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International Journal of Production Research

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A vendor-managed inventory scheme as a supply chain

coordination mechanism
a a a
Abhishek Chakraborty , A.K. Chatterjee & Arqum Mateen
a
Operations Management, Indian Institute of Management Calcutta, Kolkata, India
Published online: 28 May 2014.

To cite this article: Abhishek Chakraborty, A.K. Chatterjee & Arqum Mateen (2014): A vendor-managed inventory scheme as
a supply chain coordination mechanism, International Journal of Production Research, DOI: 10.1080/00207543.2014.921350

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 International Journal of Production Research, 2014
http://dx.doi.org/10.1080/00207543.2014.921350

A vendor-managed inventory scheme as a supply chain coordination mechanism

Abhishek Chakraborty*, A.K. Chatterjee and Arqum Mateen

Operations Management, Indian Institute of Management Calcutta, Kolkata, India

(Received 22 May 2013; accepted 29 April 2014)

In this paper, we have considered a vendor-managed inventory (VMI) arrangement in a supply chain (SC), where the
buyer imposes a penalty for shipments exceeding an upper limit. We have shown as how the industry practice of VMI
under penalty can be used as a SC coordination mechanism. The vendor can influence the buyer to increase the batch
size without making the buyer worse off. We also discuss how such a penalty scheme may be derived. Further, we have
established the equivalence of VMI under deterministic demand with that of quantity discount models, thus highlighting
the need to incorporate both cooperation and coordination perspectives while analysing SC collaboration mechanisms.
Keywords: vendor-managed inventory; supply chain coordination; quantity discount
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1. Introduction
It is well known that unilateral decision-making by firms in a supply chain (SC) affects the performance of the other
partners of the chain and thus results in SC inefficiencies (Sheen and Tsao 2007). If a SC behaves in a coordinated man-
ner, these inefficiencies can be resolved. Companies along with their partners are trying to optimise their operations by
coordinating the physical, financial and information flows. SC coordination has also been viewed as a strategic response
to the dependencies of SC members (Xu and Beamon 2006). Researchers have been actively investigating various SC
coordination mechanisms like quantity discounts, buyback contracts, revenues sharing contracts, etc. (Sarmahm,
Acharya, and Goyal 2006).
Vendor-managed inventory (VMI) is another coordination mechanism which has been gaining a lot of attention
(Marquès et al. 2010; Govindan 2013). It originated with the realisation that vendors could efficiently control the flow of
goods from raw materials to the final consumer, and the buyers could enjoy reduced stock levels and increased service lev-
els (Blatherwick 1998). It came to prominence after the VMI partnership between Wal-Mart and Proctor & Gamble became
successful in 1985 (Tyan and Wee 2003). It has been widely used across various industries by many companies like
Campbell Soup, Shell Chemicals, HP, Barilla, etc. (Cetinkaya and Lee 2000; Mishra and Raghunathan 2004).
In traditional serial inventory management systems, the buyer places the order with the vendor, who in turn fulfils
the order. This is often not in the best interests of the vendor. In VMI, it is the vendor who manages the inventory and
takes all the replenishment decisions, i.e. how much and how often to replenish on the behalf of the buyer and is
responsible for the management of stock at his location. The buyer in turn provides the vendor with access to real-time
inventory level information (Nagarajan and Rajagopalan 2008). The buyer’s interests, owing to the excess inventory that
he may be required to carry, can be safeguarded by contractual agreements. The advantages of VMI partnership include
reduction of costs not only for the buyer, but the vendor as well (Dong and Xu 2002). It also helps in mitigation of
uncertainty in demand (Lee, Padmanabhan, and Whang 2004). Further, Disney and Towill (2003) highlighted that VMI
has a role to play in the reduction of ‘bullwhip effect’ by elimination of ‘one layer of decision making’ and by elimina-
tion of ‘information flow time delays’. Additionally, with the implementation of VMI, a firm can respond better to mar-
ket changes (Kuk 2004).
Sahin and Robinson (2002) based on a survey of literature on SC integration, proposed information sharing and
coordination among the SC members as the primary drivers of SC performance. They also differentiated between ‘price
coordination’ and ‘flow coordination’, with mechanisms such as quantity discounts and two-part tariffs coming under
the former, while VMI, postponement, etc. forming a part of the latter. Fugate, Sahin, and Mentzer (2006) highlighted
that most of the academic research on coordination mechanisms takes an economic and/or normative approach. This
often presents a view disjointed from the intricacies of real-life SC coordination.

