Setup Cost Reduction and Supply Chain Coordination in Case of Asymmetric Information

Summary The model utilized in this paper captures a supply chain planning problem, in which the buyer asks the supplier to switch the delivery mode to Just-in-Time (JiT). We characterize the JiT mode with low order sizes. The buyer faces several multidimensional advantages from a JiTdelivery, which we aggregate to the buyer‘s holding costs per period. Hence, if the buyer faces high holding costs she is supposed to have high advantages from a JiT-delivery, and vice versa. On the other hand, smaller order sizes can cause an increase of the supplier‘s setup and distribution costs. In our modelling approach, the supplier‘s setup costs per period reect these disadvantages. Yet, it is well known that small order sizes are not sufficient for a successful implementation of the JiT concept. Setup cost reduction, thus, is regarded to be one main facilitator for JiT to be efficient. Our model depicts the need for accompanying process improvements by the supplier‘s option to invest in setup cost reduction (see [4]). From a supply chain perspective, an implementation of a JiT strategy will only be profitable, if the buyer`s cost advantages exceed the supplier`s cost increase. Yet, this is not always the case. The supplier, thus, may have a strong incentive to convince the buyer to abandon the JiT strategy, i.e. to accept higher order sizes. However, the buyer is supposed to be in a strong bargaining position and will not be convinced unless she is offered a compensation for the disadvantages of not implementing the JiT strategy. Yet, as long as pareto improvements are possible, the supplier can compensate the buyer while improving his own performance. Nonetheless, the above-mentioned advantages of a JiT strategy contain to a major extent private information of the buyer. Thus, they can not be easily observed and valued by the supplier. The buyer, thus, will apparently claim that switching towards higher order sizes causes substantial costs and that a high compensation is required. Assuming the strategic use of private information, it is in the supplier‘s best interest to offer a menu of contracts (see [1]). Basically, this menu of contracts aligns the incentives of the supply chain members such that a buyer with low advantages of a JiT delivery will agree upon higher order sizes than a buyer with high advantages of this supply mode. However, the incentive structure provided by this menu of contracts causes inefficiencies, because the resulting order sizes are too low compared to the supply chain‘s optimal solution. Starting from this insight, our main focus in this study is to analyse the impact of investments in setup cost reduction on this lack of coordination. Summing up, there are basically two streams of research (namely the inefficiencies due to asymmetric information and the optimal set-up cost reduction in an integrated lot-sizing decision) this paper combines.