal, respectively. This result suggest that for SKUs with higher cost of ex-
piration, the impact of rotation on the no-shipment threshold will be more substantial.

3.5.3 Machine learning approximation

Scaling our solution to a full set of SKU-distribution center combinations can be


costly; thus, we investigate approximation methods to reduce run time and imple-
mentation effort.
Our analysis includes only 219 SKUs at a single distribution center. Still, the run
time of the algorithm is considerable (approximately 4 hours on a personal computer)
due to multiple dimensions of time periods, stores, and age of the inventory. The
number of time periods varies between 1,000 and 4,000 for each combination of the
remaining shelf life, store, and SKU. Further, even after sampling stores, the number
of store-SKU combinations (2,190) is sizable. The age of inventory also increases the
problem substantially. For example, for a product with 10 weeks of remaining shelf
life, the array containing the inventory information has 10 x 7=70 elements.
The full set of data points requiring shipment rules at AlphaCo consists of 289,727

110
SKU-distribution center combinations across 390 distribution centers. Implementing
our solution for the full dataset is possible; however, it requires considerable effort
and resources. Thus, in search for a less expensive alternative to optimization, we
assess regression analysis as a heuristic to substitute for optimization.
We evaluate four regression techniques: 1) random forest, 2) regression tree, 3)
support vector machine, and 4) Poisson regression. Among these methods, random
forest, regression tree, and support vector machine are machine learning algorithms,
whereas Poisson regression is a parametric model. We consider both nonparametric
and parametric methods in our assessment to understand their relative performance.
Among the parametric methods that restrict predicted values to nonnegative inte-
gers (which is appropriate in our application), we choose Poisson regression since it
is commonly used in situations that do not require special considerations such as
overdispersion, zero-inflation, or zero-truncation.
Recently, use of machine learning in solving operations management problems has
gained popularity. In the limited existing literature, machine learning typically is used
to estimate unknown parameters of a model (e.g., parameters of a demand model).
Next, this model is used in an optimization problem (e.g., revenue maximization) [57].
In this research, we use machine learning in the reverse order. We first obtain results
from a complex optimization problem; later, the output of optimization is used as an
input to the machine learning algorithm to predict optimum values, as portrayed in
Figure 3-14.

111
data

(features)
approximated
Optimization optimum values (targets) Machine learning optimum values
algorithm algorithm (predicted values)

Figure 3-14: Approximation of optimum values with machine learning.

Our goal is to predict the optimum values that were obtained through our opti-
mization algorithm using regression techniques. As features (called independent vari-
ables in classical statistics), we leverage the parameters of the optimization model
(e.g., cost of expiration, gross margin). Our unit of analysis is an SKU-distribution
center combination. Among the parameters used in the optimization model, ship-
ment quantity and demand are SKU-store specific attributes. Therefore, they need
to be aggregated at the SKU-distribution center level. On the other hand, cost of
expiration, gross margin, cost of disposal, and shelf life are SKU specific attributes.
Then, they can be used as they are. Regarding shipment quantity and demand, we
develop the following features: total shipments, average demand rate, and standard
deviation of demand rate across stores. In addition, we include case size as a feature,
since many of the shipments are made in single cases. Table 3.3 lists the features used
in predicting the no-shipment threshold and the profitability threshold. Notice that
the cost of disposal is not used in the prediction of the profitability threshold since
this feature is not a part of the optimization model.

112
Table 3.3: Features used in prediction of no-shipment and profitability thresholds

no-shipment threshold profitability threshold

Total shipments X X
Average demand rate across stores X X
Standard deviation of demand rate across stores X X
Case size X X
Cost of expiration X X
Gross profit X X
Cost of disposal X X
Shelf life X X
Case size X X

Following the conventional approach in prediction, we split the dataset into a


training and a test dataset. The training dataset includes 150 of the SKUs, while the
test dataset includes the remaining 69 SKUs. Typically, an algorithm is trained on
the training dataset, which creates a function (i.e., predictor) that maps features to a
target (called the dependent variable in classical statistics). This function is applied
to the test dataset to make predictions. The error obtained at this step is used to
evaluate different algorithms. Our training step involves two procedures: cross vali-
dation and bagging. Figure 3-15 depicts our overall prediction approach.

113
Training Testing
(150 SKUs) (69 SKUs)
Prediction
Cross validation Bagging
Prediction
(5-fold) Best algorithm (100 samples)
100 Prediction
parameters
predictors . x100
Validation Training .
.
1 .
2 .
3
4
5 Average
prediction

Figure 3-15: Prediction process.

Cross validation: Our goal with cross validation is to tune the algorithm param-
eters (e.g., complexity parameter in regression tree) to improve accuracy. We apply
a 5-fold cross validation process which is performed as the following. The training
dataset is split into 5 partitions. At each of 5 iterations, a different partition is picked
as the validation dataset and the remaining 4 partitions are combined as the training
dataset. Also, at each iteration, the algorithm is trained using the training dataset
and is tested using the validation dataset over an array of varying parameter values.
The average error (across 5 iterations) is used to evaluate a given parameter value.
The goal is to pick the parameter value that minimizes the error. Regression tree
and support vector machine algorithms can benefit from parameter tuning more than
the other models since they include parameters that adjust for overfitting. Poisson
regression uses the iteratively reweighted least squares algorithm which typically does
not require parameter adjustments. The random forest is a sophisticated algorithm
consisting of bagging and feature selection procedures to control variance and over-
fitting.
For all computations in this research, we use the statistical language R version
3.1.2 [54] utilizing packages stats, randomForest [41], rpart [60], and e1071 [44].
For cross validation of the regression tree algorithm, we tune the complexity param-

114
eter using R’s rpart function. The complexity parameter prevents overfitting by
influencing the tree pruning process. We find that the best complexity parameter
is 0.037. For the support vector machine algorithm, we tune the gamma and cost
parameters using R’s tune and svm functions. Combinations of 0.5 and 8 for the
gamma and the cost parameters work best for the no-shipment threshold; 0.5 and 16
are the best parameter combinations for the profitability threshold.
Bagging: Bagging generates many samples from the training dataset with re-
placement. The size of the sample is the same as the size of the training dataset.
The goal is to avoid dataset overfitting and thus improve the accuracy of prediction.
Since the random forest method already includes its own bagging procedures that are
part of the algorithm, we perform bagging only for regression tree, support vector
machine, and Poission regressions. We produce 100 samples. Then, we train each
of the three algorithms on 100 different training datasets. Bagging is an important
step in our training process to mitigate the limitations of a small dataset (219 data
points).
Prediction: Because we do not perform bagging for random forest, the prediction
step for this method involves testing one predictor on the test dataset. For the other
three methods, we perform testing using the 100 predictors we produced for each
algorithm. Then, we aggregate the results by averaging the predictions over 100
cases.
We find that the random forecast algorithm performs significantly better compared
to the other regression methods, producing the smallest mean squared error (MSE)
value in predicting both the no-shipment threshold and the profitability threshold.
For the no-shipment threshold, the MSE values are 8.4, 10.1, 19.4, and 53.1 for
the random forest, regression tree, support vector machine, and Poisson regression
methods, respectively. Figure 3-16 shows the prediction results for the 69 SKUs used
in the test dataset. The x-axis represents the optimum value, while the y-axis shows

115
the predicted value. The MSE results are noted on the upper right corner of each
graph. As Figure 3-16 shows, optimum and predicted values are more aligned with the
random forest method than in other methods. The regression tree and support vector
machine methods are the second and third best performing methods, respectively. As
we can see, Poisson regression performs very poorly.

Random Forest MSE=8.4 Regression Tree MSE=10.1


25 25

20 20
Predicted

Predicted
15 15

10 10

5 5

0 0
0 5 10 15 20 25 30 0 5 10 15 20 25 30
Optimum Optimum

Support Vector Machine MSE=19.4 Poisson Regression MSE=53.1


25 25

20 20
Predicted

Predicted

15 15

10 10

5 5

0 0
0 5 10 15 20 25 30 0 5 10 15 20 25 30
-5 -5
Optimum Optimum

Figure 3-16: Performance of regression methods in prediction of no-shipment thresh-


old.

We obtained similar results predicting the profitability threshold as seen in Figure


3-17. The MSE values for the random forest, regression tree, support vector machine,
and Poisson regression methods are 16.8, 31.3, 25.9, and 272.2, respectively. Accord-
ingly, the random forest algorithm performs best. In contrast with the prediction of
the no-shipment threshold, the support vector machine method performs better than
the regression tree method here. Similar to the previous case, the performance of
Poisson regression is worse than the other three methods by a large margin.

116
Random(Forest( MSE=16.8 Regression(Tree( MSE=31.3
40" 40"
35" 35"
30" 30"
Predicted(

Predicted(
25" 25"
20" 20"
15" 15"
10" 10"
5" 5"
0" 0"
0" 10" 20" 30" 40" 50" 0" 10" 20" 30" 40" 50"
Op+mum(( Op+mum((

Support(Vector(Machine( MSE=25.9 Poisson(Regression( MSE=272.2


40" 40"
35" 35"
30" 30"
Predicted(

Predicted(
25" 25"
20" 20"
15" 15"
10" 10"
5" 5"
0" 0"
0" 10" 20" 30" 40" 50" 0" 10" 20" 30" 40" 50"
Op+mum(( Op+mum((

Figure 3-17: Performance of regression methods in prediction of profitability thresh-


old.

Poisson regression is a parametric model that is based on the linear combination of


features. On the contrary, the random forest, support vector machine, and regression
tree are non-parametric machine learning tools that do not restrict the features in
any way. The support vector machine uses hyperplanes to separate the data points in
multi-dimensional space. Regression trees (random forest is a type of regression tree)
partition the space into rectangles grouping observations within those rectangles. The
nonrestrictive nature of machine learning tools may explain why they perform well in
our application in which we predict the outcome of a complex optimization algorithm.
In addition, unlike parametric methods, machine learning tools do not need trans-
formation or scaling of features. Feature transformation is already embedded in the
support vector machine algorithm through kernel functions; also, tree methods inher-
ently do not require data transformation since the algorithm works based on the rank,
not on actual data values. Our prediction process does not include a data preparation

117
step to scale or transform the features, which could partially explain the large margin
in performance between Poisson regression and machine learning methods. Based on
our application, we conclude that machine learning tools are advantageous methods
to approximate complex optimization models with high predictive power and easy
use without a need for prior data manipulation.

