Cooperation Coordination and Competition in Supply Chain

1
Cooperation Coordination and Competition in
Supply Chain

• Prof. Yehuda Bassok
• Marshall Scholl of Business
• University of Southern California

2
Agenda

• What is new
• What are the problems
• Some solutions
• Supply Contracts
• Negotiation

3
What is the problem?

• Supply chains are composed of many players
• The objectives and interests of the different
  players are different. Resulting in each player
  pulling the wagon in a different direction and
  creating inefficiencies in the supply chain.
• Examples
• Production quantities
• Allocation of profits

4
What is the problem?

• Harry Potter magic spells losses for booksellers
• Millions of people will descend on stores for a
  copy of "Harry Potter and the Deathly Hallows" in
  July, but deep discounts mean many will struggle
  to turn a profit from the jamboree.
• "Everywhere you go there is huge, ridiculous
  discounting by the chains," said Graham Marks,
  children's editor at the British-based trade
  magazine Publishing News.
• "They are literally not going to make one penny
  out of the book. It is stupid -- just throwing
  money away ... The world has gone mad."

5
What is the problem?

• Who will make profit?

6
What is the objective?

• Coordinate the channel
• What do we mean by channel coordination?
• Profits of the different players in the channel
  are Pareto optimal. That is it is impossible to
  increase the profits of a player without
  decreasing the profit of another one.
• When the channel is not coordinated it is
  possible to improve the profits of some players
  without hurting the others. In this case no one
  should be against the change.

7
Channel Coordination

• Coordination

Utility of player B
A
F
B
Utility of player A
d
8
What are the reasons for the channel not being
coordinated?

• Lack of information
• Information about the demand is not transmitted
  up stream.
• Conflicting interest
• Retailers would like to have daily deliveries
• Daily deliveries are expensive for the suppliers
• Manufacturers would like to have a stable
  production environment.
• Buyers would like to have the flexibility to
  adjust to the demand and change orders with a
  short notice.

9
Information Sharing

• Lack of demand visibility is usually considered
  as a major challenge for efficient management of
  supply chains
• Demand distortion (bullwhip effect)
• The variability in the demand is increasing as we
  move up-stream at the supply chain.
• Was observed by Proctor Gamble making diapers.

10
The supply chain

• Retailer
• Distributor
• Wholesaler
• Manufacturer
• Flow of goods

Customer
Retailer
Wholesaler
Distributor
Manufacturer
11
The supply chain

• Transportation Delay
• Two period delay

R. Orders
D. Orders
W. Orders
Customer
Retailer
Wholesaler
Distributor
Manufacturer
12

13
Information Sharing The bullwhip effect
14
Information Sharing The bullwhip effect

• Demand distortion leads to
• High variability in the demand
• Low capacity utilization
• High inventory levels
• Poor availability
• High production cost
• High total cost

15
Information Sharing Example

• Wall-mart
• Vendor Managed Inventory System (VMI) An
  arrangement in which the vendor monitors the
  customers inventory and takes responsibility for
  the timing and quantity of replenishments
• The vendor has access to selling information
  through data rather than to orders.
• Proctor Gamble
• Wrangler
• GE

16
Information Sharing Example

• Wall-Mart transmit daily information of sales and
  inventory to the vendors
• Wall-Mart does not place the orders
• The vendor decides the timing and quantity of
  each order to warehouses and stores.
• Service level went up from 85 to 98
• Reduction in average inventory
• Large scale collaborations are very rare.
• Why?

17
Information Sharing Example

• What are the reasons for the improvements?
• Information is valuable and helps in the
  production planning and logistics processes
• Competition plays an important role.
• In some variant of VMI the improvement is due to
  the elimination of the double marginalization
  effect.

18
Information Sharing

• Reasons for not sharing information
• Trust
• Sales information is a tool in the negotiation
  process.
• Cost of technology
• Is it possible to coordinate the channel without
  sharing information?

19
Double Marginalization

• Imagine a supply chain in which
• The manufacturer production cost is 1
• The manufacturer sells the product (whole sale
  price) for 5
• The retailer sells the product for 10
• The manufacturer margin is 5 - 1 4
• The retailer margin is 10 5 5
• The channel margin is 10 - 1 9

Double Marginalization
20
Double Marginalization

• What is the problem with Double Marginalization?
• Assuming random demand
• From a system point of view (maximizing the
  profit of the system) it is optimal to produce a
  large quantity
• From the retailer point of view it is optimal to
  produce a small quantity.

