Coordinating production quantities and demand forecasts through penalty schemes

In this paper, we study coordination mechanisms through penalty schemes between manufacturing and marketing departments which enable organizations to match demand forecasts with production quantities. This research was motivated by our interactions with a leading electronics and computer manufacturer. We consider two possible organizational structures – centralized and decentralized. In the decentralized case we model a single period problem where demand is uncertain and the marketing department provides a forecast to manufacturing which in turn produces a quantity based on the forecast and the demand distribution. In the centralized case, marketing and manufacturing jointly decide on the production quantity. Among other results we show that by setting suitable penalties one can generate the same result in a decentralized system as that obtained from a centralized system. We also show that setting the correct penalty for marketing is essential for coordination. Subsequently, we analyze models where the marketing department has the ability to change the distribution of demand based on efforts (through promotion, advertising and personal relationship with customers). An interesting result indicates that it is possible to set penalties so that a coordinated decentralized system outperforms a centralized system when there are no tangible costs to the firm for the efforts expended by the marketing department.