Inventory Management and Supply Chain Finance: Theory and Empirics

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Tong, Jordan David


Song, Jing-Sheng

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A payment scheme specifies when payments are made between firms in a supply chain. It has direct implications on how supply chain inventory is financed and managed. Longer supply chains due to globalization and the recent credit crisis have increased the pressure to make financing the supply chain more efficient. It was recently reported that 81% of UK firms say that market conditions have brought procurement and finance strategies in closer alignment. Meanwhile, information technology platform advancements provide opportunity for increased variety of payment schemes. It is therefore important to understand how different payment schemes should be captured in inventory decisions. This dissertation examines the impact of supply chain finance (the set of financial payment transactions that are triggered by supply chain events) on inventory management from both normative and behavioral perspectives.

We seek to address the following questions. From a normative perspective: How does the optimal inventory policy depend on the supply chain financing structure? What is the right inventory financing scheme for a supply chain? From a behavioral perspective: How do real managers psychologically process payments when making inventory decisions, and how are they affected by the supply chain financing scheme? The results are reported in three chapters, described below.

In the first chapter, "Payment schemes and the financed inventory," we present a model of payment schemes in an echelon supply chain. A payment scheme specifies when payments are made between firms. Standard inventory decision models make strict assumptions about the payment scheme in order to avoid explicitly tracking financial flows. These assumptions, however, often do not hold in practice. We show that these assumptions can be relaxed. In particular, we introduce a model that allows us to track the financial flow of inventory models depending on the inventory policy and the payment scheme. We also define two new measures - financed inventory and margin backorders. These new measures allow us to leverage the structure of the payment scheme to define an equivalent problem that does not have to explicitly track financial flows. We apply this method to the base stock model and economic order quantity model to demonstrate the sensitivity of the optimal inventory policy to the payment scheme. Our results provide simple closed-form formulas for inventory managers and also sheds light on what is the right payment scheme for a supply chain.

The second chapter, "The effect of payment schemes on inventory decisions: The role of mental accounting," focuses on managerial behavior: how do manager's mentally process and evaluate payments when making an inventory decision? Keeping the net profit structure constant, we study how the payment scheme affects inventory decisions in the newsvendor problem. Specifically, we examine three payment schemes which can be interpreted as the inventory order being financed 1) by the newsvendor herself, 2) by the supplier, and 3) by the customer. We find in laboratory experiments that the order quantities may be higher or lower than the expected profit-maximizing solution depending on the payment scheme. Specifically, the order quantity under newsvendor own financing is greater than that under supplier financing, which is, in turn, greater than the order quantity under customer financing. This observed behavior biases orders in the opposite direction as what a regular or hyperbolic time-discounted utility model would predict, and cannot be explained by loss aversion models. Instead, the findings are consistent with a model that underweights the order-time payments, which is consistent with the "prospective accounting" assumption in the mental accounting literature. A second study shows the results hold even if all actual payments are conducted at the same time, suggesting that the framing of the payment scheme is sufficient to induce mental accounting of payments at different times. We further validate the robustness of our model under different profit-margin conditions. Our findings contribute to the understanding of the psychological processes involved in newsvendor decisions and have implications for supply chain financing practices and supply chain contract design.

The third chapter, "Reference prices and transaction utility in inventory decisions," studies another aspect of mental accounting in inventory decisions - the phenomenon that individuals often view a price as relative to other prices when making an evaluation. We present a descriptive model of the effects of reference prices and transaction utility in a newsvendor setting. The model predicts that an individual's order is irrationally increasing in past purchasing costs, decreasing in past selling prices, and decreasing in the proportion of high profit margin to low profit margin products in the decision portfolio. Three laboratory experiments support the model's predictions. These results suggest that managerial supervision and/or intervention are most valuable after a sudden increase or decrease in the cost or price of a product, or for a product that differs significantly in profit margin from other products in the category. We further extend the study to a supply chain setting. We show analytically that the supplier's optimal wholesale price is lower when the newsvendor is subject to reference effects compared to when the newsvendor is rational, and that the supplier's optimal retail price may be higher or lower depending on whether the reference effect is stronger for the newsvendor or for customers. Finally, we show that supply chains may suffer from a behavioral inefficiency we call a behavioral price whip: an increase in the transfer price between two nodes may influence the upstream node to order more than is rational while the downstream node demands less than is rational. These results suggest that suppliers should carefully evaluate the reference effect on both customers and retailers, and that everyday low pricing has a behavioral benefit over high-low pricing.





Tong, Jordan David (2012). Inventory Management and Supply Chain Finance: Theory and Empirics. Dissertation, Duke University. Retrieved from


Dukes student scholarship is made available to the public using a Creative Commons Attribution / Non-commercial / No derivative (CC-BY-NC-ND) license.