The role of e-marketplaces in relationship-based supply chains: a survey

IBM Systems Journal,  March, 2005  by W. Grey,  T. Olavson,  D. Shi

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Dynamic pricing can help manage both types of risks. Because Kleindorfer and Wu (6) review the relevant literature on strategies for linking contracting and spot markets, we limit our discussion here to examples and applications of spot and forward markets for managing risk.

Managing demand risk by using spot markets

Market-based dynamic pricing ensures that supply and demand will always be in balance in spot markets. In contrast, supply and demand is rarely in perfect balance in relationship-based contract markets. In a buyer's market, suppliers hold excess stocks of inventory. In a seller's market, buyers face either long lead times for parts or outright shortages in which their orders are rationed through an allocation mechanism of the supplier's choosing. By balancing supply and demand, market-based pricing helps buyers and sellers manage demand risk in several ways.

Spot markets help buyers manage demand risk primarily by providing a channel with continuous availability and short lead times. Spot purchases can then replace inventory buffers as a means for absorbing peak demand shocks. Buyers may pay a premium for spot purchases, but this may be offset by reductions in inventory overage and underage costs. Spot markets can also act as an effective means for allocating constrained capacity during supply shortages. (33) Furthermore, buyers may be able to reduce inventory write-downs by reselling excess inventory in spot markets before it has significantly depreciated in value.

The approach of the Hewlett-Packard Customer Support (HPCS) group to managing certain spare parts inventories illustrates how spot markets can help manage buyer's demand risk. HPCS is responsible for servicing--and often replacing--defective components in HP products. Because products under warranty generally have a five-year guaranteed minimum support period, HPCS demand for components often extends well beyond the supplier's discontinuance of the component. In the past, when the manufacturer discontinued the product, HPCS did a "lifetime buy"--it purchased enough inventory to cover all expected future component requirements. Because demand over the remaining support period (typically three to five years) was uncertain and because the value of components continued to decline during this period, inventory write-downs were large.

To address this problem, HPCS implemented a new strategy for procuring microprocessors directly from a high-tech exchange, contracting with the exchange as a broker. Under the new strategy, HPCS holds no microprocessor inventory. The exchange provides the processors on a just-in-time basis, pulling from the spot market at market prices. This not only reduces inventory write-downs during the support period, but also lowers the average price paid for the parts.

Under the original inventory strategy, lead times were from 30 to 45 days for microprocessors still under production. To meet the high service levels required for customer support, planners had to hold three to four months of inventory. Because microprocessor prices fell 60-80 percent per year, this was extremely costly. Furthermore, for discontinued microprocessors, HPCS would perform a lifetime buy, and the market value of its inventory would fall another 50-70 percent over the support period. HPCS was paying a high price for managing its demand risk, but it had no alternative. With the exchange, HPCS has a liquid market for discontinued products. It also has a channel partner providing 1-day lead times, rather than the 30-to-45-day lead times provided by the microprocessor manufacturer.