When is Vendor Managed Inventory Good for the Retailer? Impact of Relative Margins and Substitution Rates

Few retail products are completely unique and irreplaceable. Because of this, when customers cannot find a particular item at a retailer because it is out of stock, they are likely, with some probability, to switch to a substitute product from another manufacturer at the same store. Analyzing a two-product full substitution case, this paper examines two beliefs argued in the literature: (1) that, under Vendor Managed Inventory (VMI), the retailers would benefit because manufacturers would increase stocking quantities to avoid losing sales to a competitor and (2) that substitution benefits retailers who make a sale regardless. We find that the first proposition while appealing, is simply not true for many cases, especially when the manufacturer's margins are significantly less than the retailer's, or when the two products are highly asymmetric in terms of their margins or substitution rates. Moreover, we find that it is perfectly possible for VMI to hurt retailers instead of benefiting them. Our findings apply both if full backorder or lost sales are assumed. We also find that the second proposition does not hold for a wide number of cases. For full backorders, in Retailer Managed Inventory (RMI) or VMI if the substitution that increases is from the most lucrative to the least lucrative product, this will not benefit the retailer since, in this case, more customers would be "trading down"; for lost sales, we find that a similar situation arises under VMI but not under RMI. We contribute to the understanding of the inherent tradeoffs involved in deciding to use RMI or VMI in the presence of competing, substitute products.