Operations Management Session 25: Supply Chain Coordination

Operations Management

Session 25: Supply Chain Coordination

Session 25 Operations Management 2

Today’s Lecture

How information and incentives impact the performance?

Supply Chain Coordination

Vertical Integration


Manufacturers

Wholesale Distributors

Suppliers Customers

Information FlowGoods Flow

Retailers

A Simplified Supply Chain

Revenue Flow


Supply Chain Management (SCM)

Supply Chain Management (SCM) concerns the coordination and optimization of all supply, manufacturing, distribution and logistics activities from raw materials to finished goods to the customer.

SCM strives to use the supply chain as a mutually beneficial competitive tool.


Multiple Perspectives

Raw Materials Suppliers

Component Manufacturer

Systems Integrator

Assembler

Integrated Manufacturer

Logistics Provider

Distributor

Customer


SCM Goals

Maximize profits of all supply chain partners

How to do it? Get the right product, in the right quantity, to

the right customer at the right time with minimum cost, proper documentation and financial reconciliation

Difficulty: Each partner has its own goal


Channel Coordination

What are the objectives? What is channel coordination? Why are channels not coordinated? How can we coordinate channels?


Channel Coordination: Example

A single publisher sells a book to a retailer. Demand for the book is:

Production cost (c) = 9 Revenue (p) = 39 Good-will (g) = 0 Holding cost (h) = 1 Whole sale price (w) = 19 Salvage value is assumed to be 0.

Demand 1000 2000 3000 4000

Probability 0.2 0.3 0.25 0.25


Decentralized Decision Making

Simple Supply Chain

Production cost c Wholesale price w

Selling price p

Holding cost h

Manufacturer Retailer Demand


Decentralized Decision Making

How much does the retailer order?Cu = p-w

Co = w-0+h

P(D≤ Q)= Cu/(Cu+Co) = (p-w)/(p-w+w+h)

P(D≤ Q)= (p-w)/(p+h)


Centralized Decision Making

What if the supply chain was vertically integrated?

Manufacturer acquired retailer.

Production cost c Wholesale price w becomes irrelevant.

Selling price p

Holding cost h

Manufacturer Retailer Demand


Centralized Decision Making

How much does the integrated company produce?P(D ≤ Q)=(p-c)/(p+h)


Question is…

Which supply chain is better? Decentralized decision making Centralized decision making



Suppose each entity is independent. How many books will the retailer stock? P(D ≤ Base Stock) = (p – w) / (p + h)

= (39 – 19) / (39 +1) = 20 / 40 = 0.50

Demand 1000 2000 3000 4000Probability 0.2 0.3 0.25 0.25

It is optimal for the retailer to stock 2,000 books.



What is the profit of the publisher? 2000(19-9) = 20,000


What is the expected profit of the retailer?Expected Salvaged = 0.2(2000 – 1000) =

200

Expected sold = 0.2(1000) + 0.8(2000) = 1800

What is the profit of the retailer?1800(39-19) – 200(19+1) =36000-4000 = 32000

What is the profit of the channel?

32000 + 20000 = 52,000


Channel Coordination:

Suppose you own both bookstore and the publisher:

What is the optimal number of books to be printed by the publisher and offered by the retailing department?

It is optimal for the company to print 3000 books.


P(D ≤ Base Stock) = (p – c) / (p + h)

= (39 – 9) / (39 + 1) = 30 / 40 =0.75



What is the optimal expected profit of the publishing company?

Expected profit = – Printing cost – Expected holding cost + Expected revenue

Expected Salvaged = 0.2(3000 – 1000) + 0.3(3000-2000) = 700

Expected sold = 0.2(1000) + 0.3(2000) +0.5(3000)= 2300

What is the profit of the retailer?

2300(39-9) – 700(9+1) =69000-7000 = 62000



Question

Notice: The profit in the integrated company is $62,000

The profit in the disintegrated company is only $52,000

Why are they leaving some money on the table?

Double marginalization


Double Marginalization

What can be done to increase: The channel profit The publisher profit The retailer profit Recall that there is $10,000 on the table.


