Omega 49 (2014) 60–68

Contents lists available at ScienceDirect

Omega
journal homepage: www.elsevier.com/locate/omega

A delay-in-payment contract for Pareto improvement of a supply chain

with stochastic demand$
Deng Gao a, Xiaobo Zhao a,n, Wei Geng b
a
Department of Industrial Engineering, Tsinghua University, Beijing 100084, China
b
School of Economics and Management, Southwest Jiaotong University, Chengdu 610031, China

art ic l e i nf o a b s t r a c t

Article history: We consider a supply chain consisting of a single supplier and a single retailer with stochastic customer
Received 11 January 2012 demand, which is operated over an infinite horizon. We propose a delay-in-payment contract to
Accepted 24 May 2014 coordinate the supply chain. With this contract, the supplier allows the retailer to pay partial order cost
Processed by B. Lev
at the ordering epoch, and to pay the remaining portion after a permissible number of periods. The system
Available online 4 June 2014
is formulated as a stochastic dynamic programming problem. It is shown that there exists a base-stock
Keywords: policy to be optimal. Compared with the traditional wholesale-price contract, the delay-in-payment
Delay-in-payment contract with appropriate parameters can achieve a Pareto improvement (i.e., the performances of both the
Supply chain coordination supplier and the retailer using the delay-in-payment contract are better than those using the wholesale-
Stochastic demand
price contract). Numerical studies are performed to investigate both the effectiveness of the Pareto
improvement, and the impact of the major parameters of the delay-in-payment contract on the system
performance.
& 2014 Elsevier Ltd. All rights reserved.

1. Introduction
Delay-in-payment is a common form of trade credit in modern
business environments. Typically, a source organization allows a
consumer organization to pay the margin within a permissible
period after the consumer organization receives the products.
There is a lot of theoretical and empirical evidence that trade
credit is the most important short-term financial channel for
companies in, e.g., the United States [1], especially for SMEs (small
and medium-sized enterprises). Similar results are also found in
Europe [2]. In developing countries, where the financial services
are not mature, it is difficult for SMEs to obtain financial support
from banks and other financial institutions. Therefore, it is profit-
able for suppliers to offer trade credit to retailers [3].
Other than the finance field, delay-in-payment plays an important
role in operations management as well. By providing trade credit, a
supplier can maintain a long-term relationship with a retailer to
enhance the competitiveness of their supply chain. Additionally, trade
credit can be considered as a way for the supplier to offer implicit
quality guarantees, because the retailer has enough time to test the
quality [2]. For inventory management, Haley and Higgins [4] consider
$
This manuscript was processed by Associate Editor Gel.
n
Corresponding author. Tel.: þ 86 10 62784898
E-mail address: xbzhao@tsinghua.edu.cn (X. Zhao).
an EOQ model with delay-in-payment and show that the order
quantity and replenishment interval increase slightly. They also show
that the total cost decreases considerably due to the delayed payment
without any capital interest. Goyal [5] considers a similar model, but
regards the length of delay period as a decision variable. These models
only focus on a single-echelon system. It is worth considering the
mechanism of delay-in-payment in a supply chain with multiple
echelons. Teng et al. [6] analyze an EOQ model with trade credit
financing for non-decreasing demand. Taleizadeh et al. [7] consider an
EOQ model using a partially delayed payment, in which a compre-
hensive solution procedure is developed to solve several possible
cases of the problem.
In a decentralized supply chain model, both the supplier and the
retailer attempt to maximize their profits or minimize their costs,
which decreases the performance of the entire supply chain compared
to a centralized situation. Researchers have developed many coordina-
tion mechanisms to improve the performance of a supply chain, such
as buy back contract [8], quantity discount contract [9], and revenue
sharing contract [10,11]. Cachon [12] gives a comprehensive review of
supply chain coordination with contracts. A few researchers analyze
delay-in-payment contract to coordinate the supply chain, most of
which are based on EOQ models as in the following papers. Jaber and
Osman [13] propose a delay-in-payment contract with revenue
sharing to coordinate a two-echelon supply chain. Luo [14] proposes
a trade credit contract to coordinate a two-echelon supply chain in
which the supplier requests the retailer alter his current order size to

