Journal of Product & Brand Management

Service level, pricing strategy and firm performance in a manufacturer-giant retailer supply chain
Ruiliang Yan, John Wang,
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 Pricing strategy & practice

Service level, pricing strategy and firm

performance in a manufacturer-giant retailer
supply chain
Ruiliang Yan
School of Business & Economics, Indiana University Northwest, Gary, Indiana, USA, and
John Wang
School of Business, Montclair State University, Montclair, New Jersey, USA

Abstract
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Purpose – The purpose of this paper is to provide a framework to help the manufacturer and the giant retailer to obtain optimal service level, pricing
strategy, and market structure in order to maximize their respective profits.
Design/methodology/approach – A profit-maximization model is developed to determine the optimal service level, pricing strategy, and market
structure for supply chain players.
Findings – Using a profit-maximization model, it is demonstrated that optimal service level and pricing strategy exist under different market structures
in a manufacturer-giant retailer supply chain. In order to maximize their respective profits, the manufacturer and the giant retailer should cooperatively
employ a coordinative market structure as an optimal market structure and a bargaining model can be utilized to implement profit sharing for the
manufacturer and giant retailer to optimize their profits. Furthermore, it is also shown that the value of coordinative structure always increases with the
customers’ sensitivity of service, the number of customers preferring to purchase from giant retailer, and the decreasing price sensitivity.
Research limitations/implications – The study assumes that all supply chain players have perfect market information. However, market information
to the supply chain players could be incomplete and asymmetric. It is recommended that future research explores optimal service level and pricing
strategy under incomplete and asymmetric information setting.
Practical implications – The paper provides a very useful model framework to study optimum service level, pricing strategy, and market structure for
business managers who are working in the manufacturer-giant retailer supply chain.
Originality/value – The paper fills a conceptual and practical gap for a structured analysis of the current state of knowledge about service level,
pricing strategy, and market structures in a manufacturer-giant retailer supply chain. The paper provides practical, solid advice and business examples
that demonstrate the application of the optimal strategies for supply chain management.

Keywords Pricing policy, Service levels, Structures, Supply chain management

Paper type Research paper

1. Introduction seller, the total market share of Home Depot and Lowe’s is
more than 50 per cent in home improvement). Second, the
Today, with the giant retailers (i.e. Wal-Mart, Home Depot, giant retailer is able to offer much more demand-stimulating
Lowe’s, etc.) becoming more and more powerful in the services to promote manufacturer’s products. As a result, the
retailing industry, the channel coordination between the giant retailer has made itself attractive for many
manufacturers and the giant retailers has significantly manufacturers to engage in channel coordination, especially
reshaped supply chain management. There are several for those retailers whose market demand is super-large.
reasons for this. First, the giant retailer always has a large When the manufacturer and the giant retailer engage in
market demand in the retail market (Wahl, 1992; Epstein, channel coordination, an important question is what optimal
1994) and frequently is the largest distributor for the service level, pricing strategy and market structure should be
manufacturers (e.g. Wal-Mart is the world’s largest retail employed so that the manufacturer and the giant retailer can
maximize their respective profits. In this paper, we consider a
The current issue and full text archive of this journal is available at simple supply chain made up of one manufacturer and one
www.emeraldinsight.com/1061-0421.htm giant retailer. We use a profit-maximization model to
specifically study the following questions:

Journal of Product & Brand Management

19/1 (2010) 61– 66 The author gratefully acknowledges the Editor, Dr Hooman Estelami, and
q Emerald Group Publishing Limited [ISSN 1061-0421] the anonymous reviewer for their constructive comments and suggestions
[DOI 10.1108/10610421011018400] that were instrumental in improving this paper.

