Supply and Demand - Case Study: Cabbage Patch Kids

Turning the Supply Chain into a Revenue Chain Turning the Supply Chain into a Revenue Chain by Gerard P. Cachon and Martin A. Lariviere
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• Print In the summer of 1997, movie fans ? cked to their local Blockbuster video stores eager to rent The English Patient and Jerry Maguire, only to find that all ten or so copies of each had already been checked out.

Blockbuster shared their frustration. It knew it was annoying customers and losing sales. It wasn’t that the company didn’t know how many copies it could have rented; demand could easily be predicted by looking at theater receipts.

And it wasn’t that the company was inefficient at getting tapes into stores and returning rented tapes to shelves; its buying and replenishment processes were fine-tuned.

The problem was that at $60 a copy, Blockbuster couldn’t afford to stock the number of tapes it needed to serve every customer, only to replace the mall a few weeks later with copies of the next hot movies. Its suppliers, the movie studios, had to charge a high initial price to earn enough revenue themselves. But at $3 per rental, Blockbuster had to rent a tape more than 20 times to earn a profit.

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Given that peak demand for a title lasts only a few weeks, the company couldn’t justify buying enough tapes to even come close to satisfying initial demand.

The studios’ high wholesale price limited availability, and no one—not the supplier, not the retailer, not the customer—was happy. But in 1998, Blockbuster solved the problem by radically changing the way it paid its suppliers. It agreed to give the studios a share of the rental fees in return for a much lower up-front price on tapes. Here’s how it works. Suppose the supplier charges only $9 per tape instead of $60 but receives 50% of the rental revenue. Even though Blockbuster keeps only half of the revenue, or $1. 0 per rental, it breaks even after each tape has been rented a mere six times. It can now justify purchasing many more tapes. Having more tapes means more potential rentals. Combined with the drastically lower cost, this translates into a significantly higher profit for Blockbuster. For the movie studio, increased tape sales and the added revenue stream also result in more profit. Everyone goes home happy. (For a look at a plausible profit scenario, see the exhibit “The Economics of Revenue Sharing. ”) [pic] The new arrangement paid off immediately for Blockbuster.

In the year after starting the program, the company increased its market share by about 5%, which roughly equaled the share of the number-two retailer, Hollywood Entertainment. Now, revenue sharing is common throughout the industry. Our research indicates that revenue sharing will work for many products but only when two conditions are met. First, the cost to produce the additional units must be less than the incremental revenue they generate. If it is, a greater availability will increase supply chain profits, so both parties will be better off. In the video rental industry, making a movie is xpensive, but copying a tape is cheap. Consequently, the supply chain can double or quadruple inventory, and the resulting revenue rise will easily cover the additional production cost. This condition is not satisfied in all markets. Chrysler could increase revenue by expanding supplies of its PT Cruiser, but the costs involved would be prohibitive, and the greater availability might end up undermining the car’s cachet. The second criterion is that the administrative burden associated with revenue sharing must be small enough that the cost of running the program doesn’t eat up all the gains.

For the video rental industry, this is a minor concern. Suppliers need only link into the point-of-sale systems that even the smallest video retailers already use. We suspect there are other industries whose products and services satisfy these requirements and for which revenue sharing would also work well. Consider, for example, distributing music in digital formats. The expense to copy a file is essentially zero—far less than the value it creates for customers (remember, we’re focusing on the incremental cost of expanding supply, not the sunk cost of creating content).

The market is also likely to grow substantially with improved availability. Many customers find a list price of $18. 97 for a CD daunting when all they want is one song. Digitally distributing individual songs provides an opportunity to expand total industry revenues. Finally, monitoring usage is simple and easy if records are centrally maintained. In this light, Bertelsmann’s deal with Napster makes tremendous sense: Napster’s centralized structure allows for revenues to be tracked, and its 38 million users allow for rapid expansion of the market. [pic][pic][pic][pic][pic][pic]