http://dx.doi.org/10.1016/j.omega.2014.05.008
0305-0483/& 2014 Elsevier Ltd. All rights reserved.
 D. Gao et al. / Omega 49 (2014) 60–68
benefit from lower set up and inventory holding costs. Chen and Kang
[15] develop an integrated supplier-retailer model to consider a delay-
in-payment contract to determine the optimal solutions of the
retailer's order quantity and the order frequency. Du et al. [16] study
the coordination of two-echelon supply chains using a delay-in-
payment contract and/or a wholesale price contract, and show that
a coordinating policy incorporating both a quantity discount and a
credit payment option performs better than other policies. Conversely,
studies of contracts for a supply chain with multi-period and
stochastic demand are very limited. For such supply chains, the EOQ
models should not be appropriate and stochastic models can apply.
Only Li and Liu [17], Bassok and Anupindi [18] and Chaharsooghi and
Heydari [19] consider quantity discount contract, total cumulative
commitment order contract and delay-in-payment contract in their
relevant systems, respectively. Assuming that the retailer implements
a (r,Q) policy to manage its inventory, Li and Liu [17] discuss a
mechanism to achieve a type of centralized control by sharing
superior profit between the supplier and the retailer. For a finite
planning horizon system, Bassok and Anupindi [18] analyze a total
cumulative commitment order contract, obtain the retailers's optimal
ordering policy, and demonstrate relative cost saving to the retailer.
Chaharsooghi and Heydari [19] analyze a coordination model of a
multi-period supply chain with uncertain demand and lead time, and
show that a credit optionscheme can increase the overall chain
profitability as well as each member's profitability. Based on the above
literature review, we would note that there is plenty of room for
research on delay-in-payment contract for a supply chain with multi-
period and stochastic demand.
This paper focuses on a supply chain coordination problem with
stochastic demand for an infinite horizon using a delay-in-payment
contract. (For long-term relationships between the supply chain
members, the infinite periods model is more realistic.) Using a
delay-in-payment contract, the supplier allows the retailer to pay
partial order cost at the ordering epoch and to pay the remainder
within an permissible delay period. In contrast to the existing studies,
some new results are observed, which are valuable to supply chain
coordination. For example, we show that this contract can achieve a
Pareto improvement compared with traditional wholesale-price
contract. The impact of some key parameters can provide practi-
tioners with implications about how to appropriately design delay-
in-payment contracts given that the delay-in-payment scheme is
popularly implemented in practice.
The rest of the paper is organized as follows. In Section 2, we
analyze the basic model under centralized decision and decen-
tralized decision with wholesale-price contract. In Section 3, we
propose a general delay-in-payment contract, under which both
the supplier and the retailer can achieve better performance.
In Section 4, we consider a special case of the delay-in-payment
contract, and the theoretical results and numerical studies are
shown. Section 5 summarizes our research.
2. Analysis of the basic model
We consider a two-echelon supply chain operated over an
infinite planning horizon, which consists of a single supplier and a
single retailer. The inventory of the retailer is reviewed periodi-
cally. In a period t, customer demand Dt is stochastic following a
probability distribution function FðÞ with a density function f ðÞ.
Over all periods, the demand is stationary and i.i.d. from period to
period. The selling price is p. At the beginning of a period, the
retailer observes her inventory level and places an order to the
supplier. Assume that the supplier has sufficient capacity to fulfill
the retailer's order with zero lead time.
The unit production cost of the supplier is c. At the end of each
period, there may be either leftover inventory or unmet customer
61
demand at the retailer. Inventory holding cost is incurred for
leftover inventory. It is common that inventory holding cost
consists of both physical and financial components. The physical
part relates to the quantity of the physical inventory on hand, and
the financial part relates to the capital opportunity cost. Unmet
demands are fully backlogged with unit penalty cost g per period.
The sequence of events is as follows: (1) at the beginning of
period t, the retailer observes the inventory level xt; (2) the retailer
places an order to the supplier to raise the inventory level up to yt
with an order quantity yt  xt ; (3) the supplier delivers the
products to the retailer immediately; and (4) the demand is
realized, and unsatisfied demands are backlogged.
2.1. Centralized decision
Here, we provide the result of the centralized decision in brief
because it acts as a benchmark for evaluating contract performance
of coordinating supply chain. In the centralized decision model, the
variable cost is c; hence, the unit holding cost for leftover inventory at
the retailer is I ¼ I s þI c c, where Is is the unit physical cost and Icc is
the unit financial cost. In period t, production cost, holding cost and
penalty cost are cðyt xt Þ, ðI s þ I c cÞðyt Dt Þ þ and gðDt yt Þ þ , respec-
tively. Let π denote the inventory control policy, which specifies the
ordering decision. The expected total discounted profit over the
infinite horizon, given policy π and initial inventory level x0 at the
beginning of the planning horizon, is

1 
V πc ðx0 Þ ¼ E ∑ αt ½pDt  gðDt yt Þ þ  ðI s þ I c cÞðyt  Dt Þ þ  cðyt  xt Þ ;
t¼0
ð1Þ
where α (0 o α o 1Þ is the discount factor.
For the cost and the demand are stationary in time, according
to Zipkin [20, Theorem 9.4.3], there exists a stationary base-stock
policy to be optimal. Let ync be the optimal base-stock level. Then,
ync is the smallest value of y maximizing the following Jc(y):
J c ðyÞ ¼ pE½D  gEðD yÞ þ  ðI s þ I c cÞEðy  DÞ þ cy þ αcðy  E½DÞ:
ð2Þ
For J ″c ðyÞ ¼  gf ðyÞ ðI s þ I c cÞf ðyÞ r 0, i.e., Jc(y) is a concave func-
tion, ync is the solution of the following equation:
J 0c ðyÞ ¼ gF ðyÞ  ðI s þI c cÞFðyÞ  c þ αc ¼ 0: ð3Þ
Then,
 
g  c þ αc
ync ¼ F  1 : ð4Þ
Is þ Ic c þ g
The initial inventory level x0 does not affect the theoretical
result. Therefore, to facilitate comparison of performance of
different contracts, we assume that the initial inventory level is
x0 ¼ 0. Consequently, the total profit of the supply chain under the
optimal policy π n is given by
J c ðync Þ pE½D gEðD ync Þ þ ðI s þ I c cÞEðync DÞ þ cð1 αÞync  αcE½D
V nc ¼ ¼ : ð5Þ
1α 1α
2.2. Decentralized decision with wholesale-price contract
In the decentralized model, the supplier wholesales products to
the retailer, and the retailer sells the products to the customers.
A well documented contract in the decentralized model is the
so-called wholesale-price contract. Under such a contract, the sup-
plier and the retailer first determine a wholesale price w together.
Then, the retailer decides the order quantity to maximize her profit.
Contract 2.1. The wholesale-price contract specifies the wholesale
price w, determined by both parties.
62 D. Gao et al. / Omega 49 (2014) 60–68

With Contract 2.1, the expected total discounted profit of the Apparently, a lower value of θw indicates a better performance in
retailer, given policy π and initial inventory level x0 at the supply chain coordination.
beginning of the planning horizon, is given by Assume that the stochastic demand follows normal distribution

1  Nð30; 9Þ. We normalize the production cost c ¼1, fix the selling
Rπw ðx0 Þ ¼ E ∑ αt ½pDt  gðDt  yt Þ þ  ðI s þ Ic wÞðyt  Dt Þ þ  wðyt  xt Þ ; price at p¼ 4, and set the wholesale price w ¼ 1:5, 2, 2.5, 3, 3.5.
t¼0
Typically, the manager reviews the inventory weekly or monthly.
ð6Þ
In our numerical study, we assume that the decision cycle is one
and the expected total discounted profit of the supplier is month. In practice, the annual interest rate can be close to 40%

