Serguei Netessine
Modern Supply Chains: from
competition to collaboration
What made me thinking about
cooperation vs. competition (1997)
Some data
50
45
Searched ISI within Management Science,
Operations Research and M&SOM
40
35
30
25
20
Key word "Competition"
Key word
"Cooperative"
15
10
5
0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Plan for today
• Motivation: evolution of supplier management in the
automotive industry.
• Practical vices and virtues of collaboration.
• Tools for studying cooperative behavior:
• Cooperative game theory
• Contract theory
• Repeated games and reputations
• Empirical work
Sourcing in the automotive industry
• Most parts of the car are outsourced
(70% in value)
• 80% of the life-time cost is defined in
the R&D process stage
• Precise engineering specifications are
often difficult, require joint expertise of
the supplier and the assembler
• There are many forms of vertical
relations with suppliers, from integration
to partnerships to arm’s length relations
(markets).
5
Dramatic differences across manufacturers in
supplier management approaches
• Arm’s length relations: minimal information exchange (bidding on
prices) and low interdependence.
• Partnerships/collaboration: knowledge-sharing routines of
proprietary information (production processes, design, market).
6
How Toyota collaborates with suppliers
Collaborative supplier management is an often cited reason of
Toyota’s financial success.
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How does collaboration help? –
Cost reduction.
8
Vices and Virtues of Collaboration
• Benefits of collaboration (Pyke and Johnson, 2003)
• Lower cost, higher quality, improved product performance
• Most significant benefit is faster new product introduction
• Factors that determine the degree of collaboration
•
•
•
•
Strategic importance of the purchased component
Number of suppliers in the market
Complexity of the component and modularity of component architecture
Uncertainty in production cost, quality, delivery lead time, etc.
• Examples
• Boeing / GE, Rolls-Royce, Pratt & Whitney
• Ford / Lear
• Consumer electronics company / contract manufacturer
• CPFR, ECR and now “Jointly agreed growth” in retail
9
Pros and cons of collaboration
• Why collaborate?
• What hinders collaboration?
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11
Approach 1: Cooperative Game Theory
• Axiomatically defined in the 50s, but research even in economics
is quite limited relative to non-cooperative game theory.
• In essence, solutions often boil down to integer programming
problems (e.g., finding the core of the game).
• Nevertheless, applications in Operations Management are limited
• The focus is on division of profits after forming coalitions, not on
actions of players – hard to swallow for operations people.
• Typically, grand coalition is shown to be in the core of the game
(not terribly surprising).
• Hard to show anything analytically, even for deterministic
problems…
Some research examples
• Key recent authors : Granot and Granot (UBC), Greys Sosic
(USC), Mahesh Nagarajan (UBC), Moshe Dror (Arizona)
• Topics: inventory centralization, pooling queues, sharing fixed
costs. Good references:
• M. Nagarajan and G. Sosic. Game-theoretic analysis of
cooperation among supply chain agents: review and extensions.
EJOR.
• Dror, M, and B.C. Hartman. 2011. Survey of Cooperative
Inventory Games and Extensions. J. of Operational Research
Society, 62, 565-580.
• Brandenburger, A. and H. Stuart, Biform Games. Management
Science 2007, 53, 537-549.
Approach 2: Contract Theory
• Kim, S.-H. and S. Netessine, 2011. Collaborative Collaborative Cost Reduction
and Component Procurement Under Information Asymmetry. Working Paper,
http://www.netessine.com.
• Developed a model that captures pros and cons of collaborative cost reduction
• Collaboration brings lower cost and higher efficiency to the supply chain, but
both parties need to chip in  Mutual efforts are required
• Key source of inefficiency: Information asymmetry about costs
• How does a procurement contract affect an incentive to collaborate?
• Identify conditions that lead to high degree of collaboration
• Amount of cost reduction
• Demand uncertainty
• Supply chain parties’ relative contribution to collaboration
Model setup
• One manufacturer, one supplier
• Uncertain demand and inventory risk for the end-product
• Random demand D: IGFR with pdf f and cdf F
• End-product retail price is fixed at r
• Uncertain component unit cost during product design
• Collaborative cost reduction is an outcome of mutual efforts
q = “Collaboration level”
a = Elasticity of
manufacturer’s effort
em = Manufacturer’s effort
es = Supplier’s effort
• Linear cost of effort: kmem and kses
• Inspired by: Roels, G., U. S. Karmarkar, S. Carr. 2010. Contracting for collaborative
services. Management Science. 56(5), 849-863.