3.6. Comparison with current practice

3.6.1 Existing practice at AlphaCo

At AlphaCo, the shipment policy consists of three components:


1) The minimum remaining shelf life required for shipments that are from plants
to distribution centers. AlphaCo refers to this threshold as ship to satellite.
2) The minimum remaining shelf life required for shipments that are from distribu-
tion centers to retail stores, which is called ship to trade. This rule is comparable
to the no-shipment threshold we defined in this thesis.
3) The ideal remaining shelf life when the product arrives at the store, referred to
as target to trade. This threshold is similar to the profitability threshold described in
this research.
AlphaCo’s shipment policy is based on the product’s manufactured shelf life. For
example, for all SKUs with a manufactured shelf life of 10 weeks, ship to satellite,
ship to trade, and target to trade values are 7, 5, and 8 weeks, respectively. Graph
3-18 shows how the shipment policy changes with the manufactured shelf life. The
x-axis represents SKUs with distinct manufactured shelf lives, while the y-axis shows
the shipment policy along with the manufactured shelf life.

118
120
Manufactured shelf life
100 Target to trade
Ship to satellite
80 Ship to trade
(in$weeks)$ 60

40

20

0
SKUs with distinct manufactured shelf lives

Figure 3-18: Existing shipment policies at AlphaCo.

As seen on the graph, target to trade values follow the manufactured shelf life.
However, ship to satellite and ship to trade initially increase with the manufactured
shelf life but stay constant after a certain point. Basically, AlphaCo’s policy can be
seen as a mix of two industry practices discussed in Section 3.3.3 (minimum remaining
days and percent of manufactured shelf life). Unlike the rules of some manufacturers
practicing the minimum remaining days policy, shipment rules do not change across
different product categories at AlphaCo. The policy is determined based on the SKU’s
manufactured shelf life and is uniform across different distribution centers carrying
the SKU. Also, AlphaCo’s shipment policies are built upon managers’ experience and
are not based on a rigorous empirical analysis.

3.6.2 Optimization versus existing practice

This section evaluates the value of optimization. Figure 3-19 compares AlphaCo’s
ship to trade and our no-shipment threshold values for 219 SKUs included in our
analysis.

119
30
as-is (ship to trade)
25 optimization (no-shipment trehshold)

20

(in weeks)
15

10

0
SKU (219)

Figure 3-19: Existing versus optimum minimum remaining shelf life.

As the graph shows, the minimum remaining shelf life is uniform across SKUs
(either 5 or 6 weeks) with the current practice at AlphaCo. However, the optimum
remaining shelf life we found in our analysis varies across SKUs from 1 to 26 weeks.
Figure 3-20 compares AlphaCo’s target to trade (y-axis) and our profitability
threshold (x-axis) values for 219 SKUs. The data points are concentrated in the
upper diagonal of the graph, which shows that the target to trade values are gener-
ally higher than the profitability threshold. Although they both represent the ideal
amount of remaining shelf life, the difference exists since AlphaCo’s criteria for es-
tablishing target to trade is not based on profitability; target to trade values simply
follow the manufacturered shelf life as we see in Figure 3-18.

120
Target to trade (as-is) in weeks
80

60

40

20

0
0 20 40 60 80
Profitability threshold (optimum) in weeks

Figure 3-20: Existing versus optimum target remaining shelf life.

To quantify the impact of optimization on the firm’s profit, we use simulation


considering AlphaCo’s ship to trade policy and our no-shipment policy. We calculate
the net profit for sales and disposal decisions, considering only the interval between
the existing policy and the optimum policy values. We take into account only this
interval, because existing and optimum strategies are identical for values outside of
this range. Let us consider two scenarios. In the first one, AlphaCo’s existing policy
requires a minimum shelf life of 5 weeks while optimization suggests 9 weeks. For the
remaining shelf life that is less than 5 weeks, both the current and optimum strategies
suggest discarding the product; further, for the remaining shelf life that is higher than
9 weeks, both strategies suggest selling the product. However, strategies vary for
the remaining shelf life that is between 5 weeks and 9 weeks: optimization suggests
discarding the product while the existing strategy suggests selling the product. Next,
consider the opposite scenario in which the current value is higher than the optimum
value for the minimum required shelf life, 5 weeks and 3 weeks, respectively. In this
case, strategies outside of the range of 3 and 5 weeks are identical. However, for the
values within the range, optimization suggests selling the product while the existing

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rule suggests discarding the product. The following figure explains these two scenarios
and how their difference relates to the simulation approach.

Scenario 1: Scenario 2:
interval considered in interval considered in
simulation simulation

as-is: discard sell sell discard discard sell


optimization: discard discard sell discard sell sell

5as-is 9optimization 3optimization 5as-is

Figure 3-21: Dependence of simulation approach on optimum and existing minimum


shelf life.

We adopt the following approach for simulation. Considering the first scenario
depicted in Figure 3-21, we simulate the remaining shelf life for 5, 6, 7, 8, and 9 weeks.
For each value, we compute the net profit from sales and from disposal decisions. We
record the average net profit from sales under the as-is policy, while the average net
profit from disposal is recorded under the optimum policy. For example, for the SKU
that is considered in this scenario, average net profits from sales and disposal are
$-1.29 and $-0.97, respectively. Next, consider the second scenario. Similarly, we
simulate the remaining shelf life for 3, 4, and 5 weeks. In this case, the average net
profit from sales is recorded under the optimum policy, while the average net profit
from disposal is recorded under the as-is policy, $-3.15 and $-4.57, respectively for
the SKU selected in this scenario. Graph 3-22 shows the cumulative net profit for the
as-is and optimization based policies across 219 SKUs in our dataset.

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Comparison across 219 SKUs
0.00

NET PROFIT (average per day)


as-is optimization
-100.00

-200.00

-300.00

-400.00
41%
-500.00 improvement
-600.00

-700.00

-800.00

Figure 3-22: Impact of optimization on profits.

Accordingly, optimization reduces the loss by 41%. We are unable to translate


this number into savings in monetary value since we do not have data on the actual
remaining shelf life in historical shipments. As a result, we do not know how often
current rules apply in actual shipments. Neverthless, the simulation approach we use
here gives us a good idea about the relative value of optimization.

3.6.3 Machine learning approximation versus existing practice

In this section, we evaluate the benefit of machine learning approximation. Using


the same prediction process followed in Section 3.5.3, we train the random forest
algorithm using 150 SKUs and make predictions on the remaining 69 SKUs. Ap-
plying a similar simulation approach used in comparison of the current practice and
optimization, we compare the existing policy, optimum policy, and the policy based
on approximation. We evaluated two scenarios when we compared the existing and
optimum policies: 1) optimum value is higher than the existing value and 2) opti-
mum value is smaller than the existing value, as shown in Figure 3-21. In this case,
we have 12 different scenarios. Let e, o, and a denote the existing, optimum, and
approximate values, respectively, for the minimum required remaining shelf life. The
12 scenarios are 1)e>o>a, 2)o>e>a, 3)a>o>e, 4)a>e>o, 5)o>a>e, 6)e>a>o,

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7)e>o=a, 8)o>e=a, 9)a>o=e, 10)o=a>e, 11)e=a>o, and 12)o=e>a. Figure
3-23 explains the simulation approach for one example.

Scenario: o>a>e
interval considered in
simulation

as-is: discard sell sell sell


optimization: discard discard discard sell
approximation: discard discard sell sell
5as-is 7approximation 9optimization

Figure 3-23: Simulation interval in comparison of three policies: existing, optimum,


and approximation based.

For all three policies, we calculate the average net profit between the minimum
and maximum of e, o, and a. In the example depicted in Figure 3-23, the optimum,
approximate, and as-is values are 9, 7, and 5 weeks, respectively. The net profit for
the as-is policy is calculated as the average net profit from sales between weeks 5 and
7. For the optimum policy, we compute the loss from disposal for the same interval.
The net profit for approximation is calculated as the weighted average of the loss
from disposal between weeks 5 and 7 and the profit from sales between weeks 7 and
9. Each SKU falls into one of the 12 scenarios listed earlier. Lastly, we add the net
profit across 69 SKUs to compute the overall net profit for the as-is, optimization,
and approximation based policies, which is shown in Figure 3-24.

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Comparison across 69 SKUs
$0.00

NET PROFIT (average per day)


as-is optimization approximation
-$200.00

-$400.00

-$600.00 48%
improvement
-$800.00

14%
-$1,000.00
improvement
-$1,200.00

Figure 3-24: Impact of machine learning approximation on profits.

As seen in Figure 3-24, compared to the current policy, optimization provides 48%
savings, while machine learning approximation provides 14% savings for a sample of
69 SKUs considered in the analysis. Accordingly, machine learning approximation
gives us 28% of the benefit we can achieve with optimization. This is a considerable
improvement considering the minimal time (i.e., a few seconds) required to run the
machine learning algorithm.

3.7. Conclusion and future research

Currently, the industry lacks standards to manage the remaining shelf life of prod-
ucts entering the retailers’ supply chain. As a result, we see a mismatch between
retailers’ expectations and manufacturers’ practices. Further, requirements of retail-
ers and rules of manufacturers can vary across different firms for the same type of
product. Existing shipment policies are simply rules determined arbitrarily or based
on managers’ experience. Here, it seems that the industry is in need of quantitative
methods to establish shipments policies based on rigorous analysis. Rules that are
built on a solid foundation can be adopted more easily in the industry, for they can
help achieve alignment across manufacturers and retailers.