*Corresponding author. Email: abhishekc08@iimcal.ac.in

© 2014 Taylor & Francis

 2 A. Chakraborty et al.

In this paper, we will analytically show that such economic/normative analysis may not necessarily govern the
choice of a particular SC coordination mechanism. We do this by establishing that the total system costs obtained in our
models are the same for two different mechanisms, viz. VMI and quantity discounts. Having established this, we also
explore the levers available to different parties under a given VMI system. Specifically, we focus on the role of penalty,
levied in case a preset stock upper limit is exceeded, under a VMI arrangement. Further, as it has been well established
in the literature that VMI is superior to traditional inventory management systems owing to better cost savings. But
there are concerns over its applicability in certain situations. When the vendor takes the replenishment decisions, the
contractual agreement requires that the buyer is not made worse off as compared to the case of no-coordination. Hence,
our aim is to seek Pareto optimal solutions unlike the centralised solution case as discussed in Yao, Evers, and Dresner
(2007), Darwish and Odah (2010), and Ben-Daya et al. (2013), where the vendor will try to maximise his overall bene-
fits and in the process will not make the buyer worse off.
The remainder of the paper is organised as follows: the next section covers a brief literature review of VMI as a
practice in industry. In Section 3, we present a mathematical model to illustrate how VMI acts as coordinating mecha-
nism. Section 4 presents the parallelism between quantity discounting and VMI. Numerical analysis is carried out in
Section 5. We discuss the implications of the study in Section 6. Finally, we provide conclusions in the last section.

2. Literature review
SC coordination can be classified as ‘strong’ form and ‘weak’ form. An SC is said to be coordinated in strong sense if
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the set of actions that can lead to overall SC optimality are implemented (Cachon 2003). Weaker forms of coordination
require a set of actions to be implemented that make none of the partners worse off, and at least one partner must be
better off than the situation had these actions not been implemented. Strong form of coordination is difficult to achieve
in the presence of information asymmetry. This is perhaps the reason that one finds relatively more studies and applica-
tions of weak form of coordination (Corbett and De Groote 2000; Albrecht 2010).
Quantity discounting is one of the mechanisms used to achieve SC coordination and has been widely addressed
in the literature. The traditional quantity discount models as developed by Buffa and Miller (1979), Chase and
Aquilano (1981), etc. only look into finding the buyer’s optimal ordering quantity whenever the discounting sche-
dule is made available by the vendor, and thus focus only on buyer’s perspective. On the other hand, Crowther
(1967), Monahan (1984) and Lal and Staelin (1984) were the first to consider the vendor’s perspective. They
developed models that try to find the maximum gains for the vendor where the vendor offers discounts to the
buyer to entice the latter to increase the batch size. Monahan’s model considers a lot-for-lot policy (vendor does
not carry any inventory) in which the vendor tries to maximise his resulting gains and in the process compensates
the buyer through discounting for the extra inventory holding charges that the buyer incurs due to increase in the
batch size. Lee and Rosenblatt (1986) extended Monahan’s model by relaxing the lot-for-lot assumption and hence
allowing the vendor to carry inventory. Banerjee (1986) further extended Monahan’s model by considering a con-
stant finite production rate for the vendor. Detailed reviews of such type of work can be found in Weng (1995)
and Sarmah, Acharya, and Goyal (2006).
Literature classifies the VMI practice into two forms on the basis of ownership of inventory at the buyer’s premises.
The first one allows the buyer to make the payment only when the item is sold. Such an approach where the vendor
owns the inventory until it is committed to the final buyer is described as ‘VMI on consignment’ (Williams 2000;
Valentini and Zavanella 2003; Wang, Jiang, and Shen 2004). The second approach is a traditional one in which the
ownership of inventory gets transferred as soon the orders are delivered. This paper focuses on achieving SC coordina-
tion through the latter form of VMI.
Fear of opportunistic behaviour by the vendor is considered as one of the main reasons for the reluctance of the
buyers to enter into a VMI arrangement (Rungtusanatham et al. 2007). Specifically, buyers may fear that the vendor
may stock excess inventory at the former’s premises in order to minimise potential stock-outs (Cachon 2001). Many
studies have tried to study the operational benefits that can accrue due to VMI adoption. VMI offers the vendor some
routing flexibility (Campbell et al. 1998; Kleywegt, Nori, and Savelsbergh 2002). Some studies focus on the ability to
consolidate shipments (Cheung and Lee 2002). Researchers have tried to analyse both single vendor – single buyer as
well as single vendor – multiple buyer systems (e.g. Yao, Evers, and Dresner 2007; Zavanella and Zanoni 2009;
Bookbinder, Gümüş, and Jewkes 2010; Ben-Daya et al. 2013).
Both the mechanisms discussed above can be used by the vendor to entice the buyer to have orders in higher batch
sizes and hence both the above mechanisms can make the vendor better off from his initial position. The buyer, in turn,
must be compensated by the vendor so that he is not worse off. We will discuss the two mechanisms in the next
section.
 International Journal of Production Research 3

