SlhiSupply chain Purpose incentive alignmentincentive ......incentive alignmentincentive alignment (risk sharing) MTT240 Supply Chain Management Professor Andreas Norrman 24 04 201224.04.2012

S l h iSupply chain incentive alignmentincentive alignment

(risk sharing)

MTT240 Supply Chain Management

Professor Andreas Norrman24 04 201224.04.2012

Department of Industrial Management & Logisticsp g gLund University, Faculty of Engineering

PurposePurposepp

• Introduce supply chain risk sharing and how i d thicompanies can do this

• Introduce Agency theory• Stress and make explicit contracts role for

creating incentivesg• Discuss other ways of SC incentive alignment

AgendaAgendaAgendaAgenda

Supply chain risk sharingIllustrations from practiceIllustrations from practiceContract examplesContract gameContract gameAgency-theorySMART discussionConcluding remarksg

To share risk is one way to manage risks To share risk is one way to manage risks y gy g

RESIDUAL RISK

SHARE

ACCEPT

RISKMITIGATION

TRANSFER

SHARE

MITIGATION

DECREASE IMPACT

DECREASE PROPABILITY

AVOID

DECREASE IMPACT

INITIAL RISK

Many researchers argue that risk sharing is a keyMany researchers argue that risk sharing is a keyMany researchers argue that risk sharing is a key Many researchers argue that risk sharing is a key factor for successful implementation of SCMfactor for successful implementation of SCM

Among these you can find:– Cooper & Ellram 1993 Risk and Reward StructureCooper & Ellram 1993– Lambert & Cooper 2000– Mentzer et al. 2001

Risk and Reward Structure…

…one of 9 fundamental SCM

– Lee 2004– Chopra & Sodhi 2004

management components…

However, it is still quite uncommon to see the researchers really describe how to achieve this!

CostCost--plus contracts is common when outsourcing plus contracts is common when outsourcing but what incentives do they give for e g costbut what incentives do they give for e g cost–– but what incentives do they give for e.g. cost but what incentives do they give for e.g. cost

reduction?reduction?

Value addProfit 8%

Value add15%

Material cost100

Would you as supplier reduce your value add?Would you as supplier reduce your value add?Would you as supplier reduce material cost?

Demand is very uncertain in some industries, and Demand is very uncertain in some industries, and yyforecasts important planning informationforecasts important planning informationDeliveries

93 9594 989796 0099 0201 0403 05

Who takes liability for a bad forecast?

One issue is how to get the right supply chain One issue is how to get the right supply chain capacity when demand and supply are uncertain capacity when demand and supply are uncertain and business models differ. and business models differ.

$ Cost(y)

Revenue(y)

$ Revenue(y) $

Revenue(y)

Volume, y Volume, y

Cost(y)

Volume, y

Cost(y)

2nd tier supplier EMS OEMTo get full leverage here…

investments might be…investments might be needed here although not locally profitable….

Bottlenecks might be far from where the impact is seen, and companies’ business models makes them more or lesscompanies business models makes them more or less

interested to make risky investments…

One way to increase coordination is to try to One way to increase coordination is to try to li i i l h l h ili i i l h l h ialign incentives along the supply chainalign incentives along the supply chain

“A supply chain stays tight only if every company on it has

•

• ••if every company on it has reason to pull in the same direction”

“A supply chain works well if its Supply Chain Cooperationpp y

companies’ incentives are aligned – that is if risks, costs

• ••

Cooperation

and rewards of doing business are distributed fairly across the network””network

Source: Narayanan & Raman, Harvard Business Review, November 2004

Narayanan & Raman propose a three step Narayanan & Raman propose a three step h hi i i lih hi i i li

Introduction

approach to achieve incentive alignmentapproach to achieve incentive alignment

A t th iAccept the premise

Pinpoint the cause:Hidden action

Hidden informationHidden informationBadly designed incentives

Align or redesign:Contract-based solutions

Source: Narayanan and Raman (2004)

Information-based solutionsTrust-based solutions

But when & how do we find misaligned incentives?

