Source: Profs.

Ananth Raman & VG Narayanan/ Harvard

In 2001 its much vaunted supply chain snapped

CISCO shocked shareholders by disclosing $2.5 bn w/off50% of quarterly sales Contractors had everything to gain and nothing to lose by continuing to build inventory
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Misaligned Supply Chain

Insight

A supply Chain works well only when its players equally share risks, costs and rewards of doing business together.

How to make it work?

Aligned Supply Chains give big payoffs

1.

2.

3.

Acknowledge incentive problems Identify root causes of misalignment 1. Hidden action 2. Hidden information 3. Badly designed incentive schemes Align or redesign incentives

Contract Based

Information Based
Trust Based
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Implementing change in supply chains is often difficult due to behavioral or organizational issues At times, hard to change peoples behaviour because of habit or lack of knowledge. Education helpful: P&G; Toyota Often problem can be traced to incentives.

Need to focus on not only how much, but also, how, various people and firms are compensated.

Misaligned incentives at core of trust problem. Sustainable trust requires incentive alignment.
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Supply chain management involves managing processes across organization and firm boundaries.

Important to consider incentives for different decisionmakers and firms.

Good supply chain management involves thinking like an engineer (people are dumb but honest) and like an economist ( people are dishonest but smart). Designing suitable control structures vital for ecommerce intermediaries (e.g. e-bay type or B2B exchanges)
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Principal Agent

Designs Incentives Allocates Information & Decisions

Chooses Actions

Find problems & solutions through rigorous role play in the supply chain. Finding problems & solutions requires creativity. Framework alone does not lead to formulas that can be applied directly.
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HIDDEN ACTION (MORAL

HAZARD)

HIDDEN INFORMATION (ADVERSE SELECTION)

Salesperson effort Substitute products (Private Label) Moral Hazard on Safety Stock.

Pre-Contract Heart-attack insurance SoundScan: trendsetting retailers might not join Owens & Minor

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Costly for Agent

and

Impacts Principal

and

Not Contractible

Contractible Observable
and

Verifiable

and

Enforceable
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Soundscan electronically tallies every single record sold by 85% of music retailers in USA. Summary reports sold to supply chain. Newbury, which frequently carries products that feature, and works to promote new artists is a leading indicator of consumer demand. Newbury shared sales data with Soundscan for 6 years Soundscan said data would be shared only in aggregate form In addition, Newbury believed that Soundscan would not use its expertise to advise other retailers on merchandising and inventory planning
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At a trade show, Handleman Co., a rack-jobber to WalMart, bragged about how they were able to discern regional patterns from Soundscan data and use them to stock merchandise appropriately at Wal Mart Follow-up phone calls revealed that Soundscan itself had engaged in consulting arrangements with some retailers Newbury decided to withdraw from Soundscan Adverse Selection: Retailers that are leading indicators of demand would choose to stay out of Soundscan Taking logic to extreme, no retailer will join Soundscan
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O&M, a $ 3 billion distributor of medical & surgical supplies, was reeling under substantial losses in 1995, primarily due to the misaligned incentives in its supply chain Cost-plus contracts in supply chain (e.g. 7% above cost) Hospitals wanted to buy in smaller quantities

w/out paying us more , hospitals wanted us to carry more of the inventory, and make more deliveries in lower units of measure O&M wanted to ship larger quantities Large box of adult diapers that cost $ 30 yielded O&M a gross margin $2.10, while a small box of cardiovascular sutures that cost $800 yielded a gross margin of $56

Cherry Picking

With cost plus contracts O&M was also unable to identify & pursue more profitable customers- costplus contracts made it hard for O&M to evaluate the profitability of diff. customer accounts at the time of signing a contract.
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Barilla : Salespeople paid on commission based on sales in a period even tho logistics had shipping decisions Bread Co.: Drivers rewarded for sales, not penalized for stales. Better incentives can be designed in these situations Often, even bright people fail to anticipate self serving behaviour from other firms and decision makers
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Contract based Information based Trust & Relationship based ---------------- Identifying which one is appropriate under diff. circumstances requires managerial judgment and knowledge of business. Hence critical role for general manager

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Moral Hazard

Contractible outcomes:
e.g. sales commission Bread company (stale penalty) Bryn-Mawr Stereo store manager incentives

Adverse Selection

Warranty Return-rights Fees=% savings

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Moral Hazard

Measure more variables (e.g. Campbell Soup, track what distributor sold (versus what they bought) IT, mystery shoppers
Credit rating, Bill Feth at AESCO Activity-Based Costing at Owens & Minor helped in identifying hospital type. Activity based pricing overcame moral hazard.

Adverse Selection

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Key idea in trust-based solutions is to convert episodic relationships to repeat interactions. Intermediaries

Li & Fung reduces moral hazard by ensuring both supplier & importer stick to contract.
Li & F

Exporters

Moral Hazard -Child labor, bribing -Reneging on promises Adverse Selection Do not know importers Track record

Importers

Moral Hazard -reject good products that Do not sell well Adverse Selection Do not know exporters track record
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Recognizing Potential Incongruence

Often obvious Expect during reengineering, auctions

Pinpointing Goal Incongruence

Role Play: How would your decisions have been different? Look for hidden action and information Can those differences be due to incentives? Be open minded Contracting or information then Trust/ structure At times, measurement w/out incentives enough (e.g. forecast errors, lost sales) Solution for one firm, might cause problems for others Firm & decision-maker incentives
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Use solutions presented to overcome problems

Impact of Store Manager Incentives in Consumer Electronics Retailing

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BRYN MAWR

TWEETER

Bonus based on % of sales

Bonus based on % of store operating income

Min 0.2% Max 5%

Min $300 Max 20%

Deduction in pay based on shrink

Deduct $1 in pay for every dollar of shrink

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I H G F

E
D C B A 0 50 100 150 200 250

Avg Aftr Avg B'fore

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I H G F

E
D C B A -1200 -1000 -800 -600 -400 -200 0 200

Avg Aftr Avg B'fore

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BRYN MAWR: DEFENSIVE

TWEETER: AGGRESSIVE

Sales prevention environment Key Holders Focus Disintcentivizing bad behaviour Sales people 2nd class citizens

Sales Driven environment Sales Leaders Focus..

Incentivizing good behaviour Entrepreneurs

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Sales

Incentives Monetory And Nonmonetory

Store Manage r Behavio r

Shrink

Store Profit

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Growth in Industry

APP Sales Assortment

Advertising

Processes/ Training

Incentives Monetory & Non Monetory

Store Manager Behavior

Inventory

Turnover

Store Profit

Shrin k
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9.94%

in SALES

SHRINK also changed An average store loses 8,834 additional dollars per year

An average store generates 185,946 additional sales dollars per year

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$ 2,231,348 additional SALES vs $ 106,006 additional SHRINK per year INCREASE IN NET PROFIT AMOUNTS TO 2.5% OF SALES (Retailers typically earn 2% of sales) Tweeter has applied similar approach at other acquisitions.
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