3. Problem statement and mathematical model

In our models, we consider a vendor who produces a single product and sells it to a single buyer, subject to the assump-
tions listed in Section 3.1.1.
Under a VMI arrangement, the vendor takes the responsibility of the replenishment decision on behalf of the buyer.
As mentioned earlier, the buyer fears opportunistic behaviour on the part of the vendor, wherein the latter places exces-
sive stock at the former’s facility. One of the safeguards against such a scenario discussed in literature is the use of pre-
set stock levels. Zammori, Braglia, and Frosolini (2009), while discussing a standard VMI agreement based on a case of
superconductor coil winding manufacturing company, highlight stock limits as one of the key performance indicators for
the agreement. They also mention that the indicators must be linked to penalties, in case the thresholds are breached.
Elvander, Sarpola, and Mattsson (2007), based on an extensive study of 15 companies involved in VMI relationships,
also highlight the role of stock limits as important control levers under VMI. Darwish and Odah (2010) determined the
optimal replenishment policy for a vendor supplying a product to multiple buyers in the same delivery cycle. Hariga
et al. (2013) and Hariga, Gumus, and Daghfous (forthcoming) showed that the system level costs could be reduced if
some of the buyers are not necessarily replenished in the same cycle. All of the analytical studies take the stock limit
and the penalty to be given parameters. In this paper, we discuss how the stock limit and the associated penalty can be
determined for a VMI relationship.

3.1 Assumptions and notations

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3.1.1 Assumptions
(1) Final demand is deterministic and uniform in nature.
(2) No demand can be backlogged.
(3) Vendor follows a lot-for-lot policy. Hence, he does not carry any inventory.
(4) Vendor has an unlimited capacity.
(5) The buyer incurs ordering costs and holding costs. The transportation costs are included in the ordering costs.
Vendor incurs a set-up cost corresponding to each delivery batch.
(6) The buyer imposes a penalty on every extra unit from some specified upper limit that is being shipped.

3.1.2 Notations
Q Economic-order quantity (EOQ) as ordered by the buyer initially
D Final demand which is deterministic and uniform in nature
CO Ordering cost for the buyer
H Inventory holding cost (dollar per unit per unit time)
w Wholesale price charged by the vendor for each unit purchased
CS Set-up cost for the vendor for every set-up
z Upper limit of the inventory for the buyer
x Unit penalty charged by the buyer for every unit that exceeds the upper limit
k The factor by which the vendor wishes to increase the batch size.

3.2 Model development

3.2.1 Model I (x and z given) qffiffiffiffiffiffiffiffiffi
Under normal circumstances, the buyer will order according to his EOQ. His initial order will be, Q ¼ 2DCO
H and the
initial cost will be:
D QH pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
B1 ¼ CO þ ¼ 2DCO H (1)
Q 2
Vendor’s initial profit when he operates a lot-for-lot strategy (whenever the buyer places an order Q)
D
S1 ¼ wD  CS (2)
Q
 4 A. Chakraborty et al.

(There is no loss of generality in assuming the unit cost of production to be zero).

In the next stage, the vendor wishes to implement VMI and decides on the order quantity. The buyer in turn charges
a penalty equal to x for every extra unit that he is asked to carry from some preset upper limit set at z. Similar to the
treatment in existing literature, we also assume that these values have already been decided based on negotiations
between the vendor and the buyer (e.g. Hariga et al. 2013). The vendor changes his strategy to produce kQ instead of Q
units, every time he goes for production and ships it to the buyer. This larger batch size may exceed the stock upper
2
limit (Figure 1). Thus, the penalty incurred = x  ðkQzÞ
2  ðkQzÞ
kQ ¼
xðkQzÞ
2kQ .
On implementation of VMI, buyer’s new cost becomes
kQ D xðkQ  zÞ2
B2 ¼ Hþ CO  (3)
2 kQ 2kQ
Thus, buyer’s change in costs can be written as:
 