When changing e.g. logistics structures and processes, also When changing e.g. logistics structures and processes, also incentives’ alignment could be analyzedincentives’ alignment could be analyzed

Supply chain design Supply chain design

incentives alignment could be analyzedincentives alignment could be analyzed

pp y g-Physical network

-Organizational structure-Information-Processes

Supply chain design-Physical network

-Organizational structure-Information-Processes

change

-Resources-Technology

Processes-Resources-Technology

AlignmentNo

li

Supply chain incentives-Payments

Contracts/agreements

Supply chain incentives-Payments

Contracts/agreementsNo

Alignment alignment

-Contracts/agreements-Joint investments

-Metrics & measurement-Power and trust

-Contracts/agreements-Joint investments

-Metrics & measurement-Power and trust

No change

PerformanceReduced

performance due to misalignment

RiskRisk and gain sharing is not only about sharing aand gain sharing is not only about sharing aRiskRisk-- and gain sharing is not only about sharing a and gain sharing is not only about sharing a cake cake –– but making it bigger! but making it bigger!

A good contract mechanism separates those issues

•Maximizes profit (for the chain)

•Profit sharing to make everyone happy. B d ti ti ithi t i ti th t h ld b– Based on negotiation within restrictions that everyone should be happy (improve)



New risk sharing contract increased New risk sharing contract increased Illustrations

total businesstotal business

•High demand, peaks Questions

•Purchase $60, rental $3– +20 rentals for profit

• Is this a good contract for the situation?

• What are the major cost drivers

•Outlets buy to few film copies– 20% of customers (1998) could

What are the major cost drivers for the film studios?

• What is key for Blockbuster outlets to get happy customers?( )

not rent the movie they wanted outlets to get happy customers?

Source: Cachon & Lariviere, Harvard Business Review, March 2001

Agilent has implemented structured contractual Agilent has implemented structured contractual Illustrations

g pg pmechanisms for sharing risk and securing costmechanisms for sharing risk and securing cost--effective levels of availability and responsivenesseffective levels of availability and responsivenessy py p

•Delivers capital equipment (for measurements) to various high tech industryhigh tech industry•Volatile demand; outsourced manufacturing (EMS); risk of supply allocationsupply allocation•Long term structured risk sharing contracts implemented with +100 strategic suppliers (started summer 2002)g pp ( )•1st tier (including EMS) & 2nd tier suppliers: focusing on “long lead time” and/or high value supplies•Contractual parameters updated quarterly•Next step is to implement similar contracts with customersp p

The new structured contract address risk sharing The new structured contract address risk sharing Illustrations

by more explicit state liabilities, commitments etc by more explicit state liabilities, commitments etc

Volume

Agilent secures… Supplier secures…

Availability

Volume

Availability guarantees Clear planning information

Expected demand

Availability

Expected rangeLead time guarantees

information

Prices tied to flexibility

Liability

Price guarantees Purchase commitmentsLiability

Time

Contracts signals needs and wanted behaviour from involved partners

Availability and purchase commitment are key Availability and purchase commitment are key Illustrations

y p yy p yingredients in their contractsingredients in their contracts

me

Relation between

Volu

m

6 week

Total availability and commitment~ 3-5 to 1.

TotalAvailability

Lead TimeThe relation impacts

price…VMI

4 h LT

p ce

TimeQ +1 Q +2 Q +3 Q +4

Liability

Time

A buyer that take commitment signals confidence in own forecasts

Different prices can be used for different cost Different prices can be used for different cost Illustrations

driving behavior or risk situationsdriving behavior or risk situations

Th bli hMaterial: Pin ModulesSupplier: XYZ ElectronicsEffective: August 1, 2003

AVAILABILITY AND RESPONSIVENESS PRICE

Material: Pin ModulesSupplier: XYZ ElectronicsEffective: August 1, 2003


The contract establish:– How much supply Agilent

can getAVAILABILITY AND RESPONSIVENESS PRICE

Quantities guaranteed available w/4 hour LT (SMI) $1800 per unitQ4'03 1 700 units per weekQ1'04 2 000 units per week


Quantities guaranteed available w/4 hour LT (SMI) $1800 per unitQ4'03 1 700 units per weekQ1'04 2 000 units per week

– How quickly Agilent can get supply

– PricingAdditional quantity guaranteed available w/6 week LT $1750 per unit

Q4'03 500 units per weekQ1'04 700 units per week

Additional quantity guaranteed available w/6 week LT $1750 per unitQ4'03 500 units per weekQ1'04 700 units per week

Pricing– Liabilities– Penalties

AGILENT LIABILITY (COMMITMENT) PRICE

Quantities Agilent commits to buy $1700 per unitQ4'03 400 units per weekQ1'04 400 units per week

AGILENT LIABILITY (COMMITMENT) PRICE

Quantities Agilent commits to buy $1700 per unitQ4'03 400 units per weekQ1'04 400 units per week

Supply “options”

Q1'04 400 units per weekQ2'04 400 units per weekQ3'04 400 units per week

NON-PERFORMANCE

Q1'04 400 units per weekQ2'04 400 units per weekQ3'04 400 units per week

NON-PERFORMANCE

Price reduction of 1% per day late, up to 15%, for units not delivered on time.Price reduction of 1% per day late, up to 15%, for units not delivered on time.

