Supply Chain Coordination between Supplier and Retailer in a VMI

(Vendor-Managed Inventory) Relationship

Professor Bowon Kim and Chulsoon Park, KAIST Graduate School of Management, Seoul, Korea
ABSTRACT
We look into linked decision makings in a supply chain arrangement. Consider a VMI (vendor-managed
inventory) relationship, where the retailer decides the retail price while the vendor determines its capacity
commitment. Assuming its a supply chain arrangement, the retailer and the vendor need to coordinate their
decisions in order to maximize a total profit, combining the two participants profits together. Suppose the demand
follows a Bass diffusion model. Then, the vendor should take into account the demand pattern throughout the
product life cycle (PLC) when it decides its capacity commitment, which will affect its inventory management cost
during the PLC. Similarly, the retailer should change the retail price over the PLC so as to maximize the revenues
and at the same time to minimize the inventory cost. In this paper, we focus on the dynamic coordination of key
decision variables by the supply chain partners.
INTRODUCTION
Coordination is important to effective supply chain management (Kim 2000). In this paper, we explore
what specific decision variables the supply chain participants coordinate, and how these variables are dynamically
interacting with each other. We consider a specific form of SCM arrangement, i.e., VMI (vendor-managed
inventory) relationship. VMI is a supply chain arrangement, where coordination between vendor and retailer is an
essential part (Cachon and Fisher 1997, Dong and Xu 2002, Mishra and Raghunathan 2004). More specifically, in a
VMI relationship, the vendor or supplier is in charge of managing the inventory on its customers (e.g., retailers)
premise (Cetinkaya and Lee 2000, Kaipia, et al. 2002, Lee and Chu 2005).
In this paper, we study linked decision makings in a VMI (vendor-managed inventory) relationship, where
the retailer decides the retail price while the vendor determines its capacity commitment to that retailer (Hazra and
Mahadevan 2009, Serel, et al. 2001). Since it is a supply chain arrangement, the retailer and the vendor coordinate
their decisions in order to maximize a particular form of total profit, combining the two participants profits together.
The demand follows a Bass diffusion model, which the vendor should take into account throughout the product life
cycle (PLC) when it decides its capacity commitment: the capacity level will affect its inventory management cost.
Similarly, the retailer adjusts the retail price over the PLC so as to maximize profit. As the vendor and the retailer
coordinate with each other, they make decisions so as to maximize their combined revenues and minimize the
inventory costs as well as the understocking or shortage cost. We explore how all of these decisions are dynamically
interacted with each other and suggest how the managers should manage the dynamics to accomplish the optimal
outcomes.
LITERATURE AND THEORETICAL CONSTRUCTS
There are many benefits of VMI. First of all, based on highly integrated supply chain management
between the vendor and the retailer (Dong and Xu 2002), VMI can enhance efficiency in the supply chain by
economizing the inventory. Cachon and Fisher (1997) developed simple inventory management rules to operate CR
(continuous replenishment) and tested those rules, using simulation with actual demand data provided by Campbell
Soup: they found that retailer inventories were reduced on average by 66% while maintaining or increasing average
fill rates, and it further reduced the retailers cost of goods sold by 1.2%, significant in the low profit margin grocery
industry. Waller, et al. (1999) postulated that the operational benefits of VMI could be very compelling. They also
suggested that many of the technology costs associated with VMI should be declining, e.g., implementing EDI with
trading partners was becoming dramatically less expensive with the availability of Internet EDI software. Finally,
their analysis showed that the approach greatly reduces inventories for all participants in the arrangement, without
compromising service.
Kaipia, et al. (2002) put forth that in their paper the benefits of VMI are analyzed from the viewpoint of
managing the replenishment process of the entire product range, not of a single stock keeping unit. A time-based
analysis method was developed for measuring the benefits of VMI in different situations. They suggested a