61
 Service level, pricing strategy and firm performance Journal of Product & Brand Management
Ruiliang Yan and John Wang Volume 19 · Number 1 · 2010 · 61 –66

1 Under the non-coordinative structure and coordinative addresses this limitation and offers structured analysis to fill a
structure, what is the optimal service level and pricing conceptual and practical gap in the current state of knowledge
strategy that the giant retailer should employ? about the service, pricing strategy, and market structures for
2 Under which structure can both the manufacturer and the supply chain players. In this paper, we use a profit-maximization
giant retailer derive more profit? model to examine service level and pricing strategy under two
3 Under what conditions will the coordinative structure be different market structures: the non-coordinative structure and
much more valuable? the coordinative structure. Under the non-coordinative
The rest of our paper is organized as follows. Section 2 structure, the giant retailer announces its price decision and
provides a summary of the relevant literature. Section 3 service level to maximize its individual profit, and then the
presents our modeling framework and analyzes the cases of manufacturer reacts by updating its wholesale price to
non-coordinative structure and coordinative structure for the maximize its own profit. Under the coordinative structure, the
manufacturer and the giant retailer. Section 4 compares the giant retailer coordinates the whole channel to make the
two cases and presents our main results on optimal policies optimum strategies so that the whole channel profit can be
and sensitivity analysis. Conclusions and managerial maximized. Furthermore, we compare the two market
implications are presented in Section 5. All relevant proofs structures and discuss how to share the increased profit gain
are given in the Appendices for clarity of exposition. through a bargaining model. Based on our results, we propose
the optimal strategies for the manufacturer and the giant retailer
to employ.
2. Literature review
In this section, we review the relevant marketing literature to
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position our paper. Channel coordination has been studied by 3. Model framework
many researchers. Various mechanisms for coordinating In this section, we consider a supply chain made up of one
supply chain channels have been proposed. For example, manufacturer and one giant retailer. Giant retailer chooses its
Jeuland and Shugan (1983) show that quantity discount can own retail price p and service level s, and then realizes demand
be employed to achieve channel coordination. McGuire and D, which reflects the decisions of giant retailer in the following
Staelin (1983) study the importance of product key way: giant retailer’s demand is decreasing in its own retail
substitutability in a duopoly where each of two price and increasing in its service level. A similar assumption
manufacturers sells its products through a single exclusive has been used in Tsay and Agrawal (2000).
retailer. Their results show that selling through competing Specifically, we assume that the giant retailer has a
retailers is a better strategy than selling through a company- downward-sloping demand function given by:
owned store if the degree of product substitutability is high.
Gerstner and Hess (1995) propose that price discount can be D ¼ a 2 bp þ ls ð1Þ
employed to effectively improve whole channel performance.
Ingene and Parry (1995) show that coordination may where a is the number of customers who prefer to purchase
sometimes not be in the interest of the manufacturer, from giant retailer, p is the retail price charged by the giant
especially when competition exists between retailers. Iyer retailer, and b is price sensitivity. s is the service level which
(1998) demonstrates that neither quantity discounts nor a refers to the dollars expended by the giant retailer on demand-
menu of two-part tariffs are sufficient to coordinate a enhancing activities, which include immediate customer
manufacturer-retailer channel when two retailers compete support, presale advice, pre and post purchase services, in-
under price and non-price attributes. Raju and Zhang (2005) store advertising and promotions, technical and shopping
show that only when the dominant retailer is sufficiently assistance, and return service, channel assembly services, the
dominant, then a menu of two-part tariffs can be a better overall quality of the shopping experiences, etc. The
choice than a quantity discount to achieve channel parameter l is customer’s sensitivity to services, which
coordination. Koulamas (2006) conducts a theoretical study measures the efficacy of the services in stimulating demand.
to show that the manufacturers and retailers can employ a One might anticipate that the greater the value of l, the more
profit-sharing mechanism to achieve channel coordination. the service is contributable to the demand and the more the
With the emergence of the internet as a viable channel of giant retailer is also willing to spend on its service. The cost
distribution, some studies show that the online channel can be for providing the services is:
used to improve channel coordination. For example, Levary
and Mathieu (2000) show that the mixed physical and online s2
channel distribution holds most promise for the future. cðsÞ ¼ h
2
Geyskens et al. (2002) find that powerful firms with a few
online channels achieve better financial performance than less (Tsay and Agrawal, 2000).
powerful firms with many online channels. Chiang et al. The parameter h measures the cost effectiveness of services.
(2003) and Cattani et al. (2006) show that the added online The smaller the value ofh , the more effective the cost, cðsÞ, is.
channel may not always be detrimental to the retailer because These functions describe the relationship between the
a wholesale price reduction may be accompanied by the marginal service cost and the service provided. That is, the
introduction of online channel. Yan (2008) shows that adding service has a convex shape:
an online channel into traditional physical channel effectively
improves supply chain performance and a profit sharing ›cðsÞ ›2 cðsÞ
mechanism can be used to coordinate channel conflict. . 0; 2 . 0
›s › s
However, all these papers did not address the strategic value
of service in the channel coordination. Although some study did In other words, when the level of service is increased beyond a
consider channel service, such as Falk et al. (2007), little threshold point, the cost for providing the service is far larger
discussion in their literature has been given to the consideration than the benefits, due to the increased service. Thus the giant
of pricing strategy and channel coordination. Our paper retailer would not increase any more service when the level of