1  [21]. Referring to this level of the annual interest rate, we set the
Sπw ðx0 Þ ¼ E ∑ αt ½wðyt  xt Þ  cðyt xt Þ : ð7Þ monthly financial holding cost rate I c ¼ 1%; 2%; …; 10%, and the
t¼0
unit physical holding cost I s ¼ 3%. The discount factor is
The profit function (6) has a structure similar to that of the α ¼ 1=ð1 þ Ic Þ. In general, the unit penalty cost g is much higher
centralized model in Eq. (1). We can show that there exists an than the unit holding cost [20]; here, we set g ¼ 10  I c c.
optimal policy for the retailer to be a base-stock policy with base- Fig. 1 illustrates behaviors of the gap θw between the centralized
stock level given by model and the decentralized model with the wholesale-price con-
  tract. First, θw is increasing with wholesale price. Second, θw is
g  w þ αw
ynw ¼ F  1 ; ð8Þ increasing with the interest rate, i.e., the wholesale-price contract
Is þ Ic w þ g
performs worse as the interest rate increases. In an extreme case,
which is the solution of maximizing the following concave function: where the wholesale price is 3.5 and the interest rate is 10% per
month, the total profit of the decentralized model with wholesale-
J w ðyÞ ¼ pE½D  gEðD  yÞ þ  ðI s þ I c wÞEðy  DÞ þ  wy þ αwðy  E½DÞ:
price contract is 2:54% smaller than that of centralized model. Even
ð9Þ
in a relatively common case, for instance, the wholesale price is 3 and
Accordingly, as x0 ¼ 0, the retailer's maximum profit over the the interest rate is approximately 5% per month; the total profit of
decision horizon is the decentralized model with the wholesale-price contract is 0.97%
smaller than that of centralized model. Therefore, the wholesale-
J w ðynw Þ pE½D  gEðD  ynw Þ þ  ðI s þ I c wÞEðynw  DÞ þ  wð1  αÞynw  αwE½D
Rnw ¼ ¼ ; price contract is inefficient from the system's point of view.
1α 1α
ð10Þ
3. Decentralized model with a delay-in-payment contract
and the supplier's maximum profit is
ð1  αÞðw  cÞynw þ αðw  cÞE½D 3.1. The model of general delay-in-payment contract
Snw ¼ : ð11Þ
1α
Then, the total profit of the supply chain is The reason why the wholesale-price contract can barely coordi-
nate the supply chain is that the retailer's order quantity is less than
pE½D  gEðD  yw Þ  ðI s þ I c wÞEðyw DÞ cð1  αÞyw  αcE½D
n þ n þ n
V nw ¼ Rnw þSnw ¼ : ð12Þ that in the centralized model. It has been shown that order quantity
1α
can become higher in a delay-in-payment situation in the EOQ
The following proposition characterizes the relationship
model [5]. In our model, with stochastic demand, we need to
between the centralized model and the decentralized model with
investigate whether the entire supply chain (including both supplier
wholesale-price contract.
and retailer) can benefit from a delay-in-payment contract.
Proposition 2.1. In the decentralized model with wholesale-price Contract 3.1. The retailer guarantees partial payment with marginal
contract, ordering cost b at the ordering epoch and the remaining part with
additional marginal ordering cost a n periods later to the supplier.
(a) the order quantity is less than that of the centralized model, i.e., The parameters of the delay-in-payment contract ða; b; nÞ are deter-
ynw r ync , with equality for w¼c; mined by both parties.
(b) the total profit of the supply chain is smaller than that of the
In period t, the retailer's cost consists of two parts. The first part
centralized model, i.e., V nw rV nc , with equality for w ¼c.
is related to the decision in current period. This part is formed by
partial ordering cost for the order quantity ðyt  xt Þ with unit
The proof is given in the Appendix. purchasing cost b, holding cost for leftover inventory ðyt Dt Þ þ
For a given contract i, let Vi denote the total profit of the supply with unit holding cost ðI s þ I c bÞ (consisting of physical and financial
chain under the contract. components), and penalty cost for unsatisfied demand ðDt  yt Þ þ

Definition 2.1. The supply chain is said to be “coordinated” if

V i ¼ V nc with the contract i.

Proposition 2.1 indicates that Contract 2.1 can coordinate the

supply chain only when w¼c. However, the supplier earns a non-
positive profit in this case. Hence, the supplier always prefers to
shift the wholesale price to a higher value in practice. As a result,
the wholesale-price contract can hardly achieve coordination.
In the following, we evaluate the performance of wholesale-
price contract through numerical study. We define θw to denote
the relative gap between the supply chain's total profit in the
decentralized model with wholesale-price contract and that in the
centralized model,
V nw
θw ¼ 1  : ð13Þ
V nc Fig. 1. The performance of decentralized model with wholesale-price contract.
 D. Gao et al. / Omega 49 (2014) 60–68 63

with unit penalty cost g. The second part is related to the decision 3.2. The retailer's optimal decision
made in n periods ago. The retailer should pay residual ordering
cost for the order quantity ðyt  n  xt  n Þ with unit cost a, and With Contract 3.1, the retailer makes ordering decision peri-
holding cost for the leftover inventory ðyt  n  ∑ti ¼ t  n Di Þ þ with odically to maximize her profit. The optimization problem of
unit holding cost Ica (only with financial component because the maximizing profit function (14) can be formulated as the following
physical component has been accounted in the first part). dynamic programming to find the optimal policy:
For a given policy π and initial inventory level x0, the retailer's
H t ðyÞ ¼ pE½D  gEðD yÞ þ  ðI s þ I c bÞEðy  DÞ þ by  aαn y
expected total discounted profit is calculated as follows: !þ
( t þn
 I c aα n E y  ∑ D i  αE½Rt þ 1 ðy  DÞ; ð16Þ
π þ þ
Rg ðx0 Þ ¼ E ½pD0  gðD0  y0 Þ  ðI s þ I c bÞðy0 D0 Þ  bðy0 x0 Þ i¼t

