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Perspectives in Supply Chain Risk Management: A Review

Christopher S. Tang

UCLA Anderson School, 110 Westwood Plaza, UCLA, Los Angeles, CA 90095, USA

Email: [email protected]

Tel: (310) 825-4203

Web: www.anderson.ucla.edu/x980.xml

November 3, 2005

Abstract

To gain cost advantage and market share, many firms implemented various initiatives

such as outsourced manufacturing and product variety. These initiatives are effective in

a stable environment, but they could make a supply chain more vulnerable to various

types of disruptions caused by uncertain economic cycles, consumer demands, and

natural and man-made disasters. In this paper, we review various quantitative models for

managing supply chain risks. We also relate various supply chain risk management

strategies examined in the research literature with actual practices. The intent of this

paper is three-fold. First, we develop a unified framework for classifying supply chain

risk management articles. Second, we hope this review can serve as a practical guide for

some researchers to navigate through the sea of research articles in this important area.

Third, by highlighting the gap between theory and practice, we hope to motivate

researchers to develop new models for mitigating supply chain disruptions.

Keywords: Supply Chain Risk Management, Quantitative Models, Review

1. Introduction

Over the last 10 years, earthquakes, economic crises, SARS, strikes, terrorist attacks have

disrupted supply chain operations repeatedly. Supply chain disruptions can have

significant impact on a firm’s short-term performance. For example, Ericsson lost 400

million Euros after their supplier’s semiconductor plant caught on fire in 2000, and Apple

lost many customer orders during a supply shortage of DRAM chips after an earthquake

hit Taiwan in 1999. Supply chain disruptions can have long-term negative effects on a

firm’s financial performance as well. For instance, Hendricks and Singhal (2005) report

that companies suffering from supply chain disruptions experienced 33-40% lower stock

returns relative to their industry benchmarks. To mitigate supply chain disruptions

associated with various types of risks (uncertain economic cycles, uncertain consumer

demands, and unpredictable natural and man-made disasters), many researchers have

developed different strategies / models for managing supply chain risks. In this paper, we

review primarily quantitative models that deal with supply chain risks.

Also, we relate

various supply chain risk management strategies examined in the literature with actual

practices. The intent of this paper is three-fold. First, we develop a unified framework

for classifying supply chain risk management articles. Second, we hope this review can

serve as a practical guide for some researchers to navigate through the sea of research

articles in this important area. Third, by highlighting the gap between theory and

practice, we hope to motivate researchers to develop new models for mitigating supply

chain disruptions.

We now present a unified framework for classifying supply chain risk management

articles. In preparation, let us define two terms: supply chain management, and supply

chain “risk” management. First, by combining various definitions developed by others

(Christopher (1992), Council of Supply Chain Management Professional

(www.cscmp.org), Ritchie and Brindley (2001), etc.), we define supply chain

management as “the management of material, information and financial flows through a

network of organizations (i.e., suppliers, manufacturers, logistics providers,

wholesalers/distributors, retailers) that aims to produce and deliver products or services

for the consumers. It includes the coordination and collaboration of processes and

activities across different functions such as marketing, sales, production, product design,

procurement, logistics, finance, and information technology within the network of

organizations.” Second, by combining the definitions developed by others (Christopher

(2002) , Deloitte and Touche (www.deloitte.com

) and others), we define supply chain

risk management (SCRM) as “the management of supply chain risks through

coordination or collaboration among the supply chain partners so as to ensure

profitability and continuity.” Based on the definitions of supply chain management and

supply chain risk management, it appears that one can address the issue of Supply Chain

Risk Management along two dimensions:

To establish a scope for this paper, we shall not review articles that address different measures for

reducing the risk levels. Instead, we shall limit ourselves to review various approaches for mitigating the

impact of supply chain risks.

1. Supply Chain Risk – operational risks or disruption risks;

2. Mitigation Approach – supply management, demand management, product

management, or information management

The first dimension addresses the risk level of certain events. Operational risks are

referred to the inherent uncertainties such as uncertain customer demand, uncertain

supply, and uncertain cost. Disruption risks are referred to the major disruptions caused

by natural and man-made disasters such as earthquakes, floods, hurricanes, terrorist

attacks, etc., or economic crises such as currency evaluation or strikes. In most cases, the

business impact associated disruption risks is much greater than that of the operational

risks.

To mitigate the impact of supply chain risks, Figure 1 depicts four basic approaches

(supply management, demand management, product management, and information

management) that a firm could deploy through a coordinated / collaborative mechanism.

Each of these four basic approaches is intended to improve supply chain operations via

coordination or collaboration as follows. First, a firm can coordinate or collaborate with

upstream partners to ensure efficient supply of materials along the supply chain. Second,

a firm can coordinate or collaborate with downstream partners to influence demand in a

beneficial manner. Third, a firm can modify the product or process design that will make

it is easier to make supply meet demand. Fourth, the supply chain partners can improve

their coordinated or collaborative effort if they can access various types of private

information that is available to individual supply chain partners.

Figure 1. Four Basic Approaches for Managing Supply Chain Risks.

Supply Chain Risks

Supply

Management

Demand

Management

Product

Management

Information

Management

In this paper, we shall classify the supply chain risk management articles according to

these four basic approaches. In addition, we shall review the articles in the area of supply

chain management according to the issues highlighted in Table 1.

Supply

Management

Demand

Management

Product

Management

Information

Management

Strategic

Plans

Supply Network

Design

Product

Rollovers and

Product Pricing

Product Variety Supply Chain

Visibility

Tactical

Plans

Supplier

Selection,

Supplier Order

Allocation, and

Supply Contracts.

Shift Demand

Across Time,

Markets, and

Products.

Postponement

and Process

Sequencing.

Information Sharing,

Vendor Managed

Inventory, and

Collaborative

Planning,

Forecasting and

Replenishment.

Table 1. Strategic and Tactical Plans for Managing Supply Chain Risks.

Due to the fact that there are thousands of articles published in the area of supply chain

management, we are unable to review all existing articles in this paper. In addition,

because supply chain management is a multi-disciplinary research area, we feel the need

to include some marketing and management articles as well. As the scope expands, we

apologize for any unintended omission. In any event, this paper is not meant to be an

exhaustive review; however, it is intended to describe some key supply chain risk

management approaches (supply/demand/product/information management) examined by

various researchers recently.

The organization of this paper is as follows. From Section 2 to Section 5, we first review

some of the recent research work that addresses the use of supply / demand / product /

information management strategies for managing supply chain risks (operational or

disruption). In Section 6, we relate the research articles reviewed between Section 2 and

Section 5 with actual practices. Section 7 concludes this paper with some suggestions for

future research in the area of supply chain risk management.

2. Supply Management

To gain cost advantage, many firms outsourced certain non-core functions so as to

maintain a focus on their core competence (c.f., Porter (1985)). Since the 1980s, we

witnessed a sea change in which firms outsourced their supply chain operations including

design, production, logistics, information services, etc. Essentially, supply management

deal with five inter-related issues:

1. Supply network design

2. Supplier relationship

3. Supplier selection process (criteria and supplier selection)

4. Supplier order allocation

5. Supply Contract

2.1. Supply Network Design

When designing a global supply chain network, one needs to examine the following

issues:

1. Network configuration: which available suppliers, manufacturing facilities,

distribution centers, and warehouses should be selected.

2. Product assignment: which facilities (suppliers, manufacturing facilities,

distribution centers, etc.) should be responsible for processing which

subassemblies, semi-finished products, or finished products.

3. Customer assignment: which facility at an upstream stage should be responsible

for handling the “demand” generated from downstream stages.

4. Production planning: when and how much should each facility produce or

process.

5. Transportation planning: when and which mode of transportation should be used.

Most of the published work in the area of supply network design is based on various

deterministic models. For example, by considering the fixed and variable processing

cost at each facility, Arntzen et al. (1995) implemented a mixed integer programming

model at Digital Equipment Corporation that serves as a planning system for determining

optimal decisions related to issues #1, #2, #4, and #5. In addition, Camm et al. (1997)

develop an integer programming model for Procotor and Gamble that deals with issues

#1 and #3. However, these papers do not deal with the issue of supply chain risks in an

explicit manner.

More recently, some researchers investigate supply chain network design by capturing

certain risk issues arising from global manufacturing. First, Levy (1995) presents a

simulation model to examine the impact of demand uncertainty and supplier reliability on

the performance of different supply chain network designs (issues # 1 and #5). This

simulation model has helped a personal computer manufacturer to evaluate the costs and

lead times associated with two sourcing alternatives between Singapore and California.

Next, in the context of outsourced manufacturing, there are two common approaches for

the contract manufacturers to obtain the requisite parts from various suppliers. The first

arrangement is called “consignment” under which the manufacturer would first purchase

the requisite parts from different suppliers (so as to enjoy the volume discount), sort the

parts to form different kits, and then ship the kits to the corresponding contract

manufacturers. However, this arrangement has drawbacks in terms of longer lead time

and higher (shipping and handling) cost. An alternative arrangement is called “turnkey”

under which the contract manufacturer would first order the parts directly from

designated suppliers and then charge the contract manufacturer accordingly. Lee and

Tang (1998) develop a stochastic inventory model to examine the tradeoff between the

consignment and turnkey arrangements under demand uncertainty. Their analysis has

helped Hewlett Packard to determine specific arrangements with different contract

manufacturers in Singapore and Malaysia.

There are few papers that examine the supply chain network design under uncertain

exchange rates. First, Huchzermeier and Cochen (1996) develop a modeling framework

to show how one can exploit currency exchange rates by shifting production within a

global supply chain network. By incorporating issues #1, #3, #4 and #5, they formulate

the problem as a multi-period stochastic programming problem that aims to maximize the

discounted after-tax profit. They also show how flexible global supply chain can provide

real options to hedge against exchange rate fluctuations. Second, Kouvelis and

Rosenblatt (2002) develop a model for designing a 2-stage global supply chain network

model that addresses all 5 issues listed above. More importantly, they consider the case

in which government subsides and tax incentives are present in certain countries for

certain products or operations. They present a mixed integer programming problem

formulation and they provide analysis that generates insights on the effects of financing,

taxation, regional trading zones and local content rules on the design of a global supply

chain.

2.2. Supplier Relationship

As manufacturers recognize the strategic value of suppliers in the late 1980s, Helper

(1991) reports that the supplier relationship has changed dramatically from adversarial to

cooperative in the U.S. Specifically, many firms realized that suppliers can enable a firm

to focus on their own core competence and to reduce cost, reduce product development

cycle time, increase product quality at the same time. In addition, various e-markets and

information technologies enable firm to foster different types of relationships with the

suppliers, ranging from one-time purchase to virtual integration via information sharing.

Dyer and Ouchi (1993) and Dyer (1996) study various Japanese and U.S. firms and

support the idea of having long-term supplier relationship with fewer strategic suppliers.

Tang (1999) identifies four types of supplier relationships: vendor, preferred supplier,

exclusive supplier and partner. These four types differ from each other in terms of types

of contracts, length of contracts, type of information exchange, pricing scheme, delivery

schedule, etc. By considering the market condition that is measured in terms of the

strategic importance level of the part to the buyer and the buyer’s bargaining power, Tang

prescribes different supplier relationship for different market conditions.

Most of the literature reviewed in Tang (1999) focus on qualitative analysis or strategic

analysis. Cohen and Agrawal (1999) is the first to develop an analytical model for

evaluating the tradeoff between the flexibility offered by short-term contracts and the

improvement opportunities and price certainty associated with long term contracts. They

show analytically that long-term contracts may not always be optimal, and they provide

conditions under which short-term contracts are optimal. As firms expand their business

globally, their supply chains would involve more global partners. For different regional

markets, a firm may source locally so as to reduce transportation cost (due to local labor

cost or tax benefits), reduce replenishment lead times, reduce inventory. Consequently, it

is quite common for firms to source from multiple suppliers. In addition, some firms

may source from multiple suppliers so as to reduce the impact of various operational and

disruption risks. According to an empirical study conducted by Shin et al. (2000), dual or

multiple sourcing is a common business practice.

2.3. Supplier Selection Process

Boer et al. (2001) provide a comprehensive review of different methods for selecting

suppliers. They divide the supplier selection process into 3 stages, namely, formation of

selection criteria, determination of approved suppliers, and final supplier selection.

2.3.1. Supplier Selection Criteria

To form selection criteria, Boer et al. (2001) reported two decision methods (interpretive

structural modeling and expert system) for forming selection criteria. The interpretive

structural modeling technique proposed by Mandal and Deshmukh (1996) is intended to

separate dependent criteria from independent criteria, where the independent criteria are

important for screening acceptable suppliers and the dependent criteria are critical for

final supplier selection. The expert system developed by Vokurka et al. (1996) captures

the previous supplier selection process in a knowledge base, which can be used to suggest

selection criteria for future supplier selection process. In an empirical study, Choi and

Hartley (1996) investigate 26 supplier selection criteria used by different partners

(automotive assemblers, first-tier suppliers, second-tier suppliers) across the supply chain

in the auto industry. These criteria include cost reduction capability, quality

improvement capability, and the ability to change production volumes rapidly. By using

various multivariate statistical techniques (factor analysis, clustering analysis,

multivariate analysis of variance) to analyze the supplier selection criteria reported in 156

surveys, they make the following conclusions:

• The supplier selection criteria are reasonably consistent across the supply chain in

the automotive industry. At all levels, commitment to establish cooperative/long-

term relationship is an important selection criterion.

• Price is one of the least important criteria, while quality and delivery are

important criteria.

• Supplier’s technological capability and financial stability are more important

criteria for the auto assemblers.

It is interesting to note that the criterion regarding the ability to change production

volumes rapidly is not considered to be as important as other criteria such as quality and

long term relationship. Given the recent disruptions (terrorist attacks, hurricanes,

earthquakes, SARS, etc.), one may speculate that the issue of business continuity would

become an important supplier selection criterion.

2.3.2. Supplier Approval / Selection

At this stage of the process, the goal is to reduce the set of all potential suppliers to a

smaller set of approved suppliers. To do so, the decision maker has to sort / classify all

suppliers into 2 categories: approved or disapproved. Based on the supplier’s

performance on the selection criteria, Boer et al. (2001) report the following methods for

determining a set of approved suppliers: clustering analysis, data envelopment analysis,

and an Artificial Intelligence approach called case-based-reasoning method.

