Operations Management Session 25: Supply Chain Coordination

Session 25 Operations Management2 Today’s Lecture  How information and incentives impact the performance?  Supply Chain Coordination  Vertical Integration

Session 25 Operations Management3 ManufacturersWholesale Distributors Suppliers Customers Information Flow Goods Flow Retailers A Simplified Supply Chain Revenue Flow

Session 25 Operations Management4 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 Management5 Multiple Perspectives  Raw Materials Suppliers  Component Manufacturer  Systems Integrator  Assembler  Integrated Manufacturer  Logistics Provider  Distributor  Customer

Session 25 Operations Management6 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 Management7 Channel Coordination  What are the objectives? What is channel coordination? Why are channels not coordinated? How can we coordinate channels?

Session 25 Operations Management8 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 Probability

Session 25 Operations Management9 Decentralized Decision Making  Simple Supply Chain Production cost cWholesale price w Selling price p Holding cost h ManufacturerRetailerDemand

Session 25 Operations Management10 Decentralized Decision Making  How much does the retailer order? P(D≤ Q)=(p-w)/(p+h)

Session 25 Operations Management11 Centralized Decision Making What if the supply chain was vertically integrated? Manufacturer acquired retailer. Production cost cWholesale price w becomes irrelevant. Selling price p Holding cost h ManufacturerRetailerDemand

Session 25 Operations Management12 Centralized Decision Making  How much does the integrated company produce? F(Q)=(p-c)/(p+h)

Session 25 Operations Management13 Question is…  Which supply chain is better? Decentralized decision making Centralized decision making

Session 25 Operations Management14 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 Probability  It is optimal for the retailer to stock 2,000 books.

Session 25 Operations Management15 Channel Coordination  What is the profit of the publisher? 19*2000 – 9*2000 = 38,000 – 18,000 = 20,000 Demand Probability  What is the expected profit of the retailer? = – 19*2000 – 1*{0.2*(2000 – 1000)} + 39*{0.2* * *2000} = – – *(1800) = 32,000  What is the profit of the channel? = 52,000

Session 25 Operations Management16 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 Probability P(D ≤ Base Stock) = (p – c) / (p + h) = (39 – 9) / (39 + 1) = 30 / 40 =0.75

Session 25 Operations Management17 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* * * *3000}  So the Channel Profit is $62,000.

Session 25 Operations Management18 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 Management19 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 Management20 Channel Coordination: Solutions  Type of channel coordination solutions Buy back Revenue Sharing Vendor Managed Inventory (VMI) Consignment Options

Session 25 Operations Management21 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 Management22 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 Management23 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* * *3000} = – *( ) + 39*( ) = – *2300= – = $55,800 The retailer’s profit is $55,800.

Session 25 Operations Management24 Double Marginalization: The Solution  What is the profit of the publisher? = 3000*(12 – 9) – 4*{0.2* *1000} = 9000 – 2800 = 6200  What is the channel profit? = $62,000 The same profit as the integrated system.  Why is the profit the same?  Has the problem been solved?

Session 25 Operations Management25 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 Management26 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) = – w = 30 – 0.75b b = 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 Management27 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* *1000} = – = $25,800 Retailer profit = $36,200 Both players gained by the buyback arrangement

Session 25 Operations Management28 Buy Back: General Solution  General solution:  Find a solution such that:

Session 25 Operations Management29 Vertical Integration No Integration Upstream Integration Downstream Integration Raw Materials Intermediate Manufacturing Assembly D istribution End Customer Raw Materials Intermediate Manufacturing Assembly Distribution End Customer Raw Materials Intermediate Manufacturing Distribution E nd Customer Assembly

Session 25 Operations Management30 Article Reading  "Back to the Future: Benetton Transforms it’s Global network" MIT Sloan management Review, Fall 2001.

Session 25 Operations Management31 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 Management32 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 Management33 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 Management34 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 Management35 Alternatives to Vertical Integration  Long-term explicit contracts  Franchise agreements  Joint ventures  Co-location of facilities  Implicit contracts (relying on firms' reputation)