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

Operations Management
Session 25: Supply Chain Coordination
Today’s Lecture
 How information and incentives impact the
performance?
 Supply Chain Coordination
 Vertical Integration
Session 25
Operations Management
2
A Simplified Supply Chain
Manufacturers
Suppliers
Information Flow
Session 25
Wholesale
Distributors
Goods
Flow
Operations Management
Retailers
Customers
Revenue Flow
3
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
4
Multiple Perspectives
 Raw Materials Suppliers
 Component Manufacturer
 Systems Integrator
 Assembler
 Integrated Manufacturer
 Logistics Provider
 Distributor
 Customer
Session 25
Operations Management
5
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
6
Channel Coordination
 What are the objectives?

What is channel coordination?

Why are channels not coordinated?

How can we coordinate channels?
Session 25
Operations Management
7
Channel Coordination:
Example
A single publisher sells a book to a retailer.
 Demand for the book is:
Demand
Probability
1000
2000
3000
4000
0.2
0.3
0.25
0.25
 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.
Session 25
Operations Management
8
Decentralized Decision
Making
 Simple Supply Chain
Manufacturer
Retailer
Production cost c
Wholesale price w
Demand
Selling price p
Holding cost h
Session 25
Operations Management
9
Decentralized Decision
Making

How much does the retailer order?
P(D≤ Q)=(p-w)/(p+h)
Session 25
Operations Management
10
Centralized Decision Making
What if the supply chain was vertically integrated?
Manufacturer acquired retailer.
Manufacturer
Retailer
Production cost c
Demand
Wholesale price w becomes irrelevant.
Selling price p
Holding cost h
Session 25
Operations Management
11
Centralized Decision Making
 How much does the integrated company produce?
F(Q)=(p-c)/(p+h)
Session 25
Operations Management
12
Question is…
 Which supply chain is better?

Decentralized decision making

Centralized decision making
Session 25
Operations Management
13
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 0.25
 It is optimal for the retailer to stock 2,000 books.
Session 25
Operations Management
14
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 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
15
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 0.25

It is optimal for the company to print 3000 books.
Session 25
Operations Management
16
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
17
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
18
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
19
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
21
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?
Session 25

F(T) = (39 – 12)/(39+1 – 4) = 27/36 = 0.75

Exactly the same as the integrated system
Operations Management
22
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
23
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
24
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
25
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
26
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
27
Buy Back: General Solution
 General solution:
service level integrated system
pc
ph
pw
 service level retailer
ph
 Find a solution such that:
pc
pw

p  h p  hb
Session 25
Operations Management
28
Vertical Integration
No Integration
Raw Materials
Intermediate
Manufacturing
Assembly
Upstream Integration
Downstream Integration
Raw Materials
Raw Materials
Intermediate
Manufacturing
Intermediate
Manufacturing
Assembly
Assembly
Distribution
End Customer
Session 25
Distribution
Distribution
End Customer
End Customer
Operations Management
29
Article Reading
 "Back to the Future: Benetton Transforms it’s
Global network" MIT Sloan management Review,
Fall 2001.
Session 25
Operations Management
30
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
31
Vertical Integration
 To decide whether to vertically integrate,
consider:



Session 25
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
Operations Management
32
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
33
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
34
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
35