Agilent’s suppliers are, according to Agilent, very Agilent’s suppliers are, according to Agilent, very Illustrations

happy with the structured risk sharing contractshappy with the structured risk sharing contracts

“We are extremely pleased with the performance of the structured agreements We would not have been able tostructured agreements. We would not have been able to support the recent ramp without the upside requirements you presented in the structured agreements.”y p g

”Structured contract” is a good program and we would like to extend it to other boards. We have found that it is more difficult to do pricing, but it’s worth it.”

“This is the smoothest contract we have going. It’s predictable and we’re willing to commit per the terms ”predictable and we re willing to commit per the terms.



Example of contract mechanismsExample of contract mechanismspp

• Wholesale price (charged per unit of volume)• (charged per unit of volume)

• TC (q) = p * q• p=price/unit, q=quantityp price/unit, q quantity

• Franchise Fee (2 part tariff)Franchise Fee (2 part tariff)

• Revenue sharing contractsg

• Slotting Feeg

Franchise Franchise FeeFee (i.e. 2(i.e. 2--part tariff)part tariff)(( p )p )

A two-part tariff arrangement typically involves f th t i i d d t f l (A)- one fee that is independent of volume (A)

- Another that is charged per unit of volumeTC ( ) A *- TC (q) = A + p*q

- Min purchase commitment also example of a 2 part tariff

Revenue Revenue sharingsharing contractscontractsgg

Suppose that the manufacturer and retailer agree on splitting the profit so thatsplitting the profit, so that

- the retailer receives a fraction αth f t th f ti (1 )- the manufacturer the fraction (1- α)

- TC (q) = c*q + (1- α)*(p-c)*qf t ’ t t il i- c=manufacturer’s cost, p=retailers consumer price

SlottingSlotting feefee contractscontractsgg

The retailer asks for a fixed payment to list a new item for distribution (shelf place), in addition to the wholesale price

Observations:

contract

Observations:- Limits innovation and product introduction- Disciplines manufacturers to not change

products only to increase his own margins- Induce manufacturers marketing efforts

Powerful retailers used it against weak- Powerful retailers used it against weak manufacturers to increase profit



Game: Renegotiation of given contract

Y t• You represent– Purchaser at retailer/distributor– Seller at manufacturing company– Seller at manufacturing company

• Product: Heating appliance• Opportunity to renegotiate current• Opportunity to renegotiate current

– F(q) = A + B*q and now F = 0 + 850 * 3– Meaning your price is 850 and the quantity is 3g y p q y

• Private information– Distributed information must NOT be shown, but can be told

• 15 minutes negotiation• Goal – maximize profit• Hand in signed “contracts” with contract parameters

A, B and q – write on whiteboard

Discussion

• How many closed new contract? (Why?) • What did you maximize? y

• How do we increase the chain profit?How do we increase the chain profit? – First optimize based on quantity– Correct variable cost important information for the player closest

to end-customer.

• Which function for risk/gain-sharing has the variable cost? Whi h f ti f i k/ i h i h th fi d t?• Which function for risk/gain-sharing has the fixed cost?

Your results

Excel charts

Risk and gain sharing is not only aboutRisk- and gain sharing is not only about sharing a cake – but making it bigger!

•A good contract mechanism separates those issues•Maximizes profit (for the chain)

– In this case based on the real variable cost B

•Profit sharing to make everyone happy•Profit sharing to make everyone happy. – Based on negotiation within restrictions that everyone should be

happy (improve) – In this case based on fixed payment A

Different contract types suit different circumstancesDifferent contract types suit different circumstances

Can you easily measure their result?Can you observe/standardize theirCan you observe/standardize their process?

What contract/incentive is used here?What contract/incentive is used here?

Who takes the risk?



