Centralization versus Decentralization: Risk Pooling, Risk Diversification, and Supply Chain Disruptions
Amanda J. Schmitt
MIT Center for Transportation & Logistics
Lawrence V. Snyder
Lehigh University - Department of Industrial and Systems Engineering
Zuo-Jun Max Shen
University of California, Berkeley - Department of Industrial Engineering & Operations Research (IEOR)
May 20, 2012
We investigate optimal system design in a multi-location system in which supply is subject to disruptions. We examine the expected costs and cost variances of the system in both a centralized and a decentralized inventory system. We show that, when demand is deterministic and supply may be disrupted, using a decentralized inventory design reduces cost variance through the risk diversification effect, and therefore a decentralized inventory system is optimal. This is in contrast to the classical result that when supply is deterministic and demand is stochastic, centralization is optimal due to the risk-pooling effect. When both supply may be disrupted and demand is stochastic, we demonstrate that a risk-averse firm should typically choose a decentralized inventory system design.
Number of Pages in PDF File: 26
Keywords: supply disruptions, inventory management, risk diversificationworking papers series
Date posted: April 3, 2008 ; Last revised: May 21, 2012
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