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This research develops a framework (an optimization method and machine learning
approximation of optimal values) to establish targets for the minimum remaining shelf
life in manufacturers’ supply chain. Our methodology takes into account relevant
factors such as the demand rate or cost of expiration, which are disregarded in current
industry practices. We built an optimization model that produces the minimum
required remaining shelf life for a given SKU subject to the constraint that the net
profit of the sold product from sales exceeds the net profit of the unsold and disposed
product. Using shipment and product cost data from a manufacturer, we found the
optimum value to range between 1 and 26 weeks with mean and median values of 7.2
and 5 weeks, respectively, across 219 SKUs. A modified version of the model finds
the minimum remaining shelf life that ensures a positive net profit from sales. The
optimum value in this case ranged between 2 and 52 weeks with mean and median
values of 17.6 and 17 weeks. Comparing our results with the firm’s existing policy,
which requires a minimum remaining shelf life of 5 or 6 weeks, we show that the
shipment policy based on our methodology is superior by potentially improving the
savings by 41% in situations where products are shipped to retailers’ supply chain
with the designated minimum remaining shelf life.
Moreover, we perform sensitivity analysis in three areas: 1) the demand rate, 2)
sampling of stores, and 3) the assumption regarding the rotation practices on the retail
shelf. In all three areas, we found that while the results did change for some SKUs
with varying magnitudes, they remained the same for others. For the demand rate, we
assessed two scenarios: plus and minus half a standard deviation of the initial demand
rate. For nearly 65% of the SKUs, the results are robust to the varying demand rate.
Further, we evaluated 5 different store samples. We found that for 28% of the SKUs,
the results are robust, while the results for 38% of the SKUs are sensitive to varying
samples. The magnitude of the sensitivity is moderately and negatively correlated
with the total number of outlets that carry the SKU. Accordingly, we can consider

126
adjusting the sample size or the number of samples depending on the size of the pool
from which we select the sample. Regarding the assumption on shelf rotation, we
analyzed two extreme scenarios: full rotation and no rotation. We found that the
results for 51% of the SKUs are robust to varying assumptions about rotation. This
result is unexpected, as we know from literature that rotation matters in inventory
management [48]. After further analysis, we find that rotation does impact the net
profit. However, when the cost of expiration is low, the difference in net profits across
different rotation scenarios is so narrow that the minimum required remaining shelf
life for the sell versus dispose decision remains the same. Considering our findings with
the sensitivity analysis, we expect a certain level of error with our savings calculation.
However, 41% improvement is substantial; thus, we expect the value of optimization
to remain valid.
To alleviate the implementation effort, we use a novel approach in approximating
optimization, which uses machine learning tools as a heuristic. We found that the
random forest algorithm performs well predicting the optimum remaining shelf life for
the two models we study: 1) the model that finds the optimum threshold for sell or
dispose decisions and 2) the model that finds the optimum threshold for profitability.
For both models, we use the same test dataset consisting of 69 data points. For
the first model, we found that the mean squared error (MSE) values are 8.4, 10.1,
19.4, and 53.1 for the random forest, regression tree, support vector machine, and
Poisson regression methods, respectively. For the second model, MSE values are
16.8, 31.3, 25.9, and 272.2 for the same sequence of methods. Based on the first
model, we found that savings with the approximation method are 14%, accounting
for 28% of the benefit we can achieve with optimization. These results suggest that
machine learning performs well as a substitute for optimization. Additionally, the
run time of machine learning algorithms is a few seconds compared to four hours of
the optimization algorithm based on our analysis. This difference shows that machine

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learning can be a low-cost alternative to optimization. In practice, several projects
compete for the same budget, which aim to improve various aspects of operations.
Managers need to justify why their project should be selected. This justification is
provided through a cost-benefit analysis. The higher the benefit and cost ratio, the
more chances a project has for a funding. Remarkably low cost of machine learning
stands out in this competition providing moderate benefits with minimal cost.
Overall, this thesis contributes to the operations literature that studies perishable
products in two-tier supply chains in two ways. First, we introduce the industry’s
remaining shelf life problem. Second, we develop a methodology to establish shipment
policies to set up minimum required shelf life for products entering the retailer’s
supply chain. Also, we contribute to the overall operations management literature by
applying an innovative approach using machine learning algorithms to approximate
optimum solutions.
This research provides guidelines for manufacturers in determining shipment poli-
cies of perishable products and also helps increase profitability. Our framework can
aid the industry in developing standards in managing the remaining shelf life as
products move in the supply chain. It is important to note that our model solves the
problem from the perspective of the manufacturer. The model can also be used from
the perspective of the retailer. However, since retailers’ gross margin, a key param-
eter in the model, differs from the manufactures’ gross margin, the shipment policy
the model produces can differ. Thus, it still might be a challenge to establish stan-
dards that please both retailers and manufacturers. Nevertheless, our framework can
help eliminate the discrepancy in shipment policies within manufacturers or within
retailers.
With the empirical analysis in Chapter 2, we showed that inventory aging is
positively correlated with product expiration. Our motivation for this research is to
address the inventory aging problem in the supply chain. If shipment policies are cou-

128
pled with appropriate incentive mechanisms within the manufacturer’s organization,
they can address the aging problem to a certain degree. For example, if the supply
chain manager’s performance metric is impacted by the cost of unsold disposed prod-
ucts that are a result of shipment policies, he/she will be incentivized to manage batch
sizes better, improve forecast accuracy, or rotate the supply chain inventory. Man-
agers also need instructions and methods to accomplish these improvements. Future
complementary research can investigate the drivers of supply chain inventory and,
accordingly, address inventory issues. For example, if production batching is found to
be the main driver of inventory, we can investigate optimum batch sizes considering
the relevant trade-offs involved in the supply chain, including the impact on product
expiration. Analysis of warehouse rotation is also an important future research area.
Considering the labor cost of rotation, it may not be cost-effective to perform full-
rotation at all times for all products. Future research can examine the circumstances
at which it is worthwhile to perform warehouse rotation.

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Chapter 4

Design of Sales-force Compensation


Schemes Considering Product
Expiration

4.1. Introduction

Motivated by the study of the drivers of expiration presented in Chapter 2 of this


thesis, this research investigates sales-force compensation schemes that can alleviate
product expiration. During our interviews at our research collaborator, we found
that operations managers attributed product expiration to the overselling behavior
of the sales-force. Then, in our empirical analysis, we find that certain sales incentive
programs are positively correlated with the amount of expiration.
The overselling behavior of the sales-force and its impact on product expiration
is not unique to our research collaborator. The industry recognizes that overselling
is a problem generating product expiration. Furthermore, according to surveys and
qualitative studies, overselling is driven by sales-force incentives. As we can see
from the following quotes, the industry studies imply that product expiration can be

131
mitigated with proper sales-force incentive mechanisms.
"Many of the decisions that have been made in the past by the manufacturer’s
sales staff and the retailer’s procurement staff never considered the unsaleables aspect
of the procuring process. Many manufacturer sales teams have incentives for sales
without penalty for unsaleables." [1]
"There is a general consensus that corporate growth strategies and personal perfor-
mance and compensation packages often drive over-buying and over-selling decisions,
when metrics exclude data about unsaleables." [49]
"Corporate sales goals or quotas (i.e., making a number) are mentioned as the
top reason that sales people over-sell products. Personal compensation and bonus
incentives which are based on gross sales rather than net sales (i.e., minus unsaleables)
are number two." [49]
Despite the understanding that unsaleables need to be incorporated into sales-
force compensation plans, the industry does not prescribe any specific tool or precise
strategy as to how. Seemingly the only industry study dedicated to the issue, titled
"The Impact of Sales and Procurement on Reverse Logistics Management", does
not go beyond emphasizing the importance of accountability and suggesting that
manufacturers’ sales organizations need be educated about the financial implications
of unsaleables and how their role impacts results [64].
Our goal with this research is to find a sales-force compensation mechanism that
can alleviate product expiration while helping the manufacturer achieve full profit
potential. Also, we aim to understand whether currently practiced compensation
plans can fulfill this goal.
The most commonly practiced sales-force compensation scheme in the industry
is the sales-volume-based commission. Accordingly, the sales person is paid a fixed
monetary award for each unit sold (e.g., $0.30/case). Meanwhile, expired volume may
or may not be deducted from the compensation. The sales-volume-based commission

132
scheme does not seem to align incentives since the earnings of the manufacturer
and the sales representative are not based on the same performance measure. As
discussed in Section 3.3.2, expiration erodes the manufacturer’s profit significantly.
In contrast, the sales representative’s commission is not affected similarly even after
expired volume is deducted from the compensation. Let us consider a case in which the
manufacturer’s wholesale price is $4. With a gross margin of 10%, the manufacturer
earns $0.40 for each unit sold. Let us assume that the sales representative earns
$0.10 for each unit sold. If the product expires, we deduct $0.10 from the sales
representative’s compensation, while expiration costs the manufacturer at least $4 if
the retailer gets full credit for expiration. According to this example, there is a one-to-
one relationship between what the sales representative earns and loses if expiration
occurs. On the other hand, this relationship for the manufacturer is one-to-ten.
As we can see in this example, expiration hurts the earnings of the manufacturer
and the sales representative with different magnitudes under the sales-volume-based
compensation scheme.
This asymmetrical effect of expiration on the manufacturer and the sales repre-
sentative leads us to consider a profit-sharing compensation scheme as a potential
mechanism aligning the incentives. The profit-sharing scheme can be aligning since
the cost of expiration impacts the sales representative’s commission the same way it
impacts the manufacturer’s profit under the profit-sharing scheme. Consequently, we
ask the following research questions.

1. Is the sales-volume-based commission scheme effective at achieving the desired


profit and waste outcome for the manufacturer?

2. Otherwise, can a profit-sharing commission scheme align the incentives of the


manufacturer and the sales representative?

3. Is there an alternative compensation scheme that addresses the moral hazard

133
problem?