When making the final supplier selection, Boer et al. (2001) report the following decision

methods in different settings:

• Linear weighting models. By assigning different weights to different criteria, one

can compute the overall rating of a supplier by considering the weighted sum of

different criteria. In this case, the supplier with the highest rating will be selected.

• Total cost of ownership. This method is developed by Ellram (1990) that is

intended to include all quantifiable costs incurred throughout the life cycle of the

item purchased from a supplier. The supplier with the lowest total cost of

ownership will be selected.

• Mathematical programming models. Most of the methods reported in Boer et al.

(2001) are deterministic models: linear programming, goal programming, data

envelopment analysis, etc. The idea is to select supplier(s) with minimum cost.

• Simulation models. This method enables the decision maker to capture some of

the uncertainties (yield loss, stochastic lead times, etc.) related to supplier

selection. By simulating the performance of different suppliers for different

criteria under different scenarios, the method can help a decision maker to select a

supplier under uncertainty.

While Boer et al. report different approaches for managing the supplier selection process,

there are some quantitative models for supplier selection. For example, Weber and

Current (1993) present a mixed integer programming formulation that is intended to

capture multiple supplier selection criteria. Current and Weber (1994) formulate the

supplier selection problem as a variant of facility location problem. More recently,

Weber et al. (2000) present an approach for evaluating the number of suppliers to employ

by using multi-objective programming and data envelopment analysis. Dahel (2003)

extends the model presented in Weber et al. (2000) by incorporating the order quantity

decision for each supplier.

While most of the supplier selection models are deterministic models, there are few

articles that deal with the supplier selection process under operational risks. Tang (1988)

presents a supplier selection model that captures the interaction of the supplier’s quality

and the buyer’s quality control (inspection policy). By considering the interaction

between the supplier’s quality and the buyer’s internal manufacturing process, Tagaras

and Lee (1996) develop a different supplier selection model that captures different

degrees of imperfections in the buyer’s manufacturing processes. Specifically, they

consider that there are two states of the buyer’s process: normal or abnormal. When the

buyer’s process is in the normal state, the output of the process is perfect if the supplier’s

input is. However, when the buyer’s process is in the abnormal state, the output of the

process is defective regardless of the supplier’s input is or is not. By considering

different costs associated with quality of the output, Tagaras and Lee (1996) develop the

optimal supplier selection criterion that minimizes the buyer’s expected total cost

(ordering cost and cost of quality). More recently, Kouvelis (1998) presents a supplier

selection model that captures the stochastic nature of exchange rate. In his model, the

buyer needs to decide which suppliers to select and the quantity to be sourced from each

selected supplier. As a way to respond to fluctuating exchange rates, the model captures

the flexibility for the buyer to shift the order quantity among suppliers dynamically at the

expense of switch-over costs. When the switch-over cost is significantly high, he shows

that the buyer may continue to source from suppliers that are more expensive so as to

reduce unnecessary switch-over costs.

2.4. Supplier Order Allocation

After a set of suppliers is chosen, the buyer needs to determine ways to allocate the order

quantity among these selected suppliers. We shall classify the work in this area

according to different types of operational risks:

• Uncertain demands

• Uncertain supply yields

• Uncertain supply lead times

• Uncertain supply costs

2.4.1. Uncertain Demand

There is voluminous amount of published works that focus on analytical models for

determining optimal order quantity for a single supplier under demand uncertainty. The

reader is referred to some recent books Porteus (2002) and Zipkin (2000) for a

comprehensive review of various analytical models.

For the case of multiple suppliers, Minner (2003) provides a comprehensive literature

review. When the supply lead times are deterministic, all models assume that the

supplier with a shorter lead time charges a lower cost per unit. Due to the complexity of

the analysis, most discrete time models are restricted to two suppliers with lead times

differed by one period. Zhang (1996) is the only paper that deals with three suppliers

with lead times differ by one and two periods and characterize the optimal ordering

policy for each supplier.

To make the analysis of multiple-supplier inventory models more tractable, some

researchers consider two supply modes: regular and emergency. The regular supply

model is based on a regular supply lead time, while the emergency supply is available

instantaneously. Fukuda (1964) shows that the optimal ordering policy takes on the form

of “two order-up-to levels” x and y, where x < y. Specifically, the optimal ordering

policy can be described as follows: If the inventory at the beginning of a period z is less

than x, then order (x – z) units by using the emergency mode and order (y – x) units by

using the regular mode; if x < z < y, then order (y – z) units according to the regular

mode; otherwise, order nothing. Vlachos and Tagaras (2001) extend Fukuda’s model to

the case in which the emergency model is capacitated. More recently, Scheller-Wolf and

Tayur (1999) consider a Markovian periodic review inventory model and show that the

optimal ordering policy for the buyer is a modified state-dependent base-stock policy.

Specifically, they show that there exists a state-dependent optimal inventory level (target)

in each period. In each period, the buyer should first order an amount from the regular

supplier so that the inventory position after ordering is as close as possible to the target.

The buyer can place an emergency order to fill the gap between the target and the

inventory position after ordering from the regular supplier.

Due to the complex analysis of the optimal ordering policies for the multi-supplier case,

various researchers restrict their analysis to certain classes of ordering policies. For

example, Moinzadeh and Nahmias (1988) analyze an (s

, s

, Q

) ordering policy for a

continuous time model with regular and emergency supply. Specifically, when the

inventory reaches s

, a regular order of size Q

is placed. If the inventory reaches s

within the lead time of the regular order, an emergency order Q

is placed. Janssens and

de Kok (1999) analyze an ordering policy in which the buyer will always order Q units

from one supplier in each period, and will order [S – Q]+ units from the second supplier

so as to bring the inventory position to S. The reader is referred to Minner (2003) for

more details.

Instead of focusing on optimal ordering policies, Nagurney et al. (2005) develop a model

for analyzing the equilibrium behavior of a three-level supply chain consisting of

manufacturers, distributors and retailers. By considering uncertain demands at the

retailer level, they formulate the problem at each level as a non-linear programming

problem. For the retailers, the goal is to determine the optimal order quantity for each

retailer based on the wholesale price determined by the distributors. However, for the

distributors, the goal is to determine the optimal wholesale price based on the

manufacturer’s price. By considering the first order conditions of these three inter-

related problems, they show how to recast the first order conditions as a set of variational

inequalities. The reader is referred to Bazarra et al. (1993) for more details about the

relationship between variational inequalities and Nash equilibrium. By exploiting the

structure of these variational inequalities, they establish the existence of an equilibrium

and provide certain characteristics of the equilibrium.

2.4.2. Uncertain Supply Yields

Let us consider some single-stage-multiple-period models. When a buyer receives a

random fraction of the order quantity from the supplier, Gerchak, Vickson and Parlar

(1988) analyze a finite horizon problem with stationary demand distribution and show

that order-up-to policies are not optimal. Henig and Gerchak (1990) further show that

there exists a critical point for each period such that an order should be placed only when

the on-hand inventory at the beginning of the period is below the corresponding critical

point. However, the exact order quantity is a complicated function of the system

parameters. More recently, Agrawal and Nahmias (1998) present a model for evaluating

the tradeoff between the fixed costs associated with each selected supplier and the costs

associated with yield loss. They show how to determine the optimal number of suppliers

with different yields when the demand is known. To limit our focus to supply chain

management, we shall highlight some of the models that deal with multiple

stages/products. The reader is referred to Yano and Lee (1993) for a thorough review of

single stage/period models that deal with lot sizing models with random yields.

First, let us consider some multiple-stage-multiple-period models. Bassok and Akella

(1991) consider a two-stage-multiple-period model in which one stage corresponds to

raw material ordering and the second stage corresponds to actual production, where yield

uncertainty occurs only at the material ordering stage. They show that the existence of

two critical points (one for the raw material ordering stage and one for the production

stage) so that the optimal ordering quantity and the optimal production quantity would

depend upon whether the sum of (on-hand) finished goods and raw materials is larger or

smaller than these two critical points, respectively. Due to the fact that exact analysis of

multiple-stage-multiple period models is intractable, Tang (1990) restricts his analysis of

a linear control rule for a multi-stage serial production line with uncertain yields at each

stage and uncertain demand. This linear control rule intends to restore the buffer stock at

each stage to its target value in expectation. Hence, this control rule minimizes the

expected deviation of the buffer stock levels from their targets. Denardo and Lee (1996)

generalize Tang’s model by incorporating rework and unreliable machines.

Next, since the analyses of multiple-product-multiple-stage-multiple-period models are

intractable, not much work has been done in this area. Akella, Rajagopalan and Singh

(1992) study a multi-stage facility with rework that produces multiple parts. Their

analysis aims to determine an optimal production rule at each stage that minimizes the

total inventory and backorder cost. They assume that the cost function is quadratic,

which leads to optimal linear decision rules. Linear decision rules have been analyzed by

Gong and Matsuo (1997) as well. Specifically, Gong and Matsuo consider a more

general multi-stage facility with re-entrant routings. They formulate a control problem

with the objective to minimizing the weighted variance of work-in-process inventory

while ensuring that production capacity constraints are satisfied with a pre-specified

probability. Their numerical experiments suggest that the linear decision rules perform

well when compared with the optimal production policy.

2.4.3. Uncertain Lead Times

When replenishment lead times are stochastic, most researchers restrict their analyses of

multiple supplier models to the case of deterministic demand. When both suppliers have

identical lead time distributions (uniform or exponential), Ramasesh et al. (1991)

consider an (s, Q) ordering policy where the order quantity Q is evenly split between two

suppliers. Due to the complexity of the analysis, the optimal values for the reorder point

s and the order quantity Q are determined numerically. By restricting the attention to

the (s, Q) ordering policy, Sedarage et al. (1999) extends the model developed by

Ramasesh et. al (1991) by considering n > 2 suppliers and non-identical split among

suppliers. Based on the numerical analysis presented in Sedarage et al. (1999), they

show that it might be beneficial to order from some suppliers with poor lead time

performance (in terms of the mean and standard deviation of the lead time). In general,

the exact analysis of multiple suppliers with stochastic lead times is intractable.

However, exact analysis can be obtained for some special cases. For example, Anupindi

and Akella (1993) consider a two-supplier model with random demand in which the

replenishment lead time of supplier j is equal to one period with probability p

and two

periods with probability (1 – p

), where j = 1, 2. They derive the optimal ordering

policy that minimizes the total ordering, holding and backordering costs over a finite

horizon. They show that the optimal ordering policy in each period n depends on two

critical points x

and y

, where x

< y

, and the on-hand inventory at the beginning

period n, z

. Specifically, order nothing if z

≥ y

; order from one supplier if x

≤ z

< y

; and order from both suppliers if z

< x

2.4.4. Uncertain Supply Capacity

Most models assume that the supply capacity is unlimited or known. However,

unexpected machine breakdowns could affect the supply capacity. Relative little amount

of work has been done in the area of uncertain supply capacity. Parlar and Perry (1996)

present a continuous time model in which the availability of each of the n suppliers is

uncertain because of disruptions like equipment breakdowns, labor strikes, etc. By

considering the case that each supplier is either “on” or “off”, there are 2

possible

number of states for the whole system. For each of these 2

states, they analyze a state-

specific (s, Q) ordering policy so that the buyer would order Q units when the on-hand

inventory reaches s. Ciarallo et al. (1994) develop a discrete time model in which the

supply capacity is random with known probability distribution. By considering the total

(undiscounted) expected costs (ordering, inventory holding and backordering costs), they

show that the objective function is quasi-convex, which implies that an order-up-to policy

is optimal. More recently, Wang and Gerchak (1996) examine a periodic review model

with uncertain supply capacity, uncertain yields and uncertain demand. The objective is

to minimize the total discounted expected costs over a finite horizon. They show that the

optimal policy possesses the same structure as the optimal policy obtained by Hernig and

Gerchak (1990) for the case in which only random yield is considered. Specifically,

Wang and Gerchak show that the order-up-to policy is optimal.

2.4.5. Uncertain Supply Cost

While most work focus on demand uncertainty, not much work has been done in the area

of uncertain supply cost. For models that examine the issue of uncertain supply cost

imposed by an upstream supply chain partner, Gurnani and Tang (1999) analyze a

situation in which a retailer has two instants to order a seasonal product from a

wholesaler prior to the beginning of a single selling season. They consider the case in

which the wholesale price at the second instant and the demand are uncertain; however,

the retailer can improve the demand forecast by using market signals observed between

the first and second instants. In order to determine the profit-maximizing ordering

policy, the retailer needs to evaluate the trade-off between the benefit of having a more

accurate forecast and a potentially higher wholesale price at the second instant. By

formulating the problem as a 2-period dynamic programming program, they develop an

optimal way to allocate the optimal order quantity to be placed at the first and second

instants and they provide the conditions under which the retailer should delay his

ordering decision until the second instant.

Besides the work of Gurnani and Tang (1999), various researchers develop models for

exploiting uncertain currency exchange rates in a global supply chain. Kogut (1985)

develops a framework to argue that the benefit of a global supply chain lies in the

operational flexibility, which permits a firm to exploit uncertain exchange rates. To

examine this issue in a quantitative manner, Kogut and Kulatilaka (1994) develop a

stochastic model to examine the value of the flexibility to shift production between two

plants located in two different countries. By formulating the problem as a T-period

dynamic programming problem and by modeling the exchange rate process as a discrete-

time mean reverting stochastic process, they determine the option value of maintaining

two manufacturing locations with excess capacity instead of having a single

manufacturing location. However, they assume that the capacity of each plant is

unlimited so that exactly one plant will be used to produce the required quantity to meet

the total demand in each period. Dasu and Li (1997) generalize Kogut and Kulatilaka’s

model by considering the case in which both plants have limited capacity so that both

plants will be used to meet the demand in each period. They formulate the problem as an

infinite horizon dynamic program with discounting. When the production cost is concave

and when the cost of production shifting is linear, they show that the optimal production

shifting policy is a two-barrier policy if the exchange rate process satisfies certain

conditions. Specifically, under the two-barrier policy, there exists two critical points a

and b so that it is optimal to shift the production between two manufacturing locations

when the exchange rate is below a or above b. If the exchange rate is between a and b,

then it is optimal to keep the same production quantity at each location without any

shifting so as to reduce any unnecessary switch-over cost.

