Centralization vs Decentralization

Centralization versus Decentralization: Risk Pooling, Risk Diversification, and Supply Uncertainty in a One-Warehouse Multiple-Retailer System
Amanda J. Schmitt Lawrence V. Snyder
Dept. of Industrial and Systems Engineering Lehigh University Bethlehem, PA, USA

Zuo-Jun Max Shen
Dept. of Industrial Engineering and Operations Research University of California Berkeley, CA, USA

May 27, 2008
ABSTRACT We investigate optimal system design in a One-Warehouse Multiple-Retailer 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 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.

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Introduction

As supply chains expand globally, supply risk increases. Classical inventory models have generally focused on demand uncertainty and established best practices to mitigate demand risk. However, supply risk can have very different impacts on the optimal inventory management policies and can even reverse what is known about best practices for system design. In this paper, we focus on the impact of supply uncertainty on the One-Warehouse MultipleRetailer (OWMR) system, and compare two policies: centralization (stocking inventory at the warehouse only) and decentralization (stocking inventory at the retailers only). While most research 1

on the OWMR model allows inventory to be held at both echelons, we allow inventory to be held at only one echelon in order to

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