Operations Management Session 25: Supply Chain Coordination

Operations Management Today’s Lecture How information and incentives impact the performance? Supply Chain Coordination Vertical Integration Session 25 Operations Management

A Simplified Supply Chain Manufacturers Wholesale Distributors Suppliers Retailers Customers Goods Flow Information Flow Revenue Flow Session 25 Operations Management

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. Session 25 Operations Management

Multiple Perspectives Raw Materials Suppliers Component Manufacturer Systems Integrator Assembler Integrated Manufacturer Logistics Provider Distributor Customer Session 25 Operations Management

Operations Management 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 Session 25 Operations Management

Operations Management Channel Coordination What are the objectives? What is channel coordination? Why are channels not coordinated? How can we coordinate channels? Session 25 Operations Management

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 Session 25 Operations Management 8

Decentralized Decision Making Simple Supply Chain Manufacturer Retailer Demand Production cost c Wholesale price w Selling price p Holding cost h Session 25 Operations Management

Decentralized Decision Making How much does the retailer order? P(D≤ Q)=(p-w)/(p+h) Session 25 Operations Management

Centralized Decision Making What if the supply chain was vertically integrated? Manufacturer acquired retailer. Manufacturer Retailer Demand Production cost c Wholesale price w becomes irrelevant. Selling price p Holding cost h Session 25 Operations Management

Centralized Decision Making How much does the integrated company produce? F(Q)=(p-c)/(p+h) Session 25 Operations Management

Operations Management Question is… Which supply chain is better? Decentralized decision making Centralized decision making Session 25 Operations Management

Operations Management 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 4000 Probability 0.2 0.3 0.25 It is optimal for the retailer to stock 2,000 books. Session 25 Operations Management

Operations Management Channel Coordination What is the profit of the publisher? 19*2000 – 9*2000 = 38,000 – 18,000 = 20,000 What is the expected profit of the retailer? Demand 1000 2000 3000 4000 Probability 0.2 0.3 0.25 = – 19*2000 – 1*{0.2*(2000 – 1000)} + 39*{0.2*1000+0.3*2000+0.5*2000} = – 38000 – 200 + 39*(1800) = 32,000 What is the profit of the channel? 32000 + 20000 = 52,000 Session 25 Operations Management

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? P(D ≤ Base Stock) = (p – c) / (p + h) = (39 – 9) / (39 + 1) = 30 / 40 =0.75 Demand 1000 2000 3000 4000 Probability 0.2 0.3 0.25 It is optimal for the company to print 3000 books. Session 25 Operations Management

Operations Management Channel Coordination What is the optimal expected profit of the publishing company? Expected profit = – Printing cost – Expected holding cost + Expected revenue Printing Cost: – 9*3000 Expected holding cost: – 1*{0.2*(3000 – 1000) +0.3*(2000 – 1000)} Expected Revenue: + 39*{0.2*1000+0.3*2000+0.25*3000+0.25*3000} So the Channel Profit is $62,000. Session 25 Operations Management

Operations Management 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 Session 25 Operations Management

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. Session 25 Operations Management

Channel Coordination: Solutions Type of channel coordination solutions Buy back Revenue Sharing Vendor Managed Inventory (VMI) Consignment Options Session 25 Operations Management 20

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 Session 25 Operations Management

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? F(T) = (39 – 12)/(39+1 – 4) = 27/36 = 0.75 Exactly the same as the integrated system Session 25 Operations Management

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. Session 25 Operations Management

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? Session 25 Operations Management

Operations Management 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? Session 25 Operations Management

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. Session 25 Operations Management

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 Session 25 Operations Management

Buy Back: General Solution Find a solution such that: Session 25 Operations Management

Vertical Integration Session 25 Operations Management No Integration Upstream Integration Downstream Integration Raw Materials Raw Materials Raw Materials Intermediate Manufacturing Intermediate Manufacturing Assembly Intermediate Manufacturing Assembly Distribution Assembly Distribution Distribution End Customer End Customer End Customer Session 25 Operations Management

Operations Management Article Reading "Back to the Future: Benetton Transforms it’s Global network" MIT Sloan management Review, Fall 2001. Session 25 Operations Management

Operations Management 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 Session 25 Operations Management

Operations Management 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 Session 25 Operations Management

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 Session 25 Operations Management

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. Session 25 Operations Management

Alternatives to Vertical Integration Long-term explicit contracts Franchise agreements Joint ventures Co-location of facilities Implicit contracts (relying on firms' reputation) Session 25 Operations Management