We study incentive issues in an inventory management setting in which high on-shelf availability is crucial. Headquarters of a retailer delegates inventory replenishment decisions to store managers in its various stores. Store manager has complete information of the local demand process, whereas headquarters has partial
information and cannot observe unsatisfied demand. The problem is how to incentivize the manager to make an order quantity decision that minimizes the sum of headquarters’ expected overage and underage costs. We propose two incentive schemes that explicitly incorporate excess inventory and stock-outs into the store
manager’s performance measurement.We prove that a perfect alignment of incentives is possible under certain conditions. Interestingly, perfect or near-perfect alignment requires the stock-out inspection before the end of the replenishment cycle. We validate our approach and assumptions on a retailer’s actual data and show that the retailer may improve its profitability by using the proposed incentive scheme.