Risk-pooling over demand uncertainty in the presence of product modularity

Abstract In this paper, we study the effect of risk-pooling over demand uncertainty of multiple products sharing product modularity in a two-echelon distribution system. The distribution system consists of a distribution center and n retailers, each of which supplies random demand for m products. The modular product design provides management an opportunity for using the most capable product, which is also the most expensive, as joint buffer stock to substitute for other products when a stockout occurs at a retailer. We develop models to study the effect of retailer joint buffer stock on the system's expected operating costs, including buffer stock holding costs, backorder costs, and purchasing costs. The results indicate that substantial savings are possible through employment of joint buffer stock. The cost reduction depends critically upon the customer service level desired, as well as the diverse degree of variance in end-of-period net inventory across all products and all retailers. Our study provides managerial insights into basic effects of risk-pooling over demand uncertainty through product modularity.