21
Double Marginalization Example

• Assume that the demand is either
• 100 units with 0.6 probability
• 200 units with 0.4 probability.
• It is optimal for the retailer to order 100 units
• Profit retailer -5100 10100 500
• Profit manufacturer 1005 1100 400
• Profit channel 500 400 900
• It is optimal for the system to order 200 units
• Profit retailer -5200 0.610000.42000400
• Profit manufacturer -200 1000 800
• Profit channel 1200

22
Channel Coordination

• Coordination

Utility of player B
A1200
F900
B1200
Utility of player A
d
23
Double Marginalization Question

• Can the problem of double marginalization be
  solved?
• The retailer optimizes its own profits and at
  the same time he orders the channel coordinating
  quantity.
• Will such a solution benefit all the players
  (retailer and manufacturer)?

24
Double Marginalization Solution

• Suppose the manufacture is willing to buy back
  all leftover inventory for 5.
• Retailer profit(2000) -5200
  0.6(101005100) 0.42000 700
• Manufacturer profit(2000) -200 2005
  -0.61005 500
• Channel profit(2000) 1200
• Is this the best the channel can do?
• Is this the only solution?
• Is it always possible to coordinate the channel?
• What did we learn?

25
Double Marginalization Discussion

• In the previous example we assumed that the buy
  back price is 5 (r w)
• How is the buyback and whole sale prices are
  determined?
• The buyback and wholesale prices are determined
  by negotiation.
• Example
• Suppose w 4 and the buyback price is 3.33
• Is this better?
• Is it better for whom?

26
Double Marginalization Solution

• Suppose the manufacture is willing to buy back
  all the leftover for 3.33. The whole sale price
  is 4.
• Retailer profit -4200 0.6(10100
  3.33100) 0.42000 800
• Manufacturer profit -200 2004 -0.61003.33
  400
• Channel profit 1200
• The retailer benefits from the new prices.
• The manufacturer loses from the new prices
• The channel is indifferent

27
Double Marginalization Solution

• There are infinite number of pairs (wholesale
  and buyback prices) that coordinate the channel.
• Which pair is chosen?
• Determined by negotiation

28
Definition of negotiation

• Definition Two (or more) players have to divide
  a fixed surplus (cost)

29
Double Marginalization Negotiation

• The total additional profit (the pie) can be
  allocated in many different ways
• Example In our case the pie is 300.
• Nash bargaining solution is

Negotiation power Of player 1.
Share of player 1
Disagreement point of player 1
30
The Pie

• How is the pie allocated?

31
Double Marginalization Negotiation

• Taking derivative we get
• Notice that
• Each player has an incentive to inflate the
  disagreement points
• How do we know what the negotiation power is?
• What ever the negotiation power is it is always
  better to coordinate the channel.

32
Double Marginalization Negotiation

• Example
• Suppose a 0.5
• d1 d2 0
• Pie 300
• Each player gets an additional profit of 150
• Retailer gets 650
• Manufacturer gets 550
• It is possible to calculate the wholesale price
  and buy back so it is the best interest of the
  retailer to coordinate the channel and order 200
  units.

33
Negotiation in Assembly Systems

• A single assembler
• Single period problem
• The assembler faces random demand (demand
  distribution is known) for the final products
• To assemble one unit of the final product the
  assembler needs N different components.
• Each component is purchased from one of the N
  different suppliers.
• Perfect information

34
Negotiation in assembly systems

• What are the effects of bargaining on the supply
  chain structure.
• Which supply chain structure are favorable to
  suppliers or retailers?

Assembler
Assembler
Distributor
Suppliers
35
The assembly problem

• Decisions
• How many components to purchase from each
  supplier?
• How much to pay each of the suppliers, or how to
  allocate the pie?
• How to coordinate the channel, or how to maximize
  the size of the pie?
• With whom to align, or what is the structure of
  the supply chain?

36
The Sequential Bargaining Model

• How to extend the basic bargaining model to a
  bargaining model in which the assembler
  negotiates with N suppliers?
• The assembler negotiates simultaneously with the
  suppliers
• The assembler negotiates sequentially with the
  suppliers
• Does the sequence of negotiating matter?
• How is the negotiation sequence determined?

