Time-based pricing and leadtime policies for a build-to-order manufacturer

Production and Operations Management, Fall 2002 by Tang, Kewi, Tang, Jen

TIME-BASED PRICING AND LEADTIME POLICIES FOR A BUILD-TO-ORDER MANUFACTURER*

We studied time-based policies on pricing and leadtime for a build-to-order and direct sales manufacturer. It is assumed that the utility of the product varies among potential customers and decreases over time, and that a potential customer will place an order if his or her utility is higher than the manufacturer's posted price. Once an order is placed, it will be delivered to the customer after a length of time called "leadtime." Because of the decrease in a customer's utility during leadtime, a customer will cancel the order if the utility falls below the ordering price before the order is received. The manufacturer may choose to offer discounted prices to customers who would otherwise cancel their orders. We discuss two price policies: common discounted price and customized discounted price. In the common discounted price policy, the manufacturer offers a single lower price to the customers; in the customized discounted price policy, the manufacturer offers the customers separately for individual new prices. Our analytical and numerical studies show that the discounted price policies results in higher revenue and that the customized discounted price policy significantly outperforms the common discounted price policy when product utility decreases rapidly. We also study two leadtime policies when production cost decreases over time. The first uses a fixed leadtime, and the second allows the leadtime to vary dynamically over time. We find that the dynamic leadtime policy significantly outperforms the fixed leadtime policy when the product cost decreases rapidly. (BUILD-TO-ORDER; PRICING; LEADTIME; E-COMMERCE)

1. Introduction

The integration of build-to-order (BTO) and direct sales (DS) is the business model championed by Dell Computer Corporation, which has become the largest computer manufacturer in the world. This revolutionary concept of manufacturing and marketing personal computers has been widely adopted, and successful applications have been found in the personal computer, consumer electronics, furniture, and farm equipment industries (Siekman 1999). The most notable recent development is use of this business model in the automotive industry, an initiative that will have even more profound impacts on future business practice (Kelly 1999).

In this thriving manufacturing-retailing field, products such as high-tech and fashion items have relatively short life cycles, and their values to customers decrease rapidly over time. Moreover, the production cost structures of these products often change rapidly because of technological advances and global competition. Consequently, successful time-based strategies1 are vital for a BTO-DS manufacturer.

In this paper, we discuss two critical time-based policies on pricing and leadtime for a BTO-DS manufacturer. In traditional business systems, the practice of varying short-term prices (dynamic pricing) is not practical because of the time, cost, and confusion caused by filtering the information down the distribution channel to retailers. In today's e-commerce environment, however, online price adjustments can be made instantaneously at very low cost. In addition to dynamic pricing, flexible pricing is another practice that has drawn increased attention. Under flexible pricing, product prices may be determined by "an implicit one-toone negotiation between buyers and sellers," and compared with fixed pricing, flexible pricing results in prices that more closely reflect the value (utility) of the product to individual consumers (Green 1998). This practice has been commonly used by institutional buyers and sellers in determining transfer prices (Luft and Libby 1997). It has been anticipated that flexible pricing will be attractive in retailing because of the increase in direct interaction and the closer relationship between a manufacturer and its customers through the e-commerce environment (Hof and Himelstein 1999).

The second policy is related to leadtime. In general, leadtime for a manufacturer includes queue time, fabrication time, inspection time, and transportation time. It is known that a well-designed BTO-DS model can eliminate the need for distributors and result in low inventory levels and production costs. However, a delay (leadtime) exists between the time a customer places an order and the time the customer receives the order. The leadtime may cause a loss in sales or a decrease in price because the product's utility to the customer falls during the leadtime, caused, for example, by competition, technology advances, and seasonal effects. Therefore, continuous leadtime compression has been a major goal for manufacturers. A new aspect of this situation, however, has been observed and discussed recently; that is, a manufacturer may benefit from a longer leadtime if the production cost decreases over time. This has been an important phenomenon in the high-tech industry mainly because of the declining costs of components.