Centralization or Decentralization? The Effect of Cost Learning on Procurement Strategy

Abstract

This paper investigates the effect of cost learning on the manufacturer's procurement strategy in the presence of multiple local divisions and market competition, and the strategy preferences of stakeholders, such as the supplier. Firms are often confronted with a critical procurement decision: centralization versus decentralization. For this paper, we incorporate the learning effect into this crucial strategy and demonstrate its ubiquity and significant practical implications in today's technological environment. We develop a two-period model with an upstream supplier and a downstream manufacturer with multiple divisions and examine the equilibrium outcomes under the two procurement methods. The results show that, due to the cost learning effect, the manufacturer might switch his choice from centralized procurement to decentralized one; and the manufacturer may switch back to centralized one when the rate of product substitution is small. However, the preferences of the supplier, channel, and consumers may shift from decentralized procurement to a centralized one. When the product homogenization between local divisions becomes large enough and as the learning rate increases, the manufacturer shifts its optimal procurement strategy from centralization to decentralization. However, the supplier, channel, and consumers are always better off under decentralized procurement. When the learning rate is large, the preferences of the supplier and the manufacturer achieve consistency and a win-win relationship benefiting the channel and consumers. This paper is the first to take the upstream learning effect into account in the firms’ optimal purchasing strategy and advise managers of group corporations consisting of multiple local sales divisions with business expansion needs. Our findings suggest that the effect of cost learning has a critical impact on firms’ purchasing preferences, the profitability of both parties, and consumer surplus.