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HBR Spotlight

The 21st-Century Supply Chain

A supply chain stays tight only if every company on it has reasons to pull in the same direction.

by V.G- Narayanan and Ananth Raman

Aligningnee in Supply Chains

Wall Street still remembers the day it heard that Cisco's much- vaunted supply chain had snapped. On a mad Monday, April 16, 2001, the world's largest network-equipment maker shocked inves- tors when it warned them that it would soon scrap around $2.5 bil-

lion of surplus raw materials-one ofthe largest inventory write-offs in U.S. busi- ness history. The company reported in May a net loss of $2.69 billion for the quarter, and its share price tumbled by approximately 6% on the day it made that announcement. Cisco was perhaps blindsided by the speed with which the United States had advanced into recession, but how could this paragon of supply chain management have misread demand by $2.5 billion, almost half as much as its sales in the quarter? Experts blamed the company's new forecasting software, and ana- lysts accused senior executives of burying their heads in sockets, but those experts and analysts were mostly wrong.

In truth, Cisco ended up with a mountain of subassembly boards and semicon- ductors it didn't need because ofthe way its supply chain partners had behaved in the previous 18 months. Cisco doesn't have production facilities, so it passes orders to contract manufacturers. The contractors had stockpiled semifinished products because demand for Cisco's products usually exceeded supply. They had an incen- tive to build buffer stocks: Cisco rewarded them when they delivered supplies quickly. Many contractors also boosted their profit margins by buying large vol- umes from component suppliers at lower prices than Cisco had negotiated. Since the contractors and component makers had everything to gain and nothing to lose by building excess inventory, tbey worked overtime to do so without worrying about Cisco's real needs.

94 HARVARD BUSINl SS REVIEW

The 21st-Century Supply Chain

When demand slowed in the first half of fiscal 2000, Cisco found that it couldn't cut off supplies quickly. More- over, it wasn't clear what Cisco had asked its suppliers to produce and what the contractors had manufactured in anticipation of Cisco's orders. Many contractors believed that Cisco had implicitly assured them it would buy every- thing they could produce. Since Cisco hadn't stipulated the responsibilities and accountability of its contractors and component suppliers, much ofthe excess inventory ended up in its warehouses. However, the supply chain imploded because Cisco's partners acted in ways that weren't in the best interests ofthe company or the supply chain.

It's tempting to ask, in retrospect, "What was everyone thinking?" But Cisco's supply chain is the rule rather than an exception. Most companies don't worry about the be- havior oftheir partners while building supply chains to deliver goods and services to consumers. Engineers-not psychologists-build supply networks. Every firm behaves in ways that maximize its own interests, but companies as- sume, wrongly, that when they do so. they also maximize the supply chain's interests. In this mistaken view, the quest for individual benefit leads to collective good, as Adam Smith argued about markets more than two cen- turies ago. Supply chains are expected to work efficiently without interference, as if guided by Smith's invisible hand. But our research over the last ten years shows that executives have assumed too much. We found, in more than 50 supply chains we studied, that companies often didn't act in ways that maximized the network's profits; consequently, the supply chains performed poorly.

That finding isn't shocking when you consider that sup- ply chains extend across several function-> and many com- panies, each of which has its own priorities and goals. Yet all those functions and firms must pull in the same direc- tion to ensure that supply chains deliver goods and ser- vices quickly and cost-effectively. Executives tackle intra- organizational problems but overlook cross-company problems because the latter are difficult to detect. They also find it tedious and time-consuming to define roles, responsibilities, and accountability for a string of busi- nesses they don't manage directly. Besides, coordinating actions across rirms is tough because organizations have different cultures and companies can't count on shared beliefs or loyalty to motivate their partners. To induce supply chain partners to behave in ways that are best for everybody, companies have to create or modify monetary incentives.

V.G. Narayanan (vnarayanan((i''hbs.t'dit) is a professor of business tuiministration, and Ananth Raman (araman(a'hbs .edit) is the UPS Foundation Professor of Business Loi;isties, at Harvard Business School in Boston.

A supply chain works well if its companies' incentives arealigned-that is, if the risks, costs, and rewards of doing business are distributed fairly across the network. For rea- sons that we shall laterdiscuss, if incentives aren't in line, the companies'actions won't optimize the chain's perfor- mance. Indeed, misaligned incentives are often the cause of excess inventory, stock-outs, incorrect forecasts, inade- quate sales efforts, and even poor customer service.

