Operations Management

Operations Management Session 25: Supply Chain Coordination

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

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

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

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

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

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) 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 Operations Management

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

Question is… Which supply chain is better? Decentralized decision making Centralized decision making 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 • It is optimal for the retailer to stock 2,000 books. Operations Management

Channel Coordination • 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 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 • It is optimal for the company to print 3000 books. Operations Management

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 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 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. Operations Management

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

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 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? • P(D≤Q) = (39 – 12)/(39+1 – 4) = 27/36 = 0.75 • Exactly the same as the integrated system 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. 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? 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? 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. 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 Operations Management

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

Vertical Integration No Integration Downstream Integration Upstream Integration Assembly Operations Management

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

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

Operations Management