Contract design and comparison under the opportunity cost of working capital: Buyback vs. revenue sharing

Abstract

In previous research, buyback and revenue sharing contracts are regarded as equivalent in terms of the final profit and coordination ability. However, if the opportunity cost of working capital (OCWC) is considered, the parameters, coordination nature, and relative performance of the two contracts may vary with their payment structure. Considering the OCWC, we investigate the above phenomenon in two scenarios. The first is based on the decisions made with the objective of maximising accounting profit (not including OCWC). We reveal, for the first time, the relative financing effect between these two contracts, and show that these decisions may lead to managers’ misjudgement. Firms that recognise the impact of opportunity cost will exhibit different preferences between the two originally equivalent contracts. In the second scenario, we examine and compare the two contracts with the decisions based on economic profit (including OCWC) maximisation. We show that a buyback contract may degenerate into a wholesale price contract, while a revenue sharing contract may degenerate into a full credit contract. Moreover, revenue sharing contracts are Pareto dominated by buyback contracts when the supplier’s opportunity cost is higher than that of the retailer, and vice versa. Unexpectedly, the two contracts may achieve super coordination of the supply chain in terms of economic profits. These findings clarify how managers should use supply chain contracts when the opportunity cost of capital cannot be ignored.