Assortment Planning and Inventory Decisions Under a Locational Choice Model

We consider a single-period assortment planning and inventory management problem for a retailer, using a locational choice model to represent consumer demand. We first determine the optimal variety, product location, and inventory decisions under static substitution, and show that the optimal assortment consists of products equally spaced out such that there is no substitution among them regardless of the distribution of consumer preferences. The optimal solution can be such that some customers prefer not to buy any product in the assortment, and such that the most popular product is not offered. We then obtain bounds on profit when customers dynamically substitute, using the static substitution for the lower bound, and a retailer-controlled substitution for the upper bound. We thus define two heuristics to solve the problem under dynamic substitution, and numerically evaluate their performance. This analysis shows the value of modeling dynamic substitution and identifies conditions in which the static substitution solution serves as a good approximation.Operations Management Working Papers Serie

Asymmetric Consumer Learning and Inventory Competition

We develop a model of consumer learning and choice behavior in response to uncertain service at the marketplace. Learning could be asymmetric, i.e., consumers may associate different weights with positive and negative experiences. Under this consumer model, we characterize the steady-state distribution of demand for retailers given that each retailer holds constant in-stock service level. We then consider a non-cooperative game at the steady-state between two retailers competing on the basis of their service levels. Our model yields a unique pure strategy Nash equilibrium. We show that asymmetry in consumer learning has a significant impact on the optimal service levels, market shares and profits of the retailers. When retailers have different costs, it also determines the extent of competitive advantage enjoyed by the lower cost retailer.Operations Management Working Papers Serie

What Explains Superior Retail Performance?

We analyze the performance of retail firms for the period 1978-97 using public financial data. Our performance measures are long-term stock returns and whether the firm filed for bankruptcy in the period of study. We assume that over a long time period of at least five years, stock returns are a reasonable measure of the overall success of a firm. We have found a very wide disparity in performance between firms. On the one hand, retailers like Wal-Mart, the Gap and Circuit City have had phenomenal success (nineteen year compounded stock returns of 31.2%, 29.5%, and 34.5%, respectively), while on the other, 17% of the public retail firms filed for bankruptcy. We investigate how the following levers managed by the CEO of a retail firm affect performance: return on assets, sales growth, inventory turns, gross margin, financial leverage, and selling, general, and administrative expenses. The nature of the analysis is contemporaneous, providing insights into managerial actions that correlate with success as measured by stock returns, but not a prediction of future stock returns. We find that (1) return on assets, sales growth, standard deviation of return on assets and financial leverage explain more than 50% of the variation in stock returns for periods of ten years or more; (2) retailers in different segmentsâ apparel, department stores, grocery and convenience stores, drugs and pharmaceuticals, jewelry, consumer electronics, home furnishings, toys, and variety storesâ achieve similar return on assets and return on equity by following very different strategies with respect to their gross margins and inventory turns; (3) even within the same segment, high gross margin correlates with low inventory turns, and with high selling, general, and administrative expenses; (4) risk of bankruptcy is related to the mismatch between how fast a firm attempts to grow versus what growth rate it realizes. We also test for a negative correlation between sales growth and return on assets, which is widely believed to be true but is not borne out by our data.Operations Management Working Papers Serie

Securitization and Real Investment in Incomplete Markets

We study the impact of financial innovations on real investment decisions within the framework of an incomplete market economy comprised of fi rms, investors, and an intermediary. The fi rms face unique investment opportunities that arise in their business operations and can be undertaken at given reservation prices. The cash flows thus generated are not spanned by the securities traded in the fi nancial market, and cannot be valued uniquely. The intermediary purchases claims against these cash flows, pools them together, and sells tranches of primary or secondary securities to the investors. We derive necessary and suffcient conditions under which projects are undertaken due to the intermediary's actions, and firms are amenable to the pool proposed by the intermediary, compared to the no-investment option or the option of forming alternative pools. We also determine the structure of the new securities created by the intermediary and identify how it exploits the arbitrage opportunities available in the market. Our results have implications for valuation of real investments, synergies among them, and their fi nancing mechanisms. We illustrate these implications using an example of inventory decisions under random demand

Linking Finance and Operations in Retailing

Operations Management Working Papers Serie

Intermediation and Value Creation in an Incomplete Market: Implications for Securitization