37
The Sequential Bargaining Model Stage 1

• What is the disagreement point of each of the
  players?
• At the second sub-stage of the assembler
  negotiates with the supplier 2. The size of the
  pie, at this stage, must be larger than cA c2
  cA,2
• At the first sub-stage the assembler must ensure
  that he gets at least cA,2.
• At the first sub-stage we solve the following
  problem

cA,2
c2
38
The Sequential Bargaining Model Stage 1

• The assembler gets 70 (to be allocated further
  with the second supplier). The effective profit
  of both players is 70 40 30.
• Supplier 1 gets 50. His effective profit is 50
  20 30.
• At the second sub-stage the assembler negotiates
  with supplier 2.
• The size of the pie is only 70
• At the second stage we solve the following
  problem
• The effective profits of player 2 and of the
  assembler are 15 each

39
The Sequential Bargaining Model (Revenue) Stage 1

120
50
70
Supplier 1
Assembler and supplier 2
Sub-stage 1
45
25
Sub-stage 2
Supplier 2
Assembler
40
The Sequential Bargaining Model (Profit) Stage 1

60
30
30
Supplier 1
Assembler and supplier 2
Sub-stage 1
15
15
Sub-stage 2
Supplier 2
Assembler
41
The Sequential Bargaining Model Stage 1

• The effective profits of the suppliers are not
  identical.
• Are the effective profits of the players a
  function of bargaining sequence?
• If player 2 negotiates first then the effective
  profit of the assembler is 15, player 1 is 15
  and player 2 is 30.
• The bargaining sequence does not affect the
  effective profits of the assembler.
• The bargaining sequence affects the profits of
  the suppliers.
• Suppliers prefer to negotiate as early as
  possible.

42
The Sequential Bargaining Model Stage 2

• What is the reaction of the suppliers and the
  assembler to such an allocation?
• The suppliers will compete, by paying the
  assembler, for a better position in the
  bargaining sequence.
• There is a unique Nash equilibrium in the
  effective profits Each of the suppliers gets ¼
  of the effective pie. The assembler gets ½ of
  the pie.

43
The Sequential Bargaining Model Stage 2

• The assembler is using his ability to determine
  the negotiation sequence to extract more profit.

Effective profit of the first supplier
Effective profit of the assembler
Effective profit of the second supplier
44
The Sequential Bargaining Model Stage 3

• Could the suppliers retaliate to increase their
  share of the effective profit?
• Suppose the two suppliers form a single coalition
  to negotiate with the assembler.
• In this case the effective pie is allocated in
  the following way ½ to the assembler and ½ to
  the coalition (two suppliers).
• By forming a coalition the suppliers did not
  improve their position.
• Is this always true?
• The answer depends on the negotiation power of
  the different parties.

45
The Sequential Bargaining Model The Effects of
Bargaining Power

• Conclusions
• When the assembler is weak then it is the best
  interest of the suppliers to form a coalition.
• When the supplier are strong it is the best
  interest of the suppliers to negotiate as
  independent entities.

46
The Sequential Bargaining Model The Effects of
Bargaining Power

• Generalization
• Suppose there are N suppliers.
• Theorem 1 When aA the only stable formation.
• Theorem 2 When aA (0.5)1/(N-2) then the
  formation 1,2N is the only stable
  formation.
• Theorem 3 When 1/N1,2,,N is stable. The grand coalition is
  also stable.

47
Coalitions Formations and Stability

• What is a stable coalition formation?
• No coalition defects from a stable formation.
• Far sighted A coalition may defect from a
  formation even though myopically some or all its
  member lose by defecting. But by defecting from
  the formation the coalition triggers a sequence
  of defection so that eventually each member of
  the defecting coalition benefits.

48
Supply contract

• Key elements of a typical supply contract include
  
• a) capacity, the resources the supplier agrees to
  dedicate to the manufacture of the buyer's
  components--that is, dedication of manufacturing
  lines
• b) flexibility, the fluctuation in the buyer's
  demand that the supplier is willing to
  accommodate at no extra cost

49
What is flexibility?

• We discuss two types of flexibility
• The flexibility to update previous commitments
• The flexibility to purchase quantities that
  deviate from previously made commitments.

50
Information Sharing and Supply Contracts

• An agreement between the buyer and the supplier
• The buyer commits to periodical purchasing
  quantities
• The supplier provides flexibility to deviate from
  the committed quantities.

