Determining the optimal customization levels, lead times, and inventory positioning in vertical product differentiation

Abstract

In this paper we study a manufacturer's product line design decisions when selling customized products in a market where customers are heterogeneous with respect to valuation of product attributes. The product has two attributes based on which a consumer's product valuation is determined. The first attribute is customization level, defined by the extent to which consumers are involved in the value chain. The second attribute is delivery lead time which is influenced by the customization level. We consider a market that consists of two segments. Consumers in the first segment highly value customization level and are not as concerned with lead time. In contrast, customers in the second segment are very concerned with lead time and place less importance on customization level. Given such product and market characteristics, the manufacturer must make a choice whether to offer a single customized product or to exploit the benefits of market segmentation by offering two different customized products. Different from most existing work in the product line design literature that neglects the operational aspects attached to production, here we consider the pipeline and safety inventory positioning along the production processes which is interdependent with the customization level and lead time decisions. The model developed provides insights into the conditions under which the manufacturer should opt for the two-product strategy with two different customization levels or the one-product strategy with a single customization level. In particular, we show that considering pipeline inventory and safety stock costs generally leads to lower optimal customization levels, and that the two-product strategy is preferred in most cases.