Production, Manufacturing and Logistics
Managing inventories in a two-echelon dual-channel supply chain

https://doi.org/10.1016/j.ejor.2003.08.062Get rights and content

Abstract

We present a two-echelon dual-channel inventory model in which stocks are kept in both a manufacturer warehouse (upper echelon) and a retail store (lower echelon), and the product is available in two supply channels: a traditional retail store and an Internet-enabled direct channel. The system receives stochastic demand from two customer segments: those who prefer the traditional retail store and those who prefer the Internet-based direct channel. The demand of retail customers is met with the on-hand inventory from the bottom echelon while the demand in the Internet-enabled channel is fulfilled through direct delivery with the on-hand inventory from the upper echelon. When a stockout occurs in either channel, customers will search and shift to the other channel with a known probability. A one-for-one inventory control policy is applied. In order to develop operational measures of supply chain flexibility, we define a cost structure which captures two different operational cost factors: inventory holding costs and lost sales costs. We discuss several insights that are evident from the parametric analysis of the model. We also examine the performance of two other possible channel distribution strategies: retail-only and direct-only strategies. Computational outcomes indicate that the dual-channel strategy outperforms the other two channel strategies in most cases, and the cost reductions realized by the flexibility of the dual-channel system may be significant under some circumstances.

Introduction

Consider a two-echelon inventory system that consists of a manufacturer with a warehouse at the top echelon and a retail store at the bottom echelon. The manufacturer uses both a traditional retail store and an Internet-enabled channel to distribute its products. Demand from customers at the retail store is met with the on-hand inventory from the bottom echelon while orders placed through the Internet-enabled channel are satisfied directly with the on-hand inventory from the top echelon. Such a system is called a two-echelon dual-channel distribution system, or, more generally, a multi-echelon multi-channel distribution system.

The advent of the Internet has made it easier for companies who traditionally distribute their products through retail stores to engage in online direct sales. It has facilitated the adoption of multi-channel distributions. Moriarty and Moran (1990) pointed out that dual or multiple channels would become the dominant design for computer industry in the 1990s. In fact, the movement to multiple channels of distribution has also occurred in other industries. According to a recent survey, about 42% of top suppliers in a variety of industries, such as electronics, appliances, sporting goods, and apparel, have begun to sell directly to consumers over the Internet (Tedeschi, 2000). Evidently, as indicated by Keskinocak and Tayur (2001), companies are increasingly using new Internet-enabled sales channels along side the traditional retail channels to achieve supply chain flexibility.

Although the Internet-enabled channel is the motivation of this paper, the adoption of dual-channel distribution is not a novel phenomenon in the e-business era. Dual-channel distribution may take many forms, one of which is when a manufacturer both sells through intermediaries and directly to consumers (Preston and Schramm, 1965). The literature on distribution channels has pointed out important economical reasons for serving different customer segments with different channels (e.g., Moriarty and Moran, 1990; Rangan et al., 1992; Anderson et al., 1997). Because customers are heterogeneous in terms of their channel preference (Kacen et al., 2002), multiple channels may reach potential buyer segments that could not be reached by a single channel and may thus help to increase the market coverage. Also, dual channels may help companies to increase customers' awareness and loyalty of their products.

Despite its advantages, the adoption of dual-channel distribution introduces new management concerns. From a logistics perspective, combining the existing retail distribution channel with a new Internet-based direct distribution channel may cause havoc on the product demand structures, and thus may require companies to redesign the optimal inventory allocations in the two-echelon distribution environment. The fundamental task in connection with the two-echelon inventory problem is to find the balance between the stock levels at the top and the bottom echelons. How do companies set stock levels to achieve better channel performance when a new Internet-based direct distribution is introduced alongside the existing retail channel? In this paper, we incorporate the Internet-enabled direct channel into a traditional two-echelon inventory system and construct a model to determine the optimal inventory control levels for each echelon.