62
 Service level, pricing strategy and firm performance Journal of Product & Brand Management
Ruiliang Yan and John Wang Volume 19 · Number 1 · 2010 · 61 –66

service reaches a threshold point. All parameters in our model

are positive. s2
pC ¼ ðw 2 cÞða 2 bp þ lsÞ þ ð p 2 wÞða 2 bp þ lsÞ 2 h ð5Þ
The manufacturer supplies the giant retailer at a wholesale 2
price w, and incurs a cost per unit c. Consequently, the giant
where pC is the whole channel profit in the coordinative
retailer’s profit is determined by:
structure. Given the above structure, we obtain the following
s2 proposition.
pr ¼ ð p 2 wÞða 2 bp þ lsÞ 2 h ð2Þ
2 P2. When the giant retailer adopts a coordinative structure
to maximize the whole channel profit, then there exist
And the manufacturer’s profit is determined by: optimal service level and pricing strategy (sC ; pC ) for
the giant retailer, which is shown in the Appendix 2.
pm ¼ ðw 2 cÞða 2 bp þ lsÞ ð3Þ
Proposition 2 shows that when the giant retailer coordinates
The whole channel profit is written as: the whole channel profit, the optimal service level and pricing
strategy for the giant retailer to employ is (sC ; pC ). We saw in
pT ¼ pm þ pr ð4Þ Proposition 1 that when the manufacturer and the giant
retailer adopts a non-coordinative structure to maximize its
own profit, the larger the number of customers preferring to
3.1 Non-coordinative structure purchase from giant retailer, the higher service level the giant
We assume that the giant retailer adopts a non-coordinative retailer would like to provide. The giant retailer also will
structure to maximize its own profit. In this marketing charge a higher price for the product when the giant retailer
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structure, the giant retailer acting as a price leader moves first provides a higher service level to customers. It turns out that
to set its retail price pand service s. Based on giant retailer’s these results also hold for Proposition 2.
price decision and service level, and then manufacturer
determines its wholesale price w. We also assume that each 4. Analysis of the two cases
player strives to maximize individual profit with the
In this subsection, we will derive the profit differences in the
consideration of interaction with opponent. Given the above
two cases (non-coordinative structure and coordinative
structure, we obtain the following proposition:
structure) and develop some important managerial
P1. When the giant retailer adopts a non-cooperative implications.
structure to maximize its own profit, then there exist As we know, profit always is the first consideration for all
optimal service level and pricing strategy (sI ; pI ) for the firms. Therefore, it is critical to find out under which market
giant retailer, which is shown in the Appendix 1. structure the whole supply chain can derive more profits. This
can be determined by comparing the profits under different
Proposition 1 shows that when there is no channel scenarios:
cooperation (giant retailer maximizes its own profit), the .
when the giant retailer adopts a non-coordinative
optimal service level and pricing strategy for the giant retailer structure to maximize its own profit; and
to employ is (sI ; pI ). We also observe that the service level and .
when the giant retailer adopts a coordinative structure to
the retail price are always positively related with the number maximize whole channel profit.
of customers preferring to purchase from giant retailer. In
Accordingly, we obtain Proposition 3. Proof is given in
other words, the larger the number of customers preferring to
Appendix 3.
purchase from giant retailer, the higher service level the giant
retailer would like to provide. The giant retailer also will P3. When the giant retailer adopts a coordinative structure
charge a higher price for the product when the giant retailer to maximize the whole channel profit, the whole
provides a higher service level to customers. channel profit is higher than the whole channel profit
when the giant retailer adopts a non-coordinative
structure.
3.2 Coordinative structure
In this section, we analyze the coordinative structure, where Proposition 3 indicates that coordinative structure provides a
the giant retailer chooses the retail price and service level to higher profit to whole supply chain compared to the case of
maximize whole channel profit. This case is of particular non-coordination. This is to be expected as the giant retailer
interest currently because coordinative structure effectively coordinates the whole channel, more reasonable price and
improves the whole supply chain performance and both service will be set, which leads to higher profitability to the
players can benefit from it. whole supply chain. Therefore, coordinative structure
In recent literature in the area of marketing and economics, represents a better solution. This also gives powerful
the case of coordinative structure plays an important role in incentives to the supply chain players to actively employ
coordinative structure in their business.
the manufacturer-retailer supply chain for two important
The coordinative structure effectively improves the overall
reasons. One is that it is used as a base case to show the profit profit of the whole supply chain. However, one of the supply
reduction when the supply chain players have no chain players might not be sequentially optimized in the
coordination. The second reason is that in the real business coordinative structure in the sense that each player makes its
world, supply chain players are treating coordinative structure own decision without regard to the impact on the other player
as one of their major trusts in setting their operation in the non-coordinative structure. Therefore, neither the
strategies. manufacturer nor the giant retailer would be willing to accept
Thus, when the giant retailer maximizes whole channel fewer profits in the coordinative structure. Thus, in order to
profit, which is the sum of the manufacturer’s and giant ensure the success of the coordinative structure, an optimal
retailer’s profits, the profit function can be expressed as profit scheme is called acceptable to both the manufacturer
follows: and the giant retailer only if:

