The over-ordering problem in trade credit: Role of return policies

Abstract

This paper explores the role of return policies on trade credit offered by suppliers to retailers. Traditional trade credit agreements, wherein a supplier extends a short-term loan to a retailer, can lead to over-ordering by the retailer even though she is financially constrained (FC), and this can affect supply chain efficiency. With ever-increasing product-handling costs, such over-ordering can have a severe impact on the supply chain profit. Motivated by our work with an industry partner, we design a game-theoretic model to evaluate optimal stocking decisions and wholesale prices in an FC supply chain, analyze the traditional trade credit model, and establish the reasons for over-ordering by the retailer when trade credit is deployed. We then examine how product returns, prevalent in the industry, can be used to control over-ordering. We design three different mechanisms incorporating returns in a trade credit model: quantity-limit-based returns, partial refund based returns, and marginal refund based returns. We find that returns-based policies improve profits for all members of the supply chain by driving inventory reduction and reducing over-ordering when trade credit is used. We also perform numerical analysis to quantify the impact of key parameters on the optimal decision variables. Our paper contributes by suggesting easy-to-implement mechanisms for improving trade credit deployment in supply chains and provides useful insights to decision makers to incorporate returns in trade credit policies.