The analysis of multi-echelon inventory systems that pervades the business world has a long history. Clark and Scarf (1960) introduced the concept of echelon stock. Inventory control in multi-echelon systems is known to be a challenging research area. Because of the complexity and intractability of the multi-echelon problem, Hadley and Whitin (1963) recommend the adoption of single location, single echelon models for the inventory systems. Sherbrooke (1968) constructed the METRIC model, which identifies the stock levels that minimize the expected number of backorders at the lower echelon subject to a budget constraint. This model is the first multi-echelon inventory model for managing the inventory of service parts. Thereafter, a large set of models that generally seek to identify optimal lot sizes and safety stocks in a multi-echelon framework were produced by many researchers (e.g., Deuermeyer and Schwarz, 1981; Moinzadeh and Lee, 1986; Svoronos and Zipkin, 1988; Axsäter, 1990, Axsäter, 1993; Nahmias and Smith, 1994; Aggarwal and Moinzadeh, 1994; Grahovac and Chakravarty, 2001). In addition to analytical models, simulation models have also been developed to capture the complex interactions of the multi-echelon inventory problems (e.g., Clark et al., 1983; Pyke, 1990; Dada, 1992; Alfredsson and Verrijdt, 1999).

The study of multi-channel supply chains in the direct versus retail environment has emerged only recently. The focus of this stream of literature is on channel competition and coordination issues in the setting where the upstream echelon is at once a supplier to and a competitor of the downstream echelon (e.g., Rhee and Park, 1999; Tsay and Agrawal, 2003; Chiang et al., 2003). These papers analyze the dual-channel design problem by modeling the price and/or service interactions between upstream and downstream echelons. They do not deal with inventory issues.

While multi-echelon inventory control policies have been extensively studied, the theoretical basis for multi-echelon multi-channel inventory problem has not yet been well developed. One common arrangement of the extant multi-echelon inventory models assumes that the supply chain system consists of several locations whose supply–demand relationships form a hierarchy: each location places orders with one direct predecessor in the supply chain (see Svoronos and Zipkin, 1991 for more details). In this setting, one location may receive orders from several direct successors, but the successors have to be at the same echelon. Although a handful of papers have considered the model that allows some locations to bypass its direct predecessor and place orders with locations at a higher echelon or at the same echelon (e.g. Grahovac and Chakravarty, 2001), those orders are considered as emergency orders and only happen in the event of a stockout at their direct predecessor. With the trend of adopting a multi-channel distribution strategy in the recent business environment and with the development of third-party logistics, including the emergence of highly competent suppliers such as Federal Express (Narus and Anderson, 1996), the inventory distribution system wherein one location can concurrently receive orders from more than one echelon is not uncommon. Nevertheless, the inventory modeling literature thus far offers little guidance in approaching this subject.

Against this backdrop, a primary objective of this paper is to make a contribution to this important line of inquiry. Specifically, in our model the manufacturer at the upper echelon at once receives orders from its retailer and from the end customers through a direct channel. We assume that demand at the retail store is met with the retailer's on-hand inventory, while orders placed through the direct channel are shipped directly to customers with the manufacturer's on-hand inventory. We construct an analytical model and define a cost structure that captures inventory related operational costs to evaluate the performance of a two-echelon dual-channel supply system. Parametric analysis based on the model is conducted by varying the key parameters in the cost structure to obtain generalizable results. We explicitly compare the performance of three types of channel distribution strategies: retail-only distribution, dual-channel distribution, and direct-only distribution (see Fig. 1).

The recent frequently observed trends of increasing variety, customization and complexity of products have created a challenge to effective inventory management. For many products including furniture, appliances, electronics, spare parts, and fashion-oriented products, the demand for each particular product item in the product line is usually low, and it is relatively costly to hold high stock levels at the store to fill the demand. As the lost sales costs of these types of products are substantial, the pressure of maintaining a high demand fill rate is put on the entire supply chain. One-for-one control policies, also known as order-for-order replenishment policies, are widely recognized in the literature for the management of products that exhibit low demand rates. Adopting these inventory policies in the multi-echelon dual-channel inventory system, we argue that adding the Internet-enabled direct channel along side the existing retail store can increase supply chain flexibility and can thus significantly reduce overall inventory holding costs and lost sales costs.

