Contracting for Inventory in a Distribution Channel with Random Demand and Substitute Products

Retailers often stock competing products from multiple manufacturers. When the retailer stocks out of a particular item, customers who prefer the item are likely, with some probability, to switch to a substitute product from another manufacturer at the same store. In such an event, a quot;lost salequot; for the manufacturer is not a quot;lost salequot; for the retailer; thus, the cost associated with a stockout is different for the manufacturer and the retailer and consequently their target fill rates are different. Such differences in stockout cost influence the optimal contract between the manufacturer and the retailer and also impose agency costs on the channel. Such contracts, in turn, determine equilibrium inventory levels and fill rates. We show that the manufacturer would prefer higher inventory levels than the retailer. We also explore three options available to the manufacturer to mitigate this problem. We offer branding, electronic data interchange, and vendor managed inventory as marketing, informational, and structural solutions that partially redress the basic asymmetry of objectives between the manufacturer and the retailer