Where To Differentiate Your Product When Stocking Levels Are Coupled

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Ferguson, Mark E.
Lystad, Erik D.
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A critical assumption of Lee and Tang’s (1997) analysis of where in the production process a company should delay differentiation of its product is the independent treatment of installations in the production network. We show this “decoupling” approach gives rise to inaccuracies in assessing the value of delayed differentiation, frequently overestimating but also potentially underestimating the savings in inventory costs by failing to appropriately exploit the risk pooling effect. By doing so, we reveal a previously hidden factor in determining the optimal delayed differentiation strategy: the pattern of holding costs assessed for the various stages of work-in-process, which we refer to as the holding cost profile, plays an important role in the determination of the optimal strategy. Prior work has established the importance of the absolute holding cost at each stage in this decision but the relative holding costs are also important; as sharp increases in the local holding costs indicate potential cost reduction opportunities. Finally, we provide insight on the conditions when the decoupling assumption may lead to significant errors and cause a firm to make a costly mistake when determining where in the process to differentiate its product.
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