When incentives aren't aligned in supply chains, it's not just operational efficiency that's at stake. In recent years, many companies have assumed that supply costs are more or less fixed and have fought with suppliers for a big- ger share ofthe pie. Eor instance, U.S. automobile manu- facturers have antagonized their vendors by demanding automatic price reductions every year. Our research, how- ever, shows that a company can increase the size of the pie itself by aligning partners' incentives. Thus, the fates of all supply chain members are interlinked: If the com- panies work together to efficiently deliver goods and ser- vices to consumers, they will all win. If they don't, they will all lose to another supply chain. The challenge is to get all the firms in your supply network to play the game so that everybody wins. The only way you can do that is by aligning incentives.

Why Incentives Get out of Lino

C ompanies often complain to us that their supply chain partners don't seem to want to do what is in everyone's best interests, even when it's obvious

what's best for the supply chain.This obstructive attitude, we believe, is a telltale sign that incentives have gotten out of line and companies are chasing different goals.

There are three reasons why incentive-related issues arise in supply chains. First, when companies cannot ob- serve other firms' actions, they find it hard to persuade those firms to do their best for the supply network. A sim- ple illustration: Whirlpool relies on retailers like Sears to sell its washing machines because retailers' salespeople greatly infiuence consumer decisions. If Whirlpool doesn't offer lucrative margins on its products. Sears will plug products that do or will encourage shoppers to buy its private-label brand, Kenmore. However, Whirlpool can't observe or track the effort that Sears expends in pushing its products. Since Sears's actions are hidden from Whirl- pool, the manufacturer finds it tough to create incentives that induce the retailer to do what's best for both compa- nies. Such "hidden actions,"as we call them, exist all along the supply chain.

Second, it's difficult to align interests when one com- pany has information or knowledge that others in the supply chain don't. For example, most U.S. automotive

96 HARVARD BUSINESS REVIEW

Aligning Incentives in Supply Chains

The Economics of Incentive Alignment

If a company aligns the incentives ofthe firms in its supply

chain, everyone will make higher profits. This isn't an idie

claim; we can easily demonstrate it in the case of a two-

company supply chain.

Let's say a publisher prints newspapers at a cost of 45

cents per copy and sells them to a news vendor for So cents

each, and the newspaper retails for $1,00. Let's also assume

that demand for the newspaper is uniformly distributed

between lOO and 200 copies a day.

The vendor has to throw away unsold copies, so he has

to compare two kinds of costs before deciding how many

copies to stock. He loses 80 cents for every unsold copy, but

If demand exceeds supply, his opportunity cost is 20 cents

per copy. The vendor's inventory level will be optimal when

the marginal understocking cost eguals the marginal over-

stocking cost – in this case, when he orders 120 copies. The

vendor will stock fewer copies than the average demand of

150 per day because the overstocking cost (80 cents) is four

times higher than the understocking cost (20 cents). That

could lead to frequent stock-outs.

If the publisher produced and sold the newspaper him-

self, he would incur an understocking cost of 55 cents (the

retail price less the printing cost) and an overstocking cost

of 45 cents (the unit costof printing). According to our cal-

culations, the publisher's profits would be greatest if he

were to stock 155 copies, not no. (For details on how we ar-

rived at the numbers presented here, see V.C. Narayanan's

technical note "The Economics of Incentive Alignment,"

Harvard Business School, 2004.) In fact, both the publisher

and the consumers would be happier if there were more

copies of the newspaper on the stands, but the vendor

would not be. The vendor stocks less than everyone else

would like him to because it is in his best interest to do so.

The publisher therefore needs to change the incentives of

the news vendor so that when the vendor chooses an in-

ventory level that is in his best interest, it increases the pub-

lisher's profits.

One way the publisher could do that is by using a revenue-

sharing contract and lowering the price the vendor pays for

each copy from 80 cents to 45 cents. In return, the vendor

could retain, say, 65% ofthe sale price and pass on ss^siitothe

publisher. The retailer's understocking costs would remain

20 cents, but his overstocking costs would fall because he'd

pay less for each copy. The retailer would now be inclined

to stock 131 copies instead of 120. The profits of both the re-

tailer and the publisher would rise (see the table below).

Alternately, the publisher could pay the retailer mark-

down money of, let's suppose, 60 cents for every unsold

copy. That would lower the overstocking costof the retailer

and encourage him to stock more copies. The publisher

would more than make up for bearing someof that cost be-

cause of profits he'd gain in higher sales. In this case, the re-

tailer would stock 150 copies.