The analysis presented in Kogut and Kulatilaka (1994) and Dasu and Li (1997) would

become intractable for more than two countries. To address global manufacturing issues

such as supply chain network design for n > 2 countries, Huchzermeier and Cohen (1996)

present a stochastic dynamic programming problem for evaluating different global

manufacturing strategy options. For any given exchange rate in each period, they solve a

mixed integer program to determine the optimal production and distribution plan for the

entire supply chain network that maximizes the global, after-tax profit. They construct

various numerical examples by considering 16 different supply chain network designs,

each of which specifies the location of the supplier(s), production plant(s), and market(s).

Through these numerical examples, they illustrate the value of a global supply chain

network that enables firms to shift its production and distribution plan swiftly as the

exchange rates fluctuate.

2.5. Supply Contracts

When the partners across a supply chain belong to different firms or divisions, they tend

to focus on maximizing their own objectives and make their decisions independently.

Consequently, locally optimal decisions can cause operational inefficiency and globally

suboptimal decision for the entire supply chain. There are two studies highlighting the

pitfalls of an disintegrated supply chain. First, when each supply chain partner places

their order independently for the case in which the customer demand follows an AR(1)

process, Lee et al. (1997) show this locally optimal ordering decisions will create the

“bullwhip” effect that causes operational inefficiency. Second, when each supply chain

partner makes their ordering decision by maximizing their own profit for the case and

when the customer demand is a deterministic and decreasing function of retail price,

Bresnahan and Reiss (1985) show that these locally optimal decisions would result in

lower total profit for the entire supply chain. To improve operational efficiency and/or

supply chain coordination, there is a growing research interest in supply chain contract

analysis recently. Most supply contract models usually deal with a supply chain that

consists of one manufacturer (supplier) and one retailer (buyer) who faces customer

demand. Even though the economics literature in the area of supply contracts is

voluminous, economics researchers usually assume that that the customer demand is

either deterministic or stochastic in the sense that demand uncertainty is resolved before

the buyer places his order. The reader is referred to Tirole (1988) for a comprehensive

review of supply contracts literature in economics.

There are three excellent reviews of supply chain contract analysis prepared by Cachon

(2003), Lariviere (1998) and Tsay et al. (1998). These three reviews offer different

perspectives in the following sense: Tsay et al. (1998) provide a qualitative overview of

various types of contracts when the demand is deterministic and random; Lariviere

(1998) shows quantitative analyses of different types of contracts when the demand is

uncertain; and Cachon (2003) examines how supply contracts can be used to achieve

channel coordination in the sense that each supply chain partner’s objective becomes

aligned with the supply chain’s objective. Since our focus is on supply chain risk

management, we shall focus on a limited set of supply chain contract literature that deals

with various types of uncertainties. For this reason, we shall classify the supply chain

contract literature according to different risk elements and contract types. Specifically,

we shall review different types of supply contracts that can be characterized according to

the financial flow and material flow as depicted in Figure 2.

2.5.1. Uncertain Demand

Wholesale Price Contracts

Consider the following scenario: the retail price p is fixed, the retailer retains the

revenue p and retains the possession of any excess stock that can be salvaged at a price

s. Suppose that the manufacturer offers a per unit wholesale price w so that the fixed

cost F(Q) = 0, and the variable wholesale price w(Q) = w. In a single period setting, it

is optimal for the retailer to order according to the newsvendor solution based on the

corresponding cost structure. Given the retailer’s order quantity, the manufacturer needs

to determine the optimal w that maximizes her net profit. Lariviere and Porteus (2001)

show that the manufacturer’s profit function is unimodal when the customer demand

distribution F(x) with density function f(x) has an increasing generalized failure rate

(IGFR); i.e., when xf(x)/(1- F(x)) is increasing in x. Many distributions such as normal,

exponential, truncated Normal, Gamma, and Weibull are IGFR. Hence, when the

Manufacturer

(internal

marginal cost

)

Retailer

(internal

marginal cost

)

Wholesale

price

(F(Q), w(Q))

Retail

price p

Buyback

(or return

credit b)

Manufacturer

Retailer

Retailer’s order quantity Q,

where Q may need to satisfy

certain contractual terms

Customer

Demand D(p)

Buyback (or

return limit

R [Q-D]+ )

Figure 2. Financial flow and material flow under different supply chain contracts

Shared revenue α p

demand distribution is IGFR, one can determine the optimal wholesale price by

considering the first order condition. However, Lariviere and Porteus show that a simple

price contract w will not achieve channel coordination. Anupindi and Bassok (1999)

extend Lariviere and Porteus’ single period model to the case in which the retailer faces

an infinite succession of identical selling seasons so that it is optimal for the retailer to

order up to the newsvendor solution at the beginning of each season. Cachon (2002)

generalizes Lariviere and Porteus’ single period model to a two-period model with

inventory holding and demand updating. Specifically, in Cachon’s model, the retailer

can place two separate orders at two separate instants before the selling season starts;

however, the wholesale price at the second instant is known to be higher. Notice that

Cachon’s model reduces to Lariviere and Porteus’ model when the second order is not

allowed. By having the flexibility to place two separate orders, Cachon develop

conditions under which channel coordination is achieved.

Next, there are many situations in which a supply chain partner would keep his

information private. Corbett and de Groote (2000) consider a situation in which the

manufacturer does not know the retailer’s holding cost in a deterministic EOQ-type

environment. By imposing a prior distribution on the retailer’s holding cost, Corbett and

de Groote compare various channel coordination schemes in which F(Q) and w(Q) take

on different functional forms. When the demand is deterministic and decreasing linearly

in the retail price, Corbett and Tang (1998) examine the case in which the manufacturer

does not know the retailer’s internal marginal cost c

. By imposing a prior distribution

F(x) on the retailer’s internal marginal cost c

and by assuming that the prior distribution

F(x) has increasing failure rate; i.e., f(x)/(1 – F(x)) is increasing in x, they compare the

retailer’s and the manufacturer’s profits under different scenarios: one-part linear

contracts (F(Q) = 0, w(Q) = w), two-part linear contracts (F(Q) = F ≠ 0, w(Q) = w), and

two-part nonlinear contracts (F(Q) ≠ 0, w(Q) ≠ 0). Corbett and Tang study the optimal

behavior of each party under different scenarios. Ha (2001) generalizes Corbett and

Tang’s model by analyzing two-part non-linear wholesale price contracts for the case

when the demand is stochastic and price-sensitive. Ha shows that channel coordination

is not achievable under asymmetric information. When the manufacturer does not know

the retailer’s fixed ordering cost or the backorder penalty cost, Corbett (2001) examines

the benefit of having the manufacturer to own the retailer’s inventory (i.e., consignment

stock). He shows that consigning stock may not always help the manufacturer.

More recently, Babich et al. (2004) is the first to analyze supply contracts with supplier

default risk. They consider a single product model in which competing risky suppliers

compete for business with a retailer. In their model, the suppliers are leaders in a

Stackelberg game so that the suppliers would first establish the unit wholesale prices.

Then the retailer would determine the order quantity for each supplier by taking demand

uncertainty and supplier default uncertainty into consideration. By considering the

retailer’s discounted expected profit, they show that it is optimal for the competing

suppliers to increase their wholesale prices at the equilibrium when the supplier default

correlations are low and it is optimal for the retailer to order from suppliers with highly

correlated default rates.

Buy Back Contracts

In a single-period setting, it is optimal for the retailer to order according to the

newsvendor solution. To induce the retailer to order more, it is quite common for the

manufacturer to offer a return policy (also known as buy back contracts) so that the

manufacturer would “buy back” up to R% of the retailer’s excess inventory [Q – D]+

units at a unit rate of b, where R ≤ 100% and b ≤ w. Therefore, a return policy can

be specified by two parameters (R, b). Pasternack (1985) is the first to show that a

policy that allows for unlimited returns at partial credit; i.e., R = 100% and b < w, would

achieve channel coordination. Moreover, Lariviere (1998) analyze the properties of the

manufacturer’s and retailer’s profits for a class of return policies that coordinate the

channel. Emmons and Gilbert (1998) extend Pasternack’s model to the case in which the

retailer determines the order quantity Q as well as the retail price p. By considering a

specific demand distribution of D(p), they show that return policies or buy back

contracts cannot coordinate the channel. However, there exists certain buy back contracts

under which both the manufacturer and retailer can obtain higher profits. Padmanabhan

and Png (1997) consider the case in which two competing retailers facing a linear

demand curve with an uncertain intercept. Under a full returns policy (i.e., b = w), they

show that these retailers would increase their order quantities in a competitive

environment. More recently, Brown, Chou and Tang (2005) examine a multi-product

returns policy in which the retailer can return up to a percentage of the total order

quantities; i.e., the allowable return limits are pooled. By comparing the pooled returns

policy with the non-pooled returns policy (i.e., the allowable return limits are product-

specific), they present conditions under which the retailer would actually order less under

the pooled returns policy.

Revenue Sharing Contracts

In retailing, stocking out a product could have a larger impact on the manufacturer’s

profit because the customer would usually buy a similar product from the retailer. This

motivates manufacturer to provide incentive for the retailer to stock more. Clearly, a

buy back contract (or a return policy) can serve this purpose; however, the buy back

contract may not be practical in certain situations. For example, in the video rental

industry, it is not practical for the video rental stores to return excess inventory of old

DVDs to the manufacturer (distributor). This may have triggered the idea for the

manufacturer to develop a risk sharing scheme in the form of a revenue sharing contract.

The revenue sharing contract can be characterized by the wholesale price w and the

portion of the revenue to be shared α. As depicted in Figure 2, the retailer would get a

lower wholesale price w upfront but the retailer is required to remit α p for each rental

unit to the manufacturer. For instance, as described in Mortimer (2004), Blockbuster

shares probably between 30-45% of their rental revenue in exchange for a reduced

wholesale price probably at $8 instead of $65 for each DVD.

In the economics literature, Dana and Spier (2001) show that revenue sharing contracts

can be used to coordinate the supply chain, and would induce the retailers to reduce their

rental prices under competition. Mortimer (2004) conducts statistical analysis based on

the panel data collected at 6,137 video rental stores in the U.S. between 1998 and 2000.

She shows that revenue sharing contracts can enable a retailer to earn more for popular

titles or new releases. More recently, Pasternack (2002) investigates the effect of a

revenue sharing on the optimal order quantity in a newsvendor environment and he

shows analytically that a revenue sharing contract can be used to achieve channel

coordination. In addition, Cachon and Lariviere (2005) show analytically that the

revenue sharing contracts are equivalent to buy back contracts. Tang and Deo (2005)

determine the conditions for w and α under which the retailer will obtain a higher profit

under the revenue sharing scheme.

Quantity Based Contracts: Quality Flexibility and Minimum Order

To achieve operational efficiency under demand uncertainty, a manufacturer would

prefer contracts that would entice retailers to commit their orders in advance while a

retailer would prefer contracts that would allow them to adjust their orders when

necessary. As a compromise, some manufacturers would offer Quantity Flexibility (QF)

contracts to their retailers. A QF contract is specified by three parameters: a wholesale

price w, an upward adjustment parameter u, where 0 ≤ u ≤ 1, and a downward

adjustment parameter d, where 0 ≤ d ≤ 1. Consider the case in which a retailer placed

an order x sometime earlier. Suppose the retailer updates his demand forecast and

would like to revise this particular order. Under the QF contract, the retailer can adjust

his order to Q by paying w per unit as long as (1 – d)x ≤ Q ≤ (1+u)x. Notice that the

QF contract can be recast as a buy back contract under which the retailer had to buy

(1+u)x units up front but could return or cancel his commitment down to (1-d)x for a

full refund of the wholesale price w. Lariviere (1998) analyzes a QF contract with

parameters w, d, and u that coordinates the channel in a single-period setting. Tsay and

Lovejoy (1999) provide a detailed analysis of QF contract in a multi-period setting.

When it is very costly for a manufacturer to obtain more production capacity, a

manufacturer may develop a supply contract to entice each retailer to commit to a

minimum quantity in advance. Anupindi and Akella (1997) consider the case in which

the retailer is committed to a fixed quantity in each period. In return, the manufacturer

offers a discount based on the level of this fixed commitment. They prove that a

modified order up to policy is an optimal policy for the retailer. Anupindi (1993)

examines the case in which the order quantity that a retailer can place in each period is

bounded pre-specified lower and upper limits. More recently, Bassok and Anupindi

(1997) consider the case in which the retailer is committed to order at least KN units in

total over N periods. When demands are independent, identically distributed random

variables, they prove that the retailer’s optimal order policy in each period is a modified

order up to policy. Instead of focusing on the minimum total commitment for each

product, Anupindi and Bassok (1998) analyze a multi-product supply contract under

which the retailer is committed to a minimum total “dollar” value of the products to be

purchased over N periods.

When selling seasonal goods, Fisher (1997) and Fisher and Raman (1996) confirm that

the early sales data has informational value in the sense that they can help the retailer to

obtain more accurate forecast about the total sales for the whole season. Fisher and

Raman show that it is advantageous for the retailer to place a second order after

observing the first few weeks of sales data. To ensure that the second order will be

replenish within the selling season, the manufacturer needs to impose certain restrictions

on the second order quantity. Eppen and Iyer (1997) analyze a “backup agreement” that

has been used in the fashion apparel industry. The backup agreement can be

characterized by three parameters (

, w, k). Prior to the selling season, the retailer

commits to Q units for the entire selling season and confirms the first order (1 –

)Q at

wholesale price w. The retailer can place a second order up to the remaining

Q units

(i.e., the backup units) at wholesale price w and receive quick delivery. There is a

penalty cost of k for any of the backup units not purchased. Brown and Lee (1997)

consider a variant of the backup agreement arising from the semiconductor

manufacturing industry.

