Revenue Sharing Contract Model

 | June 08,2010 05:30 pm IST

Revenue sharing contract is a supply chain contract in which the manufacturer charges low wholesale price to the retailer and shares a fraction of revenue generated by the retailer. Even if no returns are allowed, everyone in the supply chain will be better off with this type of arrangement.

Under a revenue sharing contract, a retailer pays a supplier a wholesale price for each unit purchased plus a percentage of the revenue the retailer generates. Such contracts have become more prevalent in the video-cassette rental industry relative to the more conventional wholesale price contract. For example, it's Saturday night, and you're looking forward to a night at home with your VCD/DVD player watching a movie you wanted to see when it was such a big hit in the movie theaters.


You head for the New Release Section in your local video library, sift through the boxes on the shelf, and realize that all the copies of your movie-of-choice have already been rented. Even the copies of your second choice are gone. You leave frustrated.


Sounds familiar? It has happened to all of us at least one time or another. But you probably have never stopped to actually think why it happens, from a business perspective. Video rental stores typically have to spend Rs. 400-500 to purchase a DVD from a distributor. They then rent it to customers for Rs. 40 to Rs. 50. Because demand for new releases drops dramatically after the first few weeks, video retailers have a hard time making any money on the rentals. Consequently, they can only afford to buy a few VCDs/DVDs to accommodate that initial surge in demand.


Revenue sharing contracts between suppliers and retailers have been credited with allowing retailers to increase their stock of newly released movies, thereby substantially improving the availability of popular movies. Under a typical revenue sharing contract, a supplier charges the retailer a wholesale price per unit (which is lower than the original price of the VCD/DVD) plus a percentage of the revenue the retailer generates from the unit.


The supplier will charge the retailer a small up-front fee and then take a certain fraction of the rental revenues. The end result is that instead of inking a deal in which the retailer pays the supplier Rs. 500 per DVD and keeps all the revenues, the retailer now pays lower amount initially but shares a fraction of the rental revenues with the supplier.


This model has found wide scale applications in video-cassette rental industry and in insurance protection policies. The advantages of this kind of modeling include increased product availability for the end customers and increased profits for both manufacturer and retailer.

However, every coin has two sides. The system comes with its own disadvantages. First, it is administratively burdensome compared with the straightforward wholesale price-only contract. Revenue sharing takes an organizational effort to set up the deal and follow its progress. If profits are only increasing by 2 percent, rather than 50 percent, revenue sharing may not be worth the extra administrative work.


Second, revenue sharing contract has an adverse impact on the sales effort. If the retailer is getting only a small fraction of the revenue he's generating, his incentive to improve sales goes down whereas the supplier wants the retailer to buy the right quantity, and also want them to sell at a higher rate. Revenue sharing helps to make sure that the retailer buys the right quantity, but it hurts their sales effort and this makes a big difference in the overall sales rate.




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