Supply Risk Management: Financial Subsidies, Competition, and Asymmetric Information

1
Supply Risk Management Financial Subsidies,
Competition, and Asymmetric Information

• Volodymyr (Vlad) Babich
• Industrial and Operations Engineering
• University of Michigan

NSF DMII-0457445, NSF DMII-0539348
2
Outline

• Supply Risk Management
• Definition
• Examples
• Risk Management Tools
• Financial Subsidies
• Asymmetric Information
• Competition
• Challenges and Opportunities

3
Supply Risk Management. Definitions

• Supply chain management (Tang 2005 and V.B.)
• Management of material, information, and
  financial flows through a network of
  organizations (i.e., suppliers, manufacturers,
  logistics providers, financial institutions,
  wholesalers/distributors, retailers) that aims to
  produce and deliver products or services for the
  consumers and to meet objectives of the networks
  shareholders.
• Supply risk profile
• Joint distribution of events (probabilities and
  consequences) in supply chains that adversely
  affect supply chain capabilities to meet supply
  chain management objectives.
• Supply risk management
• Actions to alter supply risk profile

4
Supply Risks. Causes

• Natural disasters and pandemics
• Nokia vs. Ericsson 2000 (400m. loss)
• Aisin Seiki and Toyota 1997
• Hurricane Katrina 2005
• Taiwan Earthquake 1999 (Dell vs Apple)
• Bankruptcies
• UPF-Thompson (chassis) and Land Rover (Discovery
  model) 2001
• Delphi 2005
• Labor strikes
• California dockworker strike 2002 (retail goods
  shortage)
• Terrorism
• 9/11 (trucks delayed on Canadian border)
• Economy-wide financial shocks
• Bank runs
• IT failures and disruptions
• Changes in laws and regulations
• Fraud and human error

5
Supply Risks. Consequences

• Hendricks Singhal (2003, 2005a, 2005b)
• Declining operating performance
• 7 decline in sales growths, 11 increase in
  costs, 13 increase in inventories
• Declining market value (stock price)
• 10 abnormal return over two days following the
  announcement 40 abnormal return over 3 years

6
Supply Risks Management Tools

• Process improvement (risk culture)
• Risk assessment, due diligence and monitoring
• Chief Risk Officer and Risk Departments
• Contingency planning and training
• Collaboration with suppliers
• Insurance
• Finance
• Economic capital
• Financial securities (traded and OTC)
• Subsidies to suppliers
• Operations
• Internal fabrication
• Higher inventory
• Flexible production
• Multi-sourcing and back-up suppliers
• Marketing
• Demand management (CRM)
• Product design
• Modular product design

7
Supply Risks Management Tools. Main Drivers

• Process improvement (risk culture)
• Risk assessment, due diligence and monitoring
• Chief Risk Officer and Risk Departments
• Contingency planning and training
• Collaboration with suppliers
• Insurance
• Finance
• Economic capital
• Financial securities (traded and OTC)
• Subsidies to suppliers
• Operations
• Internal fabrication
• Higher inventory
• Flexible production
• Multi-sourcing and back-up suppliers
• Marketing
• Demand management (CRM)
• Product design
• Modular product design

Contingent Claims Benefits are incurred if an
event happens
Diversification Not perfectly correlated events
cancel each other
8
Typical Assumptions of Financial Risk Management.

• Distribution of asset returns cannot be affected
  by the composition of your portfolio or by buying
  or selling (for most investors)
• There is no private information that the buyers
  of financial assets can extract from the sellers

9
Features of Non-financial Risks. I

• Actions of some firms may affect the underlying
  risk processes
• E.g. we may be able to change distribution of Y
  by financial subsidies to the suppliers

10
Features of Non-financial Risks. II

• Multiple decision makers in supply chains
• Unlike the traditional financial portfolio
  problem, parameters (wholesale price, option
  price) are endogenously determined
• e.g. h and p may be affected by supplier
  competition

11
Features of Non-financial Risks. III

• Some firms might be better informed than others
  about supply chain risk profile (suppliers have
  more knowledge about Y )
• Screening, signaling, and moral hazard problems
• Use contract theory together with risk management
  tools to reduce uncertainty

12
Outline

• Supply Risk Management
• Definition
• Examples
• Risk Management Tools
• Financial Subsidies
• Asymmetric Information
• Competition
• Challenges and Opportunities