To answer these questions, we use a mathematical model that is based on the


principal-agent framework from microeconomic theory. Our model represents the
direct-store-delivery (DSD) setting in which retailers’ inventory levels are determined
by sales effort. DSD is important for the consumer packaged goods industry since
products distributed through the DSD system represent 24% of unit sales and 52%
of retail profits in the grocery channel [52]. In our model, the effort has a cost for the
sales representative; in addition, compensation depends on the shipment quantity.
We assume a two-stage decision-making process. In the first stage, the manufacturer
selects a compensation scheme; in the second stage, the sales person selects an effort
level. Based on our assumption of newsvendor-based ordering, the inventory that is
in excess of the consumer demand expires after one period.
For this study, we design a new compensation scheme with two parameters: a
penalty fee for a unit of expired item and a commission rate. The sales-volume-based
commission (both the gross-sales-volume and the net-sales-volume) and profit-sharing
schemes are special cases of this new scheme.
In our analysis, we use global optimization as a benchmark, in which inefficiency
due to moral hazard does not exist (i.e., effort can be observed) resulting in the
manufacturer achieving full profit potential. Jointly solving the global optimization
problem and the sales representative’s problem, we find a closed-form relationship
between the penalty fee and the commission rate. Based on this relationship, we
derive the following main results.

∙ Contrary to our prior belief, the profit-sharing compensation scheme does not
align the incentives of the manufacturer and the sales representative.

∙ Surprisingly, the sales-volume-based commission can align incentives when the


cost of effort is high or the cost of expiration is low relative to the gross margin

134
of the product.

∙ The compensation scheme designed for this research can align the incentives of
the manufacturer and the sales representative. Based on this scheme, we derive
the following strategy. When the cost of effort is high (e.g., at corporate chain
stores or competitor-dominated markets) or the cost of expiration is low relative
to the gross margin of the product, charge the sales representative a penalty
fee that is lower than the unit cost of expiration. In the reverse case in which
the cost of effort is low (e.g., at individually owned convenience stores) or the
cost of expiration is high relative to the gross margin of the product, charge the
sales representative a higher penalty fee than the unit cost of expiration.

This research clarifies the decision process of the sales representative, specifically
the impact of sales-effort cost on ordering decisions. Earlier, disregarding the role of
effort cost, we mistakenly expected the profit-sharing scheme to align the incentives
since the earnings of the manufacturer and the sales representative are based on
the same performance measure (i.e., profit). The sales representative might indeed
take into account the effort cost. At AlphaCo, the effort for creating the order is
less costly at small stores since the sales representative’s job at small stores (e.g.,
convenience stores, gas stations) is limited to generating the replenishment order
while the driver completes the remaining work (stocking the shelf). At large stores,
the sales representative is also responsible for stocking the shelf. Then, based on
our model, we expect over-ordering at small stores where effort cost is low. This
expectation is supported by our empirical analysis presented in Chapter 2, since we
find that expiration is more likely to occur at small stores even after controlling for
other factors such as case size, which can partially be explained by over-ordering.
Therefore, effort cost is a factor that needs to be considered in designing sales-force
compensation schemes.
This research also shows us that a compensation scheme with homogenous parame-

135
ters (commission rate, penalty fee for expiration) across products, channels, or regions
may not be effective. Manufacturers can benefit from customizing the compensation
parameters based on the cost of expiration and varying effort cost at different chan-
nels (convenience stores versus supermarkets) and markets (where the competitor is
dominant versus weak).
To the best of our knowledge, our research is first in academia analyzing sales-
force compensation mechanisms for settings in which sales effort determines inventory
levels and thus directly impacts product expiration. Further, our study is valuable for
practitioners since the industry lacks the knowledge about how to best incorporate
expiration into sales-force compensation schemes. Although our model represents
the DSD system in which the retailer’s inventory levels are solely determined by
manufacturers’ sales-force, our findings can also apply to the traditional channel.
Our results are relevant for the traditional channel because manufacturers’ sales teams
influence retailers’ purchasing decisions and accordingly inventory levels.

4.2. Literature review

Our research is related to the following literature: agency theory in economics, sales-
force compensation plans in marketing, marketing and operations interface, supply
chain coordination, and vendor-managed inventory.
Agency theory in Economics The analytical foundation of this work is pro-
vided by the principal-agent model. In the setting we analyze, the principal is the
manufacturing firm that operates through the direct-store-delivery channel; the agent
is the sales representative. Moral hazard occurs because the sales representative may
place too much inventory in the retail store knowing that he/she will not be fully
accountable for the cost of product expiration. This is due to the information asym-
metry such that the actions of the sales representative at retail stores are not observ-

136
able by the manufacturer. There is a vast amount of literature in economics on the
principal-agent problem. The seminal papers in agency theory include [28], [24], [56],
and [21].
Sales-force compensation plans in Marketing Basu et al. [4] are the first to
apply the agency theory to the sales-force problem. They formulate the problem and
derive results that are in alignment with Holmstrom’s [28] analysis. Assuming dimin-
ishing agent utility with pay and gamma or binomial distributions for the demand,
they derive a compensation plan as a function of sales. This represents the salary plus
commission scheme. Special cases of this scheme are: 1)straight commission, 2)slid-
ing commission (varying commission rates based on different sales brackets), 3)salary
only, 4) salary plus commission, and 5)salary plus commission beyond a target. Using
Pratt’s [53] risk tolerance definition, they show how increase, decrease, or constancy
of commission rates depend on the risk aversion characteristics of the salesperson.
The same as in Basu et al.’s [4] study, sales is a function of effort in this research.
Also, in both studies, the agent’s utility function for income and effort is additively
separable. However, our study is distinct in a number of ways. In their setting,
sales represents demand and its probability distribution is conditioned on sales effort.
In our setting, sales represents deterministic shipment quantity (i.e., store inventory
level), which is a function of sales effort; further, demand is stochastic and inde-
pendent. Moreover, we focus on product expiration and strategies to appropriately
penalize the sales representative for product expiration. This analysis is done under
a straight commission scheme.
Marketing and Operations interface A number of studies in the Operations
literature analyze the sales-force compensation problem considering inventory or pro-
duction issues. The following are notable examples.
Chen [8] proposes a sales-force compensation package to induce sales that smoothes
production considering multiple periods. This scheme evaluates and compensates the

137
sales force on a moving-time-window basis, where the length of the time window is
determined by the production lead time.
Dai and Jerath [12] develop sales-force compensation and inventory strategies
under the coordinating contract. The analysis is based on a newsvendor type model.
In the setup, sales effort impacts uncertain demand, but sales is limited by inventory.
They find that under the optimal contract, the agent is paid a bonus for meeting a
sales quota. Further, disregarding excess inventory scenarios, they focus on stockout
possibilities and accordingly find several counterintuitive results with regard to the
amount of compensation bonus and optimum inventory levels. These results are not
expected if we were to ignore the limited inventory aspect of operations.
Similar to these studies, we also analyze the sales-force compensation problem
considering inventory issues. In addition, the focus of our analysis is product expira-
tion and the setting is based on direct-store-delivery operations. Accordingly, effort
determines the deterministic order quantity and demand is stochastic. This is in
contrast with Chen’s [8] and Dai et al.’s [12] analysis in which sales effort impacts
uncertain customer demand.
Supply chain coordination The goal of channel coordination is to improve the
performance of the supply chain by aligning the objectives of channel partners (e.g., a
manufacturer and a retailer). The literature usually focuses on ordering decisions and
inventory management. Likewise, the objective of this research is to align the incen-
tives of the manufacturing firm and manufacturer’s sales representative. The setting
involves an ordering decision to manage a retailer’s inventory based on a newsvendor
type model, which is the underlying model in most supply chain coordination anal-
yses. The following are examples of the most relevant studies from the supply chain
coordination literature.
Taylor [59] evaluates channel rebates considering retailers’ sales effort. In a linear
rebate contract, the manufacturer pays the retailer for each unit sold to the consumer.

138
In a target rebate contract, the payment occurs only if the retail sales exceed a
certain threshold. When demand is not influenced by sales effort, only a target
rebate can achieve coordination that is implementable. However, in the more realistic
scenario where demand is an outcome of sales effort, a target rebate contract needs
to be coupled with a return contract for coordination. Further, the authors show
that provision of returns strengthens incentives for sales effort, contrary to the view
expressed in the literature.
Bandyopadhyay and Paul [3] explain full return policies practiced in industry,
citing examples from the direct-store-delivery channel. They model the environment
where two capacity-constrained manufacturers compete for the shelf space at the same
retailer and show that a complete-credit returns policy is the only equilibrium of the
game. This finding is in contrast to Pasternack’s [51] analysis, a seminal study in
the field, suggesting that only less than full-credit returns can coordinate the supply
chain.
Vendor managed inventory The context of this research is direct-store-delivery
(DSD) operations. Essentially, DSD is a type of vendor managed inventory (VMI)
business model. In industry, the term VMI is typically used for the traditional channel
where the manufacturer manages the inventory of retailers’ distribution centers. With
VMI, inventory levels at retailers’ distribution centers are usually communicated to
the manufacturer via an electronic data interchange; accordingly, the manufacturer
generates replenishment orders for the distribution center.
The existing literature focuses on different aspects of VMI. Cetinkaya and Lee
[7] present an analytical model for jointly coordinating inventory and transportation
decisions in VMI systems. Mishra and Raghunathan [46] focus on the brand com-
petition aspect and suggests that VMI is beneficial for the retailer since it promotes
competition and, as a result, better in-stock performance. Bernstein et al.[5] focus
on the role of VMI partnerships on supply chain coordination under simple wholesale

139
pricing schemes. Research that specifically focuses on DSD operations is scarce. One
example is the study of Chen et al. [10] analyzing the switching of Gatorade from
the traditional distribution channel to the DSD channel belonging to Pepsi. The
study determines the circumstances in which it is cost effective for Pepsi to switch
the distribution of Gatorade from the traditional channel to the DSD channel.
In summary, the sales-force compensation problem has been studied in the lit-
erature, but not from the perspective of product waste and in the context of DSD
operations. Sales operations in the DSD environment are unique, because the man-
ufacturer’s sales representative manages the store inventory, and thus sales effort
impacts inventory levels. This study builds on marketing and operations literature
analyzing the salesforce compensation problem for perishable products in DSD oper-
ations.

4.3. Model

In our model, we consider a direct-store-delivery manufacturer selling one product to


one retail store. The manufacturer employs a sales representative who creates replen-
ishment orders for the store. Typically, the store manager, employed by the retailer,
is not involved with the sales representative’s basic ordering decisions; however, it is
common to get the store manager’s consent for additional inventory placement such as
in-store displays or expansion of shelf space. If the store is large (i.e., supermarket),
the delivery is made in bulk at the store’s backroom. In this case, the sales rep-
resentative is responsible for unwrapping the pallet(s) in the backroom and moving
the inventory from the backroom to the shelf. If the store is small (i.e., convenience
store), the sales representative’s job requires less effort and is limited to visiting the
store to generate the order (the driver moves the inventory from the truck directly to
the shelf at the time of delivery).