This paper studies the impact of financial innovations on real investment decisions. We model an incomplete market economy comprised of firms, investors and an intermediary. The firms face unique investment opportunities that are not spanned by the traded securities in the financial market, and thus, cannot be priced uniquely using the no-arbitrage principle. The specific innovation we consider is securitization; the intermediary buys claims from the firms that are fully backed by cash flows from the new projects, pools these claims together, and then issues tranches of secondary securities to the investors. We first derive necessary and sufficient conditions under which pooling provides value enhancement and the prices paid to the firms are acceptable to them compared to the no-investment option or the option of forming alternative pools. We find that there is a unique pool that is sustainable, and may or may not consist of all projects in the intermediary’s consideration set. We then determine the optimal design of tranches, fully backed by the asset pool, to be sold to different investor classes. We determine the general structure of the tranches. The new securities created by the intermediary could have up to three components, one that is a marketable claim, one that represents the arbitrage opportunities available in the market due to special ability to design and sell securities to a subset of investors, and a third component that is the rest of the asset pool which is sold at a price which does not exceed arbitrage based bounds to investors. The presence of these three components in the tranching solution has direct bearing upon the size of the asset pool, and therefore value creation due to financing additional projects

Intermediation and Value Creation in an Incomplete Market: Implications for Securitization

This paper studies the impact of financial innovations on real investment decisions. We model an incomplete market economy comprised of firms, investors and an intermediary. The firms face unique investment opportunities that are not spanned by the securities traded in the financial market, and thus, cannot be priced uniquely using the no-arbitrage principle. The specific innovation we consider is securitization: the intermediary buys claims from the firms that are fully backed by cash flows from the new projects, pools these claims together, and then issues tranches of secondary securities to the investors. We first derive necessary and sufficient conditions under which pooling provides value enhancement from the new projects that are undertaken, and the prices paid to the firms are acceptable to them compared to the no-investment option or the option of forming alternative pools. We find that there is a unique pool that is sustainable, and which may or may not consist of all projects in the intermediary’s consideration set

Signaling to Partially Informed Investors in the Newsvendor Model

We analyze a signaling game between the manager of a firm and an investor in the firm. The manager has private information about the firm\u27s demand and cares about the short-term stock price assigned by the investor. Previous research has shown that under continuous decision choices and the Intuitive Criterion refinement, the least-cost separating equilibrium will result, in which a low-quality firm chooses its optimal capacity and a high-quality firm over-invests in order to signal its quality to investors. We build on this research by showing the existence of pooling outcomes in which low-quality firms over-invest and high-quality firms under-invest so as to provide identical signals to investors. The pooling equilibrium is practically appealing because it yields a Pareto improvement compared to the least-cost separating equilibrium. Distinguishing features of our analysis are that: (i) we allow the capacity decision to have either discrete or continuous support, and (ii) we allow beliefs to be refined based on either the Undefeated refinement or the Intuitive Criterion refinement. We find that the newsvendor model parameters impact the likelihood of a pooling outcome, and this impact changes in both sign and magnitude depending on which refinement is used

Estimating Demand Uncertainty Using Judgmental Forecasts

Measuring demand uncertainty is a key activity in supply chain planning. Of various methods of estimating the standard deviation of demand, one that has been employed successfully in the recent literature uses dispersion among expertsâ forecasts. However, there has been limited empirical validation of this methodology. In this paper we provide a general methodology for estimating the standard deviation of a random variable using dispersion among expertsâ forecasts. We test this methodology using three datasets, demand data at item level, sales data at firm level for retailers, and sales data at firm level for manufacturers. We show that the standard deviation of a random variable (demand and sales for our datasets) is positively correlated with dispersion among expertsâ forecasts. Further we use longitudinal datasets with sales forecasts made 3-9 months before earnings report date for retailers and manufacturers to show that the effects of dispersion and scale on standard deviation of forecast error are consistent over time.Operations Management Working Papers Serie

Assortment Planning and Inventory Decisions Under a Locational Choice Model

We consider a single-period assortment planning and inventory management problem for a retailer, using a locational choice model to represent consumer demand. We first determine the optimal variety, product location, and inventory decisions under static substitution, and show that the optimal assortment consists of products equally spaced out such that there is no substitution among them regardless of the distribution of consumer preferences. The optimal solution can be such that some customers prefer not to buy any product in the assortment, and such that the most popular product is not offered. We then obtain bounds on profit when customers dynamically substitute, using the static substitution for the lower bound, and a retailer-controlled substitution for the upper bound. We thus define two heuristics to solve the problem under dynamic substitution, and numerically evaluate their performance. This analysis shows the value of modeling dynamic substitution and identifies conditions in which the static substitution solution serves as a good approximation.Operations Management Working Papers Serie