13
Dealing with Supplier Bankruptcies the Costs and
Benefits of Financial Subsidies

• Volodymyr Babich
• Industrial and Operations Engineering
• University of Michigan

NSF DMII-0457445
14
Delphi GM Visteon Ford

• Visteon Corp.
• Considered bankruptcy in 2005
• 65 of sales are to Ford
• Ford Motor Co.
• Agreed to pay 1.6 billion in May 2005 to buy
  back and restructure 24 Visteon factories

• Delphi Corp.
• Bankrupt in October 2005
• 17 billion in assets
• 22 billion in debt and
• 4 billion in pensions
• 51 of sales to GM
• General Motors
• Both GM and Delphi executives warned of possible
  supply disruptions
• MarketWatch (May 24, 2007) GMs costs related
  to Delphis bankruptcy amount to 7 billion

15
Research Questions

• How to model supplier financial state and its
  effect on supplier operational performance?
• What are costs and benefits of financial
  subsidies from manufacturers to suppliers?
• What are the optimal joint order and financial
  subsidy policies of the manufacturer?
• Should the manufacturer share supply chain profit
  with its suppliers?

16
Model and Assumptions

• Decision maker manufacturer
• One supplier
• Dynamic, periodic review capacity reservation
  model
• Actions of the manufacturer may affect supplier
  financial state and production capacity
• Risk-neutral manufacturer or risk-neutral
  valuation
• Risk-free rate r, ? er?, ? period length
• Customer demand i.i.d. random variables

17
Suppliers Financial State

• Evolution of suppliers assets value
• Bankruptcy conditions (Assets lt Liabilities)
• Effects of financial subsidies

A ( t )
1
2
3
0
t
18
Suppliers Financial State

• Evolution of suppliers assets value
• Bankruptcy conditions (Assets lt Liabilities)
• Effects of financial subsidies

A ( t )
1
2
3
0
19
Suppliers Financial State

• Evolution of suppliers assets value
• Bankruptcy conditions (Assets lt Liabilities)
• Effects of financial subsidies

A ( t )
1
2
3
0
20
Supplier Random Capacity

• z manufacturers order
• ? financial subsidy
• K effective capacity (depends on distance to
  bankruptcy)

Random shock
Capacity Function
21
Manufacturers Operational Costs

• For the realized demand, d, and supplier
  capacity, y
• Define
• We need functionto be convex

22
Manufacturers Operational Costs. Examples

• Price taker (newsvendor)
• Supplier cost is proportional to the capacity, y
• Linear demand curve
• Iso-elastic demand curve, 0 lt g 1

23
Manufacturers Problem

• Objective Minimize expected
• Decisions Constraints
• z order quantities
• q subsidy
• States
• A supplier assets

Cost of subsidies
Operational costs
24
The Optimal Order Quantity, z

• Proposition
• For any subsidy, q , the optimal order quantity,
  z, satisfies
• Corollary
• For the newsvendor model
• the optimal order quantity, z, is the solution
  of

Similar to Ciarallo, Akella, and Morton (1994)
25
DP Recursion.

• Bellman equation
• Constraints
• Transitions

New decision variable
26
Optimal Asset Level, a

• Proposition Assume that the terminal value
  function is convex and capacity function q is
  concave, thenare convex, and Vn are convex for
  all n. LetThe optimal asset level a max (
  Sn , An )

Subsidize Up-to Policy
27
Problem with Subsidies Reduce Liabilities Model

• q (? ) is not concave (it is convex)

is not convex
Operational cost
28
Optimal Subsidy, ?. Uniqueness

• First Order Condition
• Sufficient condition for the problem to be
  unimodal in q is for function to be
  non-decreasing

29
Properties of the Model and Solution

• Value functions are decreasing in the initial
  supplier assets
• Subsidize-up-to levels are increasing in the
  initial supplier assets
• Monotone relationship between subsidize-up-to
  levels and operational cost parameters

30
Visteon - Ford

• Visteon Corp.
• Considered bankruptcy in 2005
• 65 of sales are to Ford
• Ford Motor Co.
• Agreed to pay 1.6 - 1.8 billion in May 2005 to
  buy back and restructure 24 Visteon factories and
  17,400 workers
• 300 million for inventory 250 million loan
  500 million per year

31
Visteon Ford. Newsvendor Model Parameters

• r ? 3.7 (LIBOR)
• D k 6,500,000 ( of cars sold in 2005)
• p 5000 per car (gross profit)
• F 3.84 billion (current liabilities)
• A 4.34 billion (E 0.5 billion)
• ? 0.23 (?E 0.55, ?D 0.19)
• f 3.84 billion a f 2