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hypothesis that by taking a viewpoint of the whole product range, the advantages of VMI are more readily
identified. Disney and Towill (2003) compared the expected performance of a VMI supply chain with that of a
traditional serially linked one. They showed that VMI can be significantly better at responding to volatile changes
in demand such as those due to discounted ordering or price variations.
Mishra and Raghunathan (2004) viewed VMI as a significant recent development of collaboration and
information sharing in supply chain management. They suggested a novel perspective about the benefits of VMI:
they showed that VMI intensifies the competition between manufacturers (vendors) of competing brands and that
the increased competition benefits a retailer that stocks these brands, and therefore, VMI, in addition to eliminating
retailers holding cost, reduces retailers shortage costs as well and increases its profit.
There are more studies focused on various aspects of VMI. Lee and Chu (2005) considered whether a
supply chain consisting of two members (the upstream vendor and the downstream retailer) and operating in a
newsboy environment should adopt VMI. Cetinkaya and Lee (2000) presented an analytical model for coordinating
inventory and transportation decisions in VMI systems: they considered a vendor realizing a sequence of random
demands from a group of retailers located in a given geographical region. After considering long-term as well as
short-term profit implications of VMI, Dong and Xu (2002) concluded that it is an effective supply chain strategy
that can realize many of the benefits obtainable only in a fully integrated supply chain.
From the vendors perspective, the biggest benefit comes from that it can have a direct access to the data
and information about the end customers demand. The vendor can utilize this information to streamline its
production activity and also design a new product that the market really wants. On the other hand, the retail can save
inventory management cost since under the VMI relationship it becomes the vendors responsibility to manage the
inventory. For both partners, the most important common benefit is to increase their sales and thus profits. One of
the reasons why both the vendor and the retailer increase their profit was explained by Mishra and Raghunathan
(2004). There are disadvantages or obstacles to implementing VMI. For the vendor, one obvious disadvantage is
related with increased costs to manage inventory and retain its access to the market information. The retailer also
can be reluctant to share its information or infrastructure with the vendor, being afraid that it might be possible to
lose its proprietary information and/or flexibility in managing its shelf spaces among different vendors.
In addition, we can compare VMI relationship with non-VMI one in terms of decision making. In the VMI
relationship, the vendor and the retailer share strong trust coordinate with each other when making SCM decisions,
using various coordination mechanisms. When formulating either an analytical or simulation model, it can be
embodied in the objective function that combines the two partners profits together according to specific
proportions. On the contrary, in a non-VMI relationship, there is little systematic coordination between the vendor
and the retailer. As such, their decision making processes are primarily separate.
Incentive Alignment Mechanism

Vendor:
Retailer:
Structural Levers Operational Levers
Figure 1 Coordination Mechanisms in VMI

As mentioned above, in a VMI arrangement, the vendor and the retailer employ various mechanisms to
implement their coordination (Simatupang, et al. 2002). We propose three broad categories of such coordination
mechanisms (Figure 1). There are structural mechanisms such as capacity and other physical components in the
supply chain. For instance, the vendor may have to reserve a certain amount of its own capacity for the VMI
relationship. The vendors decision on the capacity reservation is important, since it will affect the vendors cost to
make and deliver the products to the retailer and also the level of inventory the vendor wants to keep on the retailers
premise (Durango-Cohen and Yano 2006). Another set of mechanisms is operational, i.e., the supply chain
participants utilize these mechanisms as relatively short-term levers: the retailers pricing strategy is one of such
operational levers. As such, the retailer can influence the vendors behavior in addition to its own revenues by
adjusting the products price on a continuous base. Finally, there is an incentive alignment mechanism as a
coordination tool (Lee and Whang 1999, Piplani and Fu 2005). It probably is the most comprehensive among the
three mechanisms. Under this coordination mechanism, the retailer and the vendor make their decisions by taking

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into account not only its own, but also the others profit. That is, they assume a conceptual objective function that
combines their profits simultaneously.
MODEL
In this section, we first elaborate on the VMI model including key assumptions. Then, we develop a
differential games model. Although we dont obtain a closed-form solution for the analytical model, it helps us
design a robust numerical analysis and derive significant managerial implications. We consider a general VMI
model in this paper as presented in Figure 2, which can be best described by explaining the main assumptions
underlying it.
The vendor delivers its product to the retailer, who sells the product to the end customer. The end
customers demand for the product follows a Bass diffusion model (Bass 1969), i.e., x=[(M x)+(M x)x]e-p,
where x is the cumulative demand, M the potential market size, the coefficient of innovation effect, the
coefficient of imitation effect, p the market price charged by the retailer, and the coefficient associated with the
price effect (Robinson and Lakhani 1975, Bass, et al. 1994). Facing the dynamic market demand, the retailer has to
determine its price in order to optimize the objective function. The retailer incurs a unit production cost cr, when it
sells a unit product to the end customer. In addition, it pays a unit transfer price q for each unit product to the
vendor: q can be a fixed amount or a proportion of the retail price. When there occurs a shortage or understocking
cost, the retailer bears all or a part of it.
Vendor

Retailer

r1: Discounting rate

End Customer

r2: Discounting rate

Transfer Price
q=p

Price
p
Inventory
y
Holding cost
x
h
Demand
cr
Shortage cost
Production
s
Cost

=
x

Vendors Decision

Retailers Decision

Demand Pattern

U : Target Production Capacity

(Static)
u : Replenishment (Dynamic)

p : sales price (Dynamic)

Target
Production
Capacity
U

u
Replenishment
cs : Capacity building cost
cv : Production variable cost
cp : Production penalty cost