þ α½pD1  gðD1  y1 Þ þ  ðI s þ I c bÞðy1 D1 Þ þ bðy1 x1 Þ Rt ðxÞ ¼ bx þ aαn x þmaxfH t ðyÞ : yZ xg: ð17Þ
þ α ½pD2  gðD2 y2 Þ  ðI s þ I c bÞðy2  D2 Þ  bðy2  x2 Þ
2 þ þ
We define the following operator L:
þ ⋯ þ αn  1 ½pDn  1  gðDn  1 yn  1 Þ þ (
 ðI s þ I c bÞðyn  1  Dn  1 Þ þ LR  max pE½D  gEðD  yÞ þ  ðI s þ I c bÞEðy  DÞ þ  bðy  xÞ  aαn ðy  xÞ:
" yZx

 bðyn  1  xn  1 Þ þ α n
pDn  gðDn  yn Þ þ !þ )
n
 I c aα E y  ∑ Di
n
 αE½Rðy  DÞ : ð18Þ
 ðI s þ I c bÞðyn Dn Þ þ  bðyn  xn Þ i¼0
!þ #
n
 aðy0 x0 Þ  I c a y0  ∑ Di Proposition 3.1. For 0 r α o 1, L is a contraction mapping.
i¼0
"
The proof is given in the Appendix.
þ αn þ 1 pDn þ 1  gðDn þ 1  yn þ 1 Þ þ  ðI s þ I c bÞðyn þ 1  Dn þ 1 Þ þ According to Proposition 3.1, L satisfies the hypotheses of
Theorem 6.2.3 in [22]. Therefore, there exists a unique solution
!þ # ) Rn such that LRn ¼ Rn ; and for an arbitrary R0, the sequence Rn
nþ1
 bðyn þ 1  xn þ 1 Þ  aðy1 x1 Þ  I c a y1  ∑ Di þ⋯ : defined by Rn þ 1 ¼ LRn ¼ Ln þ 1 R0 converges to Rn. Hence, sequence
i¼1
fH t ðyÞg converges to H(y), and sequence fRt ðxÞg converges to R(x),
We can rearrange terms in the above equation into the where H(y) and R(x) are defined as
following form: HðyÞ ¼ pE½D  gEðD  yÞ þ  ðI s þI c bÞEðy DÞ þ  by  aαn y
( !þ
π  n
Rg ðx0 Þ ¼ E pD0 gðD0  y0 Þ þ  ðI s þI c bÞðy0  D0 Þ þ  I c aα n E y  ∑ D i  αE½Rðy DÞ; ð19Þ
i¼0
!þ #
n
 ðbþ aαn Þðy0  x0 Þ  I c aαn y0  ∑ Di : RðxÞ ¼ bx þ aαn x þ maxfHðyÞ : y Z xg: ð20Þ
i¼0
" Consequently, there exists a stationary base-stock policy to be
þ α pD1  gðD1  y1 Þ þ  ðI s þ I c bÞðy1  D1 Þ þ optimal. A detailed proof could be conducted almost the same as
Zipkin to obtain Theorem 9.4.3 in [20].
!þ #
nþ1
 ðbþ aα Þðy1  x1 Þ  I c aα
n n
y1  ∑ Di Theorem 3.1. The stationary base-stock policy with base-stock level
i¼1 yng is optimal.
"
Let F ðn þ 1Þ ðÞ denote the distribution function of ∑ni¼ 0 Di . The
þα 2
pD2  gðD2  y2 Þ þ ðI s þ I c bÞðy2  D2 Þ þ
optimal base-stock level yng is the solution of the following equation:
!þ # )
nþ2 gF ðyÞ  ðI s þ I c bÞ þ ðI s þ I c bÞF ðyÞ ðb þ aαn Þð1  αÞ  I c aαn F ðn þ 1Þ ðyÞ ¼ 0;
 ðbþ aα Þðy2  x2 Þ  I c aα
n n
y2  ∑ Di þ⋯ :
i¼2 ð21Þ

With the rearranged formulation, we have the following profit which is the first order optimality condition of the following concave
function of the retailer: function:

1 !þ
 n
Rπg ðx0 Þ ¼ E ∑ αt pDt  gðDt  yt Þ þ  ðI s þ I c bÞðyt  Dt Þ þ  bðyt  xt Þ J g ðyÞ ¼ pE½D  gEðD  yÞ þ  ðI s þ I c bÞEðy DÞ þ  I c aαn E y  ∑ Di
t¼0 i¼0
! þ )#
tþn  ðbþ aα Þð1  αÞy  αðb þ aα ÞE½D:
n n
ð22Þ
 aαn ðyt  xt Þ  I c aαn yt  ∑ Di : ð14Þ
i¼t Under the optimal base-stock policy, the retailer's optimal profit is
The capital cost of supplier depends on the partial order cost b. ( !þ
n
If b o c, i.e., the partial order cost b received by the supplier is less Rng ¼ pE½D  gEðD  yng Þ þ  ðI s þ I c bÞEðyng  DÞ þ  I c aαn E yng  ∑ Di :
than his production cost c, then the supplier has to bear capital i¼0

cost during the delay periods. If b Z c, the capital cost of the )

supplier is zero. Thus, the profit function of the supplier is given by  ðbþ aαn Þð1  αÞyng  αðbþ aαn ÞE½D =ð1  αÞ; ð23Þ
"
1
Sπg ðx0 Þ ¼ E ∑ αt fðaαn þ b  cÞðyt  xt Þ and the supplier's optimal profit is
t¼0
# ½aαn þ b  c I c ðc  bÞ þ ð1 þ α þ α2 þ αðn  1Þ Þ½ð1  αÞyng þ αE½D
Sng ¼ :
 I c ðc  bÞ þ ð1 þ α þ α2 þ αðn  1Þ Þðyt  xt Þg : ð15Þ 1α
ð24Þ
64 D. Gao et al. / Omega 49 (2014) 60–68

The optimal total profit of the supply chain is then 4. The special case of delay-in-payment contract
n
V ng ¼ pE½D  gEðD  yng Þ þ  ðI s þ I c bÞEðyng  DÞ þ  ð1  αÞcyng  αcE½D Because the best performance of the delay-in-payment con-
tract is achieved at b¼ c, as shown in Fig. 2, we consider the
!þ following special case.
n
 I c aα E yg  ∑ Di
n n
I c ðc  bÞ þ ð1 þ α þ α2 þ αðn  1Þ Þ Contract 4.1. The retailer guarantees to make a partial payment with
i¼0 marginal ordering cost c at the ordering epoch and the remaining part
o with additional marginal ordering cost a n periods later to the supplier.
ðð1  αÞyng þ αE½DÞ =1  α: ð25Þ The parameters of the delay-in-payment contract (a, n) are determined
by both parties.
It may be difficult to obtain theoretical result of the relationship In the above special case, we can obtain more properties from
between V ng and the contract parameters. To effectively evaluate the theoretical results and numerical studies, which provide us
the quality of the delay-in-payment contract, we introduce a with valuable implications to contract design.
concept of “Pareto improvement contract”, which is widely used
in the literature [23–25]. 4.1. The model