32
Visteon Ford. One Period Model
33
Visteon Ford. N period model

Subsidy for 2005 1.2 billion
34
Summary and Conclusions

• Quantify the benefits and costs of financial
  subsidies from manufacturer to supplier
• Combine financial bankruptcy model with
  operational dynamic capacity reservation model
• Optimal orders do not depend on subsidy amounts,
  in particular, they satisfy newsvendor fractile
  expression for the newsvendor operational costs
  model.
• Subsidize-up-to policy for subsidies
• Comparative statics and Ford-Visteon case study
• Conditions for the manufacturer to share profits
  with the supplier
• Symmetric information and zero supplier market
  power

35
QA
36
Outline

• Supply Risk Management
• Definition
• Examples
• Risk Management Tools
• Financial Subsidies
• Asymmetric Information
• Competition
• Challenges and Opportunities

37
Supply Risk Management Asymmetric Information
and Backup Production Option

• Zhibin Yang, Goker Aydin, Volodymyr Babich,
• Industrial and Operations Engineering
• Damian Beil
• Stephen M. Ross School of Business
• University of Michigan

NSF DMII-0457445
38
Fire at Toyotas Supplier, 1997

• A fire broke out at Aisin Seiki facility, the
  only supplier of Toyota for P-valves
• The fire threatened to interrupt Toyotas
  production

• Aisin, together with other suppliers, created
  backup supply within 2-3 days, but it cost Aisin
  7.8 Billion
• Toyota rewarded the participating suppliers with
  20 Billion

39
Asymmetric Information about Supplier Reliability

• Bankruptcy of Land Rovers chassis supplier, 2001
• UPF-Thompson announced a bankruptcy and was taken
  over by KPMG
• KPMG demanded 35M good-will payment from Land
  Rover, to continue the chassis supply
• Land Rover was unaware of the looming risk of
  bankruptcy, but UPF-Thompson knew about it.
• Suppliers private information
• Common in decentralized systems
• Supplier may misrepresent itself

40
Problem Description

• Backup production accessible by suppliers
• Asymmetric information about supplier reliability

Procurement Contract
Supplier
Manufacturer
Use Backup(increased cost)
Inflated procurement cost
Disruption
Under-delivery(penalty)
Lost revenue
41
Research Questions

• Interaction risk management strategies and
  asymmetric information about supplier reliability
• Effect of asymmetric information on risk
  management
• Value of symmetric information
• Value of backup production
• Information and backup production option
  complements or substitutes?

42
Model

• One supplier, one manufacturer, one product, one
  period
• Suppliers are subject to random production
  disruptions
• Supplier reliability high or low
• Has a backup production option
• Game-theoretic contract-design problem
• Strategic behavior of the supplier
• Revelation principle and mechanism design
• Manufacturer offers a menu of two contracts (one
  per supplier type)
• Transfer payment X
• order quantity q
• non-delivery unit penalty p

43
Model Timing of Events
Contracting
Supplier refuses contracts
Manufacturer designs a menu of two contracts
No action
Nature selects type and reveals it to supplier
Execution
Supplier accepts a contract
Execution
Supplier commences backup production
Supplier commences regular production
Supplier delivers parts
44
Model Manufacturers Contract Design
Cost of Regular Production
Cost of Backup Production
Supplier
Penalty
Contract (transfer payment, penalty, order
quantity )(? )
Manufacturer
Penalty
Market Revenue
s.t.
(I.R.)
(I.C.)
45
Manufacturers Key Trade-off

• High-type supplier has incentive to pretend to be
  low-type
• To exploit its higher reliability (lower expected
  cost)
• To extract informational rent in equilibrium
• To reduce informational rent manufacturer incurs
  operational loss by changing the contract with
  the low-type supplier

Informational rent to a High-type supplier
Operational loss due to incorrect contract with
low-type supplier
46
Optimal Contract and Effect of Asymmetric
Information
Symmetric information
Asymmetric information
47
Optimal Contract and Effect of Asymmetric
Information
Symmetric information
Asymmetric information
48
Value of Information

• Information is most valuable for the manufacturer
  when backup production cost is moderate

Value of information for the manufacturer
Information mattersdiscriminating by supplier
types
bltltr both types of suppliers use backup
production
bgtrbackup production not used at all
Information becomes irrelevant
49
Value of Backup Production Option