63
 Service level, pricing strategy and firm performance Journal of Product & Brand Management
Ruiliang Yan and John Wang Volume 19 · Number 1 · 2010 · 61 –66

stands for the share of the increased profit gain that the giant
Dpm ¼ pPm 2 pSm $ 0 ð6Þ retailer receives.
From equations (9) and (10), we have the result that as the
Dpr ¼ pPr 2 pSr $ 0 ð7Þ manufacturer’s bargaining power relative to that of the giant
retailer increases, the manufacturer’s share of the increased
where Dpm $ 0 represents the share of the increased profit
profit gain increases, and vice versa. When the bargaining
gain the manufacturer receives, and Dpr $ 0represents the
power of the giant retailer (the manufacturer) is significantly
share of the increased profit gain the giant retailer receives.
larger than that of the manufacturer (the giant retailer), the
Dpm þ Dpr ¼ pC 2 pT is defined as the increased profit gain
giant retailer (the manufacturer) will have the entire increased
from coordinative structure and is positive. pC ¼ pPm þ pPr , pPm
profit from coordinative structure.
is the manufacturer’s profit in the coordinative structure with
an optimal profit scheme, pPr is the giant retailer’s profit in the
4.2 Sensitivity analysis
coordinative structure with an optimal profit scheme. pSm is
Next, we analyze the effect of any change in the sensitivity
the manufacturer’s profit in the non-coordinative structure,
parameters on the value of coordinative structure. The
pSr is the giant retailer’s profit in the non-coordinative
objective of this study is to generate some important
structure.
managerial guidelines for business managers.
When the conditions of (6) and (7) are satisfied
We first study the effect of the customer’s sensitivity of
simultaneously, both the manufacturer and the giant retailer
service on the value of coordinative structure. We obtain the
can be better off from coordinative structure rather than
following proposition. Proof is given in Appendix 4.
acting in non-coordinative structure. Thus, an advanced
coordination mechanism is needed to coordinate the P4. The value of coordinative structure increases with
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manufacturer and the giant retailer in order to improve the customer’s sensitivity of service (largerl).
profits of both supply chain players in the coordinative Proposition 4 gives an important managerial guideline. Larger
structure. We propose “profit sharing” as an advanced customer sensitivity to the service is desirable because it
cooperation mechanism to improve the profits of both increases both the demand and profitability of the whole
supply chain players, so that each player can benefit from supply chain. Therefore, the giant retailer should actively
coordinative structure. employ any possible means to increase customer sensitivity to
In the next section, we study the profit sharing mechanism service in a product market. For example, the giant retailer
for the manufacturer and the giant retailer to implement full can use promotional means to inform customers of its good
channel coordination. service, which thus increases the customer sensitivity to the
service.
4.1 Profit-sharing and bargaining results Next, we study the effect of the number of customers
Equations (6) and (7) imply that the more the manufacturer preferring to purchase from giant retailer on the value of
receives of the increased profit gain, the less the giant retailer coordinative structure. We obtain the following proposition.
receives of the increased profit gain, and vice versa. The share Proof is given in Appendix 5.
of increased profit gain each player receives will depend on its
own relative bargaining power. Researchers have used various P5. The value of coordinative structure increases with the
models to characterize bargaining solutions. Here, we use the number of customers preferring to purchase from giant
Nash bargaining model (1950) to implement profit sharing retailer (largeru).
and to determine optimal profit schemes. Other bargaining Proposition 5 indicates that the whole supply chain benefits
models may have a different result, but the qualitative nature much more from greater value of u . The important
of the outcomes will remain the same. managerial implication is that the giant retailer should
Suppose the manufacturer’s utility function of Dpm is um and actively adopt a coordinative structure to do business under
the giant retailer’s utility function of Dpr isur . According to any circumstance, especially when a larger number of
Nash model (1950), the optimal bargaining profit scheme is customers would like to purchase from giant retailer.
obtained by solving the following problem: Next, we study the effect of price sensitivity on the value of
coordinative structure. We obtain the following proposition.
Max um ur ¼ ðDpm Þlm ðDpr Þlr ð8Þ Proof is given in Appendix 6.
where, lm is the bargaining power of manufacturer, and lr is P6. The value of coordinative structure increases with
the bargaining power of giant retailer. decreasing price sensitivity (decreasing b).
Maximizing um ur subject to the constraint Dpm þ Dpr ¼ Dp Proposition 6 shows that giant retailers should use any
yields: operational means to prevent the market from being very
lm sensitive to retail price, since lower price sensitivity always is
Dpm ¼ Dp ð9Þ beneficial to the profitability of whole supply chain. This can
lm þ lr be achieved by enhancing product quality, offering more
lr product functionality, improving customer assistance, etc. to
Dpr ¼ Dp ð10Þ offer more non-price differentiating values to the customers.
lm þ lr
Here: 5. Conclusions and managerial implications
lm
Dp
lm þ lr In this paper, we study the optimal service, pricing strategy,
and firm performance in a manufacturer-giant retailer supply
represents the share of the increased profit gain that the chain. We first derive optimal service level and pricing strategy
manufacturer receives and: under two different market structures (non-coordinative
lr structure and coordinative structure), and then we do
Dp
lm þ lr comparative statistics to determine the optimal decisions.

