The Impact of Supply Disruption Risk on a Retailer’s Pricing and Procurement Strategies in the Presence of a Substitute Product

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Author Information : R. Scott Fay (Syracuse University)
Shahryar Gheibi (Siena College)

Year of Publication : Journal of Retailing, 2021

Summary of Findings : In anticipation of potential supply disruptions, a retailer would typically benefit from ordering more units from reliable suppliers and fewer units from unreliable ones, and then reduce the price of delivered products if some products are not delivered.

Research Questions : 1. How does anticipation of potential supply disruptions affect a retailer’s optimal procurement strategy when its suppliers offer vertically differentiated products?
2. How do optimal order quantities vary with the probability of a supply disruption?
3. How should a retailer adjust its prices when a supply disruption occurs?
4. How does supply risk and a retailer’s response to this risk impact consumers?

What we know : Most companies have encountered supply disruptions and these disruptions are becoming even more frequent due to climate changes, the trend toward lengthier and more complex supply chains, the emphasis on cost efficiency, and the COVID pandemic. Such disruptions can lead to stockouts, which result in unsatisfied customers and tremendously undermine retailers' profits. Thus, it is important for retailers to develop strategies for succeeding in markets where their suppliers are not very reliable.

Novel Findings : Our paper contributes to retail practice by identifying selling strategies that are proactive rather than reactive to supply disruptions. Whereas most previous research ignores how the product mix can affect strategies for addressing supply disruptions, our proposed strategies rely on using multiple products to protect against supply disruptions. This is an important distinction because most retailers sell multiple products within a given product category and thus can obtain revenue from substitute products if another product stocks out.

Our findings provide insights into how retailers can operate most profitably when they face uncertain supply. Specifically, our analysis reveals three potentially viable strategies for dealing with an unreliable supplier: Diversification, Hyper-Diversification, and Entrenchment. Diversification is an intuitive strategy in which the retailer mitigates the effects of potential supply disruptions by procuring a larger total amount of inventory and shifting its orders toward a more reliable supplier. We coin the term Hyper-Diversification to describe a second potentially viable strategy, under which the order amounts are so large that the retailer will discard some units (rather than sell them to consumers) if the unreliable supplier successfully delivers its product. This strategy is optimal if unit costs are sufficiently low, thus giving the retailer a strong incentive to maintain high sales even when a supply disruption occurs. A third strategy, Entrenchment, is optimal when procurement costs are high and the difference in quality across products is relatively small. Under Entrenchment, the retailer addresses supply uncertainty by retreating from the market, i.e., ordering fewer units in total. Surprisingly, this retreat involves consolidation of the retailer’s procurement strategy around the unreliable supplier’s product. This interesting result can be explained as follows. High procurement costs increase the importance of being able to maintain high prices. In the event that both products are delivered, the retailer can use a high price for the reliable supplier’s product to avoid cannibalization of the other product’s sales and as a way to make the unreliable supplier’s product appear more attractive to consumers, thus enabling the retailer to obtain substantial profit margins for both products. Anticipating that it will charge a high price for the reliable supplier’s product, the retailer orders relatively few units of this product in order to avoid excess inventory.

We find that adoption of the Entrenchment strategy can harm consumers because this strategy involves reducing total order quantities and rising prices, which makes consumers worse off even when a supply disruption does not actually occur. However, if a retailer adopts Diversification or Hyper-Diversification, as one supplier becomes less reliable, the retailer orders more units from the other supplier and reduces the price of that product. Lower prices generate more surplus for consumers and higher order quantities facilitate a greater number of welfare-enhancing transactions. As a result, consumers, as a whole, can be better off. It is important and counterintuitive that consumers may prefer an environment in which supply is unreliable rather than perfectly reliable.

Implications for Practice : It is important for retailers to assess the reliability of their suppliers and adjust their order quantities accordingly BEFORE a supply disruption occurs rather than simply respond to disruptions afterward.

Implications for Society: Consumers are sometimes better off if suppliers are unreliable rather than reliable, or as an unreliable supplier becomes even less reliable.

Implications on Research: Much previous research has focused on how to prevent supply-chain disruptions and how to adapt after a disruption occurs. This paper shows that profitable strategies can be developed in anticipation of future supply disruptions. This could spur additional research that identifies other ways to preemptively address supply uncertainty.

Full Citations : Gheibi, S. & Fay, S. (2021). The impact of supply disruption risk on a retailer’s pricing and procurement strategies in the presence of a substitute product. Journal of Retailing, 96.3 (September): 359-376.

Abstract : Retailers often experience stockouts when a supplier fails to deliver an order. In this paper, we identify the optimal procurement policy of a multi-product retailer in the presence of possible supply disruptions. Our analysis reveals that, in anticipation of potential supply disruptions, a retailer would typically benefit from ordering more units from a reliable supplier and fewer units from an unreliable one. Furthermore, the total number of units ordered may increase when there is supply disruption risk. As a result, the retailer may overstock some items. However, there are situations in which a retailer would optimally respond to supply uncertainty by consolidating its selling strategy around the unreliable supplier’s product. Under such a strategy, we find the surprising result that the retailer reduces the amount it orders from a reliable supplier as an unreliable seller becomes even less reliable. We also explore how supply disruptions can affect a retailer’s optimal pricing strategy. We find that under certain conditions, it is beneficial for a retailer to lower the price of a substitute product when one supplier fails to deliver its product. Finally, we find that, on net, consumers may benefit from supply uncertainty even though supply disruptions eliminate access to a desirable product.

Scott Fay
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