Component cost reduction through
collaboration
c
Higher collaboration level q
 Lower expected unit cost
& smaller uncertainty
around it
cq = G 1 (1| q )
D0
D1 = dD 0
G 1 ( z | q )
c
d = D1/D0
= % reduction in expected unit cost
0
q
1
= % reduction in unit cost uncertainty
For analytical tractability, assume:
1. Conditional distribution G(·|q) of c is uniformly distributed
2. Lower support bound of c is constant
Sequence of events
Manufacturer decides
when to offer a contract
Contract
commitments
Demand and
unit cost are
uncertain; their
distributions are
common
knowledge
Screening
contract
Demand is realized
Manufacturer
sells the end
products in the
market
Manufacturer
exerts effort
Stage 1
Supplier exerts effort
Supplier privately learns his
type (i.e., cost is realized)
Stage 2
Supplier
begins
production of
components
Supplier delivers the
components and
financial transactions
are made
Summary of results and insights
• Collaboration is a double-edged sword for the supplier,
it may be optimal not to collaborate
• Lower expected unit cost  Potential for higher profitability
• Lower uncertainty in unit cost  Danger of being held up by the manufacturer ex-post
• Larger demand variability maps to a higher collaboration level
• Not because the supply chain parties become cooperative, but because the manufacturer
induces the supplier to increase the pie size and then eats more of it
• Expected Margin Commitment (EMC)
• Hold-up problem under price commitment, but the manufacturer does not benefit from cost
reduction
• EMC: Effective in resolving both issues
• Manufacturer prefers EMC to a screening contract when:
• Collaboration leads to a significant reduction in unit cost
• Demand variability is small or modest
• EMC in practice: Japanese auto industry
Approach 3: Relational Contracting,
Repeated Games and Reputation
• Now famous Folk Theorem (Friedman 1970) states that, in
infinitely repeated games, almost any equilibrium (including
collaboration) can be sustained if discounting of the future
payoffs is not too high.
• Interpretation: value of future relationship sustains collaboration.
• Implications for supply chains: even very simple coordinating
contracts that don’t work well in a single-period setting can work
quite well in infinitely-repeated relationships.
• See Plambeck and Taylor papers (several of them), Ren, Cohen,
Ho and Terwiesch (empirical + modeling).
• The downside: it is very hard to show anything interesting beyond
this basic result.
F. W. McFarlan, W. C. Kirby, and T. Y. Manty. Li & Fung 2006. HBS Case 307077, Harvard Business School, Boston. 2007.
G. W. Loveman and J. O’Connell. Li & Fung (Trading) Ltd. HBS Case 396075, Harvard Business School, Boston. 1995.
Li & Fung Limited: What Does it Do?
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Buyers outsource sourcing to Li & Fung
Has a global platform of suppliers
Finds suppliers that are matching the buyer
Allocates orders between suppliers
Insures good behavior
(Quality, information, etc.)
Global Platform of Suppliers
Food Products: Olam International
D. E. Bell and M. Shelman. Olam International. HBS Case 509002, Harvard Business School, Boston. 2009.
Olam’s Global Network
New breed of Sourcing Intermediaries
Explaining Intermediaries
Information Mediation (+)
Intermediary has an informational advantage (price discovery, local knowledge, etc.)
Economies of Scale (+)
By consolidating demand from multiple buyers, intermediaries can split fixed costs
Wal-Mart
What can Li and Fung do that Wal-Mart can’t?
Wal-Mart has scale (US$ 350B v/s US$ 13B)*
Wal-Mart has local knowledge (189 stores in China, 50K local employees)
Scale and Information Benefits ??
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These make us think the existing explanations are not complete
Is there another explanation for Intermediaries?