Agency theoryAgency theoryP i i l

External risksources

A t

Principal

Information

Agent

Results, deliverables

Reward (payment)

Assymetric (hidden)

information

Hidd tiContract

Hidden action

The basic components of the principalThe basic components of the principal--agent agent d l t ti thi th t t bd l t ti thi th t t bmodel are two parties, something that must be model are two parties, something that must be

done, some external risk and a contract…done, some external risk and a contract…

Information

PrincipalAgentResults, deliverables

Reward (payment)

Contract

E ternal riskExternal risksources

AgentPrincipal AgentPrincipalHidden information

Hidden informationinformation

How big is the pain?Is the pain

What is the condition of the teeth?Is the pain

cured?Hidden actionWhat is theWhat is the agent doing?

Contract:Can the principal control the actions of the dentist (behaviour)?Paid per drilled hole? Paid per hour?Paid per drilled hole? Paid per hour?How is the outcome (cured pain) measured?

Assumptions in agency theory are that the Assumptions in agency theory are that the ssu pt o s age cy t eo y a e t at t essu pt o s age cy t eo y a e t at t eparties…parties…

• can have diverse attitude to risk.– Risk averse risk neutral or risk taker– Risk averse, risk neutral or risk taker

• overall objectives differ.lik l t h t i i f ti i• are likely to have asymmetric information, i.e.

they do not know the same things.• are opportunistic, and will maximize their

individual benefits.– If necessary, they will fool you!

Do common goals and mutual interests of all parties inDo common goals and mutual interests of all parties in a supply chain exist - or is this more realistic?

The contract is the unit of analysis in Agency The contract is the unit of analysis in Agency hhtheorytheoryThe contract between principal and agent is

related to relation between information and risk situation

Behaviour-based contractsBehaviour based contracts– Salary, cost+; Detailed instructions– Principal risk taker; works with information &

assessmentassessment

Outcome-based contractsGoals coordinated through economic incentives– Goals coordinated through economic incentives

– Commission, options etc– Part of risk transferred to agent

Some interesting questions:What contracts fits different situations best?– What contracts fits different situations best?

– How can contracts be used to create the wanted behaviour?

Different contract types suit different circumstancesDifferent contract types suit different circumstances

Is there one or a few limited ways to perform the activity?

YES NO

Behaviour or Outcome based

YES

outcome based

Is there relevant

YES

result variables to measure?

NO

(Source: Rapp & Torstensson, 1994)Behaviour based “Social control”

Some challenges that the principalSome challenges that the principal--agency agency g p pg p p g yg ytheory addressestheory addresses

• Hidden action – Moral hazard

• Hidden information – Adverse selection

• Specific assets/investments – Hold up

Hidden action Hidden action -- Moral hazardMoral hazard

When one firm can take costly actions that affect the entire chain, but those actions are not contractable.

(Contractable = observable + verifiable + enforceable)

Example: Do retailer work as they should with premium brands or

do they push ”private labels” ?D li k ” i l ibl ” i d?Do suppliers work ”social responsible” as promised?

Remidies: Measure (mystery shoppers) and rewardoutcomes that are correlated with desirable actionoutcomes that are correlated with desirable action, (rewrite contracts)

Could we know if the retailer is pushing our products – or our competitors or their

own private label?p

How to differ one ton “dolphin safe tuna” How to differ one ton “dolphin safe tuna” ppfrom one ton “normal tuna”?from one ton “normal tuna”?

Hidden information Hidden information -- Adverse selection Adverse selection –– how how can you select supplier if you cannot observe can you select supplier if you cannot observe their performance?their performance?pp

”The market of lemons” – used carsD l k th ’ lit th b t• Dealers know the car’s quality, the buyers not.

• The buyers assumes average quality and this defines price levelprice level

• Dealers with cars of better quality takes them out of this market (as they will not get paid enough)this market (as they will not get paid enough)

• -> The market only contains the lemons (the lower quality cars)quality cars)

Akerlof (1970), Nobel prize 2001( ), p

What selection mechanisms could you use?What selection mechanisms could you use?yy

"if he wants to sell that horse, do I really want to buy it?