QH DCO 1 xðkQ  zÞ2
DB ¼ B2  B1 ¼ ðk  1Þ þ 1  (4)
2 Q k 2kQ
The vendor’s decision problem when the penalty and the upper bound of inventory are given is to choose the value of k
that will maximise his additional gains. Vendor’s profit on adopting the VMI strategy is givens as:
xðkQ  zÞ2
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D
S2 ¼ wD  CS  (5)
kQ 2kQ
His change in gains is given as ΔS = S2 − S1
D xðkQ  zÞ2 D
DSðkÞ ¼ S2  S1 ¼  CS  þ CS (6)
kQ 2kQ Q
Thus, the vendor’s decision problem can be expressed as:

Max DSðkÞ
k (7)
s.t. kQ  z and k  1
We will first construct the Lagrangian function Lðk; k; lÞ ¼ DSðkÞ þ kðz  kQÞ þ lð1  kÞ
D xðkQ  zÞ2 D
or; Lðk; k; lÞ ¼ CS þ  CS þ kðz  kQÞ þ lð1  kÞ (8)
kQ 2kQ Q
The KKT conditions (Bazaraa, Sherali, and Shetty 1993) are given as:
@L DCS 2xðkQ  zÞ  kQ2  QxðkQ  zÞ2
¼0) 2 þ  kQ  l ¼ 0 (9)
@k Qk k 2 Q2

kðz  kQÞ ¼ 0 (10)

lð1  kÞ ¼ 0 (11)

k  0; l0

kQ The average excess inventory carried by the buyer

Figure 1. Inventory level at the buyer.

 International Journal of Production Research 5

The cases λ ≠ 0 and μ ≠ 0 are trivial ones and they imply k·Q = z and k = 1 i.e. in either of the cases, the VMI policy
will be not be taken into consideration. Hence, we will only consider the cases when λ = 0 and μ = 0. Thus, the solution
to the KKT problem yields
rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
1 2DCS
k¼ þ z2 (12)
Q x
2
q ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
Further, DSðkÞ ¼ kQD
CS þ xðkQzÞ
2kQ  Q CS is convex at k ¼ Q
D 1
x þ z implying that the KKT point is the point of
2DCS 2

optimum.
The additional gains accrued to the vendor by adopting such a policy can be obtained by substituting the value of k
from (12) in (6).

3.2.2 Model 2 (x and z are determined endogenously)

In this subsection, we will try to establish how the VMI policy under penalty scheme can be used as an incentive mech-
anism for establishing SC coordination. A contract is said to coordinate the SC if the set of the SC actions is Nash equi-
librium, i.e. no firm has a positive unilateral deviation from the set of the SC action (Cachon 2003). In our model, the
vendor chooses the penalty, the upper limit of inventory and the factor by which the delivered lot size has to be
increased so that he can maximise his resulting gains and in the process will not make the buyer worse off. The latter
part is important. It ensures that none of the parties lose by joining a VMI system, thereby ensuring SC coordination.
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Thus, the vendor’s decision problem can be expressed as:

9
Max DSðkÞ >
k;z;x >
=
s:t: DB  0 (13)
kQ  z and >>
;
k1
We will first construct the Lagrangian function
Lðk; x; z; c; k; lÞ ¼ DSðkÞ þ c  DBðkÞ þ kðz  kQÞ þ lð1  kÞ

or; " #
   
DCS 1 xðkQ  zÞ2 QH DCO 1 xðkQ  zÞ2
Lðk; x; z; c; k; lÞ ¼  1 þ þc ðk  1Þ þ 1  þ kðz  kQÞ
Q k 2kQ 2 Q k 2kQ
þ lð1  kÞ
(14)
The KKT conditions are:
@L DðCS þ CO Þ cQH xðkQ  zÞ  ðkQ þ zÞ
¼0) þ ð1  cÞ þ  kQ  l ¼ 0: (15)
@k Qk 2 2 2k 2 Q

@L ðkQ  zÞ2
¼0) ð1  cÞ ¼ 0 (16)
@x 2kQ

@L 2xðkQ  zÞ cx
¼0) þ  2ðkQ  zÞ þ k ¼ 0 (17)
@k 2kQ 2Qk
"   #
QH DCO 1 xðkQ  zÞ2
c ðk  1Þ þ 1  ¼0 (18)
2 Q k 2kQ

kðz  kQÞ ¼ 0 (19)

lð1  kÞ ¼ 0 (20)
 6 A. Chakraborty et al.

c; k; l  0
Using the same argument, we can state that k·Q ≠ z and k ≠ 1. Hence, λ = 0 and μ = 0. Further, k·Q≠z, from (16), we get
γ = 1.
rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
CO þ CS
Solving the above optimisation problem, we get k ¼ (21)
CO
And x and z should satisfy the following condition
   
xðkQ  zÞ2 k  1 DCO 1 DCO 1
¼ QH þ 1 ¼ kþ 2 (22)
2kQ 2 Q k Q k
It can easily be shown that the solution obtained as a result of solving the KKT problem is also the optimal solution.
One thing to be noted is that the LHS of the above expression gives the total penalty that is charged by the buyer to
the vendor and the value of k is independent of both x and z.

