Optimal procurement, disposal and pricing policies for managing rental goods Sarang Deo and Christopher S. Tang UCLA Anderson School of Management, 110 Westwood Plaza, Los Angeles, CA 90095-1481, USA E-mails: sdeo@anderson.ucla.edu [Deo]; ctang@anderson.ucla.edu [Tang] Received 29 September 2005; received in revised form 3 October 2005; accepted 4 October 2005 Abstract Consider a video rental retailer who procures DVDs or video cassettes from a distributor and rents them to the customers. To meet the time-varying rental demand, the retailer needs to develop cost-effective procurement and disposal policies. In this paper, we first present a base model in which the underlying rental demand is decreasing over time, backorders are not allowed and the disposal price is exogenous. For this base model, we show that the optimal procurement quantity is equal to the sum of effective demands (rental demand net of returns) over an integral number of periods, and the optimal disposal policy can be determined by solving a simple dynamic program with polynomial complexity. We then analyze the case of endogenous disposal prices and derive optimal disposal policies by solving a quadratic optimization problem with tree constraints. We also extend the base model to allow for backorders and to cases where the retailer has multiple procurement opportunities and a contractual period where disposals are not allowed. We show that the qualitative nature of the procurement policy is preserved in these cases and the optimal procurement and selling policies can be determined using similar dynamic programming algorithms. Keywords: Procurement policy; disposal policy; pricing policy 1. Introduction The video rental industry has grown significantly recently, especially with the introduction of the DVD format. Netflix reported in their 2003 annual report that the DVD rental market in the US accounted for $5 billion in 2003 and is estimated to grow to $10 billion by 2008. The reader is referred to Netflix’s Annual report available at www.netflix.com. A video rental retailer such as Blockbuster can enter either a revenue-sharing contract or a linear pricing contract with a distributor such as Warner Brothers. In the former, the retailer can purchase the item at a reduced price, but in turn has to share the rental revenue with the distributor. In the latter, the retailer pays the usual price, which is much higher than that paid under revenue sharing, but gets to keep all the Intl. Trans. in Op. Res. 12 (2005) 595–629 INTERNATIONAL TRANSACTIONS IN OPERATIONAL RESEARCH r 2005 The Authors. Journal compilation r 2005 International Federation of Operational Research Societies. Published by Blackwell Publishing Ltd, 9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA 02148, USA.