It’s Saturday night and you’re looking forward to a night at home with your VCR watching a movie you meant to see when it was such a big hit in the movie theaters. You head for the New Release section in your local video store, 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, hoping there will be a good movie on TV.

Sound familiar? It’s 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 $60 to purchase a tape from a distributor. They then rent that tape to customers for $3 to $4. 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 cassettes to accommodate that initial surge in demand.

But it doesn’t have to be that way, suggest Wharton professor Gérard P. Cachon and Martin A. Lariviere, a professor at Northwestern University’s Kellogg Graduate School of Management. The two researchers recently completed a paper entitled, “Supply Chain Coordination with Revenue-Sharing Contracts: Strengths and Limitations.”

Using Blockbuster, a video rental chain, to illustrate their point, Cachon and Lariviere argue that the revenue-sharing contract’s success of late in the video cassette rental industry proves that in many cases, everyone in the supply chain will be better off with this type of arrangement. 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. In their paper, the researchers study how, and by how much, revenue-sharing contracts improve overall supply chain performance.

Under a typical revenue-sharing contract a supplier charges a retailer a wholesale price per unit plus a percentage of the revenue the retailer generates from the unit. “Revenue-sharing has been used for quite some time in the distribution of films with theaters,” explains Cachon. “The studio will charge the theater a small up-front fee and then take a certain fraction of the box-office revenues. It was a natural extension to bring it over into the video business.” The end result is that instead of inking a deal in which the video rental store pays the studio $60 per tape and keeps all the revenues, the retailer now pays around $8 a tape and gives half the revenues back to the studio.

According to the professors’ research, this model has been particularly successful at Blockbuster, where customers consistently complained about the poor availability of new release videos. Blockbuster decided in 1998 to enter into revenue-sharing agreements with the major studios. The rental company agreed to pay its suppliers a portion, somewhere between 30% to 45%, of its rental income in exchange for a reduction in the initial price per tape from $65 to $8.

Cachon and Lariviere report that revenue-sharing increased rentals at Blockbuster by as much as 75% in test markets; in the year after starting revenue sharing, the company increased its overall market share from 25% to 31% and its cash flow by 61%. After Blockbuster executives established this business strategy, Cachon explains, “they introduced their marketing campaigns, ‘Go Away Happy’ and ‘Guaranteed to be There.’” To put the magnitude of their gains in perspective, he added, “Blockbuster’s incremental gain in market share was equal to its No. 2 rival, Hollywood Entertainment.”

While Cachon and Lariviere use the video cassette rental industry to illustrate the success of the revenue-sharing model, the purpose of their research is to show that the performance of any supply chain can improve under this type of contract. Their research suggests this is a smarter way to do business by quantifying how much better a revenue-sharing contract performs relative to the traditional wholesale price-only contracts.

In hearing the proposal for this type of deal, says Cachon, “most people’s reactions would be, ‘Well, you’re doing this only to exploit me. If you’re going to be better off, then I’m going to be worse off’. But the research shows that if you implement these revenue-sharing contracts, both parties can be better off than before.” Surprisingly, that is true even though, when revenue sharing is implemented correctly, the supplier should sell each unit below its production cost.

Of course, no deal is perfect. If revenue-sharing had no drawbacks then everyone would be using it. Cachon and Lariviere also discuss some of the limitations of revenue-sharing contracts. The first is that it is administratively burdensome compared with the straight-forward 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%, rather than 50%, revenue sharing may not be worth the extra administrative work.

The second limitation, suggest Cachon and Lariviere, is revenue sharing’s impact on the sales effort. “As a retailer, if you’re taking in only a small fraction of the revenue you’re generating, your incentive to improve sales goes down,” Cachon explains. “As a supplier, you want the retailer to buy the right quantity, but you also want them to sell at a higher rate. Revenue-sharing helps to make sure they buy the right quantity, but it hurts their sales effort.” This is especially true, adds Cachon, in retail industries like automobile sales, where a retailer’s sales effort makes a big difference in the overall sales rate .

In the long run, Cachon and Lariviere would like to measure empirically the incremental gains video retailers experience from these contracts. They would also like to research some other industries to determine whether or not revenue sharing is appropriate. Cachon summarizes: “The big picture lesson from this research is that what may look like a problem in the supply chain due to poor execution or forecasting (lack of availability) may in fact be due to misaligned incentives. In those cases the solution comes from novel contracts like revenue sharing.”