Wednesday, October 3, 2012 Operations and Technology Management Blog
Inventory Managers Can Be Predictably Irrational, Too by Jordan Tong

If I asked you whether you would prefer to have $100 today or in three months, what would you say? Of course, you would opt to take the money today. This is because of the time value of money: you could invest the $100 for three months and make a profit.

Given these kinds of simple choices, you will always make the profit-maximizing decision, right? Actually no, not always: not if the decision is framed in a certain way. For example, imagine that you are about to book a fun hot air balloon trip two months from now. The balloon trip costs $100. You're given two options to pay for your trip: (1) drive to the departure site and pay $100 today, or (2) return to the site one month after the trip to pay the $100. Which option would you choose?

This question offers essentially the same choices as the question I presented at the beginning of this post. However, if you selected option one (pay $100 today), you're effectively choosing to have $100 three months from now rather than $100 today. What explains the difference in your decision? Psychological theory suggests that paying the $100 today is less painful because you have the trip to look forward to. Moreover, the ride in the hot air balloon will be more enjoyable because you have already paid for the trip.

My current research shows the psychological forces that influence you as a consumer also affect inventory managers who deal with more complex (and higher dollar value) decisions. In a forthcoming paper in Management Science, my coauthors and I show that, like you, inventory managers may make decisions in the opposite direction of what the time value of money dictates, depending on how the payments for inventory are framed in the financial contract. So, for the same reason you chose to pay for the hot air balloon trip today instead of in three months, managers may place a higher inventory order when offered a contract that forces them to pay more up front than an equivalent contract that permits them to delay more payment until after the selling season.

When inventory managers make irrational decisions like these, the results are significantly lower profits and problems for supply chain coordination. By revealing the psychological forces behind inventory decision-making, our findings help managers reframe decisions to encourage optimal behavior and help supplier-buyer contract writers improve supply chain efficiency.