As the exhibit shows, both the publisher and the retailer

would earn more profits under the revenue-sharing and

markdown-money contracts considered here than under

the traditional system. The increase in profits would not

come at the expense of consumers, who'd pay the same re-

tail price- Inventory levels would also go up, which would

result in greater consumer satisfaction.

Costs and Protits

Retail Price

Printing Cost

Wholesale Price

Vendor's Share of Revenue

Vendor's Compensation

for Unsold Copies

Vendor's Understocking Cost

Vendor's Overstocking Cost

nventory Level

Vendor's Daily Profit

Publisher's Daily Profit

Supply Chain's Daily Profit

Traditiona Contract

$1.00

S0.45

$0,80

100%

—

$0,20

$0.80

120 copies

$22,00

$42,00

$64 00

Revenue-Sharing Contract

$1,00

$0.45

$0,45

65%

—

$0.20

$0,45

131 copies

$23.08

$44.17

$67,25

Markdown-Money

Contract

$1,00

$0.45

$0,80

100%

$0,60

$0.20

$0,20

150 copies

S25,00

$45,00

$70.00

2004 97

The 21st-century Supply Chain

vendors fear that if they share their cost data, the Big Three auto manufacturers will use that information to squeeze the vendors' margins. For thdt reason, suppliers are reluctant to participate in improvement initiatives that would let manufacturers or other companies collect such data. Since the suppliers insist on hiding informa- tion, the Big Three's supply chains don't function as effi- ciently as they could.

Third, incentive schemes are often badly designed. Our favorite example of this problem is a Canadian bread manufacturer that felt it needed to increase its stocks in stores. The manufacturer allotted deiiverymen a certain amount of its shelf space in stores and offered them com- missions based on sales off those shelves. The delivery- men gladly kept the store shelves filled – even on days when rival bread makers were offering consumers deep discounts on their products. The Canadian haker had to throw away heaps of stale loaves, and its costs soared as a result. The deiiverymen earned handsome commissions, but the company's profits fell because of an ill-conceived incentive scheme.

Straightening Things Out

O ur research suggests that companies must align in- centives in three stages. At the outset, executives need to acknowledge that there's misalignment.

Then they must trace the problem to hidden actions, hid- den information, or badly designed incentives. Finally, by using one of three approaches that we describe in detail later in the article, companies can align or redesign in- centives to obtain the hehavior they desire from their partners.

Acceptthepremise. When we conduct straw polls with executives, almost all of them admit they hadn't thought that incentive alignment was a problem in their supply chains. We're not surprised. Most companies find if diffi- cult af first to come to grips with the relationship between incentives and supply chain problems. Fxecutives don't understand the operational details of other firms well enough to realize that incentives could be getting out of whack. In addition, companies tend to avoid the subject of monetary incentives because, if they raise il, their part- ners may suspect them of merely trying to negotiate lower prices fbr the products or services they buy.

Once companies get past these mental barriers, it's rel- atively easy fbr them to detect incentive misalignment. They should expect problems to surface whenever they launch change inifiatives, because these modify the incen- tives of key stakeholders-and most stakeholders protest loudly when incentives get out of line. For instance, in fhe Iatei99os,businesses ranging from Campbell Soupto Li/

A Step-by-step Approach

Companies face incentive problems in their

supply chains because of

>hidden actions by partner firms.

>hidden information-data or knowledge that only

some ofthe firms in the supply chain possess.

>badly designed incentives.

They can tackle incentive problems by

>acknowledging that such problems exist.

>diagnosing the cause-hidden actions, hidden

information, or badly designed incentives,

^creating or redesigning incentives that will induce

partners to behave in ways that maximize the supply

chain's profits.

They can redesign incentives by

>changing contracts to reward partners for acting

in the supply chain's best interests.

>gathering or sharing information that was

previously hidden.

>using intermediaries or personal relationships to

develop trust with supply chain partners.

"niey can prevent incentive problems by

>conducting incentive audits when they adopt new

technologies, enter new markets, or launch supply

chain improvement programs.

>educating managers about processes and incentives

at other companies in the supply chain.

>making discussions less personal by getting executives

to examine problems at other companies or in other

industries.

Claibome fought the buMwhip effect -amplified fluctua- tions in demand – by managing inventory themselves. Rather than relying on distributors and retailers for or- ders, fhe companies set up central logistics departments to make purchasing decisions. Although these initiatives could have helped the companies' supply chains, they failed because of open resistance from distributors and re- tailers, who were convinced that the manufacturers had marginalized their roles.

