its profit if it prices the vitamins at p ! 3 # CM " 2 ! 3 + 2 " 2 !

$4 per At this stage, we have seen that even in the absence of inventory-
bottle. It has annual sales related costs, quantity
of 360,000 $ 60,000 p ! 120,000 and profits of $60,000. The discounts play a role in supply chain coordination and improved
manufacturer makes a profit of supply chain profits. Unless the
$180,000, which it charges up front. Observe that the use of a two- manufacturer has large fixed costs associated with each lot, the
part tariff has increased supply discount schemes that are
chain profits from $180,000 to $240,000 even though the retailer DO optimal are volume based and not lot size based. It can be shown that
has made a even in the presence of
locally optimal pricing decision given the two-part tariff. A similar large fixed costs for the manufacturer, a two-part tariff or volume-
result can be obtained as long based discount, with the
as the manufacturer sets the up-front fee ff to be any value between manufacturer passing on some of the fixed cost to the retailer,
$120,000 and $180,000 with optimally coordinates the supply
a wholesale price of CR ! CM. chain and maximizes profits given the assumption that customer
2. Volume-based quantity discount: Observe that the two-part tariff is demand decreases when the
really a volumebased retailer increases price.
quantity discount whereby the retailer DO pays a lower average unit A key distinction between lot size–based and volume discounts is that
cost as it purchases lot-size discounts are
larger quantities each year (the franchise fee ff is amortized over more based on the quantity purchased per lot, not the rate of purchase.
units). This observation Volume discounts, in contrast,
can be made explicit by designing a volume-based discount scheme are based on the rate of purchase or volume purchased on average per
that gets the retailer DO to specified time period (say,
purchase and sell the quantity sold when the two stages coordinate a month, quarter, or year). Lot size–based discounts tend to raise the
their actions. cycle inventory in the supply
Recall that the coordinated solution results in a retail price of p ! 3 # 120,000 * (CR - $2) = $180,000
CM"2 ! 3 # 2 " 2 ! 4. Chapter 11 • Managing Economies of Scale in a Supply Chain: Cycle
Inventory 311
This retail price results in total demand of dcoord!360,000 – 60,000 4
chain by encouraging retailers to increase the size of each lot.
!120,000. The objective of
Volume-based discounts, in
the manufacturer is to design a volume-based discounting scheme that
contrast, are compatible with small lots that reduce cycle inventory.
gets the retailer DO to buy (and
Lot size–based discounts
sell) dcoord!120,000 units each year. The pricing scheme must be such make sense only when the manufacturer incurs high fixed cost per
that retailer gets a profit of at order. In all other instances, it
least $60,000, and the manufacturer gets a profit of at least $120,000 is better to have volume-based discounts.
(these are the profits that DO and One can make the point that even with volume-based discounts,
the manufacturer made when their actions were not coordinated). retailers will tend to increase
Several such pricing schemes can be designed. One such scheme is the size of the lot toward the end of the evaluation period. For
for the manufacturer to example, assume that the manufacturer
charge a wholesale price of CR ! $4 per bottle (this is the same offers DO a 2 percent discount if the number of bottles of Vitaherb
wholesale price that is optimal purchased over a quarter
when the two stages are not coordinated) for annual sales below dcoord exceeds 40,000. This policy will not affect the lot sizes DO orders ear
!120,000 units, and to
charge CR ! $3.50 (any value between $3.00 and $3.50 will work) for
sales of 120,000 or more.
It is then optimal for DO to order 120,000 units in the year and price
them at p ! $4 per
bottle to the customers (to ensure that they are all sold). The total
profit earned by DO
(360,000 - 60,000 * p) * (p - CR) = $60,000. The total profit earned by
the manufacturer is
Key Point
For products for which the firm has market power, two-part tariffs or volume-
based quantity discounts
can be used to achieve coordination in the supply chain and maximize supply
chain profits.
when CR ! $3.50. The total supply chain profit is $240,000,
which is higher than the $180,000 that the supply chain earned when
actions were not coordinated.
If the manufacturer charges $3.00 (instead of $3.50) for sales of
120,000 units or more, it
is still optimal for DO to order 120,000 units in the year and price
them at p ! $4 per bottle.
The only difference is that the total profit earned by DO now
increases to $120,000 while that for
the manufacturer now drops to $120,000. The total supply chain
profits remain at $240,000. The
price that the manufacturer is able to charge (between $3.00 and
$3.50) for sales of 120,000 or
more will depend on the relative bargaining power of the two parties.