Lessons in Operations Management CONTENTS

SLOANSELECT COLLECTION FALL 2009

A SPECIAL COLLECTION OF BUSINESS OPERATIONS INSIGHTS FROM MIT SLOAN MANAGEMENT REVIEW Lessons in Operations Management CONTENTS

SLOANSELECT COLLECTION FALL 2009

Lessons in Operations Management

1 The Bullwhip Effect in Supply Chains Spring 1997 11 7 Deadly Sins of Performance Measurement Spring 2007 21 Sharing Global Supply Chain Knowledge Summer 2008 28 Evolving From Value Chain to Value Grid Summer 2006 37 Taking the Measure of Outsourcing Providers Spring 2005 45 Rethinking Procurement in the Era of Globalization Fall 2008

REPRINT NUMBER OPS1109

LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW i The Bullwhip Effect in Supply Chains

Hau L. Lee • V. Padmanabhan • Seungjin Whang

Distorted information from one end over time. However, when they examined the orders from the reseller, they observed much bigger swings. of a supply chain to the other can Also, to their surprise, they discovered that the orders from the printer division to the company’s integrated lead to tremendous inefficiencies: circuit division had even greater fluctuations. excessive inventory investment, poor What happens when a supply chain is plagued with a bullwhip effect that distorts its demand information customer service, lost revenues, as it is transmitted up the chain? In the past, without misguided capacity plans, ineffective being able to see the sales of its products at the distri- bution channel stage, HP had to rely on the sales or- transportation, and missed ders from the resellers to make product forecasts, plan capacity, control inventory, and schedule production. production schedules. How do Big variations in demand were a major problem for exaggerated order swings occur? What HP’s management. The common symptoms of such variations could be excessive inventory, poor product can companies do to mitigate them? forecasts, insufficient or excessive capacities, poor cus- tomer service due to unavailable products or long back- ot long ago, logistics executives at Procter & logs, uncertain production planning (i.e., excessive revi- Gamble (P&G) examined the order pat- sions), and high costs for corrections, such as for expe- Nterns for one of their best-selling products, dited shipments and overtime. HP’s product division Pampers. Its sales at retail stores were fluctuating, but was a victim of order swings that were exaggerated by the variabilities were certainly not excessive. However, the resellers relative to their sales; it, in turn, created as they examined the distributors’ orders, the execu- additional exaggerations of order swings to suppliers. tives were surprised by the degree of variability. When In the past few years, the Efficient Consumer Re- they looked at P&G’s orders of materials to their sup- sponse (ECR) initiative has tried to redefine how the pliers, such as 3M, they discovered that the swings grocery supply chain should work.1 One motivation were even greater. At first glance, the variabilities did for the initiative was the excessive amount of invento- not make sense. While the consumers, in this case, ry in the supply chain. Various industry studies found the babies, consumed diapers at a steady rate, the de- that the total supply chain, from when products leave mand order variabilities in the supply chain were am- the manufacturers’ production lines to when they ar- plified as they moved up the supply chain. P&G rive on