Demand

[ ( M x) + ( M x) x ] e p

: Innovation effect
: Imitation effect
: Price effect

Figure 2 Analysis Model for VMI

The vendor has to decide two primary variables, its capacity commitment to the retailer U and the
production quantity u each period. Before entering into the VMI arrangement with the retailer, the vendor has to
decide how much capacity it will reserve for the retailer (Serel 2007). Afterwards the vendor has to decide how
much it produces for the retailer given the capacity commitment. The periodic production cost occurs in a quadratic
function with a penalty due to deviation from the committed capacity, i.e., cp(u U)2. Since there are penalty costs
for both under-production and over-production with regard to the capacity, the vendor must determine its capacity
commitment by taking into account the demand dynamics throughout the PLC. Due to the VMI arrangement, the
vendor takes care of both inventory holding cost and a part of the understocking cost, i.e., shortage cost, on the
retailers side.
Finally, since VMI is a supply chain arrangement, the retailer and the vendor are willing to coordinate their
decision-making. That is, the objective function is to maximize the total profit that combines both the retailers and
the vendors profit with appropriate weights assigned to them.
A differential games model
Consistent with the VMI model suggested in the previous section, a differential games model can be
developed, where the vendors decision problem is defined as follows:
T
2
(1)
Max
e r t qx hy + sy c ( u U ) c U c u dt
u ,U

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167

=
x

Subject to

[ ( M

y =

y
=

x) + ( M x) x ] e p

(2)

u x
+

y y

(3)
(4)
(5)

h, s, , c p ,cs ,cv : constant

The vendors objective function (1) consists of its revenues from the retailer, inventory holding cost, its
share of shortage cost (understocking cost), production penalty cost (due to deviation from the reserved capacity),
fixed cost to commit the capacity to the retailer, and its production (variable) cost. Constraint (2) describes the Bass
demand function, and (3) and (4) are necessary to determine whether there is overstocking or understocking.
Similarly, the retailers problem is defined as follows:
T

Max e r2t
p

Subject to

( ( p q c ) x (1 ) sy ) dt

(6)

the same constraints in (2) ~ (5).

The retailers objective function (6) consist of the total contribution from the sales, i.e., the period demand times the
unit contribution (price minus transfer price minus unit variable cost), and its share of shortage cost (understocking cost).

NUMERICAL ANALYSIS
Although we cannot obtain a closed-form solution for the differential games model, it sheds light on
formulating the numerical analysis. That is, numerical examples are exactly based on and consistent with the
differential games model. In order to do a numerical analysis that is realistic and empirically robust, we first verify
whether the demand function fits well a real-world case, and determine the parameter values in the demand function,
which can be used in the numerical analysis. We collected the sales data of the 8M-pixel digital cameras sold in
Japan during January 2006 ~ December 2008. Japans Camera and Imaging Products Association (CIPA 2009)
discloses in its website such data as monthly sales and sales prices of the digital cameras sold in Japan.
Numerical analysis
Using the parameter values estimated through calibration, we conduct numerical analysis. There are three
additional assumptions. First, the product is a new one and its demand follows a Bass diffusion model throughout its
PLC. Second, the product is durable and therefore there is few repeating purchase during the current PLC. Finally,
the vendor is the dominant player, i.e., enjoys a near-monopolist position in the market. As such, we assume that the
impact other competitors have on the demand dynamics is minimal at best.

Price

Price

Time
(1) Constant Price

Price

Time

Time

(2) Linear Price Change

(3) Nonlinear Change

Figure 3 Retailers price strategies

Retailers pricing strategy: For the numerical analysis, we consider three different price strategies that the
retailer can employ: as in Figure 3, they are constant, linearly monotone, and nonlinear pricing. If the retailer adopts
the constant pricing scheme, it charges the same price throughout the PLC. Using a linearly monotone pricing
strategy means that the retailer employs a linear price function, which either monotone increases or monotone
decreases throughout the PLC. Finally, under the nonlinear pricing scheme, the retailer changes the price
continuously, i.e. it can adjust its price continuously throughout PLC.

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Table 1 Parameter values in the numerical analysis (cost unit = 1,000)

cp

cv

cs

2.06

6.181

cr

12.705

r1

9.271

r2

0.00032

0.00032

0.5

6.868

(a)

s
61.812

2.49510

100

0.0042

0.5

T
7

-8

0.0045

1.321410

(b)
Graphfor unit price

Graphfor capacity
800

300,000

400

250,000

1
3

10

20

30

40
50
60
Time (Week)

70

80

90

2 3

0
0

100

(c)

200,000
0

23

10

20

30

40
50
60
Time (Week)

70

80

90

100

(d)
Graphfor Inventory

6M

1
1

3M

1
2

10

2.7 B

1 2
2 3

Graphfor NPVof cumulative vendor profit

6B

20

2 3

30

2 3

40
50
60
Time (Week)

