Compensation Policy:

Objective:

The concept of stockout compensation wherein an online retailer may offer purchasers a price
discount when the product is out of stock.

Description:

We call this a stockout compensation policy or a hybrid operation and differential pricing
policy, to contrast with the three special cases where the retailer either a) has both in-stock
and stockout periods but charges the same price in both periods (the no-compensation
policy), or b) always keeps positive stock and charges a premium price (the wait-free
operation, premium pricing policy) or c) main- tains no stock, accepts backorders, and
charges a discounted price (the stockless operation, discount pricing policy).

Retailers can announce compensations as soon as they have stockouts, and can even provide
information on expected waiting times.

There are many examples of stockout compensation in practice, both in traditional and online
retailing. For example, car dealerships have limited inventory due to high holding costs, and
some car dealers offer a price reduction if the chosen automobile is not in stock. Similarly,
movie rental stores often provide certain movies free at a later date in case the disk is not in
stock when a customer demands it.

Theorem 1 states that the firm’s optimal policy is to choose period lengths and prices such
that the two periods have equal effective prices (i.e., the price during in-stock period equals
the price during stockout plus the average waiting cost for a customer).

In general, the benefit from the stockout compensation policy increases as the holding and
waiting costs are closer.

Theorems 2 and 3 state that stock- out compensation not only increases profits, but also
increases revenues, reduces unit costs, and improves consumer surplus and market coverage.

*Inventory management has been a classic OR application from the days of the economic
order quantity (EOQ)

Wee (1999) studied inventory models where a retailer who runs an EOQ model could get a
price or quantity discount from a supplier:

Wee and Yu (1997) considered an inventory model under a temporary price discount when a
product may deteriorate during storage; Fazel et al. (1998) analyzed inventory costs for an
EOQ policy with quantity discounts; and Wee (1999) investigated a deterministic inventory
model with quantity discount, pricing and partial backordering, when the product in stock
deteriorates with time.
The demand rate for a product may be affected by marketing policies, consumer reaction to
stockouts, product deterioration etc., and many researchers have investigated the resulting
effect on inventory control.

### Kunreuther and Richard (1971) investigated the interrelationship between the pricing and
inventory decisions, assuming a known and constant demand rate. Kunreuther and Schrage
(1973) extended this result to the case of deterministic demand which shifts from period to
period. Thomas (1974) investigated the problem of optimizing price and production level
simultaneously and derived an optimal inventory policy using dynamic programming. Con-
sidering a time-dependent demand rate, Pekelman (1974) developed a model that jointly
optimizes price and production schedule. Cohen (1977) investigated the problem of simul-
taneously setting price and production levels for an exponentially decaying product. Cheng
(1990) proposed a profit maximization decision model that explicitly integrates the pricing
and sizing decisions to determine the optimal ordering policy. Fershtman and Spiegel (1986)
investigated optimal inventory and pricing policies when firms experience a learning effect,
or decreasing production costs with cumulative production experience. George (1987) devel-
oped a model for the valuing of non-replenishable inventory and examined pricing strategies
that determine the minimum price for immediate disposal of the entire stock. Sogomonian
and Tang (1993) investigated the benefit of coordinating promotion and production decision
for a firm by formulating two problems: a baseline model (two decisions are made separately)
and an integrated model (decisions are made jointly). Through their solution approach, they
evaluated the benefits of coordinating the promotion and production decisions. Chen and Min
(1994) studied the optimal inventory and pricing policies for a single seller when demand is
linear in price, and compared profit maximization and return on inventory investment.
Federgruen and Heching (1999) addressed the simultaneous determination of pricing and
inventory replenishment strategies in the face of demand uncertainty when distributions of
demand depend on the item’s price. ###

The firm’s objective is to choose prices and period lengths (and, by implication, the order
quantity) in order to maximize profits.

Lemma 1 If the period lengths are chosen such that T1 = b then p1, the price for in-stock

T2 h
period, is the same as the effective (to buyer) price pˆ2 for the stockout period. The net

demand rates in the two periods are identical.

However, in general, rational customers are likely to take future prices into account: some
potential buyers may find it optimal to delay their purchase decision, hence will not buy in
their arrival period; others who are currently non-buyers in their arrival period may choose to
buy in the other period. Is the equal-effective-prices policy implementable, and what should
the firm do under such behaviour?

We can readily see that the equal-effective-prices policy is such an equilibrium. In deriving
the policy, the firm assumes that αˆ=0andfindsthatp∗=p∗+bT2. Since, p <p+under

this policy, it would provide no incentive for customers to shift their purchase decision even
when they have advance knowledge of future prices.

the optimal price for the stockout compensation policy is lower than that of the wait-free or
stockless operations. Therefore, the firm captures a larger market with the stockout
compensation policy.

Case when: If the retailer has higher demand rate, hence has to manage greater volumes,
better pricing and inventory management becomes more important. By the same token, as the
setup cost A increases, so does the importance of the stockout compensation policy because
the retailer wants to place fewer orders, hence keeps relatively larger inventories to reduce
total inventory costs.

A - setup cost per order

H - holding cost per item per unit time

C - unit purchasing cost

b - customer’s waiting cost per unit time

D - customer arrival rate

he optimal price in the no-compensation policy is lower than the in-stock price but

∗b∗ higher than the stockout price

Theorem 4 : When customer valuations are uniformly distributed, then the optimal two- price
policy yields the same profit, order quantity, and cycle lengths, regardless of whether
consumers are given the exact or average waiting time.

Our assumption about average waiting time information is consistent with some practice and
literature: it is true with respect to all the examples cited in §1.1, and is also commonly made
in the literature, as noted in §3. This assumption makes the model tractable, and is a simpler
and more realistic implementation policy. However, in general, when customers are
heterogeneous in waiting costs and know the exact waiting time, a dynamic pricing scheme
(during the stockout period) can yield greater profits.

stockout compensation leads to a lower price, which results in a higher demand rate and
lowers the average inventory costs—is valid even in the stochastic demand setting, where
stockout compensation effectively means a lower target fulfillment rate and higher chance of
stockout.

Definitions:

Backorders: a retailer's order for a product that is temporarily out of stock with the supplier
EOQ: Economic Order Quantity
Stockout: a situation in which an item is out of stock.
Surplus: an amount of something left over when requirements have been met; an excess of
production or supply.
Holding cost: warehouse cost for storing product
stockless operation policies: There will be no warehouse, retailer ask for product from
supplier when there is demand of product from customer. There will be zero holding cost.
Price of product in this policy will be different when product is available in warehouse