Channel Coordination: Solutions

Type of channel coordination solutions Buy back Revenue Sharing Vendor Managed Inventory (VMI) Consignment Options


Double Marginalization: The Solution

Suppose the publisher is willing to purchase back all the excess inventory

In return for this service, he might change the wholesale price


Double Marginalization A Solution

Example: Production cost (c) = 9 Revenue (p) = 39 Goodwill (g) = 0 Holding cost (h) = 1 Wholesale price (w) = 12 Buy back price = 4

What is the retailer service level? P(D≤Q) = (39 – 12)/(39+1 – 4) = 27/36 = 0.75 Exactly the same as the integrated system


Double Marginalization: A Solution

It is optimal for the retailer to purchase 3,000 units.

The retailer’s profit:

= – 3000*12 – (1 – 4)*{0.2*(3000 – 1000)+0.3*(3000 – 2000)}

+ 39*{0.2*1000+0.3*2000+0.5*3000}

= – 36000 + 3*(400+300) + 39*(200+600+1500)

= – 36000 + 2100 + 39*2300= – 36000 + 84000 = $55,800

The retailer’s profit is $55,800.



What is the profit of the publisher?= 3000*(12 – 9) – 4*{0.2*2000+0.3*1000}

= 9000 – 2800 = 6200

What is the channel profit? 55800+6200 = $62,000 The same profit as the integrated system.

Why is the profit the same?

Has the problem been solved?


Review

Previously: Profit publisher: $20,000 Profit retailer: $32,000

System with buy back Profit publisher: $6,200 Profit retailer: $55,800

Do you think implementing the buy back system is feasible?



We must ensure that both publisher and retailer benefit

How can we do that? (p – w) / (p + h – b) = 0.75 (39 – w)/(39+1 – b) = 0.75 39 – w = 30 – 0.75b 9 + 0.75b = w All pairs (w,b) that satisfy the above equation will

coordinate the channel. When the channel is coordinated the retailer will

purchase 3000 units.


Double Marginalization: The solution

For some pairs (w,b), both players will benefit from coordination:

When w = 21 then b = 16 The service level is: (39–21)/(39+1–16) = 18/24=0.75 Publisher profit = 3000 * (21 – 9) –

16*{0.2*2000+0.3*1000} = 36000 – 10200 = $25,800

Retailer profit = $36,200 Both players gained by the buyback arrangement


Buy Back: General Solution

General solution:

Find a solution such that:

hp

cp

system integrated level service

retailer level servicehp

wp

bhp

wp

hp

cp



No Integration Upstream Integration Downstream Integration

Raw Materials

IntermediateManufacturing

Assembly

Distribution

End Customer

Raw Materials

Intermediate Manufacturin

g

Assembly

Distribution

End Customer

Raw Materials

IntermediateManufacturing

Distribution

End Customer

Assembly


Article Reading

"Back to the Future: Benetton Transforms it’s Global network" MIT Sloan management Review, Fall 2001.


Benetton

Factors contributing to success Delayed dyeing Network organization for manufacturing Network organization for distribution

Benetton’s strategy in supply chain management Product design (customized by region) Supply and production (strong upstream vertical integration) Retail network (mixed downstream vertical integration)

Diversifying into sports



To decide whether to vertically integrate, consider:

Cost: Cost of market transactions between firms vs. cost of administering the same activities internally within a single firm

Control: Impact of asset control, which can impact barriers to entry and which can assure cooperation of key value-adding players.

Coordination/Information Sharing


Vertical Integration: Drawbacks

Capacity balancing issues For example, the firm may need to build excess

upstream capacity to ensure that its downstream operations have sufficient supply under all demand conditions.

Potentially higher costs Due to low efficiencies resulting from lack of supplier

competition. Economy of scale/risking pooling from outsourcing


Factors against Vertical Integration

The vertically adjacent activities are in very different types of industries. For example, manufacturing is very different from retailing.

The addition of the new activity places the firm in competition with another player with which it needs to cooperate. The firm then may be viewed as a competitor rather than a partner.


Alternatives to Vertical Integration

Long-term explicit contracts

Franchise agreements

Joint ventures

Co-location of facilities

Implicit contracts (relying on firms' reputation)

Documents

Operations Management Session 25: Supply Chain Coordination