Video Vault
Background: Revenue Sharing in the Video Rental Market
Bill Peaslee and his partner Rob St. Angelo, owners of the Video Vault, a video rental store in Westborough, MA, mulled through their list of upcoming new releases. They were wrestling over what films to buy and in what quantity. The video industry in the early twenty-first century was becoming much less predictable. New pricing contracts, changing release windows, and changing demand and supply patterns made choosing inventory levels a much more challenging game.
Rentrak Corp., a distributor of DVDs to small, independent retailers, pioneered the idea of revenue sharing. Rentrak distributed the titles at lower prices and took a percentage of the rental revenue from its customer base of smaller chains and independent video dealers, sharing that percentage with the studios. Rentrak owned software that allowed its clients to send their transaction information over a secure line to Rentrak, which aggregated the information and sent it on to studios. Large chains with the clout to negotiate directly with distributors decided Rentrak was right after all, but they did not want or need the middleman. Soon, Blockbuster had signed revenue-sharing deals with all of the major distributors. The widespread use of revenue sharing fundamentally changed the economics of the industry. Under revenue sharing, distributors sold the DVD to the retailer at a much lower price in return for a percentage of the rental revenue and of the eventual used-DVD sale to consumer. The retailer also had to stock certain maximum and minimum levels of inventory depending on the movie and on the store size.
The Problem
Increasingly, much of the Video Vault profit was coming from the sales (not rental) of DVDs. The foot traffic generated by rental business and their prime location results in a lot of impulse purchases of new DVD titles displayed in the window. The problem was that studios insisted on a separate contract for DVD copies for sales and did not allow DVDs purchased (by Video Vault) for rentals to be used for DVDs purchased for direct sales to Video Vault’s customers. The studios were interested in increasing the direct sales and therefore sold direct-for-sales DVDs at a slightly smaller price to Video vault than what studios charged for DVDs meant for rental. The studios did not want the two to mix. Based on experience, Peaslee and St. Angelo had developed good thumb rules to determine how many copies to acquire for the rental business but did not have a good handle of what the demand for DVDs for direct-sale would be.
(a) Specifically, they were thinking about how many copies of a new popular title for direct-sale part. Under the standard contract, studio charges $16 per copy for direct-sale. Video Vault plans on charging its customers $20 for direct-sale of a new DVD. The direct-sales dried very quickly (within about four weeks of the release date). In addition, Video Vault needed the space to display newer titles. Therefore, after four weeks, Video Vault cleared the space by selling the unsold direct-sale DVDs for a discounted price of $5. Given the uncertainty in the direct-sale DVD part of the business, Peaslee and St. Angelo’s best guess was that the demand is going to have an average of 100 and standard deviation of 30. How many DVDs should Video Vault buy for direct-sales part?
(b) The studio offers a revenue sharing deal for direct-sales DVDs as well. Since this part is new, the deal terms are open for negotiation. The current terms are that the studio will sell to Video Vault at $9 per copy if Video Vault will share 40% of the revenue generated by direct sales of new DVDs. The per-unit manufacturing cost for studio, including royalty payments to artists, is $7. There is no requirement for the Video Vault to share proceeds from discounted sales at $5 per copy. Should Video Vault take the deal?