140
We assume a newsvendor type single-period inventory model. Although the prod-
ucts we study in this thesis have multiple periods of shelf life, it is appropriate to
assume a single-period model in our analysis because the problem of interest in this
research is to analyze compensation schemes with respect to over-ordering behavior.
For this purpose, the single-period model simplifies our analysis while capturing the
effect of excess inventory on expiration.
The events occur according to the sequence shown in Figure 4-1.

Stage 1 Stage 2

Manufacturer decides on a Sales representative decides on an Consumer demand is realized.


compensation scheme. effort level determining the order Excess inventory expires and is
quantity. returned to the manufacturer.

Figure 4-1: Sequence of events.

At the first stage, the manufacturer selects a compensation scheme, which we de-
note by 𝑠. At the second stage, with the knowledge of the compensation scheme, the
sales representative selects an effort level, denoted by 𝑒. The effort represents the
activities to place inventory at the store (e.g., create order, replenish the shelf from
backroom inventory, build displays, acquire additional shelf space). The sales repre-
sentative’s effort determines the order quantity, 𝑄(𝑒), which is concave and increasing
in 𝑒, as shown in Figure 4-2. We assume a concave relationship since each incremental
activity to increase inventory at the store requires more effort. For example, the sales
representative first replenishes the depleted inventory on the shelf. Additional inven-
tory placement, through building displays or acquiring more shelf space, increasingly
gets harder since typically the store manager is involved in these decisions. Also, the
shelf space is limited at the store, and thus we expect the order quantity eventually
to reach a limiting value.

141
Q(e) C(e)

e e

Figure 4-2: Assumed functions of order quantity, 𝑄(𝑒), and effort cost, 𝐶(𝑒).

Furthermore, we assume that the manufacturer’s distribution center is fully stocked;


thus, the shipment quantity is equal to the order quantity. After the delivery is made,
consumer demand, 𝐷, is observed. At the end of one period, excess inventory expires,
[𝑄(𝑒) − 𝐷]+ , and is returned to the manufacturer. Effort has a cost for the sales rep-
resentative, which is denoted by 𝐶(𝑒). The cost of effort represents the value of time
spent for the effort. 𝐶(𝑒) is linear and increasing in 𝑒, as shown in Figure 4-2.
Let 𝑝 denote the unit gross profit from sales (= wholesale price - cost of production
and distribution) and 𝑐 denote the unit cost of expiration (= wholesale price + cost
of reverse logistics) for the manufacturer. Thus, 𝑐 > 𝑝. The profit function of the
sales representative and the manufacturer are denoted by Π𝑆𝑅 and Π𝑀 , respectively.
For a given compensation scheme, the sales representative’s second stage problem is
as follows.
max Π𝑆𝑅 (𝑒) = [𝑐𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑜𝑛(𝑠) − 𝐶(𝑒)] (4.1)
𝑒

Then, the manufacturer’s first stage problem is the following.

max Π𝑀 (𝑠) = 𝑄(𝑒* )𝑝 − 𝐸𝐷 [𝑄(𝑒* ) − 𝐷]+ 𝑐 − 𝑐𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑜𝑛(𝑠)


𝑠
(4.2)
*
subject to 𝑒 (𝑠) ∈ arg max𝑒 Π𝑆𝑅 (𝑒) = [𝑐𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑜𝑛(𝑠) − 𝐶(𝑒)]

We analyze four compensation schemes: 1) the gross-sales-based commission, 2)


the net-sales-based commission, 3) the profit-sharing compensation, and 4) an al-
ternative scheme designed by us. These schemes are denoted by 𝑔𝑠, 𝑛𝑠, 𝑝, and 𝑎,
respectively. In addition, the commission percentages for these schemes are repre-

142
sented by 𝑟𝑔𝑠 , 𝑟𝑛𝑠 , 𝑟𝑝 , and 𝑟𝑎 . For the manufacturer and the sales representative to
participate, we assume that 0 < 𝑟𝑠 < 1 for all 𝑠. The alternative scheme involves two
parameters: the commission rate, 𝑟𝑎 , and the penalty fee that the sales representative
is charged for a unit of expiration, denoted by 𝑥. The following equations show the
compensation for the four schemes we analyze.

𝑐𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑜𝑛(𝑔𝑠) = [𝑄(𝑒)𝑝]𝑟𝑔𝑠

𝑐𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑜𝑛(𝑛𝑠) = [𝑄(𝑒)𝑝 − 𝐸𝐷 [𝑄(𝑒) − 𝐷]+ 𝑝]𝑟𝑛𝑠


(4.3)
+
𝑐𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑜𝑛(𝑝) = [𝑄(𝑒)𝑝 − 𝐸𝐷 [𝑄(𝑒) − 𝐷] 𝑐]𝑟𝑝

𝑐𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑜𝑛(𝑎) = [𝑄(𝑒)𝑝 − 𝐸𝐷 [𝑄(𝑒) − 𝐷]+ 𝑥]𝑟𝑎

Therefore, the gross-sales-based commission, net-sales-based commission, and profit-


sharing compensation schemes are special cases of the alternative scheme. This is
because 𝑥 takes the values of 0, 𝑝, and 𝑐 for the schemes 𝑔𝑠, 𝑛𝑠, and 𝑝, respectively.
Earlier we describe 𝑔𝑠 and 𝑛𝑠 as schemes rewarding a fixed monetary reward for a
unit of sales (= 𝑝𝑟𝑛𝑠 ). According to our model in (4.3), 𝑔𝑠 and 𝑛𝑠 can also be thought
of as gross-profit sharing schemes. Lastly, it is important to note that with scheme
𝑎, only a portion (= 𝑟𝑎 ) of 𝑥 penalizes the sales representative for expiration.

4.4. Analysis

As a benchmark, we consider the scenario in which the manufacturer can observe


the sales representative’s effort and pays the sales representative a fixed monetary
award to compensate for his/her effort. We refer to the manufacturer’s problem in
this scenario as the global optimization problem, denoted by 𝐺, which is shown by
the following formulation.

max Π𝐺 (𝑒) = 𝑄(𝑒)𝑝 − 𝐸𝐷 [𝑄(𝑒) − 𝐷]+ 𝑐 − 𝐶(𝑒) (4.4)


𝑒

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In this problem, the manufacturer selects an effort level that maximizes its profits.
Alternatively, we can think of the global optimization scenario as the manufacturer
performing inventory placement at the retailer, without hiring a sales representative
for the job (i.e. the manufacturer and the sales representative are the same entity).
Hiring can produce inefficient outcomes since the manufacturer cannot observe the
sales representative’s behavior and, as a result, the sales representative can over-order
knowing that he/she is not fully accountable for the cost of expiration, deviating from
the manufacturer’s interest. This situation is referred to as moral hazard.
A compensation scheme that produces the same effort level as the global optimiza-
tion aligns the incentives of the manufacturer and the sales representative, eliminating
moral hazard, and helps the manufacturer realize the full profit potential. Therefore,
in our analysis, we look at the first-order conditions of the global optimization prob-
lem and the sales representative’s profit maximization problem.

Theorem Let 𝑟𝑎* and 𝑥* denote the pair of the commission rate and penalty fee
that achieves the optimum effort level of the global optimization problem and 𝐹 (.)
denote the cumulative distribution function of demand. The relationship between 𝑟𝑎*
and 𝑥* is determined by

𝑝 − 𝐹 (𝑄(𝑒* ))𝑐
𝑟𝑎* =
𝑝 − 𝐹 (𝑄(𝑒* ))𝑥* (4.5)
* +
𝑒 ∈ arg max𝑒 𝑄(𝑒)𝑝 − 𝐸𝐷 [𝑄(𝑒) − 𝐷] 𝑐 − 𝐶(𝑒)

Proof: To find the optimum effort level in (4.4), we differentiate Π𝐺 (𝑒) with re-
spect to 𝑒 and set this amount equal to 0. This gives

𝑑𝑄(𝑒) 𝑑𝐸𝐷 [𝑄(𝑒) − 𝐷]+ 𝑑𝐶(𝑒)


𝑝− 𝑐− =0 (4.6)
𝑑𝑒 𝑑𝑒 𝑑𝑒

144
Based on the Leibniz rule

𝑑𝐸𝐷 [𝑄(𝑒) − 𝐷]+ 𝑑 (︁ 𝑄(𝑒)


∫︁ )︁
= [𝑄(𝑒) − 𝐷)]𝑓 (𝐷)𝑑𝐷
𝑑𝑒 𝑑𝑒 0
∫︁ 𝑄(𝑒)
𝑑𝑄(𝑒) 𝑑𝑄(𝑒) (︀ )︀
= 𝑓 (𝐷)𝑑𝐷 + (𝑄(𝑒) − 𝑄(𝑒) 𝑓 (𝑄(𝑒)) − 0
0 𝑑𝑒 𝑑𝑒
𝑑𝑄(𝑒)
= 𝐹 (𝑄(𝑒)) (4.7)
𝑑𝑒

From (4.6) and (4.7), we find

𝑑𝑄(𝑒) 𝑑𝐶(𝑒)
[𝑝 − 𝐹 (𝑄(𝑒))𝑐] − =0 (4.8)
𝑑𝑒 𝑑𝑒

Next, we consider the two-stage problem of the manufacturer and the sales repre-
sentative under the alternative compensation scheme. To obtain the optimum effort
𝑑Π𝑆𝑅 (𝑒)
level for the sales representative in the two-stage problem, we solve for =0
𝑑𝑒
and get
𝑑𝑄(𝑒) 𝑑𝐶(𝑒)
[𝑝𝑟𝑎 − 𝐹 (𝑄(𝑒))𝑥𝑟𝑎 ] − =0 (4.9)
𝑑𝑒 𝑑𝑒

Jointly solving (4.8) and (4.9), we obtain

𝑝 − 𝐹 (𝑄(𝑒* ))𝑐
𝑟𝑎* =
𝑝 − 𝐹 (𝑄(𝑒* ))𝑥*

This completes the proof.