Section snippets

Two-echelon dual-channel inventory model

The topology and product flows of the two-echelon dual-channel supply system considered in the paper are illustrated in Fig. 2.

Economic analysis of channel performance

In this section, we conduct an economic analysis of the model to evaluate the performance of the two-echelon dual-channel system. We define a cost structure that takes into account two different operational cost factors, the long-run average inventory holding cost and the long-run average lost sales cost.2 In the

Parametric analysis

To generate insights and obtain generalizable results from the two-echelon dual-channel inventory model, we now conduct a numerical study using the model developed in Section 3. Note that since our model is based on a queueing-theoretic foundation, the computational results yield an exact evaluation of system performance.

Evaluation of other channel strategies

Instead of using both the retail store and the direct channel, a firm can just use either one of the two channels to fulfill the demand. Now that we have evaluated the performance of the dual-channel strategy, we investigate the performance of the other two channel strategies, retail-only and direct-only channel strategies.

Model variations

Several variations of our performance evaluation procedure are possible. For example, customers who purchase online usually have to pay a shipping-and-handling (S&H) fee. Therefore, marginal costs incurred by the firm for the product sold through the retail store and the direct channel (denoted by cr and cd, respectively) may be different. In our model, we do not consider marginal costs because we implicitly assume cr=cd.

Concluding remarks

The two-echelon dual-channel inventory model presented in this paper is based on queuing models. Using analytical methods, we develop operational measures of supply chain flexibility by defining a cost structure which captures two different operational cost factors: inventory holding cost and lost sales cost. Our analysis leads to an exact evaluation of system performance.

To evaluate the possible benefits of using the dual-channel strategy, we also examine the performance of two other channel

Acknowledgements

The authors thank the anonymous referees for their valuable comments.

References (27)

  • P.K. Aggarwal et al.

    Order expedition in multi-echelon production/distribution systems

    IIE Transactions

    (1994)
  • P. Alfredsson et al.

    Modeling emergency supply flexibility in a two-echelon inventory system

    Management Science

    (1999)
  • E. Anderson et al.

    Strategic channel design

    Sloan Management Review

    (1997)
  • S. Axsäter

    Simple solution procedures for a class of two-echelon inventory problems

    Operations Research

    (1990)
  • S. Axsäter

    Exact and approximate evaluation of batch ordering policies for two-level inventory systems

    Operations Research

    (1993)
  • W.K. Chiang et al.

    Direct marketing, indirect revenues: A strategic analysis of dual-channel supply chain design

    Management Science

    (2003)
  • A. Clark et al.

    Optimal policies for a multi-echelon inventory problem

    Management Science

    (1960)
  • T.D. Clark et al.

    Complex multi-echelon inventory system management using a dynamic simulation model

    Decision Sciences

    (1983)
  • M. Dada

    A two-echelon inventory system with priority shipments

    Management Science

    (1992)
  • B.L. Deuermeyer et al.

    A model for the analysis of system service level in warehouse retailer distribution systems: The identical retailer case

  • J. Grahovac et al.

    Sharing and lateral transshipment of inventory in a supply chain with expensive low-demand items

    Management Science

    (2001)
  • G. Hadley et al.

    Analysis of Inventory Systems

    (1963)
  • Kacen, J., Hess, J., Chiang, W.K., 2002. Shoppers' attitudes toward online and traditional grocery stores. Working...
  • Cited by (256)

    • Dual-channel supply chain coordination with online reviews

      2023, Electronic Commerce Research and Applications
    View all citing articles on Scopus
    1

    Tel.: +1-217-333-8270.

    View full text