Who should read this
If you have wondered why supply chain partners don’t seem to want to do what is in everyone’s best interest, even when it’s obvious what’s best for the supply chain.

Symptoms faced if you have Misaligned Incentives
Excess inventory,
Stock outs,
Incorrect forecasts,
Inadequate sales effort and
Poor customer service

Wrong Assumptions Companies make
1. Every firm behaves in ways that maximize its own interests, but companies assume WRONGLY that when they do so they also maximize the supply chain’s interests.
2. Companies assume that supply costs are more or less fixed and have fought with suppliers for a bigger share of the pie.

Why the wrong assumption is not detected
1. It’s much more difficult to tackle inter-company problems rather than intra company issues.
2. It is tedious and time consuming to define roles, responsibilities and accountabilities for a string of businesses managers don’t manage directly.
3. Organizations have different cultures and companies can’t count on shared beliefs or loyalty to motivate partners.

Why Incentives don’t align
1. Hidden Action: When companies cannot observe other firm’s actions, they find it hard to persuade those firms to do what is best for the supply network,

Example: Manufacturer relies on retailer to sell TVs. If manufacturer does not offer lucrative margins on its products, retailer can encourage consumers to buy its private label brand. However, manufacturer cannot observe or track the effort that retailer spends in pushing its products. Since retailer’s actions are hidden from manufacturer, the manufacturer finds it tough to create incentives that induce retailer to do what is best for both companies.

2. Hidden Information: When one company has information that others in supply chain don’t, they find it hard to persuade firms to do what is best for the supply network

Example: Most automotive vendors fear that if they share their cost data, the auto manufacturers will use that information to squeeze the vendor’s margins. For this reason, vendors are reluctant to participate in improvement initiatives that would let manufacturers or other consultants from collecting such data. Since suppliers insist on hiding this info, the supply chain does not function as efficiently as it should.

3. Badly designed Incentive: When incentive schemes are badly designed, companies find it hard to persuade firms to do what is best for the supply network.

Example 1: A juice company allots deliveryman a certain amount of shelf space in stores and offers them commissions based on sales of those shelves. The deliveryman kept the store shelves filled, even when rival juice makers were offering a deep discount to the customer. The juice company had to throw away heaps of unsold bottles, and its costs soared as a result. The deliveryman earned good commissions though.

Example 2: “Grey markets” are unauthorized channels that distribute a branded product without the manufacturer’s permission. Since grey markets are not officially sanctioned by the manufacturer, their existence is assumed to hurt the manufacturer. Yet manufacturers sometimes tolerate or even encourage grey market activities. By encouraging grey market activities without officially authorizing it, the manufacturer may also be trying to target new (low-value) customers without alienating existing (high-value) customers. The existence of grey markets that arise against the manufacturer’s wishes may indicate an incentive conflict in the supply chain. Authorized retailers may have an incentive to divert to a grey market since they can price-discriminate among consumers by creating a grey market. Also, selling in a grey market incurs fewer costs for the retailers, for example, store-level services, and therefore the retailers avoid a cost that is otherwise incurred in the primary market. The firms need to consider the trade-off between the positive effects of a grey market (price discrimination and cost savings) and the negative effects (cannibalization of sales and a loss in consumer valuation).

Direction of solution
Supply chain works well if companies’ incentives are aligned – the risks, costs and rewards need to be fairly distributed across the network.

Company can increase the size of pie itself by aligning partner’s incentive.

How to Cause the Change
1. Acknowledge the problem. Even many well-seasoned executives do NOT understand the operational details of other firms. Companies avoid monetary incentive discussions, since they fear their partners may suspect of them merely trying to negotiate a lower price.

A FMCG company decided to fight the bullwhip effect by managing the inventory themselves. They set up central planning department rather than relying on retailers and distributors for orders. It was a textbook solution.

It failed.

Because there was too much resistance from distributors and retailers who were convinced that the manufacturer had just reduced their role.

2. Decide to attack the root cause, not the symptoms: As managers, you need to understand if the problem is of Hidden action, Hidden information or Badly designed incentive. Basis your analysis, you need to decide which of the techniques to use

• Contract Based
• Information Based
• Trust Based

3. Redesign the Incentive system / Contract: Unhide information and actions. For instance in the case where:

Manufacturer was relying on retailer to sell TVs – Start tracking the OUTCOME of the result (increase or decrease in sales) and draw agreement to reward accordingly
Juice company allots deliveryman commissions based on sales of those shelves. Include penalties for expired merchandise in stores, which can be tracked. While penalties will reduce the incentive to overstock, commissions will ensure that deliveryman keeps the shelves well stocked.
In the grey market example, If the retailer only diverts to a local grey market, it is sufficient for the manufacturer to employ the wholesale price contract to control the grey market; but it is necessary for the manufacturer to monitor the retailer’s temptation to sell in the grey market. If the retailer is bootlegging, the manufacturer may, in some cases, need additional tools (such as taking legal action) to ban grey markets

4. Start measuring more variables: A FMCG company offered distributors discounts several times every year. But, distributors bought more units than they sold to the retailer. This led to huge sale fluctuation for the FMCG company. The company sold 40% of an item in the 6 weeks promotion period. Imagine the pressure on supply chain. The FMCG company then invested in IT system that could track both purchases and sales of distributors. Then, by giving discount on sales but not on purchase, the FMCG company eliminated the incentive to forward buy large quantities.

Another company uses mystery shoppers to monitor cleanliness and friendliness at the retail point.

Specific Actions to take:
Companies should conduct incentive audits whenever they adopt new technology or enter new markets.
Companies should educate managers about supply chain partners.
Depersonalize situation by getting managers to examine case studies from other industries.
By changing how, rather than how much, company pays it’s partners, companies can improve supply chain performance. When that happens, ALL The firms make more money than they used to.

References

Shao and McCormick: Production and Operations Management
Narayanan and Raman: HBR