Monday, February 20, 2012

Aligning Incentives for Supply Chain Efficiency

Companies are increasingly worried about improving operational performance not only within their firm, but also across their entire supply chains. Many supply improvement efforts, however, have failed to achieve anticipated benefits because they have failed to change the behaviour of politically powerful stakeholders.

Most companies don't worry about the behaviour of their supply chain partners. Instead, they expect the supply chain to work efficiently without interference. Companies often looked out for their own interests and ignored those of their network partners. Consequently, supply chains performed poorly. Those results aren't shocking when you consider that supply chains extend across several functions and many companies, each with its own priorities and goals. Yet all those functions and firms must pull in the same direction for a chain to deliver goods and services to consumers quickly and cost-effectively.

A supply chain works well only if the risks, costs, and rewards of doing business are distributed fairly across the network. In fact, misaligned incentives are often the cause of excess inventory, stock-outs, incorrect forecasts, inadequate sales efforts, and even poor customer service. The fates of all supply chain partners are interlinked: If the firms work together to serve consumers, they will all win.

However, they can do that only if incentives are aligned. Companies must acknowledge that the problem of incentive misalignment exists and then determine its root cause and align or redesign incentives.

The following is a three stage process for aligning supply chain incentives:
  1. Recognizing Goal Incongruence:
a.    Frequently obvious to managers in the supply chain.
b.    Can be expected during reengineering efforts.
  1. Pinpointing the cause of Goal Incongruence:
    1. Look at economics of each decision from decision-maker’s and apply chain’s perspective.
    2. Identify decisions that would have been made differently if the decision-maker was trying to maximize supply chain profit.
    3. Trace these differences to moral hazard (tendency to take undue risks because the costs are not borne by the party taking the risk), and pre-and post-contract private information.
  2. Overcoming Goal Incongruence:
    1. Identify solutions to the problems
                                     i.      Adopting revenue-sharing contracts,
                                     ii.      Using technology to track previously hidden information, or
                                     iii.      Working with intermediaries to build trust among network partners.
    1. Solutions can be ranked according to how easy are to implement – contracting-based, information-based, structure-based, and trust-based.

It's also important to periodically reassess incentives, because even top-performing networks find that changes in technology or business conditions alter the alignment of incentives.

1. Harvard Business Review, Aligning Incentives for Supply Chain Efficiency, April 10, 2000

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