3.2.3 Comparison with quantity discounts (Monahan’s model)

Quantity discounting model as developed by Monahan (1984) also aims at finding the factor by which the vendor will
ask the buyer to increase the batch sizes along with the quantity discount that he will be offering that will maximise his
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resulting gains from the initial condition and in the process will not make the buyer worse off.
The factor by which the buyer will be asked to increase the batch size is given as (see Appendix for details):
rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
CO þ CS
kdis ¼ (23)
CO
 
QC1 D 1
and DSðkÞ ¼  ðk  1Þ þ ðCS þ CO Þ 1  (24)
2 Q k
Hence, under VMI whenever the vendor is asked to choose the penalty levels and the upper level of inventory to be
kept at the buyer’s premises with the subsequent increase in batch size by a constant proportion subject to the condition
that in doing so, the buyer will not be made worse off, it is found that the factor by which the vendor wishes to increase
the batch size is identical to that found in the case of quantity discounting model as developed by Monahan. Hence, it
can be stated that both the forms of SC coordinating mechanisms, i.e. VMI as well as quantity discounting are essen-
tially equivalent to each other under deterministic setting with uniform demand. Further, when the lot-for-lot condition
is relaxed, both these mechanisms are again found to be equivalent (the details are worked out in the Appendix).

4. Numerical examples and sensitivity analysis

4.1 Example 1: x and z are given
Consider the case when annual demand (D) = 1000 units, ordering cost (CO) = $10 per order, set-up cost for the vendor
(CS) = $300 per set-up, inventory carrying costs for the buyer (H) = 2 per unit per unit time. Further, we will take x = 3
and z = 150. Using (12) we get, k = 4.717, ΔS = 2034.903 and ΔB = 36.20. Next, we carry out sensitivity analysis with
respect to the vendor set-up cost, stock upper limit and penalty levied.

4.1.1 Impact of change in Cs

The impact of change in vendor set-up cost is shown in Figure 1. As the set-up cost incurred by the vendor increases, it
becomes more and more beneficial for the vendor to increase the batch size. Thus, the vendor pushes more stock to the
buyer (k increases). For a given per unit penalty and upper stock limit, the vendor would send more stock as long as
the savings from higher set-up costs can offset the increased penalty. Moreover, the savings obtained by the vendor
under VMI increase as compared to the case of independent ordering by the buyer. The latter’s total ordering and
holding costs indeed increase. However, the impact of these increased costs is cushioned by the penalty paid by the
vendor to the vendor (Table 1).
 International Journal of Production Research 7

Table 1. Impact of change in set-up cost.

Cs S1 B1 k Penalty ΔS ΔB %ΔS %ΔB

300 3000 200 4.7170 329.10 2364.001 36.19943 78.800 18.100

400 4000 200 5.3774 419.38 3256.149 63.03724 81.404 31.519
500 5000 200 5.9652 501.35 4161.802 88.07325 83.236 44.037
600 6000 200 6.5000 576.92 5076.923 111.5385 84.615 55.769
700 7000 200 6.9940 647.36 5999.149 133.6597 85.702 66.830
800 8000 200 7.4554 713.58 6926.956 154.6272 86.587 77.314
900 9000 200 7.8899 776.26 7859.296 174.5952 87.326 87.298

4.1.2 Impact of change in z and x

The impact of change in change in z is shown in Table 2, while the impact of change in x is shown in Table 3. As the
stock upper limit is increased, the vendor is able to ship larger batches without incurring additional cost. Moreover,
the penalty levied on the vendor also decreases. At the same time, buyer’s holding costs increase. On the other hand, as
the per unit penalty increases, it becomes costlier for the vendor to send the same batch size if it is more than the preset
upper limit. Thus, the vendor sends smaller batches (reduces k) in order to counter the increased penalty.
Note that in this example even after the payment of penalty, the buyer’s cost increase as compared to EOQ-based
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ordering (ΔB is positive). Thus, as a standalone measure, this scheme would not be able to coordinate the SC, as it will
be beneficial for the buyer to act independently (positive unilateral deviation). The same issue can be observed in the
VMI model forwarded by Darwish and Odah (2010). In order to entice the buyer to join the VMI arrangement, some
side payments might be necessary. These payments will compensate the buyer for any increase in costs, and may take
the form of a lump sum amount or a per unit price increase.

