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Graduate School of Management, Korea Advanced Institute of Science and Technology (KAIST), 207-43 Cheongryangri Dongdaemoon,
Seoul 130-012, South Korea
Received 1 July 1998; accepted 1 January 1999
Abstract
The importance of a long-term relationship between a manufacturing rm and its supplier(s) has been emphasized in
the literature on supply chain management. Essential to such a relationship is the coordination among participants in a
supply chain. In order to sustain the relationship, the coordination should enhance the protability of not only the
manufacturer, but also the supplier(s). In this paper, we consider a particular supply chain situation in which the
manufacturer coordinates, e.g., supports, its supplier's innovation that can eventually lead to supply cost reduction.
Developing a mathematical model, we show that although the coordination could improve the manufacturing rm's
own protability, it might not be attractive to the supplier unless the supply cost reduction should ultimately increase
the market demand to a certain extent. Under particular circumstances, if the market demand stays constant, the
manufacturer's prot increase due to the coordination equals the amount of prot loss to the supplier. The analysis
presents exact mathematical criteria to determine whether the coordination strategy can be agreeable to both the
manufacturer and the supplier. Numerical examples are employed to show the applicability of the criteria. 2000
Elsevier Science B.V. All rights reserved.
Keywords: Purchasing; Supply chain management; Optimal control theory; Supplier innovation
1. Introduction
Studies on supply chain management have
emphasized the importance of a long-term strategic relationship between a manufacturing rm and
its suppliers (Spekman, 1988; Doyle, 1989; Choi
and Hartley, 1996). The fundamental assumption
underlying this emphasis is that the long-term re-
0377-2217/00/$ - see front matter 2000 Elsevier Science B.V. All rights reserved.
PII: S 0 3 7 7 - 2 2 1 7 ( 9 9 ) 0 0 1 1 3 - 7
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570
571
Table 1
Comparison of the two models
Simple model (Section 2.1)
Manufacturing capacity
Demand structure
Competitive market
Price, p given
Deterministic demand
Decision impact
Demand information
Analysis
product's market price, the larger the market demand for the product. This situation might be
comparable with an oligopolistic or monopolistic
market condition, where a rm can increase the
market demand by lowering the product price.
How sensitive is the market demand response to
the price change will be an important component
to be determined in the analysis. Table 1 compares
the two models analyzed in this paper.
In addition, for analytical simplicity without
loss of generality, we assume that there is little
information delay between the manufacturer and
its supplier (Whang, 1993). Thus, we do not consider any ineciency due to an information distortion in the supply chain (Desiraju and
Moorthy, 1997).
2.1. A simple model: The case of constant market
demand
The rst simple model assumes constant production capacity and a given market price for the
product. In this situation, the manufacturing rm
cannot unilaterally lower its price to attract more
demand. But, it can try to reduce the cost so as to
increase the prot. The production capacity of the
manufacturing rm, i.e., essentially the market
572
Dp c1 c2 au dt;
subject to
x_ u
0 6 u 6 a;
2
x0 x0 1 specified:
As mentioned already, a is the manufacturer's total cost associated with supporting one innovation
project. We further assume that out of this a, cm is
Table 2
Summary of variables and parameters for the simple model
D: Production capacity (market demand) at t
p: Market price of the nished good
c1 : Internal unit production cost
c2 cxm : Supplier's unit supply cost to the manufacturer
c: Supply unit cost base
m
ln /m
ln v
573
We evaluate t by taking into account two conditions, kt a and kT 0. From Eqs. (6) and
(7) for t 6 t 6 T ;
m1
k_ cmDat 1
and
k cmDat 1m1 t k:
Since kT 0;
k cmDat 1
k cmDat 1
m1
m1
and
t T :
Finally,
kt cmDat 1
m1
t T a
m1
t T
a
:
cmD
574
am 1
Also from Theorem 2, the strategy can be acceptable to the supplier only if
n
o
D
c c^1 amt
bat > Dc c^T
am 1
> 0:
Therefore, the subsidy strategy would be adopted
by both manufacturer and supplier only if the two
inequality relationships are satised, i.e.,
n
o
D
c c^1 amt
bat > Dc c^T
am 1
> aat :
That is, a necessary condition must be met that
bat > aat , i.e., b > a. However, according to our
earlier argument about the `realistic condition' in
Appendix B, b < a holds rather than b > a. As a
result, we can state that in general, the subsidy
strategy cannot be acceptable to both manufacturer and supplier simultaneously if the market
575
while the product cost and its market price decreased together. In the following model, the price
is determined by the manufacturing rm as follows:
p r c1 cxm ;
r is the xed markup.
Then, Dt d1 d2 r c1 cxm .
It is practical to assume Dt d1 d2 r c1
cxm > 0 throughout the ensuing analysis: therefore, we focus on d2 that makes Dt > 0 valid.
Now the manufacturing rm faces the following optimization problem, (P2):
ZT
Maximize
rd1 d2 r d2 c1
J
0
d2 cxm au dt
subject to
x_ u;
0 6 u 6 a; x0 x0 1:
D d1 d2 p;
x at 1
x at 1
while t 6 t ;
while t > t :
576
d2 r c 1
1
am 1T
1 amt
T
c^ 1
am 1T
where
1
;
CA c 1
am 1T
1 amt
CB c^ 1
am 1T
m
m
and c^ cxt cat 1 :
c^t SB SA SF T SC SE SD
d1 d2
c^t SF T SE
states that the supplier subsidy strategy is acceptable to the supplier if and only if the total net
subsidy from the manufacturer should be larger
than the total revenue loss to the supplier.