2.5.2. Uncertain Price

While most work focus on demand uncertainty, not much work has been done in the area

of uncertain wholesale price. Li and Kouvelis (1999) consider a case in which the

wholesale price is a geometric Brownian motion with drift. Facing with uncertain

wholesale price, the retailer is required to procure exactly D units by time T, where D is

the ultimate demand at time T. Also, an inventory holding cost h(T – t) will be incurred

for each unit purchased at time t, where 0 < t < T. Li and Kouvelis evaluate the cost

associated with three different supply contracts. First, in a “time inflexible contract,” the

retailer must state up front about the purchase time. In a “time flexible contract,” the

retailer may observe price movements and decide dynamically when to buy. They

extend their model to the case in which they can procure the item from two

manufacturers.

For ease of reference, we shall provide a summary of the articles reviewed in each

section. For example, Table 2 provides a summary of the articles reviewed in Section 2

Supply Management

Issue

Sub-category References (in the order of appearance)

Supply Network

Design

General Porter (1985), Arntzen et al. (1995), Camm et al. (1997), Levy

(1995), Lee and Tang (1998), Huchzermeier and Cochen (1996),

Kouvelis and Rosenblatt (2002),

Supplier Relationship

General Helper (1991), Dyer and Ouchi (1993), Dyder (1996), Shin et al.

(2000), Tang (1999), Cohen and Agrawal (1999).

Supplier Selection

Process

Supplier Selection

Criteria

Boer et al. (2001), Mandal and Deshmukh (1996), Vokurka

(1996), Choi and Hartley (1996), Ellram (1994)

Supplier

Approval/Selection

Boer et al. (2001), Ellram (1994), Weber and Current (1993),

Weber (2000), Dahel (2003), Tang (1988), Tagaras and Lee

(1996), Kouvelis (1998)

Supply Order

Allocation

Uncertain Demand Porteus (2002), Zipkin (2000), Minner (2003), Zhang (1996),

Fukuda (1964), Vlachos and Tagaras (2001), Scheller-Wolf and

Tayur (1999), Moinzadeh and Nahmias (1988), Janssens and de

Kok (1999), Nagurney (2005), Bazarra et al. (1993),

Uncertain Supply Yields Gerchak, Vickson, and Parlar (1988), Gerchak (1990), Agrawal

and Nahmias (1998), Yano and Lee (1995), Bassok and Akella

(1991), Tang (1990), Denardo and Lee (1996), Rajagopalan and

Singh (1992), Gong and Matsuo (1997)

Uncertain Supply Lead

Times

Ramasesh et al. (1991), Sedarage et al. (1999), Akella et al.

(1993)

Uncertain Supply

Capacity

Parlar and Perry (1996), Ciarallo (1994), Wang and Gerchak

(1996), Hernig and Gerchak (1990)

Uncertain Supply Cost Gurnani and Tang (1999), Kogut (1985), Kogut and Kulatilaka

(1994), Li (1997), Kogut and Kulatilaka (1994), Dasu and Li

(1997), Huchzermeier and Cohen (1996)

Supply Contracts

General Lee et al. (1997), Bresnahan and Reiss (1985), Cachon (2003),

Lariviere (1998), Tsay (1998)

(Uncertain Demand)

Wholesale Price

Contracts

Lariviere and Porteus (2001), Anupindi and Bassok (1999),

Cachon (2002), Corbett and de Groote (2000), Corbett and Tang

(1998), Ha (2001), Corbett (2001), Babich et al. (2004)

Buy Back Contracts Lariviere (1998), Emmons and Gilbert (1998), Padmanabhan and

Png (1997), Brown, Chou, and Tang (2005),

Revenue Sharing

Contracts

Dana and Spier (2001), Mortimer (2004), Pasternack (2002),

Cachon and Lariviere (2005),

Quantity Based

Contracts

Lariviere (1998), Tsay and Lovejoy (1999), Anupundi and Akella

(1997), Anupindi (1993), Bassok and Anupini (1997), Fisher

(1997), Fisher and Raman (1996), Eppen and Iyer (1997), Brown

and Lee (1997)

(Uncertain Price)

General Li and Kouvelis (1999)

Table 2. Summary of Supply Management Articles.

3. Demand Management

In Section 2, we describe how manufacturers can use different supply management

strategies to mitigate various supply chain operational risks. However, these supply

management strategies are ineffective when the underlying supply mechanism is

inflexible. For instance, in the service industry or in the fashion goods manufacturing

industry, the supply mechanism is inflexible because the capacity is usually fixed. When

the supply capacity is fixed, many firms have attempted to use different demand

management strategies so that they can manipulate uncertain demands dynamically so

that the modified demand is better matched with the fixed supply. Due to space

limitation, we are unable to review the dynamic pricing or clearance pricing literature.

The reader is referred to Elmaghraby and Keskinocak (2003) for an extensive review of

dynamic pricing models and clearance pricing models for selling a fixed number of units

over a finite horizon. Also, we do not plan to review literature that deal with

coordination of pricing and ordering decisions. The reader is referred to Yano and

Gilbert (2004), Petruzzi and Dada (1999), Eliashberg and Steinberg (1993) for three

comprehensive reviews in this area. Instead, we shall focus on articles that emphasize on

the use of demand management strategies to “shape” uncertain demand so that a firm can

use an inflexible supply to meet the modified demand.

When a firm’s supply capacity is fixed, Carr and Lovejoy (2000) is the first to develop a

single-period model for a firm to handle multiple customers with random demand

distributions. For each customer, they consider the case in which the firm can choose to

accept only a fraction of the customer’s demand distribution. The objective is to choose

different fractions of customer demand distributions so that the firm’s expected profit is

maximized for a given supply capacity. By analyzing the mean and variance of the total

demand generated from different fractions of customer demand distributions, Carr and

Lovejoy determine the optimal portfolio of demand distributions. Van Mieghem and

Dada (1999) consider a single product firm that faces a linear demand curve with

uncertain intercept and has to decide on its production quantity and price. They consider

different strategies including one strategy that is called price postponement strategy.

Under the price postponement strategy, the firm needs to decide on the order quantity in

the first period and then determine the price in the second period after observing updated

information about the demand. Essentially, the supply is fixed after the first period.

Hence, the price postponement strategy enables a firm to use price as a response

mechanism to change demand so that the modified demand is better matched with the

fixed supply. By formulating the problem as a two-period stochastic dynamic

programming problem, Van Mieghem and Dada show that the price postponement is

more effective than other strategies being considered.

Besides the demand management strategy examined by Carr and Lovejoy (2000) and Van

Mieghem and Dada (1999), it appears that the remaining demand management strategies

are designed to generate one or more of the following effects:

a. Shifting demand across time;

b. Shifting demand across markets; and

c. Shifting demand across products.

We now review the relevant literature in each of these three categories.

3.1. Shifting Demand Across Time

In the service industries such as utilities, airlines and hotels, firms usually set higher

prices during peak seasons in order to shift demand to off-peak seasons. This type of

pricing mechanism is also known as revenue management or yield management. By

offering different prices at different times, it would enable the firm to increase the profit

generated from a fixed supply capacity by capturing customers in different segments who

are willing to pay different prices for the service offered in different times. For revenue

management literature that deals with hotel bookings, the reader is referred to Bitran and

Gilbert (1996), Badinelli (2000), and the references therein. In most cases, due to

uncertain customer arrivals and uncertain cancellations, these models are usually

formulated as a dynamic programming problem. For revenue management literature that

deals with airline reservations, the reader is referred to Dana (1999) and a comprehensive

survey provided by Weatherford and Bodily (1992). For revenue management literature

that deal with peak-load pricing for managing public utilities, the reader is referred to

Crew and Kleindorfer (1986) for a review of economics literature that deals with peak

load pricing with uncertain demand. Essentially, many economists have developed

various models using different types of demand curves and different types of demand

uncertainties to determine the peak-load pricing so that the service provider with fixed

capacity can obtain a higher profit. Besides the recent work developed by Dana (1999),

most economists assumed that the firm knows the time at which peak demand occurs.

The reader is referred to a review of revenue management prepared by Talluri and Van

Ryzin (2005).

In the context of service marketing, many service firms offer price discount to entice

customers to commit their purchase in advance. In many instances, advance-purchase

discount can be easily implemented due to new technologies such as smart cards, online

payments, electronic money, etc. As articulated in Xie and Shugan (2001), advance-

purchase discount can be a win-win strategy for the service provider and their customers.

First, advance-purchase discount enables a firm to use this discriminatory pricing

mechanism to increase sales by serving different market segments. For example, by

considering 2 market segments with different reservation values of the service, Dana

(1998) shows analytically that it is rational for customers with relatively more certain

demands (planned trips) and customers with relatively lower reservation value (leisure

travelers) to commit their purchases in advance. This result also implies that customers

with less certain demands (unplanned trips) and customers with relative higher

reservation value (business travelers) would expect to pay (a potentially higher price) in

the spot market. Second, advance-purchase discount enables customers to receive a

discount over the spot price or to reserve capacity that may not be available during the

spot period. Xie and Shugan (2001) present a two-period model in which the advance-

purchase price is announced in the first period and while the price is not announced in the

second period; however, the probability distribution of the price in the second period is

known to all customers. Since the price in the second period is unknown to the

customers and since the reservation price is uncertain for each customer, they would

make their purchase in the first period if the surplus obtained form purchasing in advance

is higher than the expected surplus obtained from purchasing later. By using backward

induction, Xie and Shugan develop the conditions under which the firm should offer

advance-purchase discount. By considering an extension in which the prices in both

periods are pre-announced, they determine the conditions under which the firm should

offer advance-purchase discount.

In the context of supply chain management, one needs to address the production planning

and inventory control issues that are not addressed in the economics or marketing

literature. In most cases, the retailers would usually pre-announce the prices for both

periods to their customers. Weng and Parlar (1999) is the first to analyze the benefit of

advance-commitment discount. They consider the case in which a retailer offers price

discount to entice customers to pre-commit their orders prior to the beginning of the

selling season. The advance-commitment discount program can be a win-win solution.

First, the customers can enjoy a lower price by pre-committing their orders early.

Second, the retailer can benefit from the reduction in demand uncertainty because the

advance-commitment discount enable the retailer to convert some uncertain customer

demands to pre-committed orders that are known in advance. By considering the demand

uncertainty reduction generated by the advance-commitment discount, Weng and Parlar

determine the optimal order quantity and the optimal discount rate for the retailer.

Tang et al. (2004) extend Weng and Parlar’s model by considering a more general

situation that can be described as follows. First, they consider a situation in which the

market consists of two customer segments with different purchasing behaviors toward

advance-commitment discount. They show how advance-commitment discount would

enable the retailer to increase the total expected sales. Second, they consider the case in

which the retailer can utilize the pre-committed orders obtained prior to the beginning of

the selling season to improve the accuracy of the forecast of the demand to be occurred

during the selling season. They show how this improved forecast would enable the

retailer to reduce the total expected over-stocking and under-stocking costs. Moreover,

they examine various benefits associated with advance-commitment discount programs.

As a follow-on study, McCardle et al. (2004) extend the model presented in Tang et al. to

the case in which two competing retailers need to decide whether to launch the advance-

commitment discount program or not. McCardle et al. show that both retailers would

offer the advance-commitment discount program at the equilibrium. However, when

there is a fixed cost for implementing this discount program, they develop conditions

under which exactly one retailer would offer the discount program at the equilibrium.

The advance-commitment discount program is applicable to non-seasonal products as

well. By studying the supply chain operations associated with steel processing, Gilbert

and Ballou (1999) present a continuous time model in which the steel distributor offers

price discount to customers who pre-commit their orders in advance. By knowing these

pre-committed orders earlier, they show that the standard deviation of the demand over

the replenishment lead time periods is reduced. By using a traditional approximate cost

model for lost sales, they show how advance-commitment discount programs would

enable a steel distributor to increase his expected profit and to improve customer service

level at the same time. By examining the profits before and after the launch of the

advance-commitment discount program, Gilbert and Ballou present an approach for

determining the optimal discount price.

All advance-commitment discount models are based on the single product case except the

model presented in Weng and Parlar (2005). Specifically, Weng and Parlar examine a

situation when a manufacturer produces a standardized product and a make-to-order

customized product. Also, the manufacturer offers advance-commitment discount to

customers who pre-commit their orders for the standardized product. By considering the

case in which the market consists of two segments with different purchasing behaviors

toward advance-commitment discount, they formulate the manufacturer’s problem as a

stochastic dynamic programming problem. They show that the advance-commitment

discount program would enable the manufacturer to increase the total expected demand

and to reduce demand uncertainty. When the standardized product is cheaper to produce,

they develop conditions under which the manufacturer should offer the advance-

commitment discount program.

While the advance-commitment discount program that is designed to enable a firm to

shift customer demands earlier, there is another strategy that would entice customers to

shift their demands later. This strategy is called “demand postponement” strategy and it

is intended to entice some customers to accept their shipments in a later period. Iyer et

al. (2003) is the first that examines the benefits of the demand postponement strategy. To

manage uncertain demand with a fixed supply capacity, they consider the case in which a

firm would offer price discount to a fraction of customers who are willing to accept late

shipments. Essentially, this strategy is akin to the overbooking situation in which an

airline may offer incentive to entice a fraction of customers who are willing to take a later

flight. Iyer et al present a two-period model and determine the optimal fraction of

customer demands to postpone. In addition, they characterize conditions under which the

firm should adopt the demand postponement strategy.

3.2. Shifting Demand Across Markets

When selling products with short life cycles in different markets, firms need to manage

product rollovers (the process of phasing out old products and introducing new products).

As articulated in Billington et al. (1998), different firms have implemented various

rollover strategies with different degrees of success. One of the key challenges for

managing product rollovers successfully is uncertain demands in different markets. To

mitigate the demand risks in different markets, Billington et al. present a “solo-rollover

by market” strategy that calls for selling the new product in different markets with non-

overlapping selling seasons. The solo-rollover by market strategy is more suitable for

situations when there is a natural time delay of the selling season in two different

markets. For example, the selling season of ski wear in the U.S. usually ends in May,

while the selling season in South America usually begins in June.

