The economic slump is forcing retailers to slash prices in order to unload inventory. However, retailers can forecast demand more accurately when manufacturers offer a variety of contract incentives upfront, according to Terry Taylor, associate professor at UC Berkeley's Haas School of Business.
"The current economy points to the importance or value of knowing what the market will look like when you’ll actually plan to sell the product," says Taylor. Taylor's research suggests strategies for both manufacturers and retailers to optimize profit. First, retailers should invest in forecasting to better predict demand. Second, manufacturers, by offering a "menu" of purchasing agreements, can encourage retailers to invest in forecasting demand.
In the working paper, "Incentives for Retailer Forecasting: Rebates versus Returns," Taylor and co-author Wenqiang Xiao, assistant professor, Stern School of Business, New York University, find that when a retailer's forecasting efforts are taken into account, contracts allowing retailers to return orders are more effective than those involving rebate offers.
Taylor describes returns and rebates as "mirror images." Return policies allow retailers to return unsold goods to the manufacturer for a pre-determined credit. Rebates, on the other hand, pay the retailer a bonus every time she sells a unit of merchandise. "A rebate compensates the retailer for selling units, whereas returns essentially compensate the retailer for not selling units," says Taylor.
"It's natural to think that rebates might be the better way to go if a manufacturer is trying to encourage a retailer to invest in forecasting. After all, a returns policy is basically an insurance policy, which means the retailer doesn’t have to worry as much about what the actual demand will end up being," says Taylor. However, the study finds placing orders with a return policy is more effective for the supplier.
"The trick is to offer a menu of choices," says Taylor. For example, a manufacturer gives the retailer the option to purchase either at a high unit price coupled with a generous return credit or, the option to buy at a low unit price coupled with a stingy return credit. Retailers who have done their forecasting homework benefit from this "menu" because they can choose the option that best fits with their sense of market demand. Using pre-season testing to forecast demand can be expensive but Taylor emphasizes, "When there is a downturn in the economy, there is less room for error."
The paper's conclusions are based on an analytical model that captures the retailer's forecasting effort, contract selection, and ordering decisions. The paper offers advice to retailers about how much time and resources they should devote to forecasting demand given a certain set of contractual terms. The value of having the better demand information depends on the terms that are available to the retailer. Taylor says retailers can benefit by thinking about the interaction between the terms of trade and their forecasting efforts.
Finally, the paper acknowledges that manufacturers might not always want to encourage their retailers to invest in forecasting. "When a retailer invests in forecasting, she obtains a strategic advantage over the manufacturer through the private information she obtains, and this can end up hurting the manufacturer," says Taylor. However, even when the manufacturer wants to discourage forecasting efforts, the paper shows that offering returns is more effective than offering rebates.
Taylor is a member of Haas' Operations and Information Technology Management Group.