Newsletter of the Stanford Global Supply Chain Management Forum Vol. 10 Issue 4 • Fall 2004

Five Steps to Service FORUM PARTNER MEMBERS Supply Chain Excellence Accenture ADX By Dirk de Waart and Steve Kemper AT Kearney Agile Software Applied Materials For decades, companies have struggled with the seemingly competing forces Cisco Systems of excellent customer service and best-in-class operational cost. The pre- Deloitte Research vailing view dictated that customer satisfaction required a high price and Dow Chemical aftermarket service was a necessary evil. Only recently have companies E2Open realized that they can run their service business as a profit center, making Hewlett-Packard IBM Corporation both their customers and their shareholders happy. The advantages of Ingram Micro Logistics achieving excellence in service supply chain management include increased Intel Corporation customer satisfaction and retention, product sales, and service contract rev- Intuit enue as well as higher margins. Given the higher emphasis of customers on Motorola after-sale support, the importance of excellence in service supply chain Nike Nokia Mobile Phones management—and the risks of not taking proper steps to improve perfor- Nomura Research Inst. mance in this area, are expected to further increase in the future. Oracle This article describes a five-step process to help companies swiftly get on palmOne that road to service supply chain excellence: PeopleSoft Samsung Electronics Step 1: Understand Your Service Supply Chain. The service supply SAP Labs LCC chain is defined as all processes and activities involved in the planning, SeeCommerce movement, and repair of materials to enable after-sales support of the Solectron company’s products. As a first step, companies should move into viewing Sun Microsystems the service supply chain as a cross-functional core process. Currently, UPS Viacore many companies tend to have the service supply chain subprocess owners report into different organizational functions, which typically subopti- AFFILIATED AIM MEMBERS mizes performance. There Advanced Micro Devices Step 2: Determine How to Measure Your Service Supply Chain. Cisco Systems is no single metric that defines the service supply chain’s performance. Ford Motor Corporation This challenge is complicated by the multitude of operational models typ- General Motors Corporation ically in play. It’s essential to choose the right metrics, that are aligned Genentech with the organization’s strategy and balance operational and financial Honda R&D Americas measures, and measure them in the right way. Otherwise, performance is Intel Corporation Sun Microsystems likely to be suboptimized. Toyota Motors Step 3: Develop the Business Case for Improvement. Enhanced service supply chain performance can drive higher business growth or lower

cont. on page 8 Research: Capacity and Quality Risk in Decentralized Supply Chains by Özalp Özer This article is a compilation of research by ity due to low demand realization (down- Professor Özalp Özer; Dr. Wei Wei, a Ph.D. side capacity risk) or lack of product avail- graduate of Stanford who is now at ability due to high demand realization Morgan Stanley; and Ph.D. student Murat (upside capacity risk). In a decentralized Kaya. Their work explores the risks in the supply chain, lack of proper capacity risk management of decentralized supply sharing exacerbates the cost of capacity chains. For more information, please con- risk. Specifically, to deliver on time, the from the market information that drives the tact Prof. Özer at [email protected]. CM secures capacity in advance of an OEM’s forecast. In this case, improper The coordination of information, as well OEM order. For such a supply chain, if allocation of excess capacity risk creates a as operations and logistics optimization, consumer demand turns out to be high, new incentive problem. For example, has become increasingly more difficult both the CM and the OEM face upside under a wholesale price contract, the OEM with recent increases in supply chain com- capacity risk. However, if consumer may influence the CM’s capacity decision plexity. These higher levels of complexity demand turns out to be low, only the CM by inflating the forecast. Note that inflating are the result of dramatic changes in man- faces downside capacity risk. the forecast does not change the OEM’s ufacturing and distribution, including Double Marginalization downside capacity risk exposure but globalization and outsourcing. As a result, The severity of capacity risk for each party reduces her upside capacity risk exposure. independent firms manage different parts depends on the contractual agreements. Anticipating this, the CM does not con- of today’s global supply chains. Each firm Under a wholesale price contract, for sider the OEM’s forecast information to be in the supply chain sets strategic and oper- example, the OEM pays a wholesale price credible. Hence, under a wholesale price ational goals to maximize its own profit by $w to the CM for each unit ordered and contract, lack of credible forecast informa- using local information such as cost struc- sells the product to the market at $r per tion sharing result in insufficient capacity tures, profit margins and forecasts. Even unit. The CM secures capacity at a unit when the OEM places actual orders. though advances in information technol- cost of $c, which could represent an equiv- Forecast manipulation is widespread in ogy enable firms to collect, process, and alent annual cost of capacity. Hence, the many industries, from apparel to high tech- share information, firms may be reluctant CM’s marginal profit (w-c) is less than the nology. PC and electronics manufacturers to do so because of conflicting incentives. vertically integrated supply chain’s mar- often submit “phantom orders” to induce Aligning incentives improves firms’ prof- ginal profit (r-c). This difference is known their suppliers to secure more capacity. In its and sustains the use of information as double marginalization. The CM, there- 2001 Solectron, a major electronics CM, technology. fore, protects himself by securing less had $4.7 Billion in excess component We attribute incentive problems to two capacity than what would be optimal for a capacity due to inflated forecasts provided major risk imbalances: capacity (inven- vertically integrated supply chain. The by OEMs. Anticipating such forecast infla- tory) risk and quality risk. Because of OEM may eliminate this adverse effect of tion, the CM may discount the forecast these imbalances, the adverse effects of decentralization by sharing the CM’s provided earlier. Unfortunately, this cau- capacity and quality risks are more severe upside capacity risk. Note that the CM’s tion can also lead to huge losses. In 1997, for a decentralized supply chain than for a marginal cost is $c, whereas the OEM’s Boeing’s suppliers were not able to fulfill vertically integrated supply chain. Here, marginal cost is zero. Hence, the OEM Boeing’s large orders because they did not we introduce our ongoing research in can, for example, agree to pay back $p per believe Boeing’s optimistic forecasts. designing contracts to eliminate or miti- unit of unused capacity. This would reduce Structured Agreements gate these adverse effects. We will typify a the CM’s marginal cost to $(c-p) and Through our private conversations with two level supply chain using a contract induce the CM to build a higher capacity, executives from several industries, we con- manufacturer (CM) and an original equip- thus aligning incentives. We refer to this as firmed that the unit cost of capacity and ment manufacturer (OEM). a pay back contract. the degree of forecast information asym- Forecast Information Asymmetry metry are two primary drivers of capacity Capacity Risk The severity of capacity risk also depends risk. Figure 1 maps the level of these Forecasting demand is inherently difficult on demand forecast information asymme- derivers for industries. For example, in the due to short product life cycles and long try. To make the right capacity decision, semiconductor industry, compared to the production leadtimes. Hence, supply the CM must have accurate forecast infor- OEM, the CM knows almost nothing about chains face the risk of either excess capac- mation. Yet, the CM is one step removed cont. on back

