Analyzing information-enabled stockout management under vendor-managed inventory

We develop a mechanism under vendor-managed inventory (VMI) by which a manufacturer provides an incentive contract to a retailer to convert lost sales stockouts into backorders. An incentive contract is required since the retailer’s efforts are not directly observable. We first show that when there are no limits on order quantities or inventory levels imposed on the manufacturer, the manufacturer will push inventory onto the retailer. The manufacturer minimizes the possibility for lost sales stockouts by maintaining high inventory levels at the retailer rather than by paying incentives to the retailer. However, modern information systems (IS), such as radio frequency identification (RFID), allow the retailer to monitor inventory at its premises and to enforce limits on order quantities. With strict limits on order quantities, the manufacturer will provide incentives to the retailer to convert lost sales stockouts to backorders. We analyze the conditions under which these incentive payments are likely to be highest.