Inventory Service-Level Agreements as Coordination Mechanisms: The Effect of Review Periods

Abstract

Asupplier stocking goods for delivery to a retailer may face a (finite-horizon) service-level agreement (SLA). In this context, the SLA is a commitment by a supplier to achieve a minimum fill rate over a specified time horizon. This kind of SLA is an important, but understudied coordination mechanism. We focus on the impact of two contract parameters: the length of the review period and the magnitude of the bonus for meeting or exceeding the service-level target. For a supplier following a base stock (order-up-to) inventory policy, increasing the bonus increases optimal supplier stocking levels, whereas lengthening the review period may increase or decrease optimal stocking levels. We investigate these mechanisms in a controlled laboratory setting and find that longer review periods are generally more effective than shorter review periods in inducing higher stocking levels. As in several earlier laboratory studies, the explanation lies in the improved feedback reliability that longer review periods provide. The primary managerial implication of our findings is that, in practice, longer review periods may be more effective than shorter ones at inducing service improvements.