Different values of 𝑟𝑎* and 𝑥* result in the manufacturer achieving the full profit
potential. Then, the alternative compensation scheme is said to be a coordinating
mechanism; also 𝑟𝑎* and 𝑥* are called the coordinating commission rate and penalty
fee.
The following graph shows a numerical application of the coordinating scheme.

145
!$60.00!!
Global optimization
Sales representative
!$40.00!!
Manufacturer

!$20.00!!
Profit

!$*!!!!
0.05! 0.15! 0.25! 0.35! 0.45! 0.55! 0.65! 0.75! 0.85! 0.95!
Effort level
!$(20.00)!

!$(40.00)!

!$(60.00)!

Figure 4-3: Global optimization versus two-stage problem. In the example, 𝑝 = 1,


𝑐 = 4, 𝑥 = 2, and 𝑟𝑎 = 0.45.

The x-axis in Figure 4-3 represents the effort level while the y-axis represents
the profit. The blue line on the top represents the profit for global optimization,
formulated in (4.4). The green and red lines show the profits for the manufacturer and
the sales representative, represented with models (4.2) and (4.1), with the alternative
scheme (𝑠 = 𝑎). In the graph, the maximum profit for all three lines intersect at the
same effort level, which indicates that coordination is achieved and the incentives of
the manufacturer and the sales representative are aligned. A coordinating mechanism
eliminates the inefficiency occurring due to moral hazard1 . Therefore, here, the sum
of the profits for the manufacturer and the sales representative is equal to the profit
achieved with global optimization (Π𝐺 = Π𝑀 + Π𝑆𝑅 ).

1
Moral hazard can occur when sales representatives place too much inventory at retail stores
knowing that they will not be fully accountable for the cost of product expiration.

146
The implications of this theorem are as follows.

Proposition 1 When the cost of expiration is low relative to the gross margin or the
cost of effort is high (𝑝 − 𝐹 (𝑄(𝑒* ))𝑐 > 0), in order to realize the full profit potential,
the manufacturer should charge the sales representative a lower penalty fee than the
cost of expiration (𝑥* < 𝑐).

Proof: Based on (4.5), 𝑥* < 𝑐 must be the case for 𝑝 − 𝐹 (𝑄(𝑒* ))𝑐 > 0 since
0 < 𝑟𝑎* < 1, which completes the proof.
We observe 𝑝 − 𝐹 (𝑄(𝑒* ))𝑐 > 0 in two situations: 1) the expiration cost is low
relative to the gross margin, or 2) the cost of effort is high, which leads to lower
optimum effort and thus lower 𝑄(𝑒* ) and 𝐹 (𝑄(𝑒* )).
The cost of effort varies across different stores, channels, or regions. It is higher at
supermarkets than at gas stations since the sales representative’s job involves stocking
the shelves and building displays at large stores (e.g., supermarkets, supercenters).
Also, it is higher at chain stores since corporate standards may restrict a sales rep-
resentative’s inventory decisions. For example, convincing the store owner to build a
permanent display at an individually owned convenience store is usually easier since,
knowing that the store takes no risk associated with excess inventory (due to full-credit
returns), store owners typically welcome display requests. In contrast, at a corporate
chain store, the store manager can resist a display request due to centrally-planned
planograms. The cost of effort is also higher at competitor-dominated markets since
retailers usually favor popular brands in shelf space allocation or when granting end-
caps and displays.
Moreover, when 𝑝 − 𝐹 (𝑄(𝑒* ))𝑐 > 0, there is a codirectional relationship between
𝑟𝑎* and 𝑥* because the derivative of 𝑟𝑎* with respect to 𝑥 is positive.

𝑑𝑟𝑎* (𝑥) 𝐹 (𝑄(𝑒* ))[𝑝 − 𝐹 (𝑄(𝑒* ))𝑐]


= >0 (4.10)
𝑑𝑥 [𝑝 − 𝐹 (𝑄(𝑒* ))𝑥]2

147
The following figure shows a numerical example of the relationship between the
coordinating commission rate and penalty fee when 𝑝 − 𝐹 (𝑄(𝑒* ))𝑐 > 0.

1"
0.8"
0.6"

r_a*%
0.4"
0.2"
0"
0" 0.5" 1" 1.5" 2"
x*%

Figure 4-4: Relationship between coordinating commission rate and penalty fee for
𝑝 − 𝐹 (𝑄(𝑒* ))𝑐 > 0. In the example, 𝑝 = 1 and 𝑐 = 2.

We interpret this relationship as follows. When we deviate from the coordinating


penalty fee by charging a higher fee, the commission rate needs to be increased as
well to prevent the sales representative from reducing his/her effort level.

Proposition 2 When the cost of expiration is high relative to the gross margin or the
cost of effort is low (𝑝 − 𝐹 (𝑄(𝑒* ))𝑐 < 0), in order to realize the full profit potential,
the manufacturer should charge the sales representative a higher penalty fee than the
cost of expiration (𝑥* > 𝑐).

Proof: 𝑥* > 𝑐 needs to be true for 𝑝 − 𝐹 (𝑄(𝑒* ))𝑐 < 0, since 0 < 𝑟𝑎* < 1.
Proposition 2 states the exact opposite of Proposition 1. We see 𝑝−𝐹 (𝑄(𝑒* ))𝑐 < 0
occurring when 1) the expiration cost is high relative to the gross margin, or 2) the
cost of effort is low, which leads to higher optimum effort and thus higher 𝑄(𝑒) and
𝐹 (𝑄(𝑒)).
Here, the derivative of 𝑟𝑎* with respect to 𝑥 is negative thus 𝑟𝑎* decreases with 𝑥* .

𝑑𝑟𝑎 (𝑥) 𝐹 (𝑄(𝑒* ))[𝑝 − 𝐹 (𝑄(𝑒* ))𝑐]


= <0 (4.11)
𝑑𝑥 [𝑝 − 𝐹 (𝑄(𝑒* ))𝑥]2

148
Figure 4-5 shows a numerical example of the relationship between 𝑟𝑎* and 𝑥* for
𝑝 − 𝐹 (𝑄(𝑒* ))𝑐 < 0.

1$

0.8$

r_a*%
0.6$

0.4$
10$ 10.5$ 11$ 11.5$ 12$
x*%

Figure 4-5: Relationship between optimum commission rate and penalty fee when
𝑝 − 𝐹 (𝑄(𝑒* ))𝑐 < 0. In the example, 𝑝 = 1 and 𝑐 = 10.

The contradirectional relationship between 𝑟𝑎* and 𝑥* seems counterintuitive. In


this scenario, not only are we penalizing the sales representative for expiration more
than what expiration costs for the firm (𝑥* > 𝑐), but also we further increase the
penalty fee if we decrease the coordinating commission rate. Intuitively, the sales
representative compensates for the high penalty fee by selling more through in-
creasing the effort. Then, the manufacturer can afford to offer a lower commission
rate. The sales representative does not respond the same way in the reverse scenario
(𝑝 − 𝐹 (𝑄(𝑒* ))𝑐 > 0) in which expiration is inexpensive for the sales representative.

Proposition 3 Effective penalty charge is less than the unit cost of expiration, 𝑐 >
𝑥* 𝑟𝑎* . Further, the weighted average of the penalty fee and gross profit is less than or
equal to the cost of expiration, 𝑝(1 − 𝑟𝑎* ) + 𝑥* 𝑟𝑎* ≤ 𝑐.
𝑝 − 𝑝𝑟𝑎*
Proof: Re-arranging the terms in (4.5), we derive 𝐹 (𝑄(𝑒*)) = . Since 0 ≤
𝑐 − 𝑥* 𝑟𝑎*
𝑝 − 𝑝𝑟𝑎*
𝐹 (𝑄(𝑒*)) ≤ 1, then 0 ≤ * *
≤ 1. Accordingly, 𝑐 > 𝑥* 𝑟𝑎* and 𝑝(1−𝑟𝑎* )+𝑥* 𝑟𝑎* ≤ 𝑐,
𝑐 − 𝑥 𝑟𝑎
which completes the proof.
𝑐 − 𝑥* 𝑟𝑎* > 0 also suggests that the sales representative is fully charged for the cost
of expiration for a portion of the expired items. Imagine 100 units expire, costing

149
the manufacturer 100𝑐. Sales representative is charged for the cost of expiration for
less than 100 units, suppose 80 units. Then, the manufacturer deducts 80𝑐 from
compensation, while sharing the gross profit with the sales representative (= 𝑄𝑝𝑟𝑎 ).

Proposition 4 The profit sharing compensation scheme is not coordinating.

Proof: Based on (4.3), profit sharing scheme is a special case of the alternative
compensation scheme in which 𝑥 = 𝑐. Then, according to (4.5), the commission rate
needs to be 1, an infeasible value for the commission rate.
Intuitively, the sales representative exerts suboptimal effort under the profit shar-
ing compensation scheme since he/she is paid only a portion of the profits while
incurring an effort cost.

Proposition 5 The gross sales based commission and net sales based commission
schemes can be coordinating only when 𝑝 − 𝐹 (𝑄(𝑒* ))𝑐 > 0.

Proof: According to (4.3), both the gross-sales-based commission and the net-
sales-based commission schemes are special cases of the alternative compensation
scheme where 𝑥 = 0 and 𝑥 = 𝑝, respectively.
* 𝑝 − 𝐹 (𝑄(𝑒*))𝑐
Based on (4.5), coordinating commission rates are determined by 𝑟𝑔𝑠 =
𝑝
* 𝑝 − 𝐹 (𝑄(𝑒* ))𝑐
and 𝑟𝑛𝑠 = . Then, under coordinating schemes, the firm needs to pay
𝑝 − 𝐹 (𝑄(𝑒* ))𝑝
a higher commission rate to the sales representative with the net-sales-based commis-
* *
sion (𝑟𝑔𝑠 < 𝑟𝑛𝑠 ).
Sales-based commission schemes can only be coordinating when 𝑝 − 𝐹 (𝑄(𝑒* ))𝑤 >
0, since:
1) If 𝑝 = 𝐹 (𝑄(𝑒* ))𝑐, then 𝑟𝑔𝑟 = 0 and 𝑟𝑛𝑟 = 0 (not feasible).
2) If 𝑝 − 𝐹 (𝑄(𝑒* ))𝑐 < 0, then 𝑟𝑔𝑠 < 0 and 𝑟𝑛𝑠 < 0 (not feasible).