Using the same method in Section 3, we have the following

Definition 3.1. A contract is said to be a “Pareto improvement
profit function of the retailer for any given policy π and initial
contract” when both parties can benefit from the contract com-
inventory level x0:
pared with the wholesale-price contract. " (
1
We perform numerical calculations to investigate the impact of Rπd ðx0 Þ ¼ E ∑ αt pDt  gðDt  yt Þ þ  ðI s þ I c cÞðyt  Dt Þ þ  cðyt  xt Þ::
t¼0
the parameter b on the supply chain performance. Assume that the
! þ )#
stochastic demand follows a normal distribution N  ð30; 9Þ. The t þn
other parameters are set as follows: c ¼3, w ¼10, p ¼20, I s ¼ 3%, aα ðyt  xt Þ  I c aα
n n
y t  ∑ Di : ð26Þ
i¼t
I c ¼ 5%, and g ¼1.5. The discount factor is α ¼ 1=ð1 þ I c Þ. For each
value of 0 o br w, we search over the possible combinations of Because the retailer pays partial order cost c to the supplier at
parameters n and a with n A f1; 2; …; 9g and 0 o a o 2ðw  bÞ=αn to the ordering epoch, the supplier does not bear any capital cost. The
numerically find the highest profit of the entire supply chain and profit function of the supplier is then given by

1
corresponding profits of the supplier and the retailer.
Sπd ðx0 Þ ¼ E ∑ αt faαn ðyt  xt Þg : ð27Þ
The results are shown in Fig. 2. The delay-in-payment contract is t¼0
found to achieve its best performance at b¼c. Moreover, there exists
By combining the profit functions (26) and (27), we have the
a Pareto improvement area in which the profits of both the supplier
total discounted profit of the supply chain:
and the retailer with a delay-in-payment contract are larger than " (
1
those with wholesale-price contract, respectively. It is also found that V πd ðx0 Þ ¼ E ∑ αt pDt  gðDt  yt Þ þ  ðI s þI c cÞðyt  Dt Þ þ
the Pareto improvement area may not be continuous. t¼0
! þ )#
tþn
 cðyt  xt Þ I c aαn yt  ∑ Di : ð28Þ
i¼t

From Theorem 3.1, the retailer's optimal policy is a base-stock

policy. The optimal base-stock level ynd is the solution of the
following equation:
gF ðyÞ  ðI s þI c cÞ þ ðI s þ I c cÞF ðyÞ  ðc þaαn Þð1  αÞ I c aαn F ðn þ 1Þ ðyÞ ¼ 0;
ð29Þ
which is the first order optimality condition of the following
concave function: !þ
n
J d ðyÞ ¼ pE½D  gEðD  yÞ þ  ðI s þ I c cÞEðy  DÞ þ  I c aαn E y  ∑ Di
i¼0

 ðc þ aαn Þð1  αÞy  αðc þ aαn ÞE½D: ð30Þ

Under the optimal base-stock policy, the retailer's optimal profit is
( !þ
n
Rnd ¼ pE½D  gEðD  ynd Þ þ  ðI s þ I c cÞEðynd  DÞ þ  I c aαn E ynd  ∑ Di
i¼0

ðc þ aαn Þðð1  αÞynd þ αE½DÞ =ð1  αÞ; ð31Þ

and the supplier's optimal profit is

aαn ðð1  αÞynd þ αE½DÞ
Snd ¼ : ð32Þ
1α
The maximum total profit of the supply chain is then
(
V nd ¼ pE½D  gEðD  ynd Þ þ  ðI s þI c cÞEðynd  DÞ þ ð1  αÞcynd  αcE½D:
Fig. 2. The performance of the general delay-in-payment contract.
 D. Gao et al. / Omega 49 (2014) 60–68 65

!þ ) guarantee Rnd Z Rnw if we have Rd ðynw Þ Z Rw ðynw Þ. From (Eqs. (10) and
n
 I c aα E yd  ∑ Di
n n
=1  α: ð33Þ 31), we have
i¼0 !þ
n
gEðD  ynw Þ þ þ ðI s þ I c cÞEðynw  DÞ þ þ I c aαn E ynw  ∑ Di
4.2. The analysis i¼0

þðc þ aαn Þ½ð1  αÞynw þ αE½D

In this subsection, we first analyze the monotonicity properties r gEðD  ynw Þ þ þ ðI s þ I c wÞEðynw  DÞ þ þ cð1  αÞynw þ αcE½D:
of the retailer's optimal order quantity and the total profit of the
supply chain with respect to the additional ordering cost a. Based Substituting (35) into the above leads to
on these properties, a compensation mechanism with the contract " !þ #
n
is then proposed. ðw  cÞI c Eðynw  DÞ þ  E ynw  ∑ Di
i¼0
Proposition 4.1. In the decentralized model with the delay-in- hðnÞ r 1 þ !þ : ð36Þ
n
payment contract 4.1, for a given n, it holds that wð1  α Þyn
wþ αwE½D þI c wE w
yn ∑ Di
i¼0