4.2 Example 2: x and z are endogenous

Consider the previous example but with both x and z now variable. Using (21) and (22) we get, k = 5.568, ΔS = 2086.45
and total penalty paid by the vendor = 374.74.

Table 2. Impact of change in stock limit.

z S1 B1 k Penalty ΔS ΔB %ΔS %ΔB

100 3000 200 4.583 420.12 2345.35 140.04 78.18 70.02

110 3000 200 4.605 400.22 2348.60 117.97 78.29 58.98
120 3000 200 4.630 381.20 2352.10 96.57 78.40 48.28
130 3000 200 4.657 363.02 2355.84 75.82 78.53 37.91
140 3000 200 4.686 345.66 2359.82 55.71 78.66 27.85
150 3000 200 4.717 329.10 2364.00 36.20 78.80 18.10
160 3000 200 4.750 313.31 2368.39 17.28 78.95 8.64

Table 3. Impact of change in per unit penalty.

x S1 B1 k Penalty ΔS ΔB %ΔS %ΔB

3 3000 200 4.717 329.10 2364.00 36.20 78.80 18.10

3.5 3000 200 4.404 335.07 2318.76 71.98 77.29 35.99
4 3000 200 4.153 339.01 2277.68 99.60 75.92 49.80
4.5 3000 200 3.948 341.45 2240.04 121.36 74.67 60.68
5 3000 200 3.775 342.74 2205.28 138.76 73.51 69.38
5.5 3000 200 3.628 343.15 2172.99 152.82 72.43 76.41
6 3000 200 3.500 342.86 2142.86 164.29 71.43 82.14
 8 A. Chakraborty et al.

Table 4. Impact of change in set-up cost.

Cs S1 k ΔS Penalty %ΔS

300 3000 5.568 2086.45 374.74 69.55

350 3500 6.000 2500.00 416.67 71.43
400 4000 6.403 2919.38 455.93 72.98
450 4500 6.782 3343.53 492.98 74.30
500 5000 7.141 3771.71 528.15 75.43
550 5500 7.483 4203.34 561.69 76.42
600 6000 7.810 4637.95 593.83 77.30

4.2.1 Impact of change in Cs

From Table 4, it can be seen that the vendor’s gains increase with the increase in vendor’s set-up cost. With an increase
in set-up cost, the vendor delivers larger batch sizes to the buyer. Correspondingly, the benefit accrued to the vendor
increases. Even though as compared to example 1, the value of k is larger in this case, yet the increase in vendor’s profit
is lower. This is because of increased penalty payments to compensate the buyer so that the latter is not worse off. Note
that in this case, the penalty payments compensate the buyer completely for his increased costs, thus ensuring coordina-
tion within the SC.
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5. Discussion
Researcher have highlighted that contrary to the belief of most academics and practitioners that VMI is, in general,
either better or worse than the traditional approach, the success of VMI depends greatly on the cost parameters involved
(Bookbinder, Gümüş, and Jewkes 2010). In this paper, we highlight the role of penalty in ensuring SC coordination.
Existing literature on such arrangements takes the penalty as exogenously given. We discuss how the vendor and the
buyer can negotiate acceptable penalty limits in an equitable way, ensuring that neither party is worse off. This also
helps in understanding why stock levels are considered as one of the key performance indicators in case of VMI. In
some cases, the buyer may have a reservation profit as a pre-condition to entering any coordination arrangement. The
treatment in this paper can be easily modified to incorporate such situations.
For model 2, it can be seen that for a given situation there may more than one feasible combination of x and z
(equation 22). It must be pointed that x and z are just the two components of the penalty, which is the actual variable of
interest. Thus, it hardly matters whether a smaller stock limit with a larger per unit penalty is chosen or vice versa. Ulti-
mately, in order to ensure that the mechanism coordinates the SC, it must be ensured that the buyer is not worse-off
and the total penalty payment is a tool for achieving that objective.
In most analytical papers on SC coordination through VMI, the cost benefits accruing due to VMI are cited as the
reason for adopting VMI. In this paper, we have highlighted the inadequacy of such approaches by establishing that
VMI and quantity discounts may lead to same cost outcomes. Under such circumstances, just the driver behind the coor-
dination changes from per unit price reduction in case of quantity discounts to penalty in case of VMI.
It is important to realise that there are two facets of SC collaboration, viz. cooperation and coordination. The former
can be understood as the joint pursuit of agreed-on goals through a shared understanding of contributions and payoffs,
while the latter can be defined as the deliberate and orderly alignment of the actions of the partners concerned (Gulati,
Wohlgezogen, and Zhelyazkov 2012). While cooperation is concerned with resource dependencies coordination is
focused on managing task dependencies. The coordination perspective must thus be complemented with an analysis of
the issues related to collaboration as well. Thus, the choice of a coordination mechanism in general and VMI in particu-
lar must be governed by a holistic appraisal of both facets of collaboration.