• Cheap backup production hurts high-type supplier
  when r is large

Profit of high-type supplier
Profit w/o backup production option

• Backup production and information about supplier
  are
• Substitutes cheap backup production (bltltr)
• Complements moderate backup production cost (br)
• Irrelevant expensive backup production (bgtr)

Value of information for the manufacturer
Substitutes
Complements
Value of information w/o backup production option
50
Conclusions

• Model
• Two-echelon supplier chain, single supplier
• Asymmetric information about supplier reliability
• Suppliers have backup production option
• Manufacturer faces a key trade-off between
• Informational rent to a high-type supplier
• Operational loss with a low-type supplier

51
Conclusions

• Two approaches to reduce supply uncertainty
• Work with suppliers with backup production option
• Gather information about the supplier
• Information is most valuable when backup
  production cost is moderate
• Manufacturer suffers from both from informational
  rent and from operational losses
• Existence of cheap backup production option
  decreases the value of information for the
  manufacturer
• Backup production option
• Benefits the manufacturer
• May hurt reliable suppliers

52
QA
53
Outline

• Supply Risk Management
• Definition
• Examples
• Risk Management Tools
• Financial Subsidies
• Asymmetric Information
• Competition
• Challenges and Opportunities

54
Supply Risk Management Diversification and
Competition

• Volodymyr Babich,
• University of Michigan
• Apostolos Burnetas
• University of Athens
• Peter Ritchken
• Case Western Reserve University

NSF DMII-0457445
55
Multi-Sourcing

• Empirical Evidence
• Multi-sourcing is widely used ---Lester 2002
  15 of Japanese companies operating in the
  domestic market single source components
• Main reasons to have multiple suppliers (Wu and
  Choi 2005) Competition and Diversification

56
Research Questions (and Some Answers)

• What are the effects of risk on
• Suppliers pricing decisions?
• Timing of payments
• Retailers order policy?
• Lowest price vs. Diversification
• What are the benefits of diversification?
• How does competition and default correlation
  affect benefits of diversification?
• Retailer may benefits from positive default
  correlation

57
Model

• Joint distribution of supplier defaults (?) is
  given
• Retailers optimization problem
• Suppliers game

58
Modeling Codependence

• Linear correlation (Pearsons) might not be
  adequate for non-elliptic distributions
  (Embrechts, McNeil, and Straumann 2002)
• Copula functions (Nelsen 1999, Embrechts,
  Lindskog, and McNeil 2003) --- difficult to
  choose appropriate class of copulas
• Direct approach, N 2 Given

59
2-Suppliers. Deterministic Demand. Equilibrium
K2 Supplier 2 price
s p01 K1 s p10 K2
s p0
Equilibrium profits R D s p00 ( c2 s p10
) S1 D s p01 ( c2 s p10 ) c1 S2
( s p10 c2 ) D U R S1 S2 s p1
c1 ( s p10 c2 ) D
Orders ( D, 0 )
s p10
Orders ( 0, D )
Orders ( D, D )
cost c2
s p0
s p01
c1 cost
K1 Supplier 1 price
Assume s p01 c1 gt s p10 c2 ? Margin of
supplier 1 gt Margin of supplier 2
60
Effects of Correlation
K2
s p0
c2
c1
K1
s p0
61
Effects of Correlation
K2
s p0
s p10
K1
s p01
s p0
62
Effects of Correlation
K2
s p0
s p10
K1
s p01
s p0
63
Effects of Correlation
K2
s p0
s p10
K1
s p01
s p0
64
Effects of Correlation
K2
s p0
s p10
K1
s p01
s p0
65
Effects of Correlation
K2
s p0
K1
s p01
s p0
66
Effects of Correlation
K2
s p0
K1
s p01
s p0
67
Effects of Correlation
K2
s p0
K1
s p01
s p0
68
2-Suppliers. Effects of Correlation Insights

• Observations
• The retailer would prefer positively correlated
  defaults of the suppliers
• The suppliers (and the system) prefer negatively
  correlated defaults
• Equilibrium prices decrease in correlation
• The benefits of competition outweigh the benefits
  of diversification
• Why?
• If supplier defaults are perfectly correlated,
  the product they offer are perfectly
  substitutable and Bertrand competition drives
  prices down
• If supplier defaults are negatively correlated,
  the products are not substitutable, there is no
  competition, and each supplier behaves as a
  monopolist.

