Haas Research Intelligence
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Retailers may find relief in manufacturer incentives that help them better forecast demand, says UC business professor
The economic slump is forcing retailers to slash prices in order to unload inventory. However, retailers can forecast demand more accurately when manufacturers offer a variety of contract incentives upfront, according to Terry Taylor, associate professor at UC Berkeley's Haas School of Business.
"The current economy points to the importance or value of knowing
what the market will look like when you’ll actually plan to sell
the product," says Taylor. Taylor's research suggests
strategies for both manufacturers and retailers to optimize profit. First,
retailers should invest in forecasting to better predict demand. Second, manufacturers,
by offering a "menu" of purchasing agreements, can
encourage retailers to invest in forecasting demand.
In the working paper, "Incentives for Retailer Forecasting: Rebates
versus Returns," Taylor and co-author Wenqiang Xiao, assistant
professor, Stern School of Business, New York University, find that when a
retailer's
forecasting efforts are taken into account, contracts allowing retailers to
return orders are more effective than those involving rebate offers.
Taylor describes returns and rebates as "mirror images." Return
policies allow retailers to return unsold goods to the manufacturer for a pre-determined
credit. Rebates, on the other hand, pay the retailer a bonus every time
she sells a unit of merchandise. "A rebate compensates the retailer
for selling units, whereas returns essentially compensate the retailer for not selling
units," says Taylor.
"It's natural to think that rebates might be the better way
to go if a manufacturer is trying to encourage a retailer to invest in forecasting.
After all, a returns policy is basically an insurance policy, which means the
retailer doesn’t have to worry as much about what the actual demand will
end up being," says Taylor. However, the study finds placing orders
with a return policy is more effective for the supplier.
"The trick is to offer a menu of choices," says Taylor.
For example, a manufacturer gives the retailer the option to purchase either
at a high unit price coupled with a generous return credit or, the option to
buy at a low unit price coupled with a stingy return credit. Retailers who
have done their forecasting homework benefit from this "menu" because
they can choose the option that best fits with their sense of market demand.
Using pre-season testing to forecast demand can be expensive but Taylor emphasizes, "When
there is a downturn in the economy, there is less room for error."
The paper's conclusions are based on an analytical model that captures
the retailer's forecasting effort, contract selection, and ordering
decisions. The paper offers advice to retailers about how much time and resources
they should devote to forecasting demand given a certain set of contractual
terms. The value of having the better demand information depends on the terms
that are available to the retailer. Taylor says retailers can benefit by thinking
about the interaction between the terms of trade and their forecasting efforts.
Finally, the paper acknowledges that manufacturers might not always want to
encourage their retailers to invest in forecasting. "When a retailer
invests in forecasting, she obtains a strategic advantage over the manufacturer
through the private information she obtains, and this can end up hurting
the manufacturer," says Taylor. However, even when the manufacturer
wants to discourage forecasting efforts, the paper shows that offering returns
is more effective than offering rebates.
Taylor is a member of Haas' Operations and Information Technology Management
Group.
(December 19, 2008)
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