October 4, 2002

1. October 4, 2002 Do shortages matter? Albany-MIT PhD Colloquium Paulo Gonçalves

2. Nintendo is warning they won’t have enough game cubes to meet initial demand when they launch next month Microsoft is saying the same thing about its xbox game system You don’t suppose they took our 20 million pre-orders seriously, do you? It’s 25 million now. I was bored yesterday

3. Agenda • Motivation • Relevance and impacts • Modeling Phantom Demand • Dynamic hypotheses • Model and analysis • Policy insights • Field Study • Networking equipment industry • Problem and motivation

4. Relevance • Supply shortages occur in several industries • Automotive – GM Suburbans (Blumenstein 1996) • Personal Computers – (Greek 2000) • Pharmaceuticals – (Hwang and Valeriano 1992) • Semiconductor – DRAM chips (Lode 1992), Pentium II (Thompson 1998), Pentium III (McWilliams 2000) • Telecommunications – (Lee et al. 1997b) • Causes of shortages • Costly capacity • Long capacity acquisition delays • High demand uncertainty • High process uncertainty

5. Impacts of Shortages • Traditional ones • Lost sales and loss of shareholder value (Singhal and Hendricks 2002) • Financial and reputation losses (Greek 2000) • Poor growth prospects (Savage 1999) • Others • Shifts in the modes of operation in supply chains • Decreased performance and increased instability • Phantom demand • Excess capacity and low capacity utilization • Increased returns and excess inventory

6. How do companies deal with shortages? • Increase supply • Increase production • Increase capacity utilization • Improve efficiency • Expand capacity • Increase sources and reliability of supply • Effective in the long-term but limited effect in the short-term • Constrain demand • Decrease product attractiveness • Increase prices • Reduce product quality • Effective in the short-term but limited ability to implement them

7. How do Shortages cause Bubbles? • Suppliers allocate capacity among retailers • Proportional to orders • Proportional to past sales • Fixed quantities • Supplier reliability decreases • Service levels drop • Delivery delays increase • Retailers reactions generate the bubble • Inflate their orders with any supplier • Place the same order with multiplet suppliers • Suppliers increase production • Invest in new capacity and increase utilization • Enter into long-term contracts • Retailers cancel orders as supply increases • Suppliers suffer the consequences

8. Manager’s Intended RationalityControl the Supply Line

9. First Unintended ConsequenceRetailers Order Ahead

10. Second Unintended ConsequenceRetailers Order Defensively

11. Supplier’s Balancing ResponseAdjust Capacity

12. Model for Supplier-Retailer System

13. Aggressive Strategy 10 8 Base Case 6 Expected Delivery Delay Myopic Strategy 4 2 0 0 2 4 6 8 Delivery Delay Structure of the System

14. Solve System with Fixed Capacity • System is unstable if agents are not fully rational • Even Myopic (fully rational) retailers will cause orders to increase

15. System Stable when Capacity Changes

16. Long Delays and High Cancellations

17. Capacity Flexibility is crucial • Supplier’s ability to build capacity quickly • Reduce the size of the bubble • Reduce the duration of the problem • Strategies to flexibility ramp up production • The semiconductor industry builds the building infrastructure (the shell) well in advance of need • Building is never a constraint in ramping up production of a new fabrication facility • The equipment is positioned as it becomes necessary

18. Impacts of Real Time Supply Chain Mgm • Alan Greenspan, Chairman of the Fed: • “The faster adjustment process raises some warning flags. Business managers have access to more information, but everyone gets similar signals. As a consequence, firms appear to be acting in far closer alignment with one another than in decades past. The result is not only a faster adjustment, but one that is potentially more synchronized, compressing changes into an even shorter time frame.”

19. Business managers views • “By sharing knowledge of orders or parts shortages or other factors, companies across the high-tech industry are probably more in sync than they ever have been before. This has been the promise of the e-business revolution, but no one ever realized how this information might be used. I'd say we're getting our first taste of how companies might react to up-to-the-minute operational information. In short, they would move more quickly to protect profits. Even Fed Chairman Alan Greenspan has theorized publicly that the improved efficiency of forecasting systems has exacerbated the severity of the economic slowdown, which gripped the country more quickly than anyone predicted.”

20. Causes of Component Shortages In the networking equipment industry • Strong demand from several industries • PCs, mobile phones, handheld devices, and telecom. • Wide adoption of lean manufacturing and build-to-order models • Limited capital investment in manufacturing equipment • Earthquake in Taiwan in September 1999 • Taiwan is the world's third-largest information technology provider after the US and Japan

21. Industry Response • Quote attributed to Stephen P. Kaufman, Chairman and CEO Arrow Electronics Inc. • “An Arrow customer builds a product that is heavily dependent on flash-memory devices. On learning that the Palm Pilot organizers use the same flash chips as his company's product, the OEM's chief executive summoned all employees to hand over their Palm Pilots. Production workers promptly pulled the flash devices out of the units and walked them down to the production lines. Employees then received vouchers for new Palm Pilots.” [1] • Cisco’s action: • “We made a conscious decision when our lead times were 12 to 13 weeks to build inventory, because we were leaving a sizable amount of revenue on the table every quarter” [2] [1] Ojo, B. and C. Serant. (2000) “Parts shortages prompt companies to adopt unusual measures,” EBN, May 22 [2] Byrne, John A. and Elign, Ben, “Cisco Behind the Hype”, BusinessWeek, January 2002.

22. “Cisco’s market value had fallen by some $430 billion, to $154 billion, one of the deepest losses of shareholder wealth in history.”[4] Significant Impact to the Bottom Line [4] Heskett, B. 2002. “Chambers’ Tale of Icarus,” c|net News.Com. (http://news.com.com/html/ne/vs/2022-1120-808669.html)

23. Macroeconomic challenges facing the industry are proof that "a 100-year flood can happen in your lifetime.“[3] “If you told me [sales] could go down 30 percent after 70 percent growth in 45 days I’d say it was mathematically impossible. And it did.”[4] John Chambers Comments • [3] --- 2001. “Cisco issues revenue warning: Says sales will be down 30% in third quarter; announces write-down, new layoffs.” The Gazette, Montreal, April 17, D1. • [4] Heskett, B. 2002. “Chambers’ Tale of Icarus,” c|net News.Com. (http://news.com.com/html/ne/vs/2022-1120-808669.html)

24. Contract manufacturers tried to help • Susan Wang, Solectron’s CFO, commenting on OEM’s orders: • Gee, if each one of the OEM’s thinks they’re going to gain share, we’re going to have more than 100 % share. That doesn’t make sense.” • Although they tried to prevent OEMs, they did not want to hear bad news.” • “If we had said no, they would have told us, ‘You’re not a good partner for me – we’ll find somebody else,’ our only responsible reply was, ‘Yes, of course, we’ll try.’”