Suppose a firm adopts the solo-rollover by market strategy. Then the firm has to decide

how much to stock for the first market during in first period; how much of the unsold

inventory from the first market to transship to the second market at the end of the first

period; and how much to stock for the second market at the beginning of the second

period. Hence, the solo-rollover by market strategy enables a firm to shift the supply

from the first market to the second market. Kouvelis and Gutierrez (1997) is the first to

examine this stocking and transshipment decisions for two markets with non-overlapping

selling seasons. They consider a firm that sells seasonal goods in a primary market in the

first period and in the secondary market during the second period. By capturing the

possibility of shipping some of the leftover inventory from the primary market to the

secondary market at the end of the selling season of the primary market, they present a 2-

period stochastic dynamic program to determine the optimal production quantity for the

corresponding market in each period and the optimal amount of leftover inventory to be

shipped from the primary market to the secondary market. Due to the possibility of

selling the leftover from the primary market at the second market, they show that the

optimal production quantity for the primary market is higher than the case when the

secondary market does not exist.

Recently, Petruzzi and Dada (2001) extend Kouvelis and Gurtierrez’s model to the case

in which the firm can use a pricing mechanism to shift some of the demand from the

primary market to the secondary market. Specifically, Petruzzi and Dada consider that

the firm can utilize information to make better pricing and ordering decisions as follows.

First, the firm can choose the selling price as well as the stocking level for the primary

market during the first season. Second, the firm can utilize the actual sales observed in

the primary market to improve the accuracy of the forecast of the demand for the

secondary market in the second season. Third, given the updated forecast, the firm can

determine the transshipment quantity to be shipped from the primary market to the

secondary market, the stocking level and the selling price of the product for the

secondary market in the second selling season. By formulating the two-period problem

as a stochastic programming problem with recourse, Petruzzi and Dada establish the

characteristics of the optimal pricing and ordering decisions for both markets.

3.3. Shifting Demand Across Products

When selling multiple products in a single market, many marketing researchers have

examined various pricing and promotion strategies to entice customers to switch brands

or products. The ultimate goal of various marketing strategies is to help a firm to

increase market share, sales, or revenue. For example, Raju et al. (1995) present a model

to capture the brand switching behavior when a store introduces a store brand to compete

with the existing national brands. They show how to determine the optimal retail prices

for the national brands and the new store brand so as to maximize the store’s revenue.

Chong et al. (2001) show how a retailer can obtain higher revenue by adjusting its

product assortments and pricing so that the store can offer its customers the right products

at the right price. The reader is referred to Lilien et al. (1992) for an extensive review of

marketing models that deal with pricing and promotion strategies. In general, these

marketing models do not deal with the operational issues arising from supply chain

management.

In the context of supply chain management, some researchers have developed models by

considering the possibility of shifting the supply/demand from one product to another. It

seems there are two basic mechanisms that would enable to firm to shift the

supply/demand from one product to another. These two mechanisms are: product

substitution and product bundling.

3.3.1. Product Substitution

Product substitution can occur in different settings. First, by selling products with similar

features, a firm can increase the product substitutability. Chong et al. (2004) show how a

firm can increase product substitutability by selecting a specific combination of products

with similar attributes/features. Moreover, they show how product substitutability can

reduce the variance of the aggregate demand. Rajaram and Tang (2001) present a single

period stochastic model of a firm that sells two substitutable products. Specifically, they

consider a situation in which a product with surplus inventory can be used as a substitute

for out of stock products. Hence, the demand of one product can be satisfied by the

supply for another product. They develop conditions under which product substitutability

would enable a firm to reduce the variability of the effective demand for each product.

Moreover, they show that the optimal order quantity of each product and the retailer’s

expected profit increase as product substitutability increases.

Second, product substitution can occur when one product dominates another product in

terms of quality or performance. For example, in integrated circuit (IC) manufacturing,

the output of each production run consists of a random number of chips with different

grades measured according to the processing speed. When higher grade chips can be

used as substitutes for the lower grade chips, Bitran and Dasu (1992) and Hsu and Bassok

(1999) present different models for determining the optimal production quantity at a

wafer fabrication facility with random yields.

Third, one can use a pricing mechanism to entice customers to shift their demand from

one product to another. Parlar and Goyal (1984) consider a case in which the retailer

would offer price discount for the old product, say, one-day old doughnut. Clearly, the

new and old products are substitutable and the retailer can change the level of product

substitution by varying the discount factor. By formulating the problem as a Markov

Decision Process and by considering the demands for the old and new products, they

determine the optimal order quantity for the new product in each period. More recently,

Chod and Rudi (2005) examine another situation in which a firm can use differential

pricing to entice customers to shift the demand for one product to another. They consider

the case in which the firm needs to decide on the production quantity of two similar

products in the first period; however, the firm can postpone the pricing decision of the

each product until the second period. By extending the model developed by Van

Mieghem and Dada (1999), Chod and Rudi show a firm can obtain a higher profit by

delaying the pricing decision until the second period.

3.3.2. Product Bundling

In addition to product substitution, a firm can change the demand of the products by

developing bundles. There is an increasing number of retail products being bundled

together and sold. Examples can be found across a range of products including food

(cans of chicken broth), apparel (under garments), cosmetics (shampoo and conditioner),

and electronics (computers and printers). When products are sold in bundles, they force

the customers to buy all products as a bundle, which will affect the effective demand of

the products. Ernst and Kouvelis (1999) examine how product bundles affect the

inventory ordering decisions of a firm. Specifically, they consider the case in which the

products are sold as a bundle and as individual products. Based on their analysis of a

two-product model, they establish the necessary and sufficient conditions for the optimal

ordering quantities. They provide insights on the degree of sub-optimality in profits

when inventory decisions are made without explicit consideration of demand substitution

between the bundles and the individual products. More recently, McCardle et al. (2005)

present a model for determining optimal bundle prices, order quantities, and profits. By

capturing the customer’s valuation of individual products, they generate the demand

distribution of the product bundle. In addition, they determine how product demand,

costs and the relationship of demand between products affect optimal bundle prices and

profits. Moreover, they present conditions under which a firm should bundle their

products. The reader is referred to Stremersch and Tellis (2002) for a comprehensive

review on product bundling literature.

Demand Management

Issue

Sub-category References (in the order of appearance)

Demand Management

General Elmaghraby and Keskinocak (2003), Yano and Gilbert (2004),

Petruzzi and Dada (1999), Eliashberg and Steinberg (1993), Carr

and Lovejoy (2000), Van Mieghem and Dada (1999)

Shifting Demand Across

Time

Gilbert (1996), Badinelli (2000), Dana (1999), Weatherford and

Bodily (1992), Crew and Kleindorfer (1986), Talluri and Van

Ryzin (2005), Dana (1998), Xie and Shugan (2001), Weng and

Parlar (1999), Tang et al. (2004), McCardle et al. (2004), Weng

and Parlar (2005), Iyer et al. (2003),

Shifting Demand Across

Markets

Billington et al. (1998), Kouvelis and Gutierrez (1997), Petruzzi

and Dada (2001),

Shifting Demand Across

Products

Raju et al. (1995), Chong et al. (2001), Lilien et al. (1992),

Product Substitution Chong et al. (2004), Rajaram and Tang (2001), Bitran and Dasu

(1992), Hsu and Bassok (1999), Parlar and Goyal (1985), Chod

and Rudi (2005), Van Mieghem and Dada (1999)

Product Bundling Ernst and Kouvelis (1999), McCardle et al. (2005), Stremersch

and Tellis (2002)

Table 3. Summary of Demand Management Articles.

4. Product Management

To compete for market share, many manufacturers expand their product lines. As

reported in Quelch and Kenny (1984), the number of stock keeping units (SKUs) in

consumer packaged goods has been increasing at a rate of 16% every year between 1985

and 1992. Marketing research shows that product variety is an effective strategy to

increase increasing market share because it enables a firm to serve heterogeneous market

segments and to satisfy consumer’s variety seeking behavior. However, while product

variety may help a firm to increase market share and revenue, product variety can

increase manufacturing cost due to an increase in manufacturing complexity. Moreover,

product variety can increase inventory cost due to an increase in demand uncertainty.

These two concerns have been illustrated in an empirical study conducted by MacDuffie

et al. (1996). They show that the production and inventory costs tend to increase as

product variety increases. Therefore, it is critical for a firm to determine an optimal

product portfolio that maximizes the firm’s profit. The reader is referred to Ramdas

(2003) for a comprehensive review of literature in the area of product variety.

To reduce the design and manufacturing costs associated with product variety, firms can

increase product variety by developing different variants based on a common platform.

For example, in the personal computer industry, different computer models are based on

a common platform. Hence, the products would share some common attributes, which

make these products mutually substitutable to a certain extent. As discussed in Section

3.3, product substitution and product bundling would enable a firm to shift demands

across products so that the firm can satisfy more customers without incurring the risk of

over-stocking. However, product substitutability is a key challenge for researchers to

develop analytical models to evaluate market share, revenue, and manufacturing cost

associated with different product portfolio. As articulated in Ulrich et al. (1998), there is

no explicit analytical model for determining an optimal product portfolio with

substitutable products. However, various researchers have examined various product

variety issues. For example, Ulrich et al. present a study of mountain bikes industry and

suggest that firms need to take their internal capabilities such as process technology,

distribution channels, product architecture, supply chain network, etc., into consideration

when making product variety decision. Krishnan and Kekre (1998) develop a regression

model to examine the impact of functional features on software development cost.

Martin et al. (1998) present a method for examining the impact of product variety on

replenishment lead time. Moreover, by considering the attribute levels of different

products associated with a product portfolio, Chong et al. (2004) develop a Logit model

for determining the mean and variance of the sales associated with different compositions

of a product portfolio. The reader is referred to Ho and Tang (1998) for a review of

articles in the area of marketing, operations management and economics that deal with

the issue of product variety. More recently, Caro and Gallien (2005) present a multi-

armed bandit model for selecting an optimal product portfolio of fashion items that

maximizes the expected profit over a finite horizon.

In the context of supply chain risk management, the key concern is to determine ways to

reduce inventory cost associated with a given portfolio of products. Based on the

classical inventory theory (c.f., Porteus (2002) and Zipkin (2000)), it is well known that

the average inventory level associated with the order-up-to policy depends on mean and

the standard deviation of the demand over the replenishment lead time. Therefore, in

order to develop a cost-effective product variety strategy, various researchers have

developed different approaches for reducing the standard deviation of the demand over

the replenishment lead time. For instance, as explained in Section 3.1, one can reduce

the demand uncertainty over the replenishment lead time periods by using pricing

mechanisms such as advance-commitment discount, peak load pricing, etc. In this

section, we shall review articles based on three specific product management strategies:

postponement, process sequencing, and product substitution. Since the issue of product

substitution has been discussed in Section 3.3.1, we shall focus our discussion on the

postponement strategy and process sequencing.

4.1. Postponement

Consider a manufacturing system that produces two end-products. The system has N

processing stages, where stage 0 is a “dummy” stage. As depicted in the Figure 3, the

first k stages are common to both end-products and after this stage the products are

differentiated in the sense that they may require different operations or different

components. We call stage k as the “point of differentiation.” Lee and Tang (1997)

describe how delayed product differentiation can be achieved via standardization of

components and subassemblies, modular design, postponement of operations, and re-

sequencing of operations. Recall that stage 0 is a dummy stage; hence, there is no

postponement if k = 0. We let T be the total lead time of the entire manufacturing

process, and L(k) be the lead time from stage 0 to stage k.

The postponement models can be classified according to operating modes (make-to-stock

k+1

Lead time L(k) Lead time (T – L(k))

Figure 3. A system with point of differentiation at stage k.

and make-to-order) and demand forecasts (no forecast updating and with forecast

updating). However, we are not aware of models that deal with make to order system

with forecast updating.

4.1.1. Make-To-Order Systems Without Forecast Updating

Lee (1996) is the first to develop theoretical analysis of the postponement strategy.

When there is no demand forecast updating, he examines the benefits of postponement in

a make-to-order (MTO) system and a make-to-stock (MTS) system. In the MTO system,

work-in-process inventory is held only at stage k and each end product is customized on

demand. Depending on the availability of the inventory at stage k and the processing

capacity at stages (k+1) through (N), the time it takes to respond to a customer is

uncertain. In an MTO system, it is common to measure the system performance

according to the mean response time and the probability of the response time being less

than a target response time. Using these two performance measures, Lee shows that the

optimal order up level S is decreasing in k. Hence, one can reduce the inventory level

by delaying the point of differentiation. While the base stock level S is decreasing in k,

the inventory holding cost rate is likely to be increasing in stage k; i.e., it is more costly

to hold inventory at a later stage. By considering the tradeoff between lower inventory

level and higher inventory holding rate, Lee provides conditions under which

postponement is beneficial.

In Lee’s model, the end products are differentiated according to a single feature. As

such, all end products can be customized from a single point of differentiation. However,

when the end products are differentiated according to multiple features, there could be

multiple points of differentiation. This observation motivates Swaminathan and Tayur

(1998a) and (1998b) to define the semi-finished products held at different points of

differentiation as “vanilla boxes.” Essentially, the firm will stock these vanilla boxes and

then customize different types of vanilla boxes into different end products on demand.

By considering the capacity for the customization process and different demand

scenarios, Swaminathan and Tayur formulate the problem as a stochastic programming

problem with recourse. By examining the structure of the stochastic programming, they

develop a solution methodology for determining the optimal configuration of vanilla

boxes that minimizes the expected stock-out cost and the inventory holding cost of

vanilla boxes.

4.1.2. Make-To-Stock Systems Without Forecast Updating

In a Make-to-stock (MOS) system, Lee (1996) consider the case in which only finished

product inventory is held; i.e., inventory is held after stage N. Conceptually speaking,

this system is akin to the single-depot, multi-warehouse distribution system examined by

Eppen and Schrage (1981). By assuming that the demand distributions for the end-

products are independently normal across time but may be correlated within a time

period, Lee applies the approximate analysis developed by Eppen and Schrage to

determine the base-stock level and the average inventory level for each end-product.