(a) the retailer's order quantity ynd is decreasing in a,
(b) the total profit of the supply chain V nd is decreasing in a.
The proof is given in the Appendix.
Proposition 4.1 states that the quality of the delay-in-payment
contract may become worse as the additional ordering cost increases.
From the perspective of maximizing the total profit of the supply
chain, the additional ordering cost should be as small as possible.
Only when a¼0, the total profit of the supply chain in the
decentralized model with the delay-in-payment contract (4.1) can
reach the benchmark profit in the centralized model, i.e., the contract
coordinates the supply chain. However, the supplier earns a non-
positive profit in such a case; therefore, it is rational for her to require
a higher additional ordering cost. In doing so, the total profit of the
supply chain is smaller than that in centralized model. Consequently,
the delay-in-payment contract (4.1) can barely coordinate the supply
chain. However, compared to the wholesale-price contract, a Pareto
improvement may be achieved with the contract.
For any given wholesale-price contract with wholesale price w,
it is intuitive to let the total ordering cost equal to w if we want to
design a delay-in-payment contract (4.1) as a Pareto improvement
contract. In other words, the present value of the additional
ordering cost is equal to the remaining ordering cost, i.e.,
a  αn ¼ w  c: ð34Þ
By offering the delay-in-payment contract, the supplier also
bears credit risk (i.e., bankruptcy of the retailer). Therefore, the
supplier may require larger marginal revenue as the permissible
delay period increases. We use a function h(n) that is increasing in
n to compensate for the potential loss of the supplier, where
hð0Þ ¼ 1. Analogous to (34), here we propose the following
approach to set the value of a with respect to n:
a ¼ ðw  hðnÞ  cÞ=αn : ð35Þ
In the rest of this paper, without special statement, we adopt a
delay-in-payment contract with parameters a determined by the
above approach.
From the supplier's perspective, the sufficient condition for accept-
ing the delay-in-payment contract is that her profit increases with the
Obviously, the right hand side of (36) is larger than 1. Therefore, it
is possible to design a function hðnÞ Z 1 to satisfy the basic require-
ment in (35).
In summary, the delay-in-payment contract with sufficient
conditions ynd Z ynw and (36) can provide Pareto improvement and
be accepted by both parties.
4.3. Numerical study
The increasing function h(n) may be convex or concave. It can
be shown that an increasing convex function cannot guarantee
Pareto improvement. Among increasing concave functions, power
type functions are widely used in many disciplines. Here, we
define hðnÞ ¼ ðβn þ1Þγ , where γ o1. To ensure the existence of a
Pareto improving area and the practicality of the contract, we also
need to set β and γ properly.
In the following, we investigate the Pareto improving area with
different combinations of β and γ. We consider that the stochastic
demand follows a normal distribution N  ð50; 152 Þ. Other para-
meters are set as follows: c ¼1, w¼3, I s ¼ 0%, I c ¼ 6%, g ¼1.8 and
α ¼ 1=ð1 þ I c Þ. We search the possible Pareto improvement area
when n A f1; 2; …; 19g. The results are shown in Table 1.
As β or γ increases, the Pareto improving area becomes narrow. To
guarantee a certain area to investigate the performance with the con-
tract, we set β ¼ 0:01 and γ ¼ 0:1 in the subsequent numerical
studies.
With the given function h(n), the delay-in-payment contract
can be determined with values of a and n that satisfy (35). The
quality of the contract can then be evaluated.
We compare the profit of each party in different models in
Fig. 3. We define Φ to be the Pareto improving area, where n A Φ is
the largest n satisfying Rd ðnÞ Z Rw and Sd ðnÞ Z Sw simultaneously.
In the bottom sub-figure, we compare the total profit of the supply
chain in the centralized model, the decentralized model with
Table 1
The Pareto improving area with different parameters.

contract, i.e., Snd Z Snw . Using (Eqs. (11) and 32), this is equivalent to β γ Pareto improving area n
aαn ½ð1  αÞynd þ αE½D Z ðw  cÞ½ð1  αÞynw þ αE½D:
0.01 0.1 [0, 14]
For aαn ¼ whðnÞ c Z w c, the following is sufficient to guarantee 0.02 0.1 [0, 8]
the above condition: 0.03 0.1 [0, 4]
0.04 0.1 [0, 3]
ð1  αÞynd þ αE½D Z ð1  αÞynw þ αE½D: 0.05 0.1 [0, 1]
0.5 0.1 [0, 0]
Thus, a sufficient condition is ynd Z ynw .
From the retailer's perspective, the sufficient condition for accept- 0.02 0.2 [0, 3]
ing the delay-in-payment contract is that her profit increases with 0.02 0.3 [0, 1]
0.02 0.4 [0, 1]
the contract, i.e., Rnd Z Rnw . Because ynd is the optimal solution of profit 0.02 0.9 [0, 0]
function (31), it is clear that Rd ðynd Þ Z Rd ðynw Þ, which is sufficient to
66 D. Gao et al. / Omega 49 (2014) 60–68
Fig. 3. The profit of each party in different models.
wholesale-price contract, and in the decentralized model with the
delay-in-payment contract. In the Pareto improving area Φ, we
can find the maximum V d ðnÞ ¼ 47:423.
Based on the same numerical example, we compare the optimal
order quantity in these models. The result is shown in Fig. 4. The
order quantity in the decentralized model with the delay-in-
payment contract is smaller than that in the centralized model,
but greater than that in the decentralized model with the wholesale-
price contract. The result implies that using the delay-in-payment
contract can alleviate the deviation by increasing the order quantity
compared to using the wholesale-price contract.
In the remainder of this subsection, we conduct extensive numer-
ical studies to compare the performance between the decentralized
Fig. 4. The order quantity of different models.
models with the delay-in-payment contract and with the wholesale-
price contract. Similar to (13) for the definition of θw, we define θd to
denote the relative gap between the the total profit of supply chain in
the centralized model and that with the delay-in-payment contract in
the decentralized model,
V nd
θd ¼ 1  : ð37Þ
V nc
We randomly generate 2000 samples. The customer demand
follows a normal distribution N  ðμ; sÞ, in which the values of μ
are randomly generated from [10, 100] uniformly and s from
½0:2μ; 0:3μ. We normalize the distributions into the finite interval
½μ  3s; μ þ3s to avoid negative demand. We normalize the produc-
tion cost as c¼1. Other parameters are generated randomly. In
practice, the wholesale price is usually between 1 and 4 times the
production cost, and the retail price is usually between 1 and 4 times
the wholesale cost. The physical cost of the leftover inventory is
I s ¼ 3%, and the unit capital cost of leftover inventory is I c w, where
the monthly interest rate Ic varies from 1% to 10%. The penalty cost per
backlogged demand per period is often 3–10 times the unit holding
cost. The parameter settings are shown in Table 2.
We plot θw and θd in ascending order of θw in Fig. 5. With the
delay-in-payment contract, the average gap is less than 0.01%, and the
worst case is 0.08%. In contrast, with the wholesale-price contract, the
average gap is 0.49%, and the worst case is 2.81%. The results show
that in most cases the decentralized system with the delay-in-
payment contract performs very efficiently with its performance close
to the centralized system. Therefore, the delay-in-payment contract is
effective and efficient enough to be used in practice.
Intuitively, the interest rate, Ic, should be an important parameter
in the supply chain. We investigate the effect of the interest rate, Ic,
based on the previous 2000 examples. In doing so, we classify all
samples into nine groups by uniformly dividing the interest rate
interval [1%, 10%] into nine subintervals and, then, compute the
average values of θw and θd of each group. The results are shown in
Fig. 6. The quality of the wholesale-price contract becomes worse
sharply, while the delay-in-payment contract maintains its high
effectiveness and efficiency. The gap between the two contracts
increases considerably with the interest rate. In the high interest rate
situation, e.g., I c ¼ 10%, the total profit of the decentralized model
with the wholesale-price contract is 0.89% lower than that of the
centralized model, whereas the total profit of the decentralized
model with the delay-in-payment contract is only 0.003% lower.
Even in common situations, e.g., I c ¼ 4% [21], the total profit of the
decentralized model with the wholesale-price contract is 0.28%
smaller than that of the centralized model, but the total profit of
the decentralized model with the delay-in-payment contract is only
0.001% smaller. This results implies that the performance of the
 D. Gao et al. / Omega 49 (2014) 60–68 67

