Supply Chain Coordination with Revenue-Sharing Contracts: Strengths and Limitations

Under a revenue-sharing contract, a retailer pays a supplier a wholesale price for each unit purchased plus a percentage of the revenue the retailer generates. Such contracts have become more prevalent in the video cassette rental industry relative to the more conventional wholesale price contract. This paper studies revenue-sharing contracts in a general supply chain model with revenues determined by each retailer’s purchase quantity and price. Demand can be deterministic or stochastic and revenue is generated either from rentals or outright sales. Our model includes the case of a supplier selling to a classical ...xed-price newsvendor or a price-setting newsvendor. We demonstrate that revenue sharing coordinates a supply chain with a single retailer (i.e., the retailer chooses optimal price and quantity) and arbitrarily allocates the supply chain’s pro...t. We compare revenue sharing to a number of other supply chain contracts (e.g., buy-back contracts, price-discount contracts, quantity-‡exibility contracts, sales-rebate contracts, franchise contracts, and quantity discounts). We ...nd that revenue sharing is equivalent to buy backs in the newsvendor case and equivalent to price discounts in the price-setting newsvendor case. Revenue sharing also coordinates a supply chain with retailers competing in quantities, e.g., Cournot competitors or competing newsvendors with ...xed prices. Despite its numerous merits, we identify several limitations of revenue-sharing to (at least partially) explain why it is not prevalent in all industries. In particular, we characterize cases in which revenue sharing provides only a small improvement over the administratively cheaper wholesale price contract. Additionally, revenue sharing does not coordinate a supply chain with demand that depends on costly retail e¤ort. We develop a variation on revenue sharing for this setting. The video-cassette retailer faces a challenging capacity problem. The peak popularity of a rental title lasts only a few weeks but the cost of a tape has traditionally been high relative to the price of a rental. In a conventional sales agreement, the retailer purchases each tape from his supplier for about $65 and collects about $3 per rental. Hence, a tape earns a pro...t only after 22 rentals. Because the demand for a tape typically starts high and tapers quickly, a retailer cannot justify purchasing enough tapes to cover the initial peak demand entirely. At Blockbuster Inc., a large video retailer, the poor availability of new release videos was consistently a major customer complaint (McCollum, 1998, Shapiro, 1998a). Seeking a solution to this problem, 1998 Blockbuster agreed to pay its suppliers a portion (probably in the range of 30-45%) of its rental income in exchange for a reduction in the initial price per tape from $65 to $8.1 If Blockbuster kept half of the rental income, the break-even point for a tape would drop to approximately six rentals, thereby allowing Blockbuster to purchase many more tapes. The introduction of revenue sharing coincided with a signi...cant improvement in performance at Blockbuster: Warren and Peers (2002) report that Blockbuster’s market share of video rentals increased from 24% in 1997 to 40% in 2002. Not surprisingly, this has led to litigation against Blockbuster and the movie studios alleging that revenue sharing contracts have hurt competition in the industry. To date, these have been unsuccessful (Wall St. Journal, 2002.) Indeed, evidence shows that the new terms of trade helped the industry in aggregate: Mortimer (2000) estimates revenue sharing increased the industry’s total pro...t by 7%. This paper studies how revenue sharing alters the performance of a supply chain. While inspired by the video-rental industry, our model encompasses many settings. It applies to any industry and any link between two levels in a supply chain (e.g., supplier-manufacturer or manufacturer-distributor). It does not matter whether the asset produced at the upstream level is rented at the downstream level (as in the video industry) or sold outright (as in the book industry) or whether demand is stochastic or deterministic. To be speci...c, our base model has a supplier selling to a single retailer. The retailer makes two decisions that 1 Blockbuster’s terms are not public. Rentrak, a distributor, o¤ers the following: the studio gets 45% of the revenue, Rentrak 10%, and the retailer 45%. (www.rentrak.com). Since Blockbuster deals directly with the studios, its terms should be at least as generous.