Managing build‐to‐order short life‐cycle products: benefits of pre‐season price incentives with standardization

Abstract In this paper we consider a firm that can produce standardized products (SP) or customized build‐to‐order products (BOP) with short life‐cycles. We develop a stochastic dynamic programming model to study the effect of offering price incentives to those customers who are willing to commit themselves to purchasing the cheaper‐to‐produce standardized product. The market’s reaction to price incentives is captured by modeling the probabilistic behavior of two exclusive groups of customers who may be “price‐sensitive” or “price‐insensitive” and who are willing to commit themselves. We develop an analytic expression for the distribution of the demand for the BOP conditional on the actual number of committed demands for SP following the price‐incentive announcement. We show that price incentives expand the total expected demand while reducing demand uncertainty and we present conditions under which it is optimal to offer a price incentive. Sequentially made price incentive and capacity decisions for the BOP that maximize expected profit are obtained by solving the dynamic programming problem. We provide a comparative statics analysis and examine the effect of varying parameter values on the optimal price‐incentive discount rate. We also describe a numerical study and present a sensitivity analysis of the profit improvement obtained after offering price incentives. We show that for low purchase probability, large number of customers in the price‐sensitive group and high profit margin price incentives can substantially improve the expected profit.