Table 2
The parameter settings.

Parameters Range

Production cost, c 1
Wholesale price, w 14
Retail price, p w  4w
Interest rate, Ic 0:01 0:1
Penalty cost, g 3I c w  10Ic w
Permissable delay periods , n 19
Mean demand of normal distribution, μ 10  100
Standard deviation of normal distribution, s 0:2μ 0:3μ

Fig. 7. Effect of wholesale price.

situation, e.g., ðw  cÞ=ðp  cÞ is between 41% and 60%, the total profit
of the decentralized model with the wholesale-price contract is 0.8%
smaller than that of the centralized model, whereas the total profit of
the decentralized model with the delay-in-payment contract is only
0.002% smaller than that of the centralized model. Therefore, the
delay-in-payment contract is effective for high wholesale price
products.

Fig. 5. Comparison between the delay-in-payment contract and the wholesale-
price contract.
Fig. 6. Effect of interest rate.
entire supply chain can be severely affected by a high interest rate.
In high interest rate environments, the retailer faces high risk for the
leftover inventory. In such a situation, the delay-in-payment contract
offered by the supplier can benefit both parties.
Another important parameter is the wholesale price w, which
distributes the profits between the supplier and the retailer. In Fig. 7,
we show the effect of the wholesale price, based on the same 2000
examples. We classify all samples into four groups by uniformly
dividing ðw  cÞ=ðp  cÞ into four subintervals and, then, calculate the
average values of θw and θd of each group. The quality of the
wholesale-price contract becomes significantly worse as ðw cÞ=
ðp  cÞ increases. In contrast, the gap of the performance with the
delay-in-payment contract increases very moderately. In common
5. Concluding remarks
The delay-in-payment contract is important for the supply chain,
not only in financial aspects, but also in operational aspects. With
the widely used wholesale-price contract, the retailer bears all of the
risks of overstocking and tends to order less than the amount that
would be optimal for the entire system. Therefore, the total profit of
the supply chain is smaller than that of the centralized model. The
supplier offers the delay-in-payment contract to the retailer, which
can be regarded as a risk-sharing mechanism. The retailer can
benefit due to lower inventory costs. As a consequence, the retailer
has an incentive to raise her optimal base-stock level. Additionally,
the supplier may benefit from the mechanism. Both parties can
achieve higher profits with a delay-in-payment contract.
For practitioners, the delay-in-payment contract is more significant
for high interest rate environments and high wholesale price products.
Small-sized or start-up retailers face strict financial constraints. How-
ever, most suppliers can receive support from financial institutions
more easily than retailers. The capital cost of a retailer is usually high,
especially in a tightening monetary policy environment. The delay-in-
payment contract offered by a supplier can be an effective financial
channel for a retailer. For high-wholesale-price products, e.g., ðw  cÞ
=ðp  cÞ is large, the order quantity of a retailer with the wholesale-
price contract is much lower than that in the centralized model.
The supplier should offer the delay-in-payment contract to encourage
the retailer to order more, so as to increase not only her own but also
the system-wide profit. A simple contract with acceptable perfor-
mance should be more popular in practice [12]. The delay-in-payment
contact is simple enough to implement. Considering that its perfor-
mance is close to that of centralized model, it is valuable in practice.
We introduce an increasing function h(n) to compensate for the
potential loss of the supplier due to credit risk brought by the
delay-in-payment contract. Credit risk is crucial in this type of
channel coordination; therefore, it is worth incorporating it into
the optimization model. Then, the analysis becomes much more
complex, which can be a subject of future research work.
Another possible future research direction is to incorporate the
decision maker's behavior issues into the contract design. Out of
68 D. Gao et al. / Omega 49 (2014) 60–68

various behavioral factors, time-inconsistent discounting, e.g., hyper- Proof of Proposition 4.1.
bolic discounting, can be considered when a delay-in-payment
contract is implemented. Then, the modeling and corresponding (a) From Eq. (29), it is not difficult to show the result by the
analysis are challenging problems. implicit function theorem.
(b) From (29), we have
gF ðynd Þ  ðI s þ I c cÞ þ ðI s þ I c cÞF ðynd Þ c þ αc  aαn ð1 αÞ  Ic aαn F ðn þ 1Þ ðynd Þ ¼ 0:
Acknowledgment

This research is supported by the National Natural Science Taking derivatives of (28) leads to
Foundation of China under grants 71031005 and 71210002, and n
dV d
partially supported by the National Natural Science Foundation of ¼ gF ðynd Þ  ðI s þ I c cÞ þ ðI s þ I c cÞF ðynd Þ  c þ αc  I c aαn F ðn þ 1Þ ðynd Þ
dy y ¼ yn
China under grants 71201134 and 71090402. d

¼ aαn ð1  αÞ Z 0:

Appendix Together with the result of (a), we can get

n n
dV d dV d dy
¼ o 0:
da fajy ¼ yn g dy y ¼ yn da
Proof of Proposition 2.1. For w Z c, it holds that d d

g  w þ αw g c þ αc
r ;
Is þ Ic w þ g Is þ Ic c þ g The proof is complete. □
which leads to
    References
g  w þ αw g  c þ αc
F 1 rF 1 :
Is þ Ic w þ g Is þ Ic c þ g [1] Petersen MA, Rajan RG. Trade credit: theories and evidence. Review of
Financial Studies 1997;10(3):661–91.
Hence,
[2] Garca-Teruel PJ, Martnez-Solano P. Determinants of trade credit: a compara-
ynw rync : tive study of European SMEs. International Small Business Journal 2010;28
(3):215–33.
Because Jc(y) is maximized at ync , we have J c ðync Þ Z J c ðynw Þ. Then [3] Fisman R. Trade credit and productive efficiency in developing countries.
World Development 2001;29(2):311–21.
J c ðync Þ Z J c ðynw Þ ¼ pE½D  gE½ðD  ynw Þ þ   ðI s þ I c cÞE½ðynw  DÞ þ  [4] Haley CW, Higgins RC. Inventory policy and trade credit financing. Manage-
ment Science 1973;20(4):464–71.
 cð1  αÞynw  αcE½D Z pE½D  gE½ðD  ynw Þ þ   ðI s þI c wÞE½ðynw [5] Goyal SK. Economic order quantity under conditions of permissible delay in
payments. Journal of the Operational Research Society 1985;36(4):335–8.
 DÞ þ   cð1  αÞynw  αcE½D ¼ J w ðynw Þ; [6] Teng JT, Min J, Pan Q. Economic order quantity model with trade credit
financing for non-decreasing demand. Omega 2012;40(3):328–35.
from which we have [7] Taleizadeh AA, Pentico DW, Jabalameli MS, Aryanezhad M. An EOQ model with
partial delayed payment and partial backordering. Omega 2013;41(2):354–68.
J c ðync Þ J w ðynw Þ [8] Hamilton E, Gilbert SM. The role of returns policies in pricing and inventory
V nc ¼ Z ¼ V nw ;
1  α ð1  αÞ decisions for catalogue goods. Management Science 1998;44(2):276–83.
[9] Tsay AA. The quantity flexibility contract and supplier–customer incentives.
with the equality to hold when w ¼c. The proof is completed. □ Management Science 1999;45(10):1339–58.
[10] Giannoccaro I, Pontrandolfo P. Supply chain coordination by revenue sharing
contracts. International Journal of Production Economics 2004;89(2):131–9.
Proof of Proposition 3.1. For u and v, assume that LvðxÞ Z LuðxÞ. Let
[11] Palsule-Desai OD. Supply chain coordination using revenue-dependent
( revenue sharing contracts. Omega 2013;41(4):780–96.
yn A arg min pE½D  gE½ðD  yÞ þ   ðI s þ I c bÞE½ðy  DÞ þ  [12] Cachon G. Supply chain coordination with contracts. Working Paper. The
yZx Wharton School of Business, University of Pennsylvania, Philadelphia; 2001.
" !þ # ) [13] Jaber MY, Osman IH. Coordinating a two-level supply chain with delay in payments
n and profit sharing. Computers and Industrial Engineering 2006;50(4):385–400.
 bðy  xÞ aαn ðy  xÞ  I c αn E y  ∑ Di  αE½uðy DÞ : [14] Luo J. Buyer–vendor inventory coordination with credit period incentives.
i¼0 International Journal of Production Economics 2007;108(1-2):143–52.
[15] Chen L, Kang F. Coordination between vendor and buyer considering trade
Then credit and items of imperfect quality. International Journal of Production
Economics 2010;123(1):52–61.
0 r LvðxÞ  LuðxÞ [16] Du R, Banerjee A, Kim SL. Coordination of two-echelon supply chains using
wholesale price discount and credit option. International Journal of Production
r pE½D  gE½ðD  yn Þ þ   ðI s þ I c bÞE½ðyn  DÞ þ   bðyn  xÞ Economics 2013;143(2):327–34.
" !þ # [17] Li J, Liu L. Supply chain coordination with quantity discount policy. Interna-
n
 aαn ðyn  xÞ  I c aαn E yn  ∑ Di  αE½vðyn  DÞ tional Journal of Production Economics 2006;101(1):89–98.
i¼0 [18] Bassok Y, Anupinidi R. Analysis of supply contracts with total minimum
commitment. IIE Transactions 1997;29(5):373–81.
 pE½D þ gE½ðD  yn Þ þ  þ ðI s þ I c bÞE½ðyn  DÞ þ  þ bðyn  xÞ [19] Chaharsooghi SK, Heydari J. Supply chain coordination for the joint determi-
" !þ # nation of order quantity and reorder point using credit option. European
n
þ aαn ðyn  xÞ þ I c aαn E yn  ∑ Di þ αE½uðyn  DÞ Journal of Operational Research 2010;204(1):86–95.
[20] Zipkin P. Foundations of inventory management. Burr Ridge, IL: McGraw-Hill
i¼0
Higher Education; 2000.
¼ α∑PfD ¼ dg½vðyn  dÞ  uðyn  dÞ [21] Ng CK, Smith JK, Smith RL. Evidence on the determinants of credit terms used
r α∑PfD ¼ dg J v  u J
in interfirm trade. The Journal of Finance 1999;54(3):1109–29.
[22] Puterman ML. Markov decision processes: discrete stochastic dynamic pro-
¼ αJvuJ: gramming. New York, USA: John Wiley Sons; 1994.
[23] Jian C, Lijun X. Coordination of the supply chain of seasonal products. IEEE
Repeating this argument in the case that LuðxÞ Z LvðxÞ implies that Transactions on Systems, Man and Cybernetics, Part A: Systems and Humans
2001;31(6):524–32.
jLvðxÞ  LuðxÞj r α J v  u J ; [24] Iyer AV, Bergen ME. Quick response in manufacturer-retailer channels.
Management Science 1997;43(4):559–70.
for all x A S. Taking the supremum over x in the above expression [25] Gan X, Sethi SP, Yan H. Coordination of supply chains with risk-averse agents.
gives the result. The proof is complete. □ Production and Operations Management 2004;13(2):135–49.