The Supply Chain Connection oooo Insert side A

Özalp Özer cont. from other side define quality as the product attributes for strategic relationship management sys- which customers prefer more to less. The tems between OEM and CM is probably a the product’s potential in the marketplace. classical quality literature narrowly good idea in addition to structured and We characterize two types of contracts defines quality as the percentage of prod- legally binding agreements. This strategic that enable credible forecast information ucts that are not defective. Today, OEMs relationship may encourage, for example, sharing. The first contract type is a capac- are outsourcing more advance functions implementation of quality programs such such as strategic sourc- as TQM or Six Sigma. ing, design, and even We refer to the adverse effect of ineffi- research and develop- ciencies caused by immeasurability of ment. The OEMs can both quality effort level and the quality use inspection tech- cost as the quality risk. niques to measure yield In our research, we design procurement and, hence, can enforce contracts that improve CM-OEM profits a certain yield in the by inducing the CM to exert effort to pro- contract. However, duce better quality products when parties when CMs undertake cannot explicitly contract on quality. With more advanced tasks, the help of our study, we characterize the measuring either the value of being able to contract on quality. CMs’ quality effort or We also quantify the value of obtaining their cost to achieve the information on the CM’s quality cost for desired quality level is supply chains in which parties can contract difficult. This difficulty on quality at the expense of writing long precludes the OEM contracts and of conducting extensive test- Figure 1: Capacity Risk Derivers from enforcing the desired quality level ing, inspection and negotiation. Our mod- ity reservation contract, which essentially with a legal contract. els shed light on the value of such activi- holds the OEM accountable for her fore- Not being able to foresee all possible ties. cast information by requiring a fee for contingencies and time to market pres- We also study the effect of the OEM’s reserving capacity. The CM provides this sures are two other reasons that make product-pricing policy on the resulting contract as a menu of fees for correspond- quality difficult to measure. Quality quality of the product. In our correspon- ing capacity level that the OEM may requirements may be better understood dence with executives from the telecom- reserve. The optimal reservation price has after the CM builds a prototype, but this munication and semiconductor industries, the characteristics of a quantity discount. step typically occurs after an outsourcing we were surprised by their two opposing The second contract is an advance pur- agreement is signed. According to a product-pricing strategies. The telecom chase agreement, which provides an Toshiba manager, if Toshiba waited until executive advocated setting market price option to the OEM to place firm orders at they were absolutely sure of every final for his final product in the contract terms an advance purchase price before the CM with his contract manu- secures capacity. This agreement credibly facturer. The semicon- signals the OEM’s forecast and induces the ductor executive advo- CM to secure the necessary capacity. cated pricing the prod- Depending on the per unit cost of uct after receiving com- capacity and the degree of forecast infor- ponents from the CM. mation asymmetry, OEM and CM can Each manager claimed choose among structured agreements that his practice would enable a mutually beneficial partnership induce the CM to pro- as summarized in Figure 2. duce a higher quality For example, when forecast information component. One of our between the parties is highly imbalanced, aims is to shed light on and per unit cost of component capacity is such opposing strate- low, then our analysis shows that the gies. advanced purchase contract generates We hope that this article higher profits for both parties. provokes more thought and instigates action to Quality Risks efficiently manage Controlling quality of a product in a Figure 2:Mutually Beneficial Contracts capacity and quality risk in decentralized decentralized supply chain is a challenge. detail and then wrote a complete contract, supply chains. We are interested in hearing OEMs face the risk of lower quality than they would be 6 to 12 months late to the about and working on related problems in a vertically integrated supply chain. We marketplace. Therefore, establishing that practitioners are facing today.

Insert side B oooo The Supply Chain Connection