Handbook of Quantitative Supply Chain Analysis

Supply chain analysis is the study of quantitative models that characterize various economic tradeoffs in the supply chain. The field has made significant strides in both theoretical and practical fronts. On the theoretical front, supply chain analysis inspires new research ventures that blend operations research, game theory, and microeconomics. These ventures result in an unprecedented amalgamation of prescriptive, descriptive, and predictive models characteristic of each subfield. On the practical front, supply chain analysis offers solid foundations for strategic positioning, policy setting, and decision making. Over the past two decades, not only has supply chain analysis become a strategic focus of leading firms, it has also spawned an impressive array of research that brings together diverse research communities. Adding to this diversity and intellectual energy is the emergence of E-Business. E-Business creates new competitive dimensions that are fast-paced, ever-changing, and risk-prone, dimensions where innovation, speed, and technological savvy often define success. Most importantly, E-Business challenges the premises and expands the scope of supply chain analysis.

Game theory (hereafter GT) is a powerful tool for analyzing situations in which the decisions of multiple agents affect each agent’s payoff. As such, GT deals with interactive optimization problems. While many economists in the past few centuries have worked on what can be considered game-theoretic models, John von Neumann and Oskar Morgenstern are formally credited as the fathers of modern game theory. Their classic book “Theory of Games and Economic Behavior”, von Neumann and Morgenstern (1944), summarizes the basic concepts existing at that time. GT has since enjoyed an explosion of developments, including the concept of equilibrium by Nash (1950), games with imperfect information by Kuhn (1953), cooperative games by Aumann (1959) and Shubik (1962) and auctions by Vickrey (1961), to name just a few. Citing Shubik (2002), “In the 50s ... game theory was looked upon as a curiosum not to be taken seriously by any behavioral scientist. By the late 1980s, game theory in the new industrial organization has taken over ... game theory has proved its success in many disciplines.”

This chapter explores the theory of supply chain intermediation. Using a bargaining theoretic framework, we set out to examine why intermediaries exist, different forms they operate, and the way they influence supply chain efficiency. The notion of intermediary has its root in the economics literature, referring to those economic agents who coordinate and arbitrate transactions in between a group of suppliers and customers. Distinctions are often drawn between a “market maker” and a “broker” intermediary Resnick et al., 1998. The former buys, sells, and holds inventory (e.g., retailers, wholesales), while the latter provides services without owning the goods being transacted (e.g., insurance agents, financial brokage). Sarkar et al. (1995) offer a list of various intermediation services. They distinguish the services that benefit the customers (e.g. assistance in search and evaluation, needs assessment and product matching, risk reduction, and product distribution/delivery) and those that benefit the suppliers (e.g. creating and disseminating product information). Taking a step further, Spulber (1996) views intermediary as the fundamental building block of economic activities. He proposes the intermediation theory of the firm which suggests that the very existence of firms is due to the needs for intermediated exchange between a group of suppliers and customers. A firm is created when “the gains from intermediated exchange exceed the gains from direct exchange (between the supplier and the customer).” He also suggests that “with intermediated exchange, firms select prices, clear markets, allocate resources, and coordinate transactions” By this definition, firms are intermediaries which establish and operate markets.

Operations Management (OM) is concerned with the study of technological systems that produce goods or services through the repetitive execution of standardized tasks. Although many of these systems are decentralized with an owner (or principal) delegating operational control to one or more noncooperative decision makers (or agents), traditional OM models suppress that feature for analytical tractability. Yet, the behavior of the noncooperative agents is also important and should be captured in OM models. Numerous recent research efforts have attempted to do that, but to maintain tractability they suppress most of the system complexity which is the landmark of OM models; see Anupindi, Bassok, and Zemel (1999), Cachon and Lariviere (1997), Lippman and McCardle (1997), Van Mieghem (1998). In addition, the few notable exceptions that capture both the processing dynamics and the agents’ behavior utilize sophisticated models whose tractability relies on specialized assumptions; see Bassok and Anupindi (1999), George (1999), Hall and Porteus (1999), Lee and Whang (1996).