George Akerlof, Nobel prize 2001

Remidies: Signalling mechanisms. E.g. offer a contract that transfer the quality risk to g q ythe seller (warranties), see how they react…

HoldHold--up (assetup (asset--specific/idiosyncratic specific/idiosyncratic p (p ( p yp yinvestments)investments)

When one firm invests in an asset that has value only with respect to its relationship with a specific supplywith respect to its relationship with a specific supply chain partner

Example: Automotive supplier make large investment in production equipment that is specific to one OEM.production equipment that is specific to one OEM. Once the investment made, the OEM has a strong incentive to negotiate a lower price (hold-up).

Remidies: reputation, repeated deals, shared ownership of assets, vertical integration.



MCC Smart

A “Green Field” approach of a new carA Green Field approach of a new car

Undressing the smart Smartville layout HambachSmartville layout, Hambach

The SMART case - preparation

Read the case, discuss in groupRead the case, discuss in groupFocus on

– The business model and how it aligns incentives and gshare/transfer different risks

R d h di iRead the case, discuss in group

SMARTVILLESMARTVILLE



Contracts do three thingsContracts do three thingsgg

• Induce coordination (bakes the cake bigger)

• Allocate risks (transfer risk – in best case to the one that can handle it best)that can handle it best)

Share profits• Share profits• Many contracts creates misaligned incentives –

hence supply chain contracts are importanthence supply chain contracts are important

SummarySummary

• Different players along the supply chain have the same view on risk sharing: the others should take the risk…g

• Risk sharing contract is seen as a key to secure capacity and flexibility in volatile industries / allocation situations

• People and change management internally is a barrier. Suppliers positive after the first “surprise”

• Increased work with analysis and negotiations for all involved• Increased work with analysis and negotiations for all involved.• Contracts mechanisms can be used for signalling and aligning

incentives• The assumptions of the agency theory could fit well with “real

business” and might complement softer SCM-theories in a constructive wayconstructive way

• Supply chains involve more than two parties, and so could risk sharing set-ups. The impact of this is not well analysed.sharing set ups. The impact of this is not well analysed.

Traditional SCMTraditional SCM--thinking has been characterized thinking has been characterized ggby an idea of collaboration and mutual goals …by an idea of collaboration and mutual goals …

JointJoint “Supply chain vision” and

mutual goals

SupplierSub-Products

Information

CustomerProducts

Information

Suppliersupplier ProductsPayment

Customeroduc s

Payment

…using agency…using agency--theory inspired framework might better theory inspired framework might better consider some “realistic issues” and use contracts to alignconsider some “realistic issues” and use contracts to alignconsider some realistic issues , and use contracts to align consider some realistic issues , and use contracts to align goals and create incentives.goals and create incentives.

“Optimal” visions and goals for

the Supply chainthe Supply chain

Potential contract

Jointly defined contract mechanisms that defines the play ground

Own goals Own goalsI f ti I f ti

Potential contractContractContract

Own goals

Supplier CustomerSub-supplier

Products

Information

Payment

Products

Information

Payment

g

New risk sharing contract increased New risk sharing contract increased Illustrations

total businesstotal business

•High demand, peaks • 1998: risk sharing contracts with major studios

•Purchase $60, rental $3– +20 rentals for profit

major studios– purchase $9– In addition 30-45% of rental turnover

•Outlets buy to few film copies– 20% of customers (1998) could

• Although if Blockbuster only keeps 50%, break-even will be 6 rentals per copy( )

not rent the movie they wantedp py

• Dramatic impact– Rentals increased with 75% at test

marketsmarkets– Market share from 25% to 31% (#2

has 5%)

Source: Cachon & Lariviere, Harvard Business Review, March 2001

How to differ one ton “dolphin safe tuna” How to differ one ton “dolphin safe tuna” ppfrom one ton “normal tuna”?from one ton “normal tuna”?

Group incentives!W k d th t f ti th t t t- We asked them to form a cooperative that we contract

- We pay premium for Dolphin safe fishing processW d t thi d t t ll ( i th l b l)- We send out third-party controllers (gives the label)

- If the third-party observes dead dolphins, everyone in the cooperati e gets penali edthe cooperative gets penalized

- We let themselves decide who should be in the cooperative or notcooperative or not.

- -> The will observe each other, and not let anyone into the “club” that could risk the outcomethe club that could risk the outcome.

- -> Adverse selection, self monitoring

Documents

SlhiSupply chain Purpose incentive alignmentincentive ......incentive alignmentincentive alignment (risk sharing) MTT240 Supply Chain Management Professor Andreas Norrman 24 04 201224.04.2012