Guide to Global Logistics--Incentives & strategic management of suppliers (part 2)

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Outsourcing requires the firm to understand what it is that allows it to leverage its customers (in the case of strategic outsourcing) and what it is that allows its 'potential' suppliers to exploit it (in the case of both strategic and tactical outsourcing). Effective relationship management is about reversing things by understanding what it is that allows the firm to control and leverage its suppliers. The question is to what end? This is where we are required to reintroduce the subject of surplus value.

The first decision that the firm must ask itself is whether the relation ship should include a value-added element. Many commentators would argue yes, citing the benefits that often flow from extending the cooperative elements of a trade. Lean thinking, for example, highlights the seven supply chain wastes that often plague buyer-supplier relationships.

These relate to overproduction (1), unnecessary inventory (2), waiting (3), motion (4), transportation (5), defects (6) and inappropriate processing (7) (for a discussion of these see Hines et al, 2000). Yet, just because extended cooperation might potentially generate additional value it doesn't mean that it will or that the buyer will be the main beneficiary if it does. Four factors play a part in determining the buyer's calculation about whether cooperation is worthwhile: the upfront investment, the potential pay-off, power and risk. Creating a value-adding relationship requires an investment, even if only in terms of the time and managerial effort that it involves. The first thing that the firm must ensure is that the expected payback matches the upfront investment. No firm is going to spend a lot of time developing its supplier of toilet rolls. The improvement for the buyer is likely to be miniscule compared to the effort.

What complicates the calculation is that both the investment and return may be hard to determine ex ante. Take defense contractors. Suppliers of defense equipment work closely with their customers (governments) to ensure that the weapons they develop are the ones that the customer wants / needs. The industry, however, is notorious for delays in introducing new equipment and cost overruns. In a number of instances the additional cost to which the customer ends up committing itself runs into the $ billions. When the equipment finally arrives, it may be too late to be useful. It may not even work properly. Consequently, there is the issue of which party takes the risk and which party obtains the reward. This is a question of power. A simple example will illustrate the nature of the calculation the buyer faces.

Take two firms: a buyer (A) and its supplier (B). B proposes to A that an upfront investment of $70 is capable of yielding cost savings of $260. In other words, the additional surplus value that has been created through cooperation comes to $190. If A exercises leverage over B it will probably think that cooperating is a good idea. As it has the power it will probably insist that B takes all of the upfront risk, agreeing to cover B's costs only if the initiative pays off. This is a no-lose situation for A. If, however, A and B are interdependent then the calculation becomes more complex. B will probably insist that A shares both the investment and the reward. This means that A must invest $25 (half the $50 cost) to get a payback of $100 (half the $200 cost savings). This leaves it with a net gain of $75 ($100 savings - the $25 costs). Once again cooperating makes sense - although the pay-off for the buyer is smaller than in the first example. What if the costs are fixed but the gains are far from certain, however. Say, for example, there was only a 25 percent chance of a successful outcome. Under these circumstances the firm would be investing $25 to get a 25% × $100 return.

The cost-benefit calculation here is finely balanced ($25 cost - $25 return = zero). Change the parameters again (e.g. increase the upfront investment by $1) and the initiative may cease to make commercial sense. This is why power is so important to all relationships: it affects the pay-off structures of buyers and sellers and thus over-determines the management of the relationship. It decides which side takes most of the risks and which side extracts most of the rewards. Furthermore, the same calculation pertains whether the firm is thinking in a dyadic or a wider supply chain context.

Incentives and the Role of Contract

The second set of supplier management issues facing supply managers concerns the management of the chosen vendor. Supply management involves two issues: relationship management and contracting. Relationship management concerns how the buyer and seller are going to interact on a day-to-day basis. Is the association between the two essentially going to be an arm's-length one, or is something closer going to be called for? If the firm has opted to pursue a value-adding relationship them presumably close interaction is required. The contracting parties will need to trade information, mutually adapt their processes etc, so that the maximum value-adding potential is achieved. At the same time, relationship management will also involve managing the tensions that exist between the two. Some forms of cooperation, for example, might be deemed neutral in the sense that they add value to the relationship without disturbing the commercial balance within it. Other forms of cooperation, however, are far from neutral. For example, if the buyer calls for the supplier to open its books, then the buyer is acquiring a considerable advantage over its supplier in that it now knows just how much money the supplier is making from the deal. Both buyers and sellers, therefore, tend to want to manage the relationship so that while it adds value it doesn't tip the balance of power the wrong way. The same goes for performance measurement. Performance measurement may be a way of monitoring how quickly things are improving - or if they are not improving, where and why this is the case. However, performance measurement is also a mechanism of control and both sides tend to be aware of this.

In contrast to relationship management, which tends to contain a value adding element as well as a controlling element, contracts are primarily about control. They are about specifying, in a legally binding way, the manner in which buyers and suppliers are to work together, i.e. who is responsible for doing what. They are also about specifying (again in a legally binding way) the outputs of the relationship: what the supplier is expected to deliver, what the buyer is expected to pay, and which party owns the rights to any exploitable technologies or processes that might emerge from the association.

