Stochastic inventory systems in a supply chain with asymmetric information: Cycle stocks, safety stocks, and consignment stock

The two critical factors distinguishing inventory management in a multifirm supply-chain context from the more traditional centrally planned perspecti ve are incentive conflicts and information asymmetries. We study the well-k nown order quantity/reorder point (Q, r) model in a two-player context, usi ng a framework inspired by observations during a case study. We show how tr aditional allocations of decision rights to supplier and buyer lead to inef ficient outcomes, and we use principal-agent models to study the effects of information asymmetries about setup cost and backorder cost, respectively. We analyze two "opposite" models of contracting on inventory policies. Firs t, we derive the buyer's optimal menu of contracts when the supplier has pr ivate information about setup cost, and we show how consignment stock can h elp reduce the impact of this information asymmetry. Next, we study consign ment and assume the supplier cannot observe the buyer's backorder cost. We derive the supplier's optimal menu of contracts on consigned stock level an d show that in this case, the supplier effectively has to overcompensate th e buyer for the cost of each stockout. Our theoretical analysis and the case study suggest that consignment stock helps reduce cycle stock by providing the supplier with an additional incen tive to decrease batch size, but simultaneously gives the buyer an incentiv e to increase safety stock by exaggerating backorder costs. This framework immediately points to practical recommendations on how supply-chain incenti ves should be realigned to overcome existing information asymmetries.