Auctions have found widespread use in the last few years as a technique for supporting and automating negotiations on the Internet. For example, eBay now serves as a new selling channel for individuals, and small and big enterprises. Another use for auctions is for industrial procurement. In both these settings traditional auction mechanisms such as the English, Dutch, First (or Second) price Sealed-Bid auctions are now commonplace. These auctions types are useful for settings where there is a single unit of an item being bought/sold. However, since procurement problems are business-to-business they tend to be more complex and have led to the development and application of advanced auction types that allow for negotiations over multiple units of multiple items, and the configuration of the attributes of items. At the heart of auctions is the problem of decentralized resource allocation.

By offering high-speed communication and tight connectivity, advances in information technology have opened new venues for companies to create flexible supply chains. Today, many companies, from the electronics, pharmaceutical, to the automotive industry, are focusing on their core competencies and outsourcing significant portions of their business operations. As supply chains become more decentralized upstream, the pricing of intermediate goods is no longer a formality used between departments — but rather the key to a company’s survival. Strangely enough, while companies have spent millions of dollars to help them reduce their operating costs, the majority continue to use crude techniques in deciding what price to charge for their products Anthes, 1999.

Suppose you must auction off a dining room set consisting of four chairs and a table. Should you auction off the entire set or run five separate auctions for each piece? It depends, of course, on what bidders care about. If every bidder is interested in the dining room set and nothing less, the first option is preferable. If some bidders are interested in the set but others are interested only in a chair or two it is not obvious what to do. If you believe that you can raise more by selling off the chairs separately than the set, the second option is preferable. Notice, deciding requires a knowledge of just how much bidders value different parts of the ensemble. For this reason, economic efficiency is enhanced if bidders are allowed to bid directly on combinations or bundles of different assets instead of bidding only on individual items. Auctions where bidders are allowed to submit bids on combinations of items are usually called combinatorial auctions. ‘Combinational auctions’ is more accurate, but we will follow convention.

The American Marketing Association defines marketing as “the process of planning and executing the conception, pricing, promotion, and distribution of ideas, goods, and services to create exchanges that satisfy individual and organizational goals.” Operations management is typically defined in texts as “management of an organization’s production system, which converts inputs into products and services.” Clearly the two are closely related. Marketing requires the operations function to deliver goods and services, while operations requires the marketing function to generate demand.

Recent years have seen scores of retail and manufacturing companies exploring innovative pricing strategies in an effort to improve their operations and ultimately the bottom line. Firms are employing such varied tools as dynamic pricing over time, target pricing to different classes of customers, or pricing to learn about customer demand. The benefits can be significant, including not only potential increases in profit, but also improvements such as reduction in demand or production variability, resulting in more efficient supply chains.

In recent years, electronic data sharing has become an industry standard. Starting as a tool to cut costs through elimination of expensive paperwork and reduction in human errors, electronic data interchange (EDI) evolved during the last two decades into an enabler for the creation of new supply chain business models. For example, managers realized that by cutting lead times they can bring their products to the market faster and thus save much in inventory costs and at the same time reduce lost sales. This gave rise to important practices such as quick response (QR) (Hammond 1990, Frazier 1986) and Efficient Consumer Response (ECR) (Kurt Salomon Associates 1993). Visibility turned quickly into a popular word in the supply chain manager’s vocabulary: For example, by providing suppliers with access to inventory and Point-of-Sale (POS) data, companies such as Wal-Mart gained a substantial increase in the level of product availability due to the ability of their vendors to better plan and execute their logistics processes — hence, replacing costly inventory by information. In recent years, rapid evolution in electronic commerce and information technology has paved the way for the implementation of a variety of coordination mechanisms in supply chains, and in many cases it has provided the necessary means for supply chain partners to restructure the way they conduct business (Andersen Consulting 1998, Magretta 1998). Visibility through EDI is, for instance, at the backbone of advanced collaborative manufacturing and e-trade concepts (i2 TradeMatrix 2001).

Advanced information technologies and expanded logistics infrastructure are reshaping the global business environment. Buyers and sellers can now share information and exchange decisions in real time while products can be moved from place to place globally within days. In order to gain competitive advantage in the new business landscape, firms are redefining their business models not only to enhance back-end logistics efficiency but also to improve front-end customer satisfaction. Available to Promise (ATP) is a business function at the forefront of this trend since it plays the prominent role of directly linking customer orders with enterprise resources and must evaluate the tradeoff between front-end and back-end performance.