Conventional contracts take two main forms: tight and flexible. The shift from tight to flexible contracts tends to occur as the risk within the relationship increases. Risk, in this context, has a very specific meaning. It refers to events that can be foreseen but that have a probability of occurring of less than one but greater than zero.

Where the probability is one or zero (i.e. the event is certain), this means that an element to a deal is can be specified (or ignored) with total confidence. This allows the parties to use a tight contract. For example, if an organization requires laptops for a hundred employees, it is relatively easy for it to specify when it wants the machines, what it will pay and what level of after-sales support it will need.

By contrast, where there is a lack of clarity surrounding particular aspects of the deal, but where the lack of clarity falls within clearly defined limits (i.e. where the probability is between one and zero), the parties may seek to include a flexible element to the contract to take account of this ambiguity. This allows the requirement / reward relationship to be adjusted in a predictable way. For example, an organization requiring the development of a new piece of software may know what is needed but may not know how long it will take to develop the new product. Because the organization is aware, however, that the main variable driving cost will be the staff-hours required to develop the software, the terms of the contract are set out so as to reflect the range of potential effort levels.

However, some events are genuinely uncertain in the sense that they were not, or could not have been, anticipated prior to reaching the original agreement. Such events may range from occasional but devastating acts of God (or man) to the more mundane. For example, many IT agreements are entered into before the requirement has been properly worked out. Under such circumstances it is simply not possible to draft a contract flexible enough to take account of all future possibilities. In the place of contracts, therefore, firms must use relational agreements. The purpose of such agreements is to provide a structured framework within which the terms of a deal can be renegotiated as the future becomes clear.

Although a buyer-supplier relationship may largely consist of one of these control mechanisms, on occasion it can contain elements of all three.

For example, short-term, arm's-length relationships tend to call for tight contracts but may include a subsidiary element. Longer-term arm's-length relationships tend to require the flexible element to increase. Long-term cooperative relationships (whether they are adversarial or non-adversarial) tend to call for all three.

Of course, while contracts aim to serve as instruments of control, whether in fact they succeed in this function depends on the ex post power balance. As we saw in our discussions on outsourcing and contractual risk, if the buyer loses his or her power then the contract may not be worth the paper it is written on. As the political philosopher Thomas Hobbes once put it, 'contracts without the sword are but empty breath'. In the case of either a tight or flexible contract the threat of the courts is only credible if they can be accessed at relatively low cost and if the plaintiff believes that it has a good chance of winning. Where fault is ambiguous or where an agreement has been poorly drafted, then the use of a contract as an incentive mechanism will start to break down. The reluctance to use this mechanism may then be further eroded by the fear that if the plaintiff fails to make an effective case, then it will also be saddled with the costs.

In addition to this, the plaintiff may also have to manage a disintegrating relationship while a replacement is found - assuming that one can be found in a timely manner.

In the case of relational agreements, where there may be no contract or at least where the terms of the contract do not cover the issues in question, the courts may not be an option at all. Neither might be the termination of the agreement. This is because the incidence of significant sunk and switching costs in arrangements that are likely to require a relational agreement tends to be quite high. This is why observers like Williamson (1985) generally recommend that parties look to mechanisms like the posting of hostages, which can be forfeited should the relationship collapse, as a way of maintaining some control. And, if such arrangements cannot be agreed upon, they would advise that either the organization look for a different vendor or else it should consider the possibility of vertical integration.

Incentives and the Impact of Internal Politics

While all of the proceeding discussions are fundamental to the process of the supply management, they are not in themselves complete. This is because so far the firm has been treated as a black box. However, this is not an accurate representation of either the buyer or the supplier. Each is a complex political entity, comprised of different functional actors, each with differing expectations regarding how the other party can and should be managed. Unless the internal politics of the firm are properly aligned to the external opportunities, then the ability to manage the other party effectively may be lost.

However, for the buying organization, creating this effective internal alignment is easier said than done. Operationally, the key to effective supply management is usually effective demand management, but as often as not a supply manager will experience considerable difficulty in getting the managers in other functions to recognize this point. In order to source effectively it is essential that buying organizations develop appropriate specifications, avoid unnecessary (last-minute) changes to specification, create regular patterns of demand and ensure that as little buying as possible takes place outside of the organization's commercial rules.

Most importantly, however, it is essential that organizations do not unnecessarily fragment spend, thereby spreading their demand across an artificially large number of suppliers. The reason for this is twofold.

First, it raises transaction costs - substantially in some instances. Second, it reduces the potential leverage that the organization has over its suppliers. And, as has already been indicated: generally speaking, the weaker the leverage, the poorer the deals.