6. Conclusions
This paper seeks to make three main points. First, it discusses how a VMI scheme with penalty can act as a coordina-
tion mechanism. Second, it presents an analytical approach to estimate the penalty parameters (stock limit and penalty
per unit). Lastly, it establishes the equivalence of VMI and quantity discounts under the specified assumptions, hence
focusing on the need to take a more comprehensive ‘collaboration’ perspective. The VMI scheme in this paper and
quantity discount both seek to induce the buyer to order in larger quantities. The incentive, however, changes from per
unit price reduction in case of discounts to penalty payment under VMI. Further research can focus on integrated
analysis of VMI-based SC coordination including its pre-requisites, drivers and inhibitors.
 International Journal of Production Research 9

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Appendix 1. Derivation of Monahan’s model

A buyer would like to operate at his EOQ. His initial ordering plan and costs are given as
D wQ pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
B1 ¼ w  D þ CO þ C1 ¼ w  D þ 2DwCO C1 (25)
Q 2
rffiffiffiffiffiffiffiffiffiffiffiffi
2DCO
where; Q ¼ (26)
wC1
In that case, the vendor’s total profit can be given by
D
S1 ¼ wD  CS (27)
Q
Whenever, the vendor comes up with a proposal of discount, he in turn wants the buyer to increase his order size by k times. The dis-
count offered acts as a side payment that will compensate the buyer for carrying higher inventory. When the vendor offers a per unit
discount of Δw to the buyer, the buyer’ final cost is then given by
D kQw
B2 ¼ ðw  DwÞ  D þ CO þ C1
kQ 2
Vendor’s total profit now becomes
D
S2 ¼ ðw  DwÞD  CS
kQ
Vendor’s net additional gain is given by
 
D D D 1
DS ¼ S2  S1 ¼ ðw  DwÞD  CS  wD þ CS ¼ Dw  D þ CS 1  (28)
kQ Q Q k
Similarly, buyer’s change in costs is given by
 International Journal of Production Research 11

D kQw D Qw
DB ¼ B2  B1 ¼ ðw  DwÞ  D þ CO þ C1  w  D  CO  C1
kQ 2 Q 2
  (29)
D 1 Qw
¼ Dw  D  CO 1  þ C1 ðk  1Þ
Q k 2
Vendor’s decision problem is thus choosing the values of k and Δw that will maximise the value of ΔS and in the process will keep
ΔB ≤ 0 i.e.
 )
Max DS ¼ Dw  D þ D Q CS 1  k
1
  (30)
s.t. Dw  D  Qw
2 C1 ðk  1Þ  Q CO 1  k
D 1

 
Since the expression DS ¼ Dw  D þ D
Q CS 1  k
1
will attain its maximum value at the minimum value of Δw which is
2D C1 ðk 1Þ  CQO ð1  1k Þ. The vendor would not like to give the buyer any extra surplus, as it would reduce his own profits. This
Qw

reduces the above constrained optimisation problem to the following unconstrained maximisation problem.
 
wQC1 D 1
Max  DSðkÞ ¼  ðk  1Þ þ ðCS þ CO Þ 1 
2 Q k
Solving the above problem, we get
rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
CO þ CS
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k¼
CO

Appendix 2. Equivalence of VMI and quantity discount when lot-for-lot assumption is relaxed
When the lot for lot condition is relaxed, it can be shown that VMI mechanism is again equivalent to quantity discounting. Let HS be
the holding cost of the vendor. Whenever, the buyer places an order of Q units, the vendor, produces a batch of nQ units (see Lee
and Rosenblatt 1986). Average inventory carried out by the vendor is given as:

1 1 nðn  1Þ
Average inventory ¼ ½ðQ1  QÞ þ ðQ1  2QÞ þ . . . þ ðQ1  ðn  1ÞQÞ ¼ ðn  1ÞQ1  Q
n n 2
(∵ Q1 = nQ, substituting the same result in the above expression we get)
= Q n1
2 where Q1 is the production batch size of the vendor.