In summary, there exists a compensation scheme that aligns the incentives of the
manufacturer and the sales person preventing overselling while achieving full profit

150
potential for the manufacturer. Under the coordinating scheme, the sales person is
charged with a penalty fee which varies depending on product cost and market char-
acteristics. Moreover, sales-volume based compensation scheme and profit-sharing
scheme are special cases of the coordinating scheme. Profit-sharing scheme is never
coordinating; sales-volume based compensation scheme can be coordinating under
certain circumstances.

4.5. Conclusion and future research

The industry acknowledges the existence of over-selling and its impact on product
expiration yet no specific strategy has been prescribed to alleviate the problem. In
this research, we study sales-force compensation schemes from the perspective of
product waste. We build a theoretical model representing the decision process of the
manufacturer and the salesperson based on the principal-agent framework. Through
the model, we evaluate several compensation schemes. These schemes are the sales-
volume-based commission scheme, profit-sharing scheme and an alternative scheme
we design for this study. The alternative scheme consists of two parameters: the
commission rate and the penalty fee that is imposed on the sales representative for
each expired item. We find that the alternative scheme can align the incentives of
the manufacturer and the sales representative when the commission rate depends on
the penalty fee through a closed-form relationship. We find that the profit-sharing
scheme is never coordinating and sales-volume-based compensation can be coordi-
nating in some situations, which are unexpected findings. Earlier we expected the
reverse coordination outcome since the sales representative’s and the manufacturer’s
earnings are based on the same performance measure under the profit-sharing scheme,
unlike sales-volume-based compensation. Finally, we derive the following strategy for
practitioners. When the cost of expiration is low (high) relative to the gross margin

151
of the product or when the cost of effort is high (low) as in competitor dominated
markets or corporate chain stores, the penalty fee should be lower (higher) than the
product’s expiration cost.
Our model assumes that the demand and order quantity are independent, which
is a limitation in our analysis since the general belief in the industry is that inventory
drives sales. Academic research supports this belief [18]. In the more realistic situation
where demand is an increasing function of inventory, we expect the optimum effort
level to be higher in the manufacturer’s problem than in the scenario with the current
model assumptions. Optimum effort level would be higher since expiration would be
lower if demand increases with order quantity. Nevertheless, our finding regarding
the two strategies for the penalty fee (that the penalty fee should be high when the
cost of expiration is high or effort cost is low; it should be low in the reverse scenario)
might still hold true. In a future study, we intend to extend our analysis considering
the dependency of demand on order quantity.
In addition, two future empirical studies can complement our research. The first
study can examine how sales representatives make inventory decisions in practice.
Our analysis (as well as many academic studies in similar settings) is based on the
assumption that the sales representative chooses an optimum effort level considering
the trade-off between earnings and effort cost. We do not know whether this as-
sumption is true. According to a manager at our collaborator, some salespeople even
consider the product’s weight (thus the required physical effort to process inventory)
relative to the commission per case of shipment. Accordingly, these salespeople will
not promote heavy products which do not generate sufficient income while taking
higher risk with products with high commission amount. Our preliminary analysis
supports this belief. During our interviews at AlphaCo, we found out that the state of
California is an exception in the country practicing a commission-only compensation
plan (required by labor unions) while the rest of the U.S. practices a base salary plus

152
commission scheme. Accordingly, a sales representative in California earns more per
unit of shipment than in other states. Using a binary indicator for California and con-
trolling for shelf life, case size, and store types (e.g., supermarket, convenience store,
drug store, etc.), we performed a regression analysis predicting the amount of expira-
tion, similar to the analysis presented in Chapter 2. We find that the probability of
expiration is higher in California, which could be explained by over-ordering due to
the higher commission rate. This analysis is high level (based on a binary indicator
for one geography) and thus is limited. A comprehensive study, using historical order,
commission, and product characteristic data (e.g., weight per case, packaging type),
is needed to understand whether salespeople favor items that require little effort and
generate high earnings. Such a study will be valuable for practitioners as well as
academics doing theoretical research.
The second study can test the theory this thesis generates. Our theory suggests
that we can reduce expiration, while maintaining profit, through a compensation
scheme that penalizes the sales representative for expiration with a penalty fee varying
depending on product cost and market characteristics. An experimental study can
examine whether the compensation scheme we offer with this research is effective at
reducing expiration.

153
154
Chapter 5

Concluding Remarks

This thesis studies the unsaleables (i.e., damaged, expired, and discontinued products)
problem of consumer packaged goods (CPG) in retail supply chains. Unsaleables is
an important problem for the CPG industry due to their substantial financial and
environmental implications. At our collaborator, a food and beverage manufacturer,
the cost of product waste is equivalent to 50% of the firm’s annual profits. Financial
significance of waste is not unique at our collaborator. The annual cost of unsaleables
is $15 billion for the CPG industry, which constitutes 1-2% of gross retail sales [30].
Industry leaders tells us that annual waste cost can be even higher than the net profit.
The reimbursement provided by manufacturers alleviates this impact; as a result, the
cost of waste affects both manufactures’ and retailers’ profits alike.
Financial impact of product waste affects firms’ bottom-lines, and thus their share-
holders’ income. However, the environmental impact of waste affects all of us as a
society. Indeed, 17% of the industry’s waste is disposed at landfills creating a sig-
nificant burden for the environment [30]. Let us consider our collaborator. The
warehouse manager we interviewed revealed that one full truckload of waste is picked
up at his facility every week to be disposed at landfills. This firm has approximately
350 warehouses in North America. If other warehouses were to follow the same dis-

155
posal method (landfills as opposed to, for example, donation at food banks), roughly
350x52=18,200 trailers of waste may be dumped at landfills every year. This estimate
is for only one company. The overall volume of waste disposed at landfills by CPG
companies must be massive.
Given how much unsaleables impact firms’ profits, it is surprising that industry
has not progressed much on this problem. For example, firms still struggle with col-
lecting unsaleables data since product handling in reverse logistics is very expensive.
There has been more progress on damage and discontinuation types of unsaleables
since audits and improvements in business processes have been effective at identifying
the root causes with these types and accordingly addressing the problems. However,
product expiration category remains relatively untouched since expiration is complex
spanning multiple functions (e.g., manufacturing, warehousing, sales and procure-
ment, store operations). Our collaborator conducted an audit study to identify the
root causes of product waste. Product damage was successfully sorted (e.g., nails
on the pallet, insufficient glue, etc.) but audits revealed only one insight regarding
product expiration which is whether the product on the shelf was rotated. Contrary
to the general belief, they found that in majority of cases where an expired product
is found, the shelf was actually rotated. Regardless, because the other root causes
were not understood, the action taken as a result of this study focused on rotation
(packages are color coded in production; the color changes every month to make it
easier to spot the older products). Overall, the expiration category of unsaleables has
been growing over the years while the damage and discontinuation categories decline.
Consequently, we focus on product expiration in this thesis.
We start our research with a descriptive study on the root causes of product
expiration; this study is presented in Chapter 2. We compile a list of hypothesized root
causes of product expiration based on interviews and site visits at our collaborator,
industry reports, unsaleables conference, and our supply chain knowledge. These

156
root causes are product case sizes, aging of inventory in the manufacturer’s supply
chain, negligence of inventory rotation on the retail shelf, rules on minimum order
sizes, sales incentive programs, and forecasting complexity. Using our collaborator’s
archival data (e.g., shipments, returns, inventory counts, shelf life, case size, etc.)
and an econometric model, we estimate the relative impact of different root causes on
product expiration. Our main finding is that the best opportunity to reduce expired
product volume lies in case sizes reduction. This is a surprising finding given that
no interviewee at our collaborator mentioned the product case size as one of the root
causes of product expiration. At the same time, it is not surprising if we consider
that (according to an industry study) most items at grocery stores are slow moving
products (more than half of products sell less than one unit per week) [63]. At our
collaborator, approximately, 80% of the orders are single case orders. Then, we expect
that reduction in case size (e.g., from 24 units to 12 units) reduces the expired volume.
According to our analysis, the next best areas of opportunity to reduce expiration
are sales incentives and inventory aging in the supply chain. Unfortunately, there is
no straightforward remedy for these challenges as there is with case sizes. Therefore,
we devote the remainder of the thesis for the analysis of these two areas. Chapter 3
is concerned with inventory aging in the manufacturer’s supply chain. Chapter 4 is
on the subject of sales incentives.
In Chapter 3, we evaluate the manufacturer’s sell-or-dispose decision for aged in-
ventory. Some manufacturers practice shipment rules for old inventory such that the
product that has a remaining shelf life below a certain level is not released for sale
to the retailer and is disposed directly at the manufacturer’s distribution center. The
problem with existing rules is that they are arbitrarily set up and do not consider
relevant factors such as the demand rate and product costs. We develop an analytical
model to set up optimum inventory aging targets based on the demand rate, cost of
expiration, shelf life, and gross margin of products. Using our collaborator’s data,