51
Supply Contracts Flexibility

• Flexibility commitments
• The buyer makes a commitment to purchase every
  period a certain quantity q1,,qN.
• At period 1 the buyer can purchase any quantity
  between (1-fL)q1 and (1fH)q1
• In addition, the buyer may update the previous
  commitments in the following way q1,2 must be
  between (1-f2,L)q2 and (1f2,H)q2
• Similar adjustments are made for all other periods

52
Supply Contracts Flexibility
Q
New forecast at period 1
Flexibility
1
53
Flexibility Example

• A buyer make a commitment to purchase every month
  1000 units.
• Suppose
• f1 3
• f12 4
• f13 4
• f14 5

54
Flexibility Example

• At the beginning of the first month (January) the
  buyer may purchase any quantity between 970 and
  1030.
• In addition he may update the order quantity for
  the second month to any quantity between 960 and
  1040. Suppose he chooses 1040.
• For the third period (March) he can do the same
• For April he may chose any quantity between 950
  and 1050.

55
Flexibility Example

• At the beginning of the second month a new round
  of commitment updates is conducted.
• The supplier may purchase any quantity between
  971040 and 1031040
• He may update in the same fashion the previously
  made commitments.

56
Supply Contracts

• What are the advantages of such contracts?
• What is the value of flexibility?
• How much flexibility do we need?

57
Supply Contracts

• The trade-offs for the buyer and the supplier are
  clear
• the supplier usually incurs additional cost by
  providing flexibility, because of the need for
  additional production capacity and/or inventory
  of raw materials and finished components to meet
  the buyer's uncertain demand in a timely manner.

58
Supply Contracts

• Owing to the higher flexibility, the buyer is
  able to meet, with greater probability, the
  uncertain demand and thus realize savings.
• It is important to notice that although providing
  flexibility is costly for the supplier, the
  benefits for the buyer may be high enough that
  the total system (supplier and buyer) realizes
  savings.

59
Supply Contracts

• These savings may be allocated between the
  supplier and the buyer so that both benefit and
  realize savings due to the high flexibility in
  the system.
• As a means of allocating the savings due to
  flexibility, the supplier may be willing to offer
  different levels of flexibility at appropriate
  costs to the buyer.

60
Supply Contracts

• It is important to remember that as time passes
  and more information is collected, the buyer has
  the flexibility to change his or her previously
  made commitments.
• but this flexibility is limited. The magnitude
  of the flexibility is greater for periods further
  away.
• The reason is the further away the period is,
  the more times the commitments may be updated.
  This captures the notion that once the supplier
  begins to produce the component, the supplier can
  offer very limited flexibility.

61
Supply Contracts

• On the other hand, the supplier has a
  considerably greater flexibility dealing with
  orders to be delivered in the distant future.
• In many instances, suppliers are unable or
  unwilling to provide very large long-term
  flexibility in such instances, they limit the
  sum of the changes that may be made by the buyer.
  

62
Supply Contracts

• It is possible to provide information of the
  following type
• The buyer might be willing to pay 41.7 per
  unit (instead of 40) in order to have purchase
  and update flexibilities of 0.2.
• Any cost higher than 41.7 per unit would make it
  not worthwhile for the buyer to receive
  flexibilities of 0.2.
• This cost is referred to here as break-even
  cost. As intuition would suggest, the higher the
  variability, the higher the worth of flexibility.

63
Supply Contracts Case

• Two different supply contracts are evaluated and
  compared.
• Old Contract (currently in place) have
• a horizon of six months and provide the
  following flexibility
• The buyer may change the size of previously made
  orders to be delivered three, four, five, and six
  months in the future by no more than 20 (
  0.2).
• The size of the orders to be delivered one or two
  months in the future cannot be changed ( 0).

64
Supply Contracts Case

• New Contract in which
• orders to be delivered in the next period have
  an update flexibility of 30 ( 0.3),
• orders to be delivered two periods in the future
  have 50 update flexibility ( 0.5).
• Orders to be delivered three, four, five, and
  six months in the future have a very high update
  flexibility ( close to 1).

65
Supply Contracts Case

• It is clear why the Company found the new
  contract more attractive than the old one.
• The suppliers preferred the old contract. In the
  negotiation process between the buyer and the
  supplier, it is crucial to understand and know
  the exact worth of the additional flexibility in
  the new contract.