Pinpoint the cause. Executives must get to the root of incentive problems, so they can choose the best approach

HARVARD BUSINrh.S RliVlhW

Aligning Incentives in Supply Chains

to bring incentives back into line. In our consulting work with companies, we often use role play for this purpose. We ask senior managers fo identify decisions that would have been made differently if they or their suppliers had focused on the supply chain's interests instead of their own interests. We then ask why decision makers acted as they did. in some cases, the answers suggest improper training or inadequate decision-support tools for manag- ers; most of the time, however, they point to mismatched goals. And we try to figure out whether the decisions were motivated by hidden actions, hidden information, or badly designed incentives.

Aligning incentives is quite unlike other supply chain challenges, which are amenable to structured problem- solving processes that involve equations and algorithms. In our experience, only managers who understand the motivationsof most companies in their supply chain can tackle incentive-related issues. Since alignment also re- quires an understanding of functions such as marketing, manufacturing, logistics, and finance, it's essential to in- volve senior managers in the process.

Align or redesign. Once companies have identified the root causes of incentive problems, they can use one of three types of solutions-contract based, information based, or trust based-to bring incentives back into line. Most orga- nizations don't have the influence to redesign an entire chain's incentives-they can change only the incentives of their immediate partners. While it is often the higgest com- pany in the supply chain that aligns incentives, size is nei- ther necessary nor sufficienf for the purpose. In the late 1980s, the $136 million Swedish company Kanthal,a sup- plier of heating wires, said that it would impose penalties whenever the $35 billion GF. changed specifications with- out warning. The mighty GB agreed to contract changes requested by its small partner, and incentives became hef- ter aligned as a result.

Reurriting Contracts

One way companies can align incentives in supply chains is hy alfering contracts with partner firms. When misalignment stems from hidden actions,

executives can bring those actions to the surface-unhide them, as it were-by creating a contract that rewards or penalizes partners based on outcomes. To retum to an earlier example. Whirlpool may not be able to see what Sears's salespeople do to promote fhe manufacturer's washing machines, but it can frack fhe outcome oftheir efforts-namely, increased or decreased sales-and draw up agreements to reward them accordingly.

It's necessary to alter contracts when badly designed incentives are the problem. Let us think back to the

Canadian bread manufacturer whose deiiverymen over- stocked stores when they were paid sales-based commis- sions. The company changed the deliverymen's behavior by altering their contracts to include penalties for stale loaves in stores, which could be tracked. While the penal- ties reduced the incentive to overstock stores, the com- missions ensured that the deiiverymen stili kept shelves well stocked.

That may appear to be a minor change, but it's a signif- icant one. Companies often underestimate the power of redesigning contracts. Small changes in incentives can transform supply chains, and they can do so quickly, lake the case of Tweeter, a consumer-electronics retail chain that in May 1996 acquired the loss-making retailer Bryn Mawr Stereo and Video. For years, Bryn Mawr's stores had reported lower sales than rivals had. Tweeter's exec- utives realized early that the incentives that Bryn Mawr offered its store managers would not lead to higher sales. For instance, while Tweeter penalized managers for a small part of the cost of products pilfered from their stores, Bryn Mawr deducted the full value of stolen goods from their pay. Since store managers faced more pressure fo prevent shoplifting than to push sales, they behaved accordingly. They placed impulse-purchase products like audiotapes and batteries behind locked cases, which re- duced theft but killed sales. They spent more time track- ing merchandise receipts than they did showing products to consumers. They shut down stores while receiving mer- chandise fo ensure there was no loss in inventory; never mind the sales they lost in the process.

After the acquisition. Tweeter stopped deducting re- tail shrink from Bryn Mawr sfore managers'salaries and started paying them a percentage of fhe profits from their stores. While both sales and shrink affect profits, the re- tailer effectively increased the importance of sales rela- tive to shrink. The store managers therefore directed their efforts toward increasing sales rather than decreasing shrink. Although Tweeter left the store name unchanged, kept the product mix intact, and retained the same store managers, Bryn Mawr's sales rose by an average of lo'if. in 1997. As managers moved merchandise to shelves where consumers could touch products, shrink also increased, from $122 a month to $600 a month per store. Net-not, however, Bryn Mawr'sprofitsroseby2.s%of sales in those 12 months. Tweeter didn't have to change people to cre- ate a new culture at Bryn Mawr; it just changed their in- centives. (For more details, see Nicole DeHoratius and Ananth Raman's"lmpactof Store Manager Incentives on Retail Performance," a Harvard Business School Working Paper, September 2000.)

By changing how, rather than how much, they pay part- ners, companies can improve supply chain performance.

