What can game theory teach us about Financial Supply Chain Management?

What can game theory teach us about Financial Supply Chain Management?

Posted by Pete Loughlin in Financial Supply Chain Management, Supply Chain Finance, The Rest 17 May 2012

Do you ever wonder why it is that businesses don’t co-operate? Each business operates in isolation making decisions that appear to give themselves the best advantage. But it’s rare that they do get to an optimal position and they are not likely to unless they change the rules of the game.

Purchasing Insight logoThere’s a classic mathematical problem called “the prisoners dilemma”.  A simplified version goes like this:

There are two prisoners suspected of conspiring together to commit a crime. There is little actual evidence to convict either and the police are relying on a confession by either or both of them. They are separated and each is offered an identical deal. The deal is that if a suspect confesses, they get 5 years instead of the mandatory 10 years if they are convicted. What should they do?

This is an example of a game and when analyzed using game theory, (not to be confused with gamification by the way), it turns out that each party is most likely to betray each other and spend 5 years in jail rather than remain silent and enjoy the best possible outcome, freedom.  It’s counter intuitive in some ways but consider the prisoners’ dilemma. Whatever the other prisoner does, each can improve their likely outcome by confessing. The most likely outcome of this “game” is that each rats on the other.

The prisoners’ dilemma is a very powerful model that illustrates why, depending on the rules of the game, outcomes are not always optimal and there are many close analogies in the real world. Take for example a treasury manager’s behavior in a commercial business. In order to minimize the cost of working capital, it makes sense to pay suppliers as late as possible. Cash rich companies can get a return of about 1% on cash. On the other side of the supply chain fence sits the supplier. The cost to them of working capital – funding the time lag imposed by the customer – is in the region of 20%.

There’s a useful, if somewhat simplistic, way of looking at this. The cost of doing business is 19%. That’s the difference between the cost of working capital of the buyer and supplier. That’s the amount of money leaking from the supply chain. It is the cost of taking a siloed, blinkered approach to financial supply chain management. And it’s an inevitable cost. Why? Because the rules of the game say that, like the prisoners, no collaboration is allowed.

But there’s a better approach. In the real world, the banks aren’t the police. They don’t make the rules. Business makes the rules. If the buyer used their cash reserves to support the suppliers’ working capital requirement, the 19% can stay with the supply chain, distributed appropriately between the buyer and supplier. Sound unthinkable? Impractical? Well it isn’t and what’s more, everybody is better off. Except of course, the banks.

  • […] recent post in Supply Chain Insight, “What can game theory teach us about Financial Supply Chain Management?” highlights the overall financial impact of paying suppliers as late as possible. The key […]

  • Tony Colwell May 18, 2012 at 5:30 pm /

    For most manufacturing businesses and many service businesses, continued financial success is dependent on the performance of the end-to-end supply chain. The reality is that supply chains compete, not individual businesses. So it seems sensible to me that management teams should aim to optimize the end-to-end supply chain. Habitual late payment to suppliers is just one example of a failure to collaborate – in this case within a business, between procurement and financial functions – which will compromise the performance of the supply chain. For further comment see “Supply chain: a cross-functional collaboration… or the blinkered approach of functional silos?” http://acuityconsultants.com/wp/?p=797

  • Ola Yerox May 19, 2012 at 4:11 pm /

    Pete, great article. It certainly isn’t unthinkable. And what’s more, you can be sure the supplier isn’t taking a 19% hit; he’s sharing the pain far and wide; including the buyer himself, so the business isn’t saving all that money they think they are.

    Collaboration is the way…

Post a comment