Designing Supply Chain Backorder Contracts for Customer Retention

Stockout is an unfortunate event for businesses. While prior literature has focused on how to prevent stockouts from occurring, we study how supply chain firms can best react to them by converting a potential lost sale or customer into a retained backorder or customer when they do happen. In particular, we examine how an upstream supply chain firm may use an incentive contract with a downstream firm in an inventory system managed by either the downstream or upstream firm to retain customers in Business-to-Business markets. The upstream firm promises the downstream firm a certain level of compensation ex ante in exchange for efforts by the retailer to convert potential lost sales, due to stockouts, to backorders. The findings show that the inclusion of a backorder incentive contract may change firms’ decision patterns. Significant differences between who manages the inventory in terms of inventory levels, prices to induce retailer backorder efforts, supply chain profits, and their sensitivity to factors such as long-term customer value, are explored and discussed. A contingent effort cost is also considered and the results are presented.