Aligning Incentives for Supply Chain Efficiency

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Aligning Incentives for Supply Chain Efficiency
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Incentives in Supply Chains

• Implementing change in supply chains is often
  difficult due to behavioral or organizational
  issues.
• At times, hard to change peoples behavior
  because of habit or lack of knowledge.
• Often, problem can be traced to Incentives.
• Focus on not only how much, but also how, various
  people and firms are compensated.
• B2B exchanges cannot work (at high volume) if
  incentive issues are not resolved.
• Good supply chain management involves thinking
  like an engineer (people are dumb but honest)
  and like an economist (people are dishonest but
  smart).

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Principles of Incentive Alignment

• What have we learned from multiple case studies
  and papers?

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Principal-Agent Theory
Find problems and solutions through rigorous
role-play in the supply chain.
Finding problems and solutions requires
creativity. Framework does not lead to formulas
that can be applied directly.
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What causes Incentive Misalignment?

• Hidden Action or Hidden Information
• Hidden means uncontractible,
• That is, you cannot write a contract on it or
• You cannot base incentives on this information.
• If you could contract on this information, there
  would be no incentive misalignment.

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So, how to Align Incentives?

• Unhide the hidden action or information!
• Ways to unhide.
• Measurement Explicitly track the hidden action.
• Contract Implicitly track the hidden action.
• Unhide through repeated interaction.

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Video Rental

• Supply Chain Close-Up The Video Vault
• V.G. Narayanan Lisa Brem, HBS Case Study
  9-102-070

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Video Rental Stockouts

• Out-of-stocks were the single biggest problem in
  our industry.
• Studios sell videocassettes to video rental
  stores at 60, which rent them out for around 3.
  Salvaged at 3.
• The incremental cost for studios to put an
  additional tape on the retailers shelf is less
  than 3.
• To break even, the retailer needs to rent the
  tapes 20 times. But the channel breaks even on
  the first rental.
• What is action/decision that cannot be monitored?
• Changes in mid-1990s
• Consumers refused to substitute, unhappiness
  tracked in surveys
• Blockbuster and similar chains became big clients.

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Revenue Sharing

• Sell the tapes at 3 to retailer and ask the
  retailer for a share of the revenues (typically
  around 50).
• Profits for both studios and retailers increased
  while customers benefited too.
• Retailer guaranteed in-stocks of hot titles.
• Rentrakmonitors scanner data.
• Additionally performs audits and surprise checks
  to monitor compliance with revenue sharing
  contracts.
• Blockbuster proposed to all studios, one
  (Warner?) agreed. Results convinced other studios
  to adopt revenue sharing as well.

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Impact of Store Manager Incentives in Consumer
Electronics Retailing

Harvard Business School Working paper, Nicole
DeHoratius and Ananth Raman
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Store Manager Incentives

• Bryn Mawr
• Bonus based on of sales
• Min 0.2
• Max 5
• Deduction in pay based on shrink
• Deduct one dollar in pay for every dollar of
  shrink

• Tweeter
• Bonus based on of store operating income
• Min 300
• Max 20

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Store Manager Behavior

• Bryn Mawr Defensive
• Sales Prevention Environment
• Key Holders
• Focus
• Disincentivizing bad behavior
• Sales people 2nd class citizens

• Tweeter Aggressive
• Sales Driven Environment
• Sales Leaders
• Focus
• Incentivizing good behavior
• Entrepreneurs

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Did Incentives Drive Sales and Shrink?
Sales
Incentives Monetary Non-Monetary
Store Profit
Store Mgr. Behavior
Shrink
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Rival Hypotheses
APP (Automatic Price Protection)
Growth in Industry
Assortment
Sales
Processes/Training
Advertising
Incentives Monetary Non-Monetary
Store Profit
Store Mgr. Behavior
Inventory
Turnover
Shrink
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Store Level Impact of Change in Incentive System

• 9.94 in SALES
• An average store generates
• 185,946
• additional sales dollars per year

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

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Chain-Wide Impact

• 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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Distribution of Medical Supplies

• The Market for Services

Harvard Business School Case Study 100055
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Medical Supplies Distribution

• Most distributors of medical supplies were losing
  money. Owens and Minor, a 3 Billion distributor,
  in its 1995 annual report described the company
  struggling through the two toughest quarters in
  the companys history.
• Some competitors could offer lower prices because
  they were owned by large manufacturers.
• Cost-plus contacts in supply chain. (e.g. 7
  above cost)

