Optimizing the Learning Curve
How Pricing Can Be Connected to Efficiency Gains
When a company launches a new product, there is nearly always some inefficiency in the manufacturing process at first. And, typically, with the passage of time, there is a learning curve in which the firm figures out how to manufacture the product more efficiently.
The normal pricing inefficiency that exists in any relationship between manufacturer and retailer, known as “double marginalization” because both parties are affected, becomes more severe as the learning curve makes manufacturing more efficient.
Tao Li, a new assistant professor of operations management and information systems, has been looking into how revenue-sharing agreements between manufacturers and retailers can make the supply chain more efficient and boost profits.
“Other approaches to supply-chain efficiency, such as quantity discounts, two-part tariffs and buy-back programs don’t really coordinate the chaos,” Li says. “But we found that by using a revenue-sharing contract, it’s possible to control the supply-chain chaos so that both the manufacturer and retailer are better off.”
“It is a game played by both the manufacturer and the retailer.”
The findings are reported in a working paper titled “Dynamic Pricing, Procurement, and Channel Coordination with Stochastic Learning,” which Li co-authored with Xiuli He of the University of North Carolina at Charlotte, and Suresh P. Sethi, at the University of Texas at Dallas.
In this sort of supply chain situation, the key issue is double marginalization, which refers to the pricing inefficiency that occurs when the manufacturer sets a wholesale price based on anticipated manufacturing costs and the retailer sets a retail price based on anticipated demand.
That disparity can become worse as the learning curve makes the manufacturing process more efficient and less costly at the same time demand for the product is easing after the typical flurry of sales when the product was first introduced.
Li says that academic studies to this point have focused on the learningcurve issue from the manufacturer’s perspective. In the paper he and his colleagues wrote, he says, “we look at it as a game played by both the manufacturer and retailer.”
Additionally, they look at it over two different periods: when the product first comes out, and later, when manufacturing efficiency has peaked but demand is falling off.
(Yet another consideration, originally taken up in this paper but subsequently broken out into a second one, is how to factor in the question of whether the retailer has the ability to carry over inventory from the first period to the second, which could add another distortion to the supply-chain efficiency.)
What Li and his colleagues found was that a well-constructed revenue-sharing agreement between the manufacturer and retailer can smooth out the disparities in the process.
As an example of how that might work, Li outlined a contract arrangement in which the retailer and manufacturer split sales revenues 50-50 in the first period of a contract, then the retailer takes a 60 percent share in the second period.
(He notes that negotiated rates aren’t always optional because large retailers, such as Target and WalMart have the clout to get themselves a larger share, which creates another form of distortion.) Li also said that the retailer may not necessarily be better off by getting a larger share of the revenue in the second period.
When the arrangements are optimal, the result is likely to be that the manufacturer’s share of the retailer’s revenue allows it to charge a lower wholesale price at the outset, which means the retailer can charge a lower sales price, perhaps stimulating additional consumer demand.
In the second period, when sales drop, the retailer gets a bigger cut, while the manufacturer’s margin is improved by greater production efficiency. Lower wholesale and retail prices then create a better chance of growing total sales.
“Reducing wholesale prices improves the efficiency of the supply chain,” Li says, “and that grows the pie of total sales. Once the pie becomes larger, both the manufacturer and retailer are better off.”