Operations Management
Session 25: Supply Chain Coordination
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Today’s Lecture
How information and incentives impact the performance?
Supply Chain Coordination
Vertical Integration
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Manufacturers
Wholesale Distributors
Suppliers Customers
Information FlowGoods Flow
Retailers
A Simplified Supply Chain
Revenue Flow
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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.
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Multiple Perspectives
Raw Materials Suppliers
Component Manufacturer
Systems Integrator
Assembler
Integrated Manufacturer
Logistics Provider
Distributor
Customer
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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
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Channel Coordination
What are the objectives? What is channel coordination? Why are channels not coordinated? How can we coordinate channels?
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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
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Decentralized Decision Making
Simple Supply Chain
Production cost c Wholesale price w
Selling price p
Holding cost h
Manufacturer Retailer Demand
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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)
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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
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Centralized Decision Making
How much does the integrated company produce?P(D ≤ Q)=(p-c)/(p+h)
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Question is…
Which supply chain is better? Decentralized decision making Centralized decision making
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Channel Coordination
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.
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Channel Coordination
What is the profit of the publisher? 2000(19-9) = 20,000
Demand 1000 2000 3000 4000Probability 0.2 0.3 0.25 0.25
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
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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.
Demand 1000 2000 3000 4000Probability 0.2 0.3 0.25 0.25
P(D ≤ Base Stock) = (p – c) / (p + h)
= (39 – 9) / (39 + 1) = 30 / 40 =0.75
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Channel Coordination
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
Demand 1000 2000 3000 4000Probability 0.2 0.3 0.25 0.25
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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
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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.
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Channel Coordination: Solutions
Type of channel coordination solutions Buy back Revenue Sharing Vendor Managed Inventory (VMI) Consignment Options
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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
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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
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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.
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Double Marginalization: The Solution
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?
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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?
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Double Marginalization: The Solution
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.
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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
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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
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Vertical Integration
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
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Article Reading
"Back to the Future: Benetton Transforms it’s Global network" MIT Sloan management Review, Fall 2001.
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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
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Vertical Integration
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
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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
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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.
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Alternatives to Vertical Integration
Long-term explicit contracts
Franchise agreements
Joint ventures
Co-location of facilities
Implicit contracts (relying on firms' reputation)