Moreover, Lee shows that the finished product inventory level for each end-product is

decreasing in the point of differentiation k. As articulated in Lee (1996), the

postponement strategy can be implemented in a MTO or a MTS system. This

observation motivates Su et al. (2005) to develop a model to compare the total supply

chain costs associated with postponement in a MTO and a MTS system. Their analysis

shows that the MTO system is more cost effective when the number of end products

exceeds a certain threshold level.

When the end products are differentiated according to different features, the

corresponding manufacturing process can have multiple points of differentiation. Garg

and Tang (1997) to extend the model presented in Lee (1996) by considering a system

with multiple points of differentiation. Since system with multiple points of

differentiation is akin to a multi-echelon distribution system, Garg and Tang first extend

Eppen and Schrage’s two-echelon model to a three-echelon model. Then they show that

postponement at each of the differentiation points would result in inventory savings.

Instead of relying on the approximate analysis developed by Eppen and Schrage to

evaluate different postponement strategies, Aviv and Federgruen (1998b) show how one

can develop an exact analysis of the model presented in Garg and Tang (1997).

Lee and Tang (1997) examine a system that can keep work-in-process inventory at every

single stage. They develop a stochastic inventory model by capturing the investment cost

per period for redesigning the products and / or processes, the unit processing cost, and

the inventory holding cost at each stage. Their analysis is based on a decomposition

scheme in which the manufacturing process is decomposed into N independent stages,

each of which will follow an order-up-to level policy. The decomposition scheme

enables them to approximate the system-wide cost function associated with the point of

differentiation k. By examining the underlying property of this explicit cost function,

they develop conditions under which no postponement is optimal; i.e., the optimal point

of differentiation is stage 0. Also, they discuss the conditions under which postponement

is beneficial.

In the postponement literature, most researchers assume that the production capacity is

unlimited. To examine how production capacity can affect the value of postponement,

Gupta and Benjaafar (2004) develop a queuing model for examining the benefits of

postponement in a MTO and a MTS system with limited production capacity. When the

production capacity for stages 1 through k (point of differentiation) is limited, Aviv and

Federgruen (2001a) present a multi-product inventory model for the case when the

product demand is random and periodical. They show that the underlying inventory

model can be formulated as a Markov Decision Process, and that delayed product

differentiation is always beneficial even when the system has limited capacity.

4.1.3. Make-To-Stock Systems With Forecast Updating

In the postponement literature, most researchers assume that the product demands in each

period are random, but they are independent across time and their distributions are

known. As a result of these assumptions, the benefit of postponement is derived from

“risk pooling” in the sense that all stages before the point of differentiation (stage k)

would plan according to the “aggregate demand” instead of individual product demand.

Besides risk pooling, postponement enables a firm to delay the product differentiation so

that the production quantity decision for the final products can be made in a later period

of time. When the timing of this decision is delayed, the firm can use the actual demands

observed in earlier period to obtain more accurate forecasts of future demands. To

explore further about the benefit of postponement with forecast updating, Whang and Lee

(1998) extend the make-to-stock model presented in Lee (1996) by considering the case

in which the demand D

(t) of end-product i in period t possesses the following form:

),(,,...,2,1,,...,2,1,)(

ijijijij

aNandTtniwheretD

σεεµ

≈==+=

∑

Whang and Lee assume that the parameters a

and σ

are known. This demand

distribution is a form of random walk that enables one to capture a series of random

shocks (economic trends, random noises, etc.). As time goes on, the decision maker can

use the shocks observed in earlier periods (i.e., some of the ε

’s are now known) to

develop a more accurate forecast of D

(t). By incorporating the capability to obtain

more accurate demand forecast as time goes on, Whang and Lee show that one can obtain

substantial reduction in the end-product inventory by using more accurate forecasts. In

addition, they show analytically that significant inventory savings can occur even when

the point of differentiation k occurs in the early stage.

Aviv and Federgruen (2001b) consider a more general demand distribution in which the

parameters of the demand are unknown. In their model, they consider the case in which

the decision maker would update the demand forecast in a Bayesian manner. They show

analytically that the standard deviation of the total demand over the lead time periods is

decreasing over time. Furthermore, they show that this standard deviation is decreasing

in the point of differentiation k. This implies that it is more beneficial to update the

demand forecast when postponement occurs in a later stage. The reader is referred to

Garg and Lee (1998), Aviv and Federgruen (1998b), and Yang et al. (2004) for

comprehensive reviews of research literature that examine different postponement issues.

4.2 Process Sequencing

As noted in Section 4.1, postponement is an effective way to reduce variabilities in a

supply chain. Lee and Tang (1998) suggest that variabilities can also be reduced by

reversing the sequence of manufacturing processes in a supply chain. Their suggestion is

motivated by the re-engineering effort at Benetton. In the woolen garment industry,

virtually all manufacturers will use the dye-first-knit-later sequence; i.e., dye the yarns

into different colors first and then knit the colored yarns into different finished products.

However, as a way to reduce inventory, Benetton pioneered the knit-first-dye-later

process by reversing the “dyeing” and “knitting” stages (c.f., Dapiran (1992)).

Intuitively speaking, the knit-first-dye-later strategy would be beneficial when there is

only one style of woolen sweaters with multiple colors. This is because it would result in

delaying product differentiation after the “knitting” stage. However, when there are

multiple styles and multiple colors, it is not clear which strategy is better. To determine

the conditions under which a particular process sequence is better, Lee and Tang (1998)

develop a model of a production system that produces products with 2 features (A and B),

each of which has 2 choices (1 and 2). As depicted in Figure 4, the product demands

, X

) are assumed to be multi-nomially distributed with parameters (N; θ

, θ

), where the total demand N is normally distributed with mean µ and

standard deviation σ, and θ

corresponds to the probability that the customer will

choose choice i of feature A and choice j of feature B. By considering p as the

probability that a customer will purchase a product with choice 1 of feature A and by

examining the conditional probabilities: Prob(B1 | A1) = f(p) and Prob(B1 | A2) = g(p),

one can express θ

in terms of p, f(p) and g(p).

Lee and Tang argue that the total expected cost associated with the intermediate products

is proportional to the sum of the variances of demands in a period. As such, they show

that the process sequence A-B has a smaller variance than the process sequence B-A if:

(µ - σ

){p(1-p) – [pf(p) + (1-p)g(p)]{1 – [pf(p) + (1-p)g(p)]}} < 0. This result has the

following implications. Consider the special case in which f(p) = g(p) = q, where q is

independent of p. If the product demand is stable (i.e., when µ > σ

), then the process

sequence A-B has a lower variance when feature (attribute) A is less variable than

attribute B (i.e., when |0.5 – p| > |0.5 – q|). However, the reverse is true when µ < σ

By considering the sum of the standard deviations as an alternative measure, Kapuscinski

and Tayur (1999) conduct their analysis associated with the special case. They show that

it is optimal to process the attribute with less variable first, regardless of the values of µ

and σ

Some researchers have generalized Lee and Tang’s model in the following manner.

First, Federgruen (1998) develops a general definition of when attribute A is more

variable than attribute B in terms of θ

. He shows a more general conditions under

which the process sequence A-B has a smaller variance than the process sequence B-A.

Figure 4. A Two-Stage System with 2 Features and 2 Choices.

1-p

g(p)

f(p)

Next, Jain and Paul (2001) generalize Lee and Tang’s model by incorporating two

important characteristics of fashion goods markets, namely, heterogeneity among

customers and unpredictability of customer preferences. More recently, Yeh and Yang

(2003) develop a simulation model by incorporating additional factors such as lead times,

ordering policies, and inventory holding cost. By using the data obtained from a garment

manufacturer, they show how their simulation model can be used to select a process

sequence that minimizes the total expected cost.

Product Management

Issue

Sub-category References (in the order of appearance)

Product Management

General Quelch and Kenny (1994), MacDuffie et al. (1996), Ramdas

(2003), Ulrich et al. (1998), Krishnan and Kekre (1998), Martin et

al. (1998), Chong et al. (2004), Ho and Tang (1998), Caro and

Gallien (2005), Porteus (2002), Zipkin (2000)

Postponement

General Lee and Tang (1997),

Make to order systems

without forecast

updating

Gunasekaran and Ngai (2005), Lee (1996), Tayur et al (1998a),

Tayur et al. (1998b)

Make to stock systems

without forecast

updating

Lee (1996), Eppen and Schrage (1981), Su et al. (2005), Garg and

Tang (1997), Aviv and Federgruen (1998b), Lee and Tang (1997),

Gupta and Bejaafar (2004), Aviv and Federguen (2001a)

Make to stock systems

with forecast updating

Whang and Lee (1998), Lee (1996), Aviv and Federguen (2001b),

Garg and Lee (1998), Aviv and Federguen (1998b), Yang et al.

(2004)

Process Sequencing

Lee and Tang (1998), Kapuscinski and Tayur (1999), Federguen

(1998), Jain and Paul (2001), Tayur (1999), Yeh and Yang (2003)

Table 4. Summary of Product Management Articles.

5. Information Management

As explained in Fisher (1997), most consumer products can be classified as fashion

products or functional products. Basically, fashion products usually have shorter life

cycles and higher levels of demand uncertainties than the functional products. Therefore,

different information management strategies would be needed to manage for different

types of products especially in the presence of supply chain risks. For this reason, we

shall classify the work in this section according to the product types: fashion products and

functional products.

5.1. Information Management Strategies for Managing Fashion Products

As articulated in section 4, reducing the standard deviation of the demand over the

replenishment lead time would result in inventory reduction for the entire supply chain.

When managing products with short life cycles, short replenishment lead times could

enable a retailer to place more than one order over the selling season. For example,

various researchers consider a situation in which a retailer can place two orders over the

selling season. Specifically, the retailer can place one order prior to the beginning of the

selling season and another order during the selling season. In the fashion goods industry,

this type of replenishment system is called the “quick response” system. Clearly, the

second order provides a great opportunity for the retailer to obtain more accurate demand

forecast by using the actual sales data. Fisher and Raman (1996) develop a two-period

stochastic dynamic programming model with demand forecast updating to analyze the

quick response system. By implementing their model at a skiwear company called

Obermeyer, they illustrate how the quick response system would enable Obermeyer to

achieve a higher customer service level with a lower level of inventory. The reader is

referred to Raman (1998) for a review of quantitative models of quick response systems.

Gurnani and Tang (1999) analyze a similar quick response system except that the unit

cost for the second order is uncertain. By formulating the problem as a two-period

dynamic programming problem, they show that an order-up-to level policy is optimal.

Instead of focusing on the retailer’s perspective, Iyer and Bergen (1997) and Iyer (1998)

analyze the impact of a quick-response system on both retailers’ and manufacturers’

inventories. Specifically, they show that, when the customer service level is at least 0.5,

the quick-response system is not Pareto in the sense that the retailer would obtain a

higher expected profit and the manufacturer would achieve a lower expected profit. They

develop conditions under which a quick-response system is beneficial to both the retailers

and manufacturers. Donohue (2000) considers a variant of the quick-response system in

which the retailer can place their orders in two modes: low cost with long lead time and

high cost with short lead time. By formulating the problem as a two-period dynamic

programming problem, she derives an optimal ordering policy and an optimal contract

that coordinates the supply chain.

All quick response models assume that the manufacturer can always fill the second orders

placed by the retailers. However, as articulated in the Benetton case prepared by

Signorelli and Heskett (1984), manufacturers may not be able to guarantee complete

fulfillment of the second order. Smith et al. (2002) investigate the retailer’s optimal order

quantities, the retailer’s profit, and the manufacturer’s profit for the case when the

manufacturer can fulfill the second order partially. By considering a stylized model, they

show that the manufacturer should provide either complete fulfillment or no fulfillment

of the second orders when the underlying demand distribution is either uniform or

exponential. Specifically, they show analytically that partial fulfillment of the second

orders is never optimal for the manufacturer.

5.2. Information Management Strategies for Managing Functional Products

When managing products with long life cycles, market information is critical for

generating accurate demand forecasts. However, since wholesalers, distributors,

manufacturers, and suppliers are farther remove from the consumer market, they usually

do not have first-hand market information such as point of sales data, customers’

preferences, and customer response to various pricing and promotion strategies. Instead,

upstream supply chain partners usually generate their demand forecasts based on the

orders placed by their downstream partners. Planning according to the orders placed by

the downstream partners would create a phenomenon called the “bullwhip effect” that

was coined by Procter and Gamble. Essentially, the bullwhip effect depicts the

phenomenon in which the orders exhibit an increase in variability up the supply chain,

even when the actual customer demands were fairly stable over time (c.f., Sterman

(1989)). The increase in variability of the orders up the supply chain can cause many

problems for the upstream partners including higher inventory, lower customer service

level, inefficient use of production and transportation capacities, etc. In order to mitigate

the bullwhip effect, one needs to identify the root causes.

Lee et al. (1997b) is the first to show that the bullwhip effect can occur even when every

supply chain partners operate optimally and rationally. The bullwhip effect has also been

shown independently by Bagahana and Cohen (1998). To establish the existence of the

bullwhip effect, Lee et al. develop a 2-level supply chain that consists of a retailer and a

manufacturer. They assume that the retailer “knows” that the underlying demand process

follows an auto-regressive process AR(1) so that the demand in period t, denoted by D

is equal to:

ttt

DdD

++=

−1

Notice that d represents the base demand level, ρ represents the correlation of demands

in successive periods, where |ρ| < 1, and ε

represents the error term that is normally

distributed with mean 0 and standard deviation σ . Lee et al. (1997b) consider the case

in which the retailer would act rationally by following an order-up-to level policy and by

placing an order Q

in period t. To show that the bullwhip effect occurs, they prove that

Var(Q

) ≥ Var(D

More recently, Gilbert (2005) generalizes Lee et al. model by considering a more general

demand process than the AR(1) process that is known as the Autoregressive Integrated

Moving Average (ARIMA) time-series. When the underlying demand process is an

ARIMA process, Gilbert shows that the order quantity Q

associated with the order-up-

to level policy is also an ARIMA process. Li et al. (2005) develop a simulation model

for the case when the demand process is an ARIMA process. By varying the values of

the parameters associated with the ARIMA process, they show that the bullwhip effect

does not always occur. More importantly, they discover an “anti-bullwhip effect” that

would occur for certain values of the parameters by showing that Var(Q

) ≤ Var(D

);

i.e., the variance of the order quantity is lower than the variance of the demand.

