Centralization of stocks: Retailers vs. manufacturer

A well-known result in inventory theory is that physical centralization of stocks in a system with multiple retailers decreases total costs and increases total profits for the retailers. However, does this centralization also benefit the manufacturer, whose goods the retailers stock, when customers unsatisfied at retailers due to stock-outs are considered lost sales? In this paper we consider a model with two retailers and one manufacturer. We then compare two systems: one in which the retailers hold stocks separately and the other in which they cooperate to centralize stocks at a single location. We show that whether or not centralization of stocks by retailers increases profits for the manufacturer depends on the level of ‘market search’ in the supply chain. Market search is measured as the fraction of customers who, unsatisfied at their ‘local’ retailer due to a stock-out, search for the good at the other retailer before leaving the system. Specifically, we show that there exists a threshold level for market search above which the manufacturer loses. Furthermore, for ‘very high’ search levels, even the system profit (sum of manufacturer and retailer profits) may decrease upon centralization. We then compare the performance of the two systems under optimal pricing/subsidy mechanisms and show that often a manufacturer is better off in a decentralized system with high market search. We conclude with a discussion of the role of information systems in the decentralized systems.