2 3 1

70

3 1

3 1

80

90

-0.6 B

100

(e)

1 23 1 2 3 1 2

10

3
1

20

30

40
50
60
Time (Week)

70

80

90

100

(f)
Graphfor NPVof total profit

Graphfor NPVof cumulative retailer profit

10 B

6B

3B

3 12
12 3 1 2

10

20

1 2

30

3
1

2
1

40
50
60
Time (Week)

4.97 B

-60 M

70

80

90

100

3 2
1 23 1 2
1

10

20

3
1

30

2
1

1
1

40
50
60
Time (Week)

70

80

90

100

Figure 4 Graphs from the numerical analysis (-1-: constant pricing, -2-: linear pricing, -3-: nonlinear pricing)

Coordination mechanisms: We also pay attention to coordination between the supply chain partners. As
discussed in the literature review, in a VMI relationship, there are three broad categories of coordination mechanism.
First, there is a structural lever the SC partners can utilize, e.g., the vendors capacity commitment to the retailer.
The structural lever is of a long-term decision, which involves an upfront investment or commitment before the
partners enter the VMI relationship and affects subsequent decision dynamics throughout the product life cycle
(PLC). Second, there are operational levers such as production or delivery quantity, inventory level, and pricing
throughout the PLC. The SC partners continuously adjust the operational levers in order to optimize their objectives.
Finally, there is an incentive alignment mechanism. Suppose that there exists an entity that has authority to oversee
and control the SC partners. When the entity tries to optimize for the VMI arrangement as a whole, it probably
maximizes an objective function, which consists of the two participants profits according to certain proportions. For
instance, such an objective function might consist of (Vendors Profit) and 1 (Retailers Profit), 0 1 .
Then, the incentive alignment mechanism is to adjust to achieve the optimal profit for the SC arrangement as a
whole. For the numerical examples, we use the parameter values as in Table 1.
Observations from numerical analysis
The numerical analysis results are presented in Figure 4. There are three cases according to the retailers
pricing strategies, based on the base case, where the vendor can choose its capacity before the VMI relationship

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starts. In Figure 4, there are 6 graphs: (a) shows the capacity level chosen by the vendor it is the lowest when the
retailer employs a linear pricing strategy, while it is almost the same when the retailer chooses either constant or
nonlinear pricing strategy; (b) presents the retailers pricing strategy the retailer increases its price throughout the
PLC when it adopts a linear pricing strategy, whereas its nonlinear pricing strategy shows a concave pattern; (c)
depicts the dynamics of the inventory level it clearly indicates that the more rigid the retailers pricing strategy, the
more fluctuating the inventory level; (d) presents the vendors cumulative profit the more flexible the retailers
pricing strategy, the larger the vendors profit; (e) presents the retailers cumulative profit similar with the vendors
profit, the more flexible its pricing strategy, the larger its own profit, but the difference among pricing strategies
seems much smaller than in the vendors case; (f) displays the total cumulative profit of the supply chain, i.e.,
combining the vendors and the retailers profits together we can reach the same conclusion as in (d) and (e).
We can recapitulate three most important managerial insights from the numerical analysis. (1) For the linear
pricing strategy, the firm increases its price over time. For the nonlinear pricing strategy, the firm increases for a
while and then decreases its price, i.e., the pattern shows a concave one. (2) The more flexible the pricing strategy,
the less fluctuating the inventory level. It implies that the firm smoothes its inventory by adjusting its price deftly.
(3) Overall, the more flexible the pricing strategy, the larger the vendors cumulative profit and also the retailers.
MANAGERIAL IMPLICATIONS AND DISCUSSION
In this paper, we strive to understand the dynamic interaction among key decision factors in a VMI relationship
as supply chain coordination. We first set up a differential games model to formalize the problem in an analytical way.
Using the insight from the differential games model, we conduct a numerical analysis and present numerical examples,
from which we derive managerial implications. The SC partners in a VMI relationship utilize multiple coordination levers
in a way to optimize their common objective, i.e., to maximize the combined profit. When the SC partners are allowed to
choose/adjust the structural and operational levers flexibly, they fully coordinate their decision variables and reach
solutions consistent with the system-wide optimization. For instance, we observe that the more flexible the pricing
strategy, the less fluctuating the inventory level throughout the PLC. That is, there is a complementary relationship
between the vendors inventory level and the retailers pricing strategy. In essence, we propose that such a complementary
relationship exists between other factors, e.g., between the vendors capacity commitment and the retailers pricing
strategy. Although the numerical analysis is done in a particular setting, weve experimented many times and found out
that the patterns shown in our numerical examples are robust enough to support our observations. Moreover, the parameter
values used in the numerical analysis were estimated from actual market data of the 8M-pixel digital cameras sold in Japan
between 2006 and 2008. As such, the numerical examples are indeed based on reality.

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