157
we find that the optimum target largely varies across products in accordance with
cost parameters and demand. This variation is in contrast with existing rules which
are uniform across products. Further, we find that optimization generates substan-
tial savings since sell-or-dispose decisions are based on cost implications under the
optimization model. Ultimately, if the manager is held accountable for the cost of
unsold and disposed products, shipment rules can help reduce product expiration by
providing an incentive for supply chain managers to improve inventory freshness (e.g.,
through better management of batch sizes, more accurate forecasts, etc.).
In Chapter 4, we examine sales-force compensation schemes from the perspec-
tive of product expiration caused by over-ordering. Based on the principal-agent
framework, we develop a mathematical model of the decision making process of the
manufacturer and the sales person. Our model is directly applicable to the direct-
store-delivery sales and distribution model, in which manufacturers’ sales-force de-
termine store inventory levels. We design a sales-force compensation plan that aligns
the incentives of the manufacturer and the sales person. This plan holds sales people
accountable for the cost of expiration through a penalty fee to encourage them to
order just enough, achieving full profit potential for the manufacturer. This penalty
fee depends on the product cost and market characteristics. Our analysis suggests,
contrary to prior belief, that a profit-sharing payment scheme does not align the in-
centives of the manufacturer and the sales representative. We also find that, again in
contrast with prior belief, sales-volume based compensation plan (a commonly prac-
ticed scheme in industry) can align the incentives of the manufacturer and the sales
person.
The tools that inform these studies (econometrics, optimization, machine learning)
make this a methodologically diverse thesis that contributes to supply chain theory
and practice. Further, with this thesis, we introduce new problems to the operations
literature. To the best of our knowledge, the unsaleables problem was not stud-

158
ied before by the operations management research community; our descriptive study
on the relative impact of expiration drivers is first in literature studying perishable
inventory from a holistic perspective (analyze the impact of different organizational
functions such as sales, product design, production, warehousing, and store operations
on product expiration). Our descriptive study also exposes a number of prescriptive
research areas from case size optimization to production/transportation batching op-
timization. Similarly, the second research in this thesis is first in literature studying
shipment rules in a two-tier supply chain for perishable products. Lastly, our third
study on sales-force compensation plans is novel, applying the principal-agent frame-
work to a direct-store-delivery setting in which manufacturers’ sales people determine
store inventory levels via sales effort.
The three studies in this thesis are motivated by industry challenges. Our findings
can be directly applied as strategies to reduce the amount of product expiration.

Recommendations for practitioners


Based on our overall understanding of unsaleables and our findings in this thesis,
we recommend the following processes and actions to practitioners:
1. Sort unsaleables into four categories as damaged, expired, retailer discon-
tinued and manufacturer discontinued products.
Sorting is expensive, but if done efficiently, is very beneficial. To make the process
efficient, for example, unsaleables could be collected in four different containers (each
labeled with the type) in the back room. Scanning and sorting processes and systems
can be co-designed to collect data efficiently. Since each unsaleables type occurs due
to different dynamics, sorting is a first step in identifying the root cause.
Existing conflict in the industry regarding unsaleables policies seems to occur since
the root cause by an instance of unsaleables is unknown. If it was known, the respon-
sible party could compensate for the cost. Therefore, sorting (as the first step to iden-

159
tify root causes) can form the basis for unsaleables policies. Unsaleables policies
can be established separately for four types of unsaleables. It is reasonable
to expect that the retailer absorbs the cost for retailer-discontinued products, and
likewise, the manufacturer absorbs the cost for manufacturer-discontinued products.
Regarding the damage type, if damage is observed for the same product consistently,
it most likely occurs due to a packaging failure as opposed to mishandling. Thus,
damage can be further categorized as "packaging issue" versus "mishandling" during
the scanning process; these subcategories can be compensated by manufacturers and
retailers, respectively. Subcategorization of damage could eliminate or lessen the need
for expensive audits.
2. GMA and FMI allocate funds for a system that helps facilitate unsalebales
data sharing. We recommend that retailers continue to inform manufacturers on
the root causes of unsaleables regardless of the reimbursement policy.
3. Focus on case size management. Our research finds that large case sizes are
the largest contributor to the amount of expiration. To obtain a rough understanding
about this affect in a given supply chain, one can perform a simple data summary
such as a report showing the expiration percentage by case size (e.g., 2% for 24 unit
cases, 1.7% for 12 unit cases, 1.5% for 6 unit cases).
One remedy to the case size problem is to reduce case sizes (e.g., from 24 units to
12 units). Another solution is to design modular cases that can be split, for example
in half, allowing for fractional ordering (e.g., 1/2 case order). We recommend that
retailers urge manufacturers to address the case size problem.
4. Establish rules for the remaining shelf life considering the product’s de-
mand rate. In this thesis, we developed an optimization model to determine the
minimum remaining shelf life of a product that is leaving the manufacturer’s supply
chain. Practitioners can directly replicate our approach. For practitioners who do
not have resources to undertake an optimization effort, based on the insight we gain

160
from our analysis, we recommend that the minimum required shelf life is established
in a fixed number of days or weeks, not in a percentage of the manufactured shelf life
(a common practice by retailers). This fixed number should depend on the product’s
demand rate with an inverse relationship (e.g., 3 weeks for a fast-moving item versus
7 weeks for a slow-moving item).
Some manufacturers have the capability to capture the remaining shelf life of
items as they move in their supply chain. Retailers can request this information
electronically, for example attached to the advanced shipping notice, for incoming
shipments. This information helps retailers to increase compliance to the minimum
required shelf life rules. In addition, retailers can use this information when negoti-
ating the unsaleables policies for expired products (e.g., the retailer can enforce the
full-reimbursement policy for a manufacturer that frequently sends old products).
5. FMI advocates for retailers to mandate manufacturers print barcodes
on the case of the product informing the product’s manufactured date. Current
manual process discourages retailers from capturing this important information. Some
manufacturers print this information on the single product (e.g., a bottle) as opposed
to the case; this makes it even more inefficient for retailers to capture the data.
6. Incorporate the unsaleables performance (on expired and discontinued prod-
ucts) in sales-force compensation schemes. Based on our analysis, manufacturers
at a minimum should deduct the expired and discontinued product volume from com-
pensation, in particular for products with a low to medium gross margin (the risk
from unsold inventory can be justified for high gross margin products). Our analysis
differentiates compensation strategies depending on the product’s gross margin and
market characteristics. Practitioners can follow our strategy, penalizing the sales-
force for expiration more for low margin products in competitor dominated markets
than for high margin products in markets with high brand penetration. For example,
under the sales-volume-based commission scheme, twice or three times of the expired

161
volume can be deducted from gross sales volume for low margin items and in markets
with high brand penetration.
7. Establish incentive systems to prevent expiration. Some retailers already
have effective incentive structures in place; see industry case studies in Table 1.1. For
example, a retailer established a system in which stores receive a standard credit for
unsaleables and are charged for what they return; also, stores that return excessive
levels are penalized while below average stores are rewarded. Manufacturers can sim-
ilarly incentivize supply chain managers (for example, using the remaining shelf life
as a metric) and sales-force, as we discussed earlier in recommendation 6.

Future work
Unsaleables is a complex and broad problem involving multiple organizational
functions and channel partners with conflicting objectives. In this thesis, we narrow
our focus to product expiration type of unsaleables and study problems in three areas:
root causes of product expiration, the remaining shelf life problem, and sales-force
incentives. There are still several more important issues that can benefit from future
academic research.
In our opinion, the most important issue is the incentive problems in the channel.
Unsaleables policies determine the terms of reimbursement provided by manufacturers
for the cost of unsaleables. Two main policies in practice favor either the manufacturer
or the retailer, depending on the balance of power. Typically, the benefited party
has little incentive to improve the practices that cause unsaleables. For instance,
either the manufacturer does not have an incentive to supply fresher products to the
retailer (e.g., when the policy provides a wholesale discount for future unsaleables) or
the retailer does not have an incentive to manage store inventory better (e.g., when
the policy provides full reimbursement). Future research can develop an unsaleables
policy that aligns the interests of manufacturers and retailers.

162
Similar incentive problems exist within a firm, manufacturer or retailer. Practices
leading to unsaleables span multiple functions (e.g., manufacturing, sales, warehous-
ing, logistics, procurement, store operations). In practice, either one function absorbs
the cost regardless of cause or no particular function is accountable for the cost of
unsaleables [64]. As a result of these misaligned incentives, we see behaviors such as
the sales force flooding the market with excess inventory or plant managers not hav-
ing any regard to waste implications when determining production batch sizes. These
behaviors can be altered by designing coordination mechanisms to reduce the occur-
rence of expiration. In this thesis, we address the incentive problem of the sales-force.
Similarly, unsaleables performance needs to be incorporated into the performance
metrics of other functions contributing to the problem.
Batching in manufacturing and transportation is another outstanding issue im-
pacting product expiration. Both in practice and in academia, batching problems
are solved independent of the impact of batching on product expiration in the down-
stream supply chain. Practitioners typically consider the handling cost and demand
in determining shipment sizes and consider the production-line productivity and de-
mand in production size decisions. To improve profitability for perishable products,
it is important to consider product expiration effects in batching decisions.
Another potential opportunity to reduce product expiration is shelf space op-
timization. The existing literature studies the shelf space allocation problem con-
sidering cross-correlation of demand and substitution effects disregarding expiration
outcomes. If excess shelf space is allocated to a slow-moving item or an item with
a short shelf life, then its effect on expiration should be included in the cost of shelf
space allocation. Shelf allocation can be optimized based on a multi-product model
considering profit, expiration cost, shelf life, and cross-correlation of demand. This
work is important for perishable products in retail operations since it incorporates an
important factor, shelf lives, to shelf space allocation decisions.

163
Furthermore, sustainable packaging practices are an important topic in unsaleables.
Sustainable packaging has implications both for product damage and expiration.
Manufacturers reduce plastic to decrease material cost and waste going to landfills,
but ironically reduced plastic makes products vulnerable to damage in the supply
chain increasing unsaleables. Also, biodegradable packages are believed to be pre-
ferred by consumers but reduce the shelf life of products increasing the probability of
expiration. Future research can investigate optimal package designs considering all
trade-offs involved in the supply chain.
Lately, retailers have been occupied with the problem of handling damaged prod-
ucts that are categorized as hazardous materials by law. Examples to these products
include batteries, bleach, paints, and pesticides. The environmental protection agency
requires that these items are collected at proper disposal facilities as opposed to be-
ing mixed with the rest of unsaleables which are collected at reclamation centers.
Recently, several retailers were fined significant amounts for mishandling hazardous
waste (e.g., Walmart paid $81.6 million in 2013, Target $22.5 million in 2011, Wal-
greens $16.6 million in 2012 [29]). This problem has been a substantial concern for
retailers. Thus, the industry is looking for efficient means to process these items in
reverse logistics.

164
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