Thus, Inventory Holding Cost for the vendor = Q  n1

2 HS

Hence, the vendor’s total cost is given as

D n1 D Q1 =Q  1 D Q1 Q
TCðQ1 Þ ¼ CS þ Q  HS ¼ CS þ Q  HS ¼ CS þ HS  HS
Q1 2 Q1 2 Q1 2 2

The first-order condition for cost minimisation gives

rffiffiffiffiffiffiffiffiffiffiffiffi
dTCðQ1 Þ DCS HS 2DCS
¼ þ ¼ 0 ) Q1 ¼
dQ1 Q21 2 HS
 
D Q1 HS
Vendors net profit is given as S10 ¼ w  D  CS  Q  1 (31)
Q1 Q 2
where Q1 is given by above equation. The buyer’s initial cost will remain the same as (1). In case of quantity discount, when the
batch sizes are revised by a factor k1 the subsequent changes in cost and profit of the buyer and vendor is given as:
B02 ¼ B2 as given in (3)
 
D Q1 HS
S20 ¼ ðw  DwÞ  D  CS  k1 Q  1 (32)
k1 Q1 Q 2
 12 A. Chakraborty et al.

 
0 DCS 1 Q1  Q
DS ¼ S20  S10 ¼ DwD þ 1  HS ðk1  1Þ (33)
Q1 k1 2
Thus, the vendor’s problem is to solve
 
D Q1 HS
Max S20 ¼ ðw  DwÞ  D  CS  k1 Q  1
k1 Q 1 Q 2
 
DCO 1 Q
S.T. DwD   1 þ Hðk1  1Þ
Q k1 2


 
Substituting, we get Max DS 0 ¼ D 1  k11 CQO þ QCS1  ðk1  1Þ Q2 H þ Q12Q HS
   
dDS 0 1 CO CS Q Q1  Q
First-Order Condition ¼D 2 þ  Hþ HS ¼ 0
dk1 vffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
k1 Q Q1 2 2
u

u 2D Co
þ QC1s  
t Q DCO 1 Q
k1 ¼ and DwD ¼  1   þ Hðk1  1Þ
Q  H þ ðQ1  QÞHS Q k1 2
Under VMI using the same arguments as given in the main body of the paper, we can write

xðkVMI Q  zÞ2
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kVMI Q D
B2VMI ¼ þ CO 
2 kVMI Q 2kVMI Q
 
QH DCO 1 xðkVMI Q  zÞ2
DB ¼ ðkVMI  1Þ þ 1  0
2 Q kVMI 2kVMI Q
 
D Q1 HS xðkVMI Q  zÞ2
S2VMI ¼ wD  CS  kVMI Q  1 
kVMI Q1 Q 2 2kVMI Q
   
D 1 Q1 HS xðkVMI Q  zÞ2
DSVMI ¼ CS 1  Q  1 ðkVMI  1Þ 
Q1 kVMI Q 2 2kVMI Q
 
QH DCO 1 xðkVMI Q  zÞ2
DBVMI ¼ ðkVMI  1Þ þ  0
2 Q kVMI  1 2kVMI Q
Substituting, we get
     
D 1 Q1 H QH DCO 1
Max DSVMI ¼ CS 1  Q  1 ðkVMI  1Þ  ðkVMI  1Þ  1
Q1 kVMI Q 2 2 Q kVMI
First-order condition gives
dDSVMI ðkVMI Þ DCS ðQ1  QÞHS QH DCO
¼   þ 2 ¼0
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi

ffi dkVMI 2
Q1 kVMI 2 2 QkVMI
Q þQ1
Co Cs
2D

kVMI ¼ QHþðQ1 QÞHS which is same as that of quantity discount. Hence the equivalence is established between these two coordinat-
ing mechanisms.
Further, whenever, the vendor acts as a manufacturer i.e. having a finite production rate, the only modification happens in his total
cost, which is given as:
D Q1 =Q  1 Q1 D Q
TCðQ1 Þ ¼ CS þ Q  HS + HS = CS þ Q1 HS  HS
Q1 2 2 Q1 2
The resultant value of revised batch size under both VMI and quantity discount is given as
vffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi

 ffi
u
u 2D Co þ Cs
 t Q Q1
kCon ¼
QH þ ðQ1  QÞHS