Of course, a certain level of fragmentation will always arise. For one thing, different business units within an organization often have very different missions and as a consequence have very different supply requirements. Additionally, when attempting to consolidate demand, organizations are often confronted by legacy issues. Standardizing demand may offer only a false economy if it is accompanied by significant write off costs. Finally, organizations have to balance the short-term gains that may arise from obtaining volume deals with the long-term risk that they may become overly dependent on a particular supplier. Over time this dependence may translate into higher prices and poorer service. Together, these factors combine to create what the authors have described else where as a 'natural level of fragmentation' . This natural level can be defined as the point at which any further consolidation results in a 'net reduction in organizational performance / welfare, notwithstanding any commercial gains that might have accrued from the consolidation initiative' (p 161). Where exactly this point lies will vary by commodity, organization and time.

Furthermore, where that point lies will often be one of the major areas of dispute between supply managers and their internal clients. This is because issues of consolidation are as much political issues as they are technical ones. There are a number of reasons why an internal client may not recognize that there are benefits to be obtained from consolidation.

First, there is the issue of functional culture. Managers from different departments are usually functional specialists. Their specialisms may be largely commercial (as in the case of sales or purchasing), or largely operational (as in the case of human resource management (HRM) or production). Alongside the specialized knowledge that resides in a department there is often also a strong functional culture. This culture reflects the training of staff but it also reflects the management priorities of particular departments. For example, because a production manager's performance is measured in terms of faults or downtime, he or she is likely to be particularly sensitive to anything that might spoil or interrupt output. Such sensitivity may be justified, if what is being proposed poses a real threat to operational sustainability. For example, it would be ridiculous for an oil company to attempt to save a couple of thousand dollars on industrial valves if the downside risk was several hundred thousand pounds in lost production if the new and untried products failed. However, a natural sensitivity can easily become an unnatural over-sensitivity. The same production manager may refuse to participate in an initiative that will save sixty thousand pounds because there is an infinitesimal chance that the new product might fail.

Second, there is the principal-agent problem. Principal-agent problems arise because managers and indeed all employees have divided loyalties.

For example, managers have a loyalty to the organization that pays their wages. For many commentators, this loyalty constitutes (or should constitute) the manager's primary loyalty. In practice, however, managers also develop loyalties for those around them, and particularly depart mental colleagues. And less creditably, managers also have loyalties to their own interests. Where firm and department / personal priorities conflict, it is often the firm's priorities that are sacrificed.

This is significant from the perspective of a consolidation program because although such a program is intended to benefit the organization as a whole, it does not necessarily follow that consolidation will benefit all departments equally (or at all), or that the initiative will be without cost (or indeed that these costs will be evenly distributed). It is relatively easy for a manager to sign up to a consolidation program if the supplier that stands to get most of the organization's business is the one that he or she is already using and the price that is being offered represents an improvement. It is less clear, however, that a manager would be enthusiastic if the new deal is more expensive for him or her, or if it involves the termination of a relationship that is particularly valued.

Regardless of whether the dissent arises because managers have failed to understand the advantages of the initiative, or because they under stand the advantages for the organization but are anxious to avoid the costs to their department (or them personally), such dissent is likely to make implementation problematic. Faced with such opposition, organizations have one of four options. Option one involves taking the path of least resistance and doing nothing. Options two, three and four all require the organization to confront the problem. Option two involves persuasion: demonstrating to the manager concerned that any fears are exaggerated or unfounded and setting them against the very obvious benefits. This may or may not work. However, it is most likely to work where a hostile manager has misunderstood the issues involved. It is less likely to work when a manager understands the issues and realizes that the initiative is not in his or her particular interest. Under these circumstances, the supply manager may pursue option three: coercion. Coercion involves the threat of sanctions or the use of the organization's authority structures to override the opposition of the hostile party. The limitation of this strategy, however, is that the procurement function often sits towards the bottom of the organization's hierarchy and the procurement manager lacks the clout to make credible threats. Furthermore, more senior colleagues may prove reluctant to intercede on the procurement manager's behalf if it involves confronting one of the organization's more powerful constituencies. Option four, therefore, is bribery. Bribery involves compensating a manager for the costs of participation. It is perhaps not surprising if a manager does not want to get involved in a consolidation program if all of the benefits flow to the centre. However, if some of the benefits can be passed back to the manager, then the initiative may appear to be more worthwhile.

Conclusion

Exchange takes place in the first instance because it is mutually profitable.

Closer forms of cooperation occur because they can increase this level of profitability. However, mutually profitable exchange is not the same as equally profitable exchange. Buyers and sellers are competitors as well as collaborators. Consequently it is important for supply chain managers to understand the following things: first, they must understand when it is not sensible to exchange (that is, when exchange imposes unacceptable levels of strategic and contractual risk). Second, they must also understand (when it is sensible to exchange) how to craft the incentive structures that will maximize the return to their organizations. Obviously, such structures need to cover relationships between buyer and supplier.

However, they are also needed to regulate relationships within the organization. This is because poor demand management can have significant knock-on effects. Consequently, managers within an organization need to be encouraged (through the threat of sanction or the promise of reward) to engage in activities designed to maintain the organization's control over its external environment At root, therefore, the study and practice of supply chain management is the study of managerial and contractual incentives.

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