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Impact of Misaligned Incentives on Operations

• Hospitals wanted to buy in smaller quantities.
• Without paying us more, hospitals wanted us to
  carry more of the inventory, and make more
  deliveries in lower units of measure.
• OM wanted to ship larger quantities.
• Cherry Picking
• Large box of adult diapers that cost 30 yielded
  OM a gross margin 2.10, while a small box of
  cardiovascular sutures that cost 800 yielded a
  gross margin of 56.
• With cost-plus contracts, OM was also unable to
  identify and pursue more profitable customers.
• Costplus contracts made it hard for OM to
  evaluate the profitability of different customer
  accounts at the time of signing a contract.

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Management under Cost contracts

• Our negotiation with the customer entailed them
  to get our fee down to 6 of the product price
  and us trying to get it up to 8. There was no
  discussion of a change in services it was simply
  who had the strongest will to win. Mike
  Stefanic, OM, Dir of Budgets
• Constant pressure to reduce SGA expenses at
  distributors. Warehouse personnel costs had to be
  watched very carefully. OM reduced these costs
  from 12.5 of net sales in 1984 to 6.8 in 1994
  but these costs had started rising again in 1995.

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Activity-Based Costing

• Customer Profitability determined by
• The type of service requested (JIT)
• Number of purchase orders per month
• Number of lines per purchase order
• Number of deliveries per week
• Method of order
• Inventory carrying cost
• Many customers unprofitable.

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Activity-Based Pricing The Concept

• Developed a price for each activity. (e.g.,
  expedited delivery, smaller shipment sizes,
  kitting -- identify price for each activity).
• Some hospitals stopped using OM -- unprofitable
  ones?
• Overall sales increased rare profitable
  distributor growth in profits 1.35 billion
  sales in activity based pricing contracts (out of
  total sales of 4.2 Billion).
• One of few medical distributors that offers
  services (profitably).

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Transitioning to the New Contract

• We had an academically perfect concept but we
  needed a way to sell it.
• Contract based on two drivers orders/month,
  lines ordered per month.
• Shared cost and profit data with customers.
• An accountant-salesman. Customers accepted
  accountants because they werent salesmen.
• Opportunistic Contract for Ideal.

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Other Implementation Barriers

• Hospital accounting systems budgets and transfer
  prices -- were based on cost contracts.
• To derive benefits from ABP, hospitals had to
  change their behavior and processes.
• Billing, ordering and all the logistical
  services involvedhave to be streamlined and made
  compatible with our systems.Evaluating entire
  systems and costing individual processes takes
  time and resources. Jose Valderas, Regional Vice
  President, Owens and Minor.

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Fashion Supply Chains

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Globalization of Supply
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Global or Chinese?
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Misaligned Incentives in Fashion Supply Chains
Importer
Contract Enforcement Often weak
Exporter

• Importers Fears
• Risk of reneging
• Compliance
• -child labor
• Bribing
• Designs could be leaked

• Exporters Fears
• Rejection on frivolous grounds
• failure to pay
• Designs could be leaked

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Aligning Incentives in Fashion Supply Chains

• Personal Relationships
• Sport Obermeyer Joint venture with Raymond Tse,
  Hong Kong supplier. Business moved to China
  (Raymonds ancestral village) in mid 1990s but
  Raymond ran the show.
• What if commitment to a single supplier is too
  costly?
• Intermediaries in Prato, Italy Or Hong Kong
• In 1981, Prato system has 15,000-20,000 firms
  with 80,000 people, and annual sales of 1.6
  billion (80K/firm).
• Each firm highly specialized.
• Commitment to single supplier infeasible and
  inflexible.
• Episodic relations between customer (in NY) and
  supplier but repeat relationship with Menichetti.
• Why does this induce incentive alignment?

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Barriers to Incentive Alignment

• Often, in ways managers think about these issues.
• Incentives (how you pay) often confused with
  negotiations (how much you pay).
• Behavioral problems not recognized as incentive
  problems. Hard for people to acknowledge that
  their own behavior is driven by incentives.
• Managers with ability to set contracts dont
  understand operational details well enough to
  understand impact of contracts. (Problems tucked
  in operational details.)