To gain an edge over competitors in an increasingly global and competitive marketplace, companies today need to differentiate themselves not only in cost, but in the overall “value” of the products and the services they offer. As customers demand more and more variety of products, better, cheaper, and faster, an essential value feature for customer acquisition and retention is the ability to quote short and reliable lead times. Reliability is important for customers especially in a business-to-business setting, because it allows them to plan their own operations with more reliability and confidence [67].

For any company with a product to sell, how to make that product available to the intended customers can be as crucial a strategic issue as developing the product itself¹. While distribution channel choice is a very traditional concern, for many companies it has recently come under intense scrutiny due to a number of major developments. The expanding role of the Internet in consumer and business procurement activity has created new opportunities for access to customers. Information and materials handling technologies have broadened the feasible set of sales and distribution activities that a producer might reasonably perform. The economics of materials delivery has been transformed by the pervasive logistical networks deployed by third-party shipping powerhouses such as Federal Express and United Parcel Services. As a result, many manufacturers are reconsidering their approaches to distribution, with particular attention to the role of intermediaries².

Spun.com, a small CD/DVD Internet retailer, has about 200,000 CD titles listed on its web site. Surprisingly, the company does not hold/own any inventory of CDs. Instead, the company partnered with the wholesaler Alliance Entertainment Corp. (AEC), which stocks CDs and ships them directly to Spun.com’s customers with Spun.com labels on the packages. In this way, the retailer avoided an estimated inventory investment of $8M Forbes (2000), since it only paid the distributor for sold products. AEC calls this distribution system “Consumer Direct Fulfillment.” According to the company’s web site, “... using AEC as a fulfillment partner gives you more time and resources to focus on attracting more consumers to your store ...”. The list of retailers practicing such forms of Internet business includes Zappos.com (Inbound Logistics 2000), Cyberian Outpost (Computer Reseller News 1999) and many others.

The Internet has provided traditional manufacturers and retailers a new avenue to conduct their business. On one hand, utilizing the Internet channel potentially could increase the market for the firm and, due to synergies involved, reduce the costs of operations. On the other hand, a new channel threatens existing channel relationships through possible cannibalization. This chapter explores recent research on coordination opportunities that arise for firms that participate in both traditional channels as well as internet channels. Three areas of coordination are discussed: procurement, pricing, and the backend operations of distribution and fulfillment.

Supply chain management is no longer a local issue. As economies develop, foreign firms from more and more countries become competitive suppliers, and more and more countries become competitive locations for manufacturing. Transportation efficiencies have eased supply chain globalization. Furthermore, the internet has enhanced communication and coordination, simplifying the globalization of companies and enabling supply chain management across borders. Global companies, then, must develop strategic international facility network structures to handle the complex production and distribution of goods throughout the supply chain.

The supply chain of a typical product starts with material input, followed by production, and finally distribution of the end product to customers. The cost of a product includes not only the cost of factory resources to convert materials to a finished item but also the cost of resources to make the sale, deliver the product to customers, and service the customers. Consequently, in order to reduce cost, firms have to plan all the activities in the supply chain in a coordinated manner. It is well recognized that there is a greater opportunity for cost saving in managing supply chain coordination than in improving individual function areas.

The Internet has opened new venues for companies to create flexible systems (or “supply webs”) by offering high-speed communication and tight connectivity. This presents a tremendous potential to change the way companies distribute goods, communicate with suppliers and customers, and collaborate both within their company and with their business partners. Hence, businesses increasingly look for ways to use these new tools to achieve “collaboration” and “coordination” between entities within their company, as well as between entities within their supply chain.

The increasing presence of the Internet in everyone’s life is changing the way business is done. The financial services industry is no exception. As of March 2000, 27.5 million individuals were cyberbanking—up from nine million a year before. The euphoria witnessed towards the end of last decade surrounding the use of the internet in service provision, was based primarily on the notion of“infinite scalability,” that is the ability to serve increasing numbers of customers at low incremental costs. This notion justified high valuations of internet firms from venture capitalists. e-banking¹ within the information-based environment of financial services made infinite scalability appear even more promising compared to other types of e-commerce.