1) Cisco's supply chain collapsed in 2001 due to misaligned incentives that encouraged contractors to build excess inventory without concern for Cisco's real needs. 2) Most supply chains have misaligned incentives that cause problems like excess inventory, stock-outs, and poor customer service. 3) Well-designed incentives like 7-Eleven's that closely align partners' interests through penalties, profit sharing, and trust build efficient supply chains with low stock-outs.

1. Aligning
Incentives
in Supply Chains
Presenter: Liu Qi

2. CISCO –
World’s largest network equipment maker
• In 2001, its much vaunted supply chain had snapped
• CISCO shocked investors by scraping $2.5 billion of
surplus raw materials - one of the largest inventory
write-offs in U.S. business history
• Reason: contractors had everything to gain and
nothing to lose by building excess inventory, they did
not worry about CISCO's real needs

3. CISCO's supply chain is the rule rather than an
exception
• Companies don't worry about the
behavior of their partners
• Every firm behaves in ways that maximize
its own interests rather than the supply
chain's interests

4. A supply chain can work well when certain
conditions applied
A supply chain works well if its
companies' incentives are aligned
risks, costs, and rewards of doing
business are distributed fairly across the
network

5. Incentive plays an important role in supply chain
• well designed and aligned incentives can make a supply
chain more efficient and create a win-win situation
• misaligned incentives may cause
– excess inventory
– stock-outs
– incorrect forecasts
– inadequate sales efforts
– even poor customer service

6. An example of well designed and aligned
incentives in supply chain: 7-Eleven
world's largest operator, franchisor
and licensor of convenience stores
it has low stock out rates and in
2004 had an inventory turnover of
55
30% gross profit margin, one of the
most profitable retailers in the world

7. An example of well designed and aligned
incentives in supply chain: 7-Eleven Cont.
close alignment between 7-11's interests and its
partners
incentives are clear, e.g.,fail to deliever on time will
result a penalty payment
share rewards with partners
build deep trust with partners

8. However, it is hard to align incentives
• companies cannot observe other firms'
actions
• information is not available for everyone
• incentive schemes are often badly designed

9. How to realign incentives in your supply chain
Acknowledge incentive problems
-hidden actions
Diagnosing the cause -hidden information
-badly designed
incentives
Align or redesign

10. Align or redesign incentives
Rewriting contracts
Revealing hidden information
developing trust

11. Rewriting Contracts
• creating a contract that rewards or penalizes
partners based on outcomes
• a powerful tool - small changes in incentives
can transform supply chains quickly - should be
used before other apporaches
e.g. rewriting contracts between video retailers and
studios

12. Video Retailers VS. Studios?
from traditional contract to revenue sharing contract
rental revenue increased by 15%, profit increased 5%

13. Revealing Hidden Information
• basic rule: making actions visible
• most effective way: tracking and
monitoring more business variables
• other methods: information system,
mystery shoppers

14. Developing Trust
• use intermediaries to align the incentives
of the two parties
• build long term relationship based on a
mutual benefit belief

15. Two caveates of aligning incentives
• a solution that resolves incentive
misalignment for one company may
exacerbate the problem for another
• companies must align the incentives of all
the key decision makers in their supply
chains

16. Conclusion
• companies should always study their supply chains
• conduct incentive audits
• educate managers about their supply chain partners
• examine case studies from other industries