Centralization versus Decentralization: Risk Pooling, Risk Diversification, and Supply Uncertainty in a One-Warehouse Multiple-Retailer System

Abstract:     
We investigate optimal system design in a One-Warehouse Multiple-Retailer system in which supply is stochastic. We examine the expected costs and cost variances of the system in both a centralized and a decentralized inventory system when supply is either completely disrupted or subject to yield uncertainty. We show that using a decentralized inventory design reduces cost variance through the risk-diversification effect, and that when demand is deterministic and supply may be disrupted, 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.

Keywords: supply disruptions, inventory management, risk diversification

Working Paper Series