Theorem 6. Given the conditions assumed in this
section, the manufacturing rm's strategy to support
its supplier innovation can be acceptable to both the
manufacturer and the supplier if and only if Eqs. (9)
and (10) are satised simultaneously. That is,
1
1 amt
c^ 1
T
d2 r c 1
am 1T
am 1T
> aat ;
n
o
bat > d1 c^t SF T SE
n
o
d2 c^t SB SA SF T SC SE SD :
As in the constant demand situation, if a > b is
held, the condition becomes
1
1 amt
T
c^ 1
d2 r c 1
am 1T
am 1T
n
o
> aat > bat > d1 c^t SF T SE
n
o
d2 c^t SB SA SF T SC SE SD :
11
Unlike Theorems 3 and 6 indicates that it could be
possible for both the manufacturing rm and its
supplier to become better o from manufacturer's
supporting the supplier innovation. Under what
circumstances Eq. (11) holds depends on many
factors such as characteristics of the market demand as expressed in d1 and d2 , decision time horizon captured by T, and the supplier innovation
capability embedded in m, i.e., its learning rate.
However, the most critical dierence between the
model assumptions is concerned with the nature of
the market demand structure. Therefore, in the
numerical examples, it is reasonable for us to ex-
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Table 3
Parameter values for numerical analysis
T
c1
cs
d1
/m
100
10
500
0.95
578
579
cycle that can benet most: in this kind of industry, we can expect a relatively small initial market
demand, but a huge potential for demand growth
as innovation occurs.
We have tried other parameter values and were
able to derive qualitatively similar conclusions.
However, the principal implication of this numerical exercise is to show that it is possible for
both manufacturer and supplier to get better o by
coordinating the supplier innovation if the market
demand for the nal product is sensitive to the
product price set by the manufacturing rm to a
certain extent. Despite being relied on numerical
examples, this is a quite strong conclusion since
Theorem 3 mathematically proved that this kind
580
Zt
581
J Dp c1 T c^DT t aat
n
o
D
c c^at 1 ;
am 1
where c^ cxt m cat 1m .
In order to evaluate whether the supplier subsidy strategy makes the manufacturing rm better
o, we need to compare the prot (J ) based on the
strategy with that involving no such supplier subsidy. Dene J0 as the total prot the manufacturing rm can earn without supporting its
supplier's innovation.
We can calculate
J0 Dp c1 cT :
A:2
A:3
am 1
Therefore, in order for the subsidy strategy to be
attractive to the manufacturing rm, it must be
that J > J0 or J J0 > 0. By combining
Eqs. (A.2) and (A.3), we obtain the necessary
condition for the protable supplier subsidy
strategy as
J J0 Dc c^T c^Dt aat
n
o
D
c c^at 1
am 1
n
o
D
c 1 amt ^
c
Dc c^T
am 1
Dp c1 cat 1 aa dt
aat > 0:
0
m
Dp c1 cat 1 T t :
A:1
Dp c1 cat 1 dt
t
Dp c1 cat 1m T t :
Therefore, the total manufacturer's prot becomes
Appendix B
We can calculate
J s
Zt
Dcat 1m cs ba dt
ZT
D^
c cs dt
t
B:1
582
where cs is the supplier's unit internal manufacturing cost: it can be either raw material cost or
other base cost that cannot be reduced through the
innovation.
Let's dene b as the net project benet the
supplier can obtain from the manufacturer's support for a unit project/experiment. If the cost the
supplier must spend in order to implement the
project/experiment is cs P 0 (it is the external expenses, i.e., direct cost, the supplier must pay to
conduct an innovation project), b cm cs . From
the manufacturer's perspective, the total cost per
project is a, while the supplier's net benet from
the support is only b, which remains within the
supplier after the project has been done: b becomes
an embedded asset to the supplier. In general, we
can impose a realistic constraint that cs < cm < a
and b cm cs < a cs < a.
Eq. (B.1) takes the particular form since the
supplier's net prot from supplying products (intermediate goods) to the manufacturer is Dcat
1m cs at t 6 t , but Dcat 1m cs at t such
that t < t 6 T .
Eq. (B.1) can be rewritten as
Appendix C
Each of the prots can be determined as follows:
Zt
J~
m
frd1 d2 r d2 c1 d2 cat 1 aag dt
ZT n
t
rd1 d2 r d2 c1 d2 cT d2 rc c^T
o
d2 r n
c c^1 amt aat : C:1
am 1
J~0 rd1 d2 r c1 cT
rd1 d2 r d2 c1 d2 cT :
J~ J~0 d2 rc c^T
D
^
cat 1 c
am 1
D
^
cat 1 c:
am 1
B:2
Therefore, if the supplier subsidy strategy is benecial to the supplier, it must be satised that
J s J0s > 0. From Eqs. (B.1) and (B.2), we have
the following.
J s J0s bat Dc c^T
n
o
D
c c^1 amt :
am 1
o
d2 r n
c c^1 amt aat > 0
am 1
implies
1
d2 r c 1
am 1T
1 amt
T > aat :
c^ 1
am 1T
c cT ba c^Dt
Dc cs T D^
C:2
c cs T t ba cs Dt
J s D^
o
rd1 d2 r d2 c1 d2 c^ dt
Appendix D
Applying the previous reasoning, we calculate
s
J~
Zt
cs bag dt
ZT nh
d1
t
i
o
c cs dt;
d2 r c1 c^ ^
D:1
D:2
n
o
bat > d1 c^t SF T SE
n
o
d2 c^t SB SA SF T SC SE SD ;
where
SA r c1 c c^ cs ;
SB r c1 c^ cs ;
SC r c 1 c s ;
h
i
1
c^2 at 1 c2 ;
a2m 1
h
i
1
c^at 1 c ; SF c c^:
SE
am 1
SD
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