NUVLMBFR 2004 99

The 21st-century Supply Chain

When that happens, all the firms in the chain make more money than they used to. (See the sidebar "The Fconom- ics of Incentive Alignment."} In the 1990s, Hollywood movie studios, such as Universal Studios and Sony Pic- tures, found that frequent stock-outs at video retailers, like Blockbuster and Movie Gallery, posed a major prob- lem. A lack of inventory on store shelves meant that everyone suffered: The studios lost potential sales, video rental companies lost income, and consumers went home disgusted. Inventory levels were low because the incen- tives of the studios and the retailers weren't in line. The studios sold retailers copies of movies at $60 a videotape. At an average rental of $3, the retailers had to ensure that each tape went out at least 20 times to break even. The studios wanted to sell more tapes, but the retailers wished to buy fewer tapes and rent them out more often.

When the studios and the retailers explored the possi- bility of sharing revenues, incentives began fo tee up. Since it cost the studios only $3 to create a copy of a movie, they could recoup their investment the first time a consumer rented a tape. In theory, that meant the studios

went away disappointed. Industry experts estimated that rental revenues from videotapes increased by 15% in the United States, and the studios and the retailers enjoyed a 5'. growth in profits. Perhaps most important, stock- outs at video rental stores fell from 25'̂ '. before revenue sharing to less than 5% after revenue sharing.

Revealing Hidden Information

C ompanies can also align incentives across the supply chain by tracking and monitoring more business variables, therehy making actions visi-

ble, or hy disseminating informafion throughout the sup- ply chain.

The most effective way to reveal hidden actions is to measure more variables. Infhe late 19H0S,Campbell Soup offered distributors discounts several times every year, hoping that the savings would be passed on to retailers. However, distributors boLight more units than they sold to retailers, so Campbell's sales flucfuatcd wildly. For in- stance, the company sold 40% of its chicken noodle soup

'"1 By changing how, rather than how much, they pay partners, companies can improve supply chain performance. When that happens, everyone in the chain makes more money.

could stock many more copies than the retailers could. For fhe model fo work, though, the studios needed to de- rive income not from tape sales but from rentals-as the retailers did.

In the late 1990s, when video rental companies pro- posed revenue-sharing contracts, the studios raised no objections. They agreed to sell tapes to the retailers for around $3 per tape and receive 50% of the revenues from each rental. However, the studios needed to track the re- taiiers' revenues and inventories for the revenue-sharing system to work. The studios and the video rental com- panies relied on an intermediary, Rentrak, which ob- tained data from the retailers' computerized records and conducted store audits to ensure that all tapes were ac- counted for. ln fact, the contract-based solution wouldn't have worked if Rentrak hadn't revealed previously hidden information in the supply chain.

In less than a year, it became clear that revenue sharing had led to a happy ending in the video rental industry. The studios saw a hounce in their bottom lines, retailers began to earn more money, and consumers no longer

each of those years during six-week promotional periods. The uptick put a lot of pressure on the company's supply chain. When Campbell realized that it gathered data on distributors' purchases but nof on their sales, it invested in information technology systems that could track both. Then^ by giving the distributors discounts on sales but not on purchases. Camphell eliminated the incentive to forward-buy large quantities. That helped improve the supply chain's performance.

Technology isn't always needed for managers to ob- serve more variables. Some companies employ mystery shoppers – agents who pose as custoiners – to ascertain whether,say,distributors are pushing products or retailers are offering services. Like many franchisers, Mobil uses mystery shoppers to monitor restroom cleanliness and employee friendliness at its gas stations.

Information systems derived from the principies of activity-based cosf ing are crificai for measuring the costs associated with hidden actions. No company knows that befferthan Owens & Minor, a large distrihutor of medical supplies. Hospitals used to pay O&M a fixed percentage of

100 IIARVARH KUSiNl SS KLVIEVV

Aligning Incentives in Supply Chains

the cost of items delivered. They could, however, buy supplies di- rectly from manufacturers if if was cheaper to do so. For example, the hospitals sometimes bought high- margin products such as cardio- vascular sutures from manufac- turers to avoid fhe distributor's markup. The hospitals expected O&M to supply products with high storage, handling, and trans- portation costs-adult diapers, for instance-even though those items gave the distributor low margins. Cost-plus contracts led to a mis- alignment in another area, too: In general,disfributors were often re- luctant to provide services such as just-in-time deliveries, while the hospitals demanded more such ser- vices for the same fixed markup.

O&M found an opportunity to realign incentives when if switched to an activity-based costing system and got a handle on the profit- ability of its services to

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