1. Operations Management
Session 25: Supply Chain Coordination

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

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

4. 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

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

6. 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

7. 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

8. 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

9. 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

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

11. 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

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

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

14. 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

15. 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* * *2000}
= – – *(1800) = 32,000
What is the profit of the channel?
= 52,000
Session 25
Operations Management

16. 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

17. 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* * * *3000}
So the Channel Profit is $62,000.
Session 25
Operations Management

18. 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

19. 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

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

21. 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

22. 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

23. 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 Management

24. 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 Management

25. 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

26. 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
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 Management

27. 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 Management

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

29. 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

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

31. 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

32. 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

33. 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

34. 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

35. 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