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Understanding the Appeal of Sub-optimal contracts

May 01, 2013

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Research by Rebecca Hamilton and Wedad Elmaghraby

The goal of business is to maximize profits, so it just didn’t make sense to researchers at the University of Maryland’s Robert H. Smith School of Business why many retailers and suppliers sign deals that leave money on the table.

Rebecca Hamilton, associate professor of marketing, Wedad Elmaghraby, associate professor of management science and operations management, and Smith PhD candidate Anna Devlin wanted to figure out why the retail industry usually favors wholesale contracts, where retailers buy bulk orders from suppliers, and rarely employ shared-risk contracts, where retailers and suppliers work in partnership to increase sales.

They took a look at the highly “perishable” fashion industry, where trends can change seemingly overnight. In a standard wholesale agreement, retailers have to be very good at forecasting what they will be able to sell for top dollar to avoid losing money on excess inventory when fashions change. With shared-risk contracts, a supplier agrees to buy back items that don’t sell or offers money to help market or discount items. On paper, the researchers say shared-risk contracts make more sense for retailers – who won’t have to shoulder all of the risk – and suppliers, who can often get retailers to order more inventory with this type of structure. So why are these contracts so rarely used?

Working with a NSF grant, Elmaghraby, Devlin and Hamilton first interviewed fashion retailers and suppliers to see if they were even aware of the contracts (they are), and how they typically structure contracts. Then the researchers designed a series of experiments, using the Smith School’s Behavioral Laboratory, in which participants acted as a women’s shoe supplier interacting with a computerized retailer. Previous research has looked at whether parties use shared-risk contracts correctly, but the Smith researchers are the first to look at why parties choose particular contracts.

What they found was shared-risk contracts might not be as good as they thought because of the symbiotic relationship required between the parties for the arrangement to really work well. Suppliers see a “moral hazard” with retailers when they don’t know their business practices.

“With shared-risk contracts, the supplier is ‘in bed’ with the retailer for a longer period of time because now they are at the whim of the retailer’s decision as to how they are going to run their business to stimulate demand, and that is actually scary,” Elmaghraby says.

The experiments revealed that suppliers only preferred shared-risk contracts if they felt confident that the retailer would exert a lot of effort to sell goods, such as investing in marketing activities or in-store displays. The results also show suppliers are more likely to choose shared-risk contracts when the deal with the retailer includes a variable salvage value, meaning retail discounts on items left over at the end of the season were based on remaining quantities rather than a predetermined discount amount. Fewer items left mean retailers only have to offer a small discount to clear excess inventory, so suppliers see a deal with variable salvage value as extra incentive for retailers to put forth effort to sell more.

So which type of contract is ultimately better for suppliers?

“It depends on the retailer and the retailer’s business structure and how costly it is for them to stimulate demand,” says Elmaghraby. “If it’s cheap, then we should expect retailers to exert effort even in shared-risk contracts and both parties will do quite well. But if the retailer is operating in an environment where it is really costly to drum up sales and get the customer through the door, then shared-risk contracts can be a fallback where retailers are less motivated to go after sales. In that case, these contracts are worse for suppliers.”

Hamilton and Elmagraby say their research revealed the complexity of retail relationships and that multiple factors should be considered when ironing out contracts. And not just in the fashion retail industry – any industry where retailers have to decide how many units of an item to stock should be ripe for these types of shared-risk contracts, says Hamilton. She and her co-authors hope this study sheds light on the opportunity these contracts can offer.

“There is money on the table that both retailers and suppliers can get to if they think about these more sophisticated kinds of contracts,” Hamilton says. “If they learn about them and figure out how to use them appropriately, they can increase their profits.”

“Understanding the Appeal of Suboptimal Contracts” is forthcoming inManagement Science.

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About the University of Maryland's Robert H. Smith School of Business 

The Robert H. Smith School of Business is an internationally recognized leader in management education and research. One of 12 colleges and schools at the University of Maryland, College Park, the Smith School offers undergraduate, full-time and part-time MBA, executive MBA, online MBA, MS in business, PhD and executive education programs, as well as outreach services to the corporate community. The school offers its degree, custom and certification programs in learning locations in North America and Asia.