Aligning Incentives for Supply Chain EfficiencySource: Profs. AnanthRaman & VG Narayanan/ Harvard

CISCO – World’s largest network eqpt. maker2

CISCO’s supply chain is the rule, rather than the exception.3Misaligned Supply ChainDistributorCompanySupplier

InsightA supply Chain works well only when its players equally share risks, costs and rewards of doing business together.How to make it work?4

Lead PractitionersAligned Supply Chains give big payoffs5

How to Realign Incentives in Your Supply ChainAcknowledge incentive problemsIdentify root causes of misalignmentHidden actionHidden informationBadly designed incentive schemesAlign or redesign incentives6

Align/ Redesign Supply Chain7

Results of Poor Incentives/ Alignment8

Incentives in Supply ChainsImplementing change in supply chains is often difficult due to behavioral or organizational issuesAt times, hard to change peoples’ behaviour because of habit or lack of knowledge. Education helpful: P&G; ToyotaOften 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.9

Supply Chain ControlSupply chain management involves managing processes across organization and firm boundaries.Important to consider incentives for different decision-makers 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 e-commerce intermediaries (e.g. e-bay type or B2B exchanges)10

Theoretical FoundationsEconomics; especially principal-agent theory.Substantial academic research in operations management currently focuses on role of contracts & incentives.Most managers acknowledge importance of incentives.But, framework lacking in spite of academic research.11

Principal-Agent Theory12PrincipalAgentIncentivesDesigns IncentivesAllocates Information &DecisionsChoosesActionsFind 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.

Root CausesHidden Action (Moral Hazard)Hidden Information (Adverse Selection)Salesperson effortSubstitute products (Private Label)Moral Hazard on Safety Stock.Pre-ContractHeart-attack insuranceSoundScan: trend-setting retailers might not joinOwens & Minor13

Moral Hazard Exists when:14NotContractibleCostly forAgentImpactsPrincipalandandContractibleEnforceableObservableVerifiableandand

Soundscan & Newbury ComicsSoundscanelectronically 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 yearsSoundscansaiddata 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 planning15

Adverse Selection in SoundscanAt 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 MartFollow-up phone calls revealed that Soundscan itself had engaged in consulting arrangements with some retailersNewbury decided to withdraw from SoundscanAdverse Selection: Retailers that are leading indicators of demand would choose to stay out of SoundscanTaking logic to extreme, no retailer will join Soundscan16

Owens & Minor, Inc.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 chainCost-plus contracts in supply chain (e.g. 7% above cost)Hospitals wanted to buy in smaller quantitiesw/out paying us more , hospitals wanted us to carry more of the inventory, and make more deliveries in lower units of measureO&M wanted to ship larger quantities“Cherry Picking”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 $56With 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.17

Problems also due to Badly designed IncentivesBarilla : Salespeople paid on commission based on sales in a period even tho’ logistics had shipping decisionsBread Co.: Drivers rewarded for sales, not penalized for “stales”.Better incentives can be designed in these situationsOften, even bright people fail to anticipate self serving behaviour from other firms and decision makers18

Overcoming Goal IncongruenceContract basedInformation basedTrust & Relationship based-----------------Identifying which one is appropriate under diff. circumstances requires managerial judgment and knowledge of business. Hence critical role for general manager19

Contract-based SolutionsMoral HazardContractible outcomes:e.g. sales commissionBread company (stale penalty)Bryn-Mawr Stereo store manager incentivesAdverse SelectionWarrantyReturn-rightsFees=% savings20

Information-based SolutionsMoral HazardMeasure more variables (e.g. Campbell Soup, track what distributor sold (versus what they bought)IT, mystery shoppersAdverse SelectionCredit rating, Bill Feth at AESCOActivity-Based Costing at Owens & Minor helped in identifying “hospital type”. Activity based pricing overcame moral hazard.21

Trust-based SolutionsKey idea in “trust-based” solutions is to convert episodic relationships to repeat interactions.IntermediariesLi & Fung reduces moral hazard by ensuring both supplier & importer stick to contract.22ExportersMoral Hazard-Child labor, bribingReneging on promisesAdverse SelectionDo not know importersTrack recordLi & FImportersMoral Hazard-reject good products thatDo not sell wellAdverse SelectionDo not know exporters trackrecord

Reneging on promises

Aligning IncentivesRecognizing Potential IncongruenceOften obviousExpect during reengineering, auctionsPinpointing Goal IncongruenceRole Play: How would your decisions have been different?Look for hidden action and informationCan those differences be due to incentives? Be open mindedUse solutions presented to overcome problemsContracting or information then Trust/ structureAt times, measurement w/out incentives enough (e.g. forecast errors, lost sales)Solution for one firm, might cause problems for othersFirm & decision-maker incentives23

Impact of Store Manager Incentives in Consumer Electronics Retailing24

Store Manager Incentives (Consumer Electronics Retail Chain)Bryn MawrTweeterBonus based on % of salesMin 0.2%Max 5%Deduction in pay based on shrinkDeduct $1 in pay for every dollar of shrinkBonus based on % of store operating incomeMin $300Max 20%25

Bryn Mawr Sales in $ K for various stores26

Bryn Mawr Store Comparison SHRINK $27

Store Manager BehaviourBryn Mawr: DefensiveTweeter: Aggressive“Sales prevention” environmentKey HoldersFocus…Disintcentivizing bad behaviourSales people 2nd class citizens“Sales Driven “ environmentSales LeadersFocus..Incentivizing good behaviourEntrepreneurs28

Did Incentives Drive Sales & Shrink29SalesIncentivesMonetoryAndNon-monetoryStoreManagerBehaviorStoreProfitShrink

Rival Hypothesis30Growth in IndustryAPPSalesAssortmentAdvertisingProcesses/ TrainingIncentivesMonetory &Non MonetoryStoreManagerBehaviorStoreProfitInventoryTurnoverShrink

Store Level Impact of Change in Incentive System9.94% in SALES An average storegenerates 185,946additional sales dollars per yearSHRINK also changedAn average store loses 8,834additional dollars per year31

Chain-Wide Impact$ 2,231,348 additional SALESvs$ 106,006 additional SHRINK per yearINCREASE IN NET PROFIT AMOUNTS TO 2.5% OF SALES(Retailers typically earn 2% of sales)Tweeter has applied similar approach at other acquisitions.32