64
 Service level, pricing strategy and firm performance Journal of Product & Brand Management
Ruiliang Yan and John Wang Volume 19 · Number 1 · 2010 · 61 –66

Our results indicate that optimum service and pricing strategy Ingene, C.A. and Parry, M. (1995), “Channel coordination
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Furthermore, our results also show that the value of
No. 1, pp. 91-100.
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sensitivity. Management, Vol. 42 No. 5, pp. 6-13.
The findings in our research may have managerial McGuire, T.W. and Staelin, R. (1983), “An industry
significance. Our findings can be useful for supply chain equilibrium analysis of downstream vertical integration”,
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Possible future work extending from the present paper is
possible in various ways. First, in this paper we assumed that
consumers have perfect market information. However, Further reading
information with the consumers could be incomplete, thus
Huang, Z.M., Li, S.X. and Mahajan, V. (2002), “An analysis
we can explore the service level and pricing strategy under
of manufacturer-retailer supply chain coordination in
incomplete information settings. Second, in this paper our
analysis is based on a single period model, therefore, for cooperative advertising”, Decision Sciences, Vol. 33 No. 3,
future potential research, we can investigate how service level pp. 469-94.
and pricing strategy might work in a multi-period
environment. In the future, aside from considering other Appendix 1
factors, we can extend our study to consider nonlinear pricing
schedule in the supply chain management. D ¼ a 2 bp þ ls ðA1Þ

The profit for the giant retailer is given as follows:

References
Cattani, K.D., Gilland, W.G. and Swaminathan, J.M. (2006), s2
pr ¼ ð p 2 wÞD 2 h ðA2Þ
“Boiling frogs: pricing strategies for a manufacturer adding 2
a direct channel that competes with the traditional The profit for the manufacturer is given as the follows:
channel”, Production and Operations Management, Vol. 15
No. 1, pp. 40-57. pm ¼ ðw 2 cÞD ðA3Þ
Chiang, W.Y., Chhajed, D. and Hess, J.D. (2003), “Direct
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Epstein, E. (1994), “Power retailers are not going to control In the non-coordinative structure, let the profit marginal for
it all”, Beverage World, Vol. 113, pp. 13-15. giant retailer is g, then when the manufacturer and the giant
Falk, T., Schepers, J., Hammerschmidt, M. and Bauer, H.H. retailer are independent, by maximizing equation (A3), we
(2007), “Identifying cross-channel dissynergies for obtain:
multichannel service providers”, Journal of Service a þ bc 2 bg þ ls
Research, Vol. 10 No. 2, pp. 143-60. wI ¼ ðA5Þ
Gerstner, E. and Hess, J. (1995), “Pull promotions and 2b
channel coordination”, Marketing Science, Vol. 14 No. 1, Then substituting (A5) into equation (A2) and maximizing,
pp. 43-60. we then obtain:
Geyskens, I., Gielens, K. and Dekimpe, M.G. (2002),
“The market valuation of internet channel additions”, 2hða 2 bcÞ
gI ¼ ðA6Þ
Journal of Marketing, Vol. 66, pp. 102-19. 4bh 2 l2

65
 Service level, pricing strategy and firm performance Journal of Product & Brand Management
Ruiliang Yan and John Wang Volume 19 · Number 1 · 2010 · 61 –66

Thus:
I lða 2 bcÞ
s ¼ ðA7Þ
4bh 2 l2 2b2 ða 2 bcÞ2 h3
pC 2 pT ¼ .0
Furthermore, we substitute (A6) and (A7) into the ð2bh 2 l2 Þð4bh 2 l2 Þ2
corresponding functions and obtain:
Proposition 3 is proved.
3ah þ bch 2 cl2
pI ¼ g I þ wI ¼
4bh 2 l2
lða 2 bcÞ Appendix 4
sI ¼
4bh 2 l2 Because:

hða 2 bcÞ2 ð6bh 2 l2 Þ 2b2 ða 2 bcÞ2 h3

pT ¼ pC 2 pT ¼ .0
2ð4bh 2 l2 Þ2 ð2bh 2 l2 Þð4bh 2 l2 Þ2
Since price, service level and profit could not be negative, thus Thus:
4bh 2 l2 . 0 or 4bh . l2 .
4b2 ða 2 bcÞ2 lh3 ð8bbh 2 3l2 Þ
›ðpC 2 pT Þ=l ¼ .0
Appendix 2 ð4bh 2 l2 Þ3 ð2bh 2 l2 Þ2
When the giant retailer adopts the coordinative structure to
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Proposition 4 is proved.
maximize the whole channel profit and uses the same way as
Appendix 1:
Appendix 5
ða þ bcÞh 2 cl2
pC ¼ Because:
2bh 2 l2
ða 2 bcÞl 2b2 ða 2 bcÞ2 h3
sC ¼ pC 2 pT ¼ .0
2bh 2 l2 ð2bh 2 l2 Þð4bh 2 l2 Þ2
where 2bh . l2 . Thus:
Substituting:
4b2 ða 2 bcÞh3
C ða þ bcÞh 2 cl2 ›ðpC 2 pT Þ=u ¼ .0
p ¼ ð2bh 2 l2 Þð4bh 2 l2 Þ2
2bh 2 l2
Proposition 5 is proved.
and
ða 2 bcÞl
sC ¼ Appendix 6
2bh 2 l2
Because:
into the profit function, then we obtain:
2b2 ða 2 bcÞ2 h3
ða 2 bcÞ2 h pC 2 pT ¼ .0
pC ¼ ð2bh 2 l2 Þð4bh 2 l2 Þ2
4bh 2 2l2
Thus:

Appendix 3 4bh3 ðabcl2 ð8bh 2 3l2 Þ þ b2 c2 ð4b2 h2 2 2l4 Þ

›ðpC 2 pT Þ=b ¼ 2
Because: ð4bh 2 l2 Þ3 ð2bh 2 l2 Þ2

ða 2 bcÞ2 h ,0
pC ¼
4bh 2 2l2
Proposition 6 is proved.
and

hða 2 bcÞ2 ð6bh 2 l2 Þ Corresponding author

pT ¼
2ð4bh 2 l2 Þ2 Ruiliang Yan can be contacted at: [email protected]

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