In supplier-retailer interactions, the retailer may carry inventories strategically as a bargaining mechanism to induce the supplier to drop the future wholesale price. As per Anand, Anupindi, and Bassok (2008), the introduction of strategic inventories always benefits the supplier and possibly also the retailer if the holding cost is sufficiently low (due to the contract-space-expansion effect). Is such a move beneficial for the supply chain agents in the presence of process improvement efforts? Such efforts— initiated by suppliers—ultimately reduce production cost and may translate into lower wholesale prices as well as lower consumer prices. We find that strategic inventories may stimulate investment in process improvement when the holding cost is high (as it encourages the supplier to further reduce future cost to eliminate the need for strategic inventories), but may suppress such investment when the holding cost is low (as strategic inventories are cheap to stock and hence cannot be eliminated). Our key result, contrary to the existing literature, is that strategic inventories may be harmful to both supply chain agents in the presence of process improvement. In that case, the supplier effectively over-invests in process improvement efforts, inducing the retailer to reduce the stock of strategic inventories, while reversing the benefits of the contract-space-expansion effect. We also consider variations to the model, whereby the supplier may delay his investment decision, the holding cost may be a function of the wholesale price set by the supplier, consumers may behave strategically, and the planning horizon may consist of multiple periods.

Introduction

Firms are constantly engaged in improving their internal processes in order to reduce the unit cost of production. New technologies and opportunities allow firms to take advantage of emerging solutions that facilitate future reductions in the cost of their operations. For instance, 3D printing bears a significant potential for firms in the manufacturing sector to transform their processes, ultimately allowing them to have a cheaper and a more efficient production system (examples include GE or the PSA Group, a French automotive firm, see Fortune, 2016). Cost reduction efforts are not limited to adoption of new technologies and can also emerge as an outcome of traditional process management methods. Indeed, according to a cost management survey, streamlining business processes turned out to be one of the main tactical approaches for Fortune 1000 firms to remain competitive (Deloitte, 2013). One such example is the continuous improvement program at John Deere, which seeks to embrace lean processes and further engage suppliers in order to reduce the overall cost of the end products. The benefits of such investments in new technologies and improved processes may not be immediate, as the integration and implementation requires an overhaul of the design (of the product and/or the process), may be time consuming, and possibly may need to wait until the facility can be shut down.1 Due to their nature, such process improvement and cost reduction efforts usually require long lead times. Namely, investment into such efforts are made well in advance before the outcome of the impact on the cost reduction are realized (Li & Wan, 2016).