Why Li & Fung? Stated Reasons
Changing economic conditions
Political Risks
Trade barriers rise and fall
Exchange Rates Fluctuate
Getting supplier to do “the right thing for you” (good behavior)
Insuring product quality
Keeping proprietary information safe
Adequate capacity building and booking
“Preferences over Suppliers change over time”
“Supplier compliance is a major business and reputation risk”
“Li and Fung ensures good Supplier Behavior and keeps us flexible”
Alternate Sourcing Strategies
Direct Sourcing
Mediated Sourcing
Supplier
Buyer
Supplier
Buyer
Supplier
Supplier
Intermediary

Belavina, E. and K. Girotra, 2011. The Relational Advantages of Intermediation. Forthcoming,
Management Science.
 Preferences over suppliers change over time, Repeated Game
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Due to changing sourcing costs
Transportation costs
Currency, tariffs, pass-through input costs
Good/Bad Behavior, Contractual Incompleteness
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Supplier does not reserve appropriate levels of capacity
Proper information sharing
Supplier does not conform to environmental and social norms
Findings
• Sourcing is rich in opportunities for suppliers to behave bad. In such environments
it often pays off to commit to long-term relationship - promise future business to your
supplier to elicit good behavior. These commitments come at a cost of flexibility.
• Intermediaries allow to relieve the tradeoff between committed long-term
relationships and flexible sourcing.
• Why? Because to fulfill the promise of future business intermediaries can use
business coming on behalf of multiple buyers. If one buyer does not want to source
from the supplier, the other buyer might.
• This is why intermediaries are much better in the modern global sourcing world.
This is a novel explanation of why intermediaries can help you source better.
• A follow-up paper:
• A supply chain with many self-interested tiers/levels can perform better than a
supply chain with fewer tiers.
Approach 4: Empirical Work
• Alliances: a long-standing form of company collaboration.
• Long history of studying alliance formation, dissolution and
behavior in the field of strategy.
• Multi-market competition studies: competing in multiple
markets may soften competition in favor of collaboration.
• Hard to get data on supply chain alliances, and even supply
chain contracts.
• Ren, Cohen, Ho and Terwiesch – the study of relational
forecast sharing in a semiconductor industry.
• But there are other industries in which data is readily available.
Airline Alliance Involves Various Activities…
● Codeshaing agreement: sell tickets
on flights operated by partner airlines
● Reciprocal Frequent Flyer Program
● Cost reduction: facility and personnel
sharing, joint procurement
Alliance Considerations
Policy Makers’ Concerns
Airlines’ Defense
• Overlapping markets
• Reduced competition
• Fare and capacity collusion
• Raised entry barriers for other
airlines
• Precursor of a merger
• Operational efficiency, consumer benefits
• Higher flight frequency
• Easier connections
• Cost benefits passed on to consumers
• Competition
• “Remain independent and continue
to compete with others”
Li, J. and S. Netessine. 2011. Partnering with Competitors - An Empirical
Analysis of Airline Alliances and Multimarket Competition. Working Paper,
http://www.netessine.com.
UA/US Flight Network Before Alliance
UA/US Flight Network After Alliance
Conceptual Model
Airline
City-pair
1998
1999 ------------------------------------------------------------------------------>2006
1
UA
…
Jan 2003
United and
US Airways
M
1
US
…
M
1
DL
…
M
1
CO
…
M
1
NW
…
M
1
AA
…
M
Nov 1998
Continental
and Northwest
Alliance
Jun 2003 DeltaContinental –
Northwest
Alliance
Findings
• In the post alliance era, airlines are more likely to enter/stay (additional 10%)
and increase capacity (5 more flights/week) in the markets where their partners
possess a strong market power.
• This finding cannot be explained by traditional operational models which predict
that capacity increases with higher competition, and hence it should decrease
under alliances.
• The reason this happens: increasing market pricing power due to collaboration
• Increasing pricing power ($8.6 one way coupon, $18 round-trip)
• For policy markets: monitor post-alliance changes, and require airlines not to
increase overlap with partners on certain routes
• For airline practitioners: may have over-adjusted capacity, probably in order
to please alliance partners and increase zones of influence of the alliance.
Summary
• There is a notable movement among companies from pure
competition towards the mix of competition and collaboration.
• Research on collaboration in operations management is
lagging behind but beginning to take shape.
• There is a variety of promising methodologies:
• Cooperative games (not so promising).
• Contract theory applications (somewhat promising).
• Repeated games (quite promising).
• Empirical work (very promising).
• Much of this work is very recent – join the party!