Centralization versus decentralization: Risk pooling, risk diversification, and supply chain disruptions

• Published in: Omega (Oxford) Vol. 52; pp. 201 - 212
• Main Authors: Schmitt, Amanda J., Sun, Siyuan Anthony, Snyder, Lawrence V., Shen, Zuo-Jun Max
• Format: Journal Article
• Language: English
• Published: Oxford Elsevier Ltd 01.04.2015; Pergamon Press Inc
• Subjects: Centralization; Decentralization; Design optimization; Inventory control; Risk; Risk management; Studies; Supply chain disruptions; Supply chain management; Systems design; Supply chain disruptions; Inventory control; Risk
• ISSN: 0305-0483; 1873-5274
• DOI: 10.1016/j.omega.2014.06.002

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. •We model a multi-location supply chain where supply may be disrupted.•We show that decentralizing inventory reduces cost risk through risk diversification.•Risk diversification tends to have a stronger effect than demand risk pooling.•Therefore a risk-averse firm should typically choose to decentralized inventory.