69
3-Supplier Equilibriums

• Provide conditions for equilibrium with 3-, 2-,
  1- suppliers
• Explicit expressions for equilibrium profits

70
N-Suppliers

• The more suppliers are available, the lower are
  the equilibrium prices
• If it is possible to divide suppliers into
  groups, where within each group suppliers are
  perfectly correlated, then the retailer can
  benefit both from competition and diversification

Wholesale prices supplier costs
Wholesale prices supplier costs
71
2-Suppliers. Stochastic Demand. Equilibrium

• Identical suppliers
• Demand has mean 150 and standard deviation 50
• Codependence between supplier defaults increases
  in p00

72
Centralized vs. Decentralized Systems

• As the codependence between defaults increases,
  the system becomes more coordinated
• However, total system profits are decreasing

73
Effect of Survival Probability

• Independent defaults
• Suppliers profits are non-monotone

74
Timing of Payments

• In equilibrium the retailer and the suppliers are
  indifferent between the timing of payments, if
  the payments are linear in quantities
• The up-front prices take into account survival
  probability

75
Summary and Conclusions

• N-supplier equilibrium with either deterministic
  or stochastic demand
• Exogenous wholesale prices ? the negative
  codependence between defaults benefits the
  retailer and the system
• Endogenous wholesale prices ? the retailer may
  benefit from positive default codependence
• competition among suppliers drives down wholesale
  prices
• With more than two suppliers it is possible for
  the retailer to enjoy benefits of competition and
  diversification simultaneously
• The wholesale prices and profits of suppliers
  could be non-monotone in their survival
  probability
• If payment policies are linear in the order
  quantity ? in equilibrium, the suppliers and the
  retailer are indifferent between up-front and
  on-delivery payments.
• The on-delivery prices are greater than up-front
  prices by the survival probability.

76
QA
77
Outline

• Supply Risk Management
• Definition
• Examples
• Risk Management Tools
• Financial Subsidies
• Asymmetric Information
• Competition
• Challenges and Opportunities

78
NSF DMII-0539348
79
Trends Great Interest in the Field

• 80 participants
• We were expecting 40
• Business, engineering, science, and mathematics
  fields were represented
• Researches and practitioners, domestic and
  international from universities, industry
  research labs, insurance companies, consulting
  companies, manufacturing companies participated.
• Received 54 applications for student poster
  session
• 14 were selected
• Conference sponsors
• The National Science Foundation The College of
  Engineering at the University of Michigan The
  Department of Industrial and Operations
  Engineering at the University of Michigan The
  Stephen M. Ross School of Business at the
  University of Michigan The Financial Engineering
  program at the University of Michigan The Tauber
  Manufacturing Institute at the University of
  Michigan DaimlerChrysler Corporation Ford Motor
  Company General Motors Corporation Lockheed
  Martin Corporation

80
Trends Strategic Role of Risk Management

• Old risk management
• hedging exposure in financial markets
• quantifying the reliability of the equipment
• New risk management
• Customer relationship management
• Market share and competition
• Mergers and industry consolidation
• Collaborative relationships with the suppliers

81
Needed Unified Methodological Approach

• Risk management in operations and supply chain
  management
• Combines operations, finance, actuarial science,
  reliability and quality control, financial
  engineering, economics
• Challenge of integrating the language used by
  experts of various subfields
• The broad set of tools is needed to bring
  together, in practice, interdisciplinary teams
  within corporations to tackle risk management
  problems
• Financial Engineering discipline for managing
  and pricing financial risks
• Risk management in operations and supply chain
  management - risk and decision analysis in
  operations

82
Needed Empirical Research

• Financial engineering
• made great impact in practice because of the
  empirically verifiable results and empirically
  verifiable successes
• Integrated risk management in operations and
  supply chains
• progress maybe impeded by the lack of data
• Rare events
• Intellectual property
• Proprietary concerns
• Negative publicity
• Further work is needed to identify problems for
  which data is available, to develop new methods
  of analyzing data, and to create appropriate
  databases

83
Important Research Opportunities

• Risk metrics for management in operations.
  Time-risk tradeoffs
• Econometric methods for enterprise risk
  measurement and management
• Identification of empirically verifiable results
  and issues
• Computational methods for managing complex risk
  portfolios.
• Coordination between operational and financial
  decisions (including financing and hedging
  decisions)
• Games, the role of incentives, and asymmetric
  information in risk management

84
QA