Trade Credit with Costly Sales Revenue Verification

Problem definition : Trade credit is a common mechanism for financing retail inventories. A supplier who offers trade credit may not observe sales revenue and verification is costly. When a retailer offers to pay less than the full loan amount, the supplier may either accept the offered amount or initiate verification. We investigate the impact of costly sales revenue verification on the equilibrium wholesale price and loan limit, with the goal of determining whether the supplier’s profit is greater when verification is cost-free as opposed to when it is costly. Methodology/results : We formulate and analyze the interaction between a supplier, who is the shot caller, and a retailer within the confines of a wholesale-price net-terms contract via a game theoretic model and derive their in-equilibrium actions. Our key finding is that the presence of positive verification costs can increase the supplier’s expected profit compared with the setting where verification costs are zero. We show that this happens when the retailer’s assets and the verification costs are sufficiently high, but not too high. There exist parameters for which the retailer’s terminal wealth and the supply chain profit are also higher under positive verification costs. Managerial implications : Our paper provides assurance to suppliers that they need not be concerned about sales transparency when the retailer’s assets and the verification costs are in the midrange. Moreover, it shows how suppliers can utilize the levers of loan limit and wholesale price to extract most of the supply chain profit gains from positive verification costs. Our results are relevant in settings where suppliers have pricing power and dictate the contract terms.