While Lee et al. (1997b) show that the bullwhip effect will occur when the retailer has

knowledge about the demand distribution, Chen et al. (1998), (2000a) and (2000b)

investigate the occurrence of the bullwhip effect for the case when the retailer does not

know the underlying demand process follows an AR(1) process; however, the retailer

would use a moving average or an exponential smoothing method to forecast future

demands. They show that the bullwhip effect will occur and that the bullwhip effect will

be larger when the retailer uses an exponential smoothing forecast instead of a moving

average forecast. More recently, Zhang (2004) extends the work of Chen et al. by

examining the impact of different forecasting methods on the bullwhip effect.

To mitigate the bullwhip effect, Lee et al. (1997c) identify four root causes of the

bullwhip effect: demand forecasting, batch ordering, supply shortage, and price

variations. In addition, they propose strategies for mitigating the bullwhip effect

including: information sharing, vendor managed inventory, and collaborative forecasting

and replenishment planning. We now review articles that examine the benefits of these

three strategies.

5.2.1. Information Sharing

Lee et al. (2000) study the benefits of information sharing in a two-level supply chain.

They consider the case in which the retailer has the information about the underlying

demand distribution (i.e., an AR(1) process) and the retailer would order according to an

order-up-to policy in each period. When there is no information sharing, the

manufacturer has the information about the underlying demand distribution and the

retailer’s ordering policy; however, the manufacturer does not have the information about

the actual demand realized in period t (i.e., the manufacturer does not know the

realization of the error term ε

in period t). When there is information sharing, the

retailer would share the information about the actual demand realized in period t as well.

By assuming that there exists a reliable exogenous source of inventory, information

sharing has no impact on the retailer because the retailer’s orders are always received in

full. By examining the inventory level and the relevant costs incurred by the retailer and

the manufacturer, Lee et al. show analytically that information sharing is beneficial to the

manufacturer, not the retailer. Moreover, information sharing is most beneficial to the

manufacturer especially when the correlation coefficient ρ is high. Also, in order to

entice retailer to share demand information with the manufacturer, Lee et al. suggest

various mechanisms including price discount and replenishment lead time reduction.

Cheng and Wu (2005) extend Lee et al.’s model to the multi-retailer case and they

conclude that information sharing would enable the manufacturer to reduce both the

inventory level and the total expected cost. Lee et al. commented that information

sharing would be less valuable to the manufacturer if the manufacturer uses the historical

stream of orders from the retailer to forecast demand. Raghunathan (2001) confirms this

idea analytically when the underlying demand is an AR(1) process. More recently, Gaur

et al. (2005) extend Raghunathan’s model to the case in which the demand process is a

more general process than the AR(1) process, namely, the AR(p) process for p ≥ 1 and

the autoregressive moving-average process ARMA process.

By assuming that the underlying demand is independent and identically distributed,

Gavirneni et al. (1999) develop a model to examine the benefits of information sharing

for the case in which the manufacturer has limited production capacity. In their model,

the retailer has the information about the underlying demand distribution and the retailer

would order according to an (s, S) policy. Under the (s, S) policy, the retailer would

place an order in a period only when the inventory level drops below s. When there is no

information sharing, the manufacturer has the information about the underlying demand

distribution and the retailer’s ordering policy; however, the manufacturer does not have

the information about the retailer’s inventory level. When there is information sharing,

the retailer would share the information about the actual inventory level with the

manufacturer in each period. They show that information sharing is beneficial to the

manufacturer especially when the manufacturer’s production capacity is higher or when

the demand uncertainty level is moderate. Cachon and Fisher (1997) and (2000) analyze

the benefits of information sharing for the N-retailer case in which the manufacturer has

limited production capacity. By assuming that each retailer implements a (R, nQ) policy,

they show analytically that information sharing is beneficial to the retailer and the

manufacturer. In addition, Cachon and Fisher (2000) show numerically that lead time

reduction will be more beneficial than information sharing.

Zhao et al. (2002) develop a simulation model to examine the impact of forecasting

methods such as moving average, exponential smoothing, and Winters’ method, etc., on

the value of information sharing in a supply chain that has 1 manufacturer and N retailers.

They show that the cost savings for the entire supply chain are more substantial when the

retailers share information about future orders with the manufacturer than the case in

which the retailers share information about the customer demand. While many

companies reported that sharing information (such as customer demand, inventory level,

or demand forecast) among supply chain partners is beneficial, there are several obstacles

for supply chain partners to share private information. For instance, retailers are reluctant

to share information with the manufacturer because of fear (lower bargaining power,

information leakage, etc.). Besides fear, there are other problems associated with

forecast sharing in practice. Terwiesch et al. (2005) articulate that when a retailer revises

his forecasts (or soft orders) frequently before placing a firm order, the manufacturer may

ignore the revisions. Also, when a manufacturer is unable to fulfill the firm order in one

period, the retailer may inflate his soft orders in future periods to ensure sufficient supply.

As such, this could lead to a lose-lose situation. By using the data collected from a

semiconductor company, Terwiesch et al show empirically that the manufacturer would

penalize the retailer for unreliable forecasts by delaying the fulfillment of forecasted

orders. Also, they show that the retailer would inflate their orders in the form of

excessive order cancellations. Therefore, both manufacturer and retailer would lose

when sharing forecast information.

5.2.2. Vendor Managed Inventory

As articulated in Lee et al. (2000), information sharing is beneficial to the manufacturer

not the retailer. As such, many manufacturers develop various initiatives to entice the

retailer to share demand information with the manufacturer. Besides offering price

discount, various manufacturers launched an initiative called Vendor Managed Inventory

(VMI). Under the VMI initiative, the retailers delegate the ordering and replenishment

planning decisions to the manufacturer. In return, the manufacturer gains direct

information access regarding customer demand and retailers’ inventory positions. To

ensure that the retailer will achieve higher customer service levels with lower inventory

costs, the manufacturer either owns the inventory at the retailer’s warehouse subject to a

minimum inventory level or issues some form of promises that the inventory at the

retailer’s warehouse will stay within certain pre-specified limits.

Under the VMI initiative, the retailer can reduce the overhead and operating costs

associated with replenishment planning, while enjoying certain guaranteed service levels.

Even though the manufacturer takes on the burden to manage the retailer’s inventory

under the VMI initiative, the manufacturer can derive the following benefits: (1) reduced

bullwhip effect due to direct information access regarding customer demands and (2)

reduced production/logistics/transportation cost due to coordinated production /

replenishment plans for all retailers. Disney and Towill (2003) develop a simulation

model to analyze the bullwhip effect under the VMI initiative. Their simulation results

confirm that VMI can reduce the bullwhip effect by 50%. Clearly, reducing the bullwhip

effect and coordinated planning would enable the manufacturer to reduce inventory.

Johnson et al. (1999) examine the performance of VMI in different settings: (a) the

manufacturer has limited capacity and (b) some retailers adopt the VMI scheme while the

remainders adopt the information sharing scheme. By considering the case that VMI

would enable the manufacturer to coordinate the replenishment plan by consolidating the

customer demands (instead of orders placed by the retailers), they show that VMI would

reduce inventories for the manufacturer and the retailer.

Aviv and Federgruen (1998a) develop an analytical model to evaluate the retailer’s and

the manufacturer’s operating cost under an information sharing scheme and an VMI

initiative. Under both systems, the manufacturer has information about customer

demand. However, the replenishment plans are determined by the retailers under the

information sharing scheme, while the manufacturer decides on the timing and magnitude

of the replenishment shipments to the retailers. Therefore, under the information sharing

scheme, the effective demand process faced by the manufacturer is essentially the

superposition of orders placed by the retailers in an uncoordinated manner. By

considering that the underlying demand distribution is normal and by using the fact that

the manufacturer has the authority to coordinate the customer demands under the VMI

initiative, Aviv and Federgruen show that the manufacturer can reduce the production

and inventory costs under both systems. To examine further about the benefit of the VMI

initiative under which the manufacturer has the authority to determine the delivery

schedule and the delivery quantity for each retailer, Cetinkaya and Lee (2000) presents an

analytical model for determining an optimal coordinated replenishment and delivery plan

for different retailers located in a given geographical region. By assuming that the

demands at the retailers are independent Poisson processes, they compute an optimal

replenishment quantity and delivery schedule that minimizes the total production,

transportation and inventory carrying costs while meeting certain customer service levels.

Besides the analytical models that examine the benefits of the VMI initiative, there are

other studies that are based on simulation models. The reader is referred to Sahin and

Robinson (2005) and the references therein. Several retailers and manufacturers reported

successful implementations of VMI. For example, Clark and Hammond (1997) show

that the VMI initiated by Campbell Soup provided a win-win situation for Campbell

Soup and the retailers. For additional examples of successful implementations of VMI,

the reader is referred to Aviv and Federgruen (1998a), Cetinkaya and Lee (2000), and the

references therein.

5.2.3. Collaborative Forecasting

Under the information sharing scheme or the VMI initiative, not much collaborative

effort is needed. To induce collaboration between the retailers and the manufacturers,

Voluntary Inter-industry Commerce Standards (VICS) association developed an initiative

called Collaborative Planning, Forecasting and Replenishment (CPFR). Under this

initiative, both parties would develop mutually agreeable demand forecasts jointly. To

develop mutually agreeable demand forecasts, the manufacturer would generate an initial

demand forecast based on his market intelligence on products, and the retailer would

create her own initial demand forecast based on customer’s response to pricing and

promotion decisions. Both parties would share their initial demand forecasts and would

reconcile the differences in their forecast to obtain a common forecast. Once both parties

agree on the common demand forecasts, the retailer would develop a replenishment plan

and the manufacturer would develop a production plan independently. The reader is

referred to www.cpfr.org for more details.

The crux of CFPR is collaborative forecasting. Aviv (2001) is the first to develop a

framework for modeling the collaborative forecasting process between a retailer and a

manufacturer. To specify the demand process when there is no collaborative forecast, he

specifies the demand process based on an individual party p’s perspective, where p = r,

m, where r denotes the retailer and m denotes the manufacturer. Specifically, when

there is no collaborative effort, the underlying demand process D

from party p’s

perspective is given by:

εψ

++= , for p = r, m,

where d represents the base demand level, ψ

represents the cumulative forecast

adjustment made by party p in past periods up to the beginning of period t, and ε

represents the residual forecast error of party p’s forecasting method.

By considering the correlation between ψ

and ψ

, one can capture the correlation

between the forecast adjustments made by the retailer and the manufacturer. Under the

collaborative forecasting initiative, Aviv assumes that the retailer and the manufacturer

would select the best forecast adjustment ψ

so that the forecast error is minimized.

Based on this specific construct, Aviv computes the optimal collaborative forecast

adjustment in each period. For the retailer, he computes the variance of the total demand

over the replenishment lead time under no collaborative forecast and under collaborative

forecast. For the manufacturer who needs to satisfy the order placed by the retailer, he

computes the mean and the variance of the total aggregate order quantity to be placed by

the retailer under no collaborative forecast and under collaborative forecast. Even when

these quantities can be expressed in closed form expressions, it is intractable to evaluate

the benefit of collaborative forecast analytically. As a surrogate, Aviv develops an

aggregate supply chain performance measure that is based on the variance of the whole

system: the sum of the variance of the total demand over the retailer’s replenishment lead

time and the variance of the total order quantity over the manufacturer’s replenishment

lead time. Aviv (2001) shows analytically that collaborative forecast would reduce the

system-wide variance. In Aviv (2002), he extends the analysis presented in Aviv (2001)

to the case in which the demand is auto-correlated. Specifically, he considers the case in

which the demand process possesses the following form:

ttt

DdD

εψρ

+++=

−1

, for p = r, m.

In Aviv (2005), he extends the analysis to the case in which the manufacturer operates in

an environment that calls for production smoothing.

As articulated in Aviv (2001), it is very difficult to evaluate the benefit of CPFR

analytically even for a two-level supply chain. Therefore, many of the comparisons are

conducted numerically. While these numerical examples generate insights, there is no

guarantee that these insights are applicable to a more realistic supply chain. This

observation has motivated Boone et al. (2002) to develop a simulation model to compare

the performance of the CPFR initiative with the performance of a traditional

replenishment policy based an a reorder point. By using the data collected from a

Fortune-500 company and by using a simple process to generate demand forecast, their

simulation model suggests that CPFR would increase customer service level and reduce

inventories for both the manufacturer and the retailer. The reader is referred to Aviv

(2004) for a comprehensive review of CPFR literature.

Information

Management Issue

Sub-category

References (in the order of appearance)

Information

Management

General Fisher (1997)

Managing Products

with Short Life Cycles

General Fisher and Raman (1996), Gurnani and Tang (1999), Iyer and

Bergen (1997), Iyer (1998), Donuhue (2000), Signorelli and

Heskett (1984), Smith (2002)

Managing Products

with Long Life Cycles

General Sterman (1989), Lee et al. (1997b), Bagahana and Cohen (1998),

Gilbert (2005), Li et al. (2005), Chen (1998), (2000a) (2000b),

Zhang (2004), Lee (1997c)

Information Sharing Lee et al. (2000), Cheng and Wu (2005), Raghunathan (2001),

Gaur et al. (2005), Gavirneni et al. (1999), Cachon and Fisher

(1997), Cachon and Fisher (2000), Zhao et al. (2002), Terwiesch

et al. (2005)

Vendor Managed

Inventory

Lee et al. (2000), Disney and Towill (2003), Johnson et al. (1999),

Aviv and Federgruen (1998a), Cetinkaya and Lee (2000), Sahin

and Robinson (2005), Clark and Hammond (1997)

Collaborative

Forecasting

Aviv (2001), Aviv (2002), Boone et al (2002), Aviv (2004)

Table 5. Summary of Information Management Articles.

6. Managing Supply Chain Risks

Upon examining the underlying assumptions of the models reviewed so far, it appears

most of the quantitative models are designed for managing operational risks. Even

though these quantitative models often provide cost effective solutions for managing

operational risks, there do not address the issue of disruption risks in an explicit manner.

Before we present some potential research ideas for managing supply chain disruption

risk in the next section, we shall examine how disruptions risks are managed in practice

and relate these practices to the models reviewed earlier. After reviewing some

qualitative analyses presented in various risk management and supply chain risk

management articles, we can summarize the key findings as follows:

1. Managers’ attitude towards risks. Sharpira (1986) and March and Sharpira (1987)

study managers’ attitude towards risks and they conclude that:

• Managers are quite insensitive to estimates of the probabilities of possible

outcomes.

• Managers tend to focus on critical performance targets, which affect the way they

manage risk.

• Managers make a sharp distinction between taking risks and gambling.

The first conclusion can be explained by the fact that managers do not trust, do not

understand, or simply do not much use precise probability estimates. This is consistent

with the results obtained by other researchers (c.f., Kuneuther (1976), Fischoff et al.

(1981)). Since managers are insensitive to probability estimates, March and Sharpira

(1986) noted that managers are more likely to define risk in terms of the magnitude of

loss such as “maximum exposure” or “worst case” instead of expected loss defined

earlier. The second conclusion is based on the observation that most managers are

measured by a set of performance targets. March and Sharpia (1986) argue that these

performance targets would cause the managers to become more risk averse (or risk

prone) when their performance is above (or below) certain target. Finally, the third

conclusion is driven by the fact that companies tend to reward managers for obtaining

“good outcomes” but not necessarily for making “good decisions.”

2. Managers’ attitude towards initiatives for managing supply chain disruption

risks. According to various major case studies conducted by Closs and McGarrell

(2004), Rice and Caniato (2003) and Zsidisin et al. (2001) and (2004b), they concluded

that:

• Most companies recognize the importance of risk assessment programs and use

different methods, ranging from formal quantitative models to informal

qualitative plans, to assess supply chain risks. However, most companies invested

little time or resources for mitigating supply chain risks.

• Due to few data points, good estimates of the probability of the occurrence of any

particular disruption and accurate measure of potential impact of each disaster are

difficult to obtain. This makes it difficult for firms to perform cost/benefit

analysis or return on investment analysis to justify certain risk reduction programs

or contingency plans.

• Firms tend to underestimate disruption risk in the absence of accurate supply

chain risk assessment. As reported in Kunreuther (1976), many managers tend to

ignore possible events that are very unlikely. This may explain why few firms

take commensurable actions to mitigate supply chain disruption risks in a

proactive manner. As articulated in Repenning and Sterman (2001), firms rarely

invest in improvement programs in a proactive manner because “nobody gets

credit for fixing problems that never happened.”

6.1. Robust Strategies for Mitigating Operational and Disruption Risks

In the absence of accurate measures of the probability of an occurrence of a major

disruption and the potential impact of a disruption, Tang (2005) argue that firms will

become more willing to implement certain “robust” supply chain strategies for mitigating

disruption risks if these strategies possess two specific properties:

• Efficiency – the strategy would enable a firm to manage operational risks

efficiently regardless of the occurrence of major disruptions.

• Resiliency – the strategy would enable a firm to sustain its operation during a

major disruption and recover quickly after a major disruption. The reader is

referred to Christopher (2004), Chopra and Sodhi (2004), and Lee (2004) for

different approaches for establishing resilient supply chains.

Tang’s argument is based on the fact that efficiency and resiliency are critical for firms to

ensure profitability and business continuity, which is congruent with the definition of

supply chain risk management defined in Section 1. Also, when a robust strategy is

efficient, most firms can perform cost/benefit analysis or return on investment to justify

strategies for improving efficiency under operational risks. As such, the management is

more willing to implement a strategy that would enhance the efficiency and resiliency.

Upon reviewing the strategies reviewed in Sections 2, 3, 4, and 5 along with the strategies

firms have implemented for mitigating operational and disruption supply chain risks, we

now highlight certain robust strategies for improving the efficiency and resiliency of a

supply chain.

6.2. Robust Supply/Demand/Product/Information Management Strategies

6.2.1. Robust Supply Management Strategies

Among the supply management strategies described in Section 2.4, it appears the multi-

supplier strategy is the most common approach for reducing supply chain risks. For

example, both Sheffi (2001) and Kleindorfer and Saad (2005) recommend the use of

multiple suppliers as a way to manage supply chain operational and disruption risks. For

example, as articulated in Huchzermeier and Cohen (1996) and others, spreading multiple

suppliers in multiple countries would enable a firm to manage operation risks such as

normal exchange rate fluctuations efficiently. In addition, having multiple suppliers in

multiple countries can make a supply chain more resilient during a major disruption. For

example, When Indonesia Rupiah devalued by more than 50% in 1997, many Indonesian

suppliers were unable to pay for the imported components or materials, and, hence, were

unable to produce the finished items for their U.S. customers. However, with a network

of 4,000 suppliers throughout Asia, Li and Fung (www.lifung.com), the largest trading

company in Hong Kong for durable goods such as textiles and toys, shifted some

production from Indonesia to suppliers in other Asian countries. Also, Li and Fung

provided financial assistance such as line of credit, loans, etc., to those affected suppliers

in Indonesia to ensure that their U.S. customers would receive their orders as planned.

The reader is referred to McFarlan (2002) for details.

In many instances, the buyer does not have the luxury to shift production among different

suppliers because of the very limited number of suppliers available in the market. To

cultivate additional suppliers, certain supply contracts described in Section 2.5 could

serve as robust strategies that would make a supply chain more efficient and resilient.

For instance, revenue (or risk) sharing contracts are known to be efficient because it can

coordinate the channel partners when facing uncertain demand (c.f., Pasternack (2002)).

In addition, revenue sharing contracts could make a supply chain more resilient. For

example, due to uncertain specification of the flu vaccine in any given year, the uncertain

market demand, and the price pressure from the U.S. government, there are only two

remaining vaccine makers for the U.S. market. This has created a shortage of 48 million

flu shots in 2004 when Chiron’s Liverpool plant was suspended due to bacteria

contamination (c.f., Brown (2004)). To make the flu vaccine supply chain more resilient,

the U.S. government could consider offering certain risk sharing contracts to entice more

suppliers to re-enter the flu vaccine market. For instance, the government could share

some financial risks with the suppliers by committing a certain quantity of flu vaccine in

advance at a certain price and buy back the unsold stocks at the end of the flu season at a

lower price. With more potential suppliers, the U.S. government would have the

flexibility to change their orders from different suppliers quickly when facing major

disruptions.

6.2.2. Robust Demand Management Strategies

There are at least two robust demand management strategies reviewed in Section 3.

First, as described in Section 3.3, there are many demand management strategies that

would enable a supply chain to shift demand across products. By having the capability to

shift demand across products, these strategies can make a supply chain more efficient and

resilient. For example, in Section 3.3.1, when facing uncertain demand, Chod and Rudi

(2005) present a responsive pricing strategy that would enable a firm to increase profit by

shifting demand across products. Hence, a responsive pricing strategy would improve

supply chain efficiency. In addition, a responsive pricing strategy could improve supply

chain resiliency as well. For example, when facing a supply disruption of computer parts

from Taiwan after an earthquake, Dell immediately offered special price incentives to

entice their online customers to buy computers that utilized components from other

countries. The capability to shift customer choice swiftly enabled Dell to improve its

earnings in 1999 by 41% even during a supply crunch (c.f., Veverka (1999)).

Besides the responsive pricing strategy described in Section 3.3, the demand

postponement strategy described in Section 3.1. can be a robust demand management

strategy that would enhance supply chain efficiency and resiliency. Under the demand

postponement strategy, a manufacturer may offer price discounts to some retailers to

accept late shipments. Essentially, this strategy is akin to the overbooking situation in

which an airline may offer incentive to entice a fraction of customers who are willing to

take a later flight. By having the capability to shift some of the demands to a later period,

it would certain help a firm to manage both operational risks and disruption risks.

6.2.3. Robust Product Management Strategies

Among the product management strategies reviewed in Section 4, the postponement

strategy described in Section 4.1 is a robust strategy for enhancing the efficiency and the

resiliency of a supply chain. As reported in Lee (1996), postponement is an effective

strategy for improving supply chain efficiency when facing uncertain demands for

different products. In addition, the postponement strategy can increase supply chain

resiliency. For example, after Philip’s semiconductor plant was damaged in a fire in

2000, Nokia was facing a serious supply disruption of radio frequency chips. Since

Nokia’s cell phones are designed according to the modular design concept, Nokia was

able to postpone the insertion of these radio frequency chips until the end of the assembly

process. Due to this postponement strategy, Nokia was able to reconfigure the design of

their basic phones so that the modified phones could accept slightly different chips from

Philip’s other plants and other suppliers. Consequently, Nokia satisfied customer

demand smoothly and obtained a stronger market position. The reader is referred to

Hopkins (2005) for details.

6.2.4. Robust Information Management Strategies

As reported in Section 5, strategies based on information sharing, vendor managed

inventory, or collaborative forecasting and replenishment planning would increase

“supply chain visibility” in the sense that the upstream partners have access to

information regarding the demand and inventory position at downstream stages. As

supply chain visibility improves, each supply chain partner can generate more accurate

forecast of future demands and better coordination. We have described various articles

in Section 5 that show how these strategies would enable a supply chain to become more

responsive to customer demand with less inventory and lower cost. Hence, the

information management strategies reported in Section 5 would increase supply chain

efficiency. However, we are unable to find examples that show how these information

management strategies would increase supply chain resiliency. In the absence of

specific examples, we have reasons to believe that the CPFR strategy can enable a supply

chain to develop a production planning system that would improve resiliency. While

Aviv (2005) discuss the mechanism for supply chain partners to generate a common

demand forecast in a collaborative manner, we are not aware of specific models in the

literature that deal with the collaborative replenishment planning. We envision a more

complete CPFR system may improve supply chain resiliency. For example, consider a

CPFR system in which all supply chain partners generate a common demand forecast,

share inventory information, and adopt a common ordering rule that is based on the

“proportional restoration rule” developed by Denardo and Tang (1992). Specifically,

under the proportional restoration rule, the retailer would order Q

and the manufacturer

would order Q

in period t, where:

.])()[()(

ITITdQandITdQ

αα

−+−+=−+=

Notice that d represents the common demand forecast, T

represents the “target”

inventory position for party p, I

represents the inventory held at party p at the

beginning of period t, and 0 < α

≤ 1 represents party p’s restoration factor, where p

= r, m. Denardo and Tang (1992) use various numerical examples to show that this

ordering rule is efficient. In addition, Denardo and Tang (1996) show analytically that

this ordering rule would “restore” the inventory level at each stage to its target even when

the demand forecast d is inaccurate. Thus, one can conclude that such a CPFR system

would improve supply chain efficiency and resiliency.

7. Conclusions

In this paper, we have reviewed various quantitative models for managing supply chain

risks. We found that these quantitative models are designed for managing operational

risks primarily, not disruption risks. However, we argue that some of these strategies

have been adopted by practitioners because these strategies can make a supply chain

become more efficient in terms of handling operational risks and more resilient in terms

of managing disruption risks.

Since there are few supply chain management models for managing disruption risks, we

would like to present six potential ideas for future research.

1. Demand and Supply Process. Virtually all models reviewed in this paper are

based on the assumption that the demand or the supply process is stationary. To

model various types of disruptions mathematically, one may need to extend the

analysis to deal with non-stationary demand or supply process. For instance, one

may consider modeling the demand or the supply process as a “jump” process to

capture the characteristics of major disruptions.

2. Objective Function. The performance measures of the models reviewed in this

paper are primarily based on the expected cost / profit. The expected cost / profit

is an appropriate measure for evaluating different strategies for managing

operational risks. When dealing with disruption risks that rarely happen, one may

need to consider alternative objectives besides the expected cost / profit. For

instance, Sharpira (1986) and March and Sharpira (1987) articulated that

managers tend to focus on performance targets. Hence, when developing

strategies for managing supply chain disruption risks, one may consider using

certain performance targets such as recovery time after a disruption. The reader is

referred to Brown and Tang (2005) and the references therein regarding various

alternative performance targets in the context of single-period inventory models.

3. Supply Management Strategies. When developing supply management

strategies for managing disruption risks, both academics and practitioners suggest

the idea of “back-up” suppliers. To capture the dynamics of shifting the orders to

these back-up suppliers when a major disruption occurs, one need to develop a

model for analyzing dynamic supply configurations of suppliers including

contract manufacturers, transportation providers, and distribution channels.

4. Demand Management Strategies. Among the demand management strategies

presented in Section 3, it appears that dynamic pricing / revenue management has

great potential for managing disruption risks because a firm can deploy this

strategy quickly after a disruption occurs. In addition, revenue management looks

promising especially after successful implementations of different revenue

management systems in the airline industry for managing operational risks.

5. Product Management Strategies. When selling products on line, e-tailers can

change their product assortments dynamically according to the supply and

demand of different products. This idea can be extended to brick and mortar

retailers for managing disruption risks. Chong et al. (2001) show that store

manager can manipulate customer’s product choice and customer’s demand by

reconfiguring the set of products on display, the location of each product and the

number of facings of each product. They suggest that one can utilize dynamic

assortment planning to entice customers to purchase certain products that are

widely available (when other products are in short supply).

6. Information Management Strategies. Among the information management

strategies described in Section 6, we think the Collaborative Planning, Forecasting

and Replenishment (CPFR) strategy is promising because it fosters a tighter

coordination and stronger collaboration among supply chain partners. While

Aviv (2005) develops a mechanism for generating collaborative forecasts, there is

no model that captures the collaborating replenishing planning. It is conceivable

that the value of a more complete CPFR system is much higher than a system that

is solely based on collaborative forecasting.

While the number of supply chain research articles published over the last 10 years has

grown exponentially on a yearly basis, we believe this trend will continue because there

are plenty of new research areas to explore including strategies for managing supply

chain disruption risks, the impact of RFID technology on supply chain management, and

the impact of government policies on supply chain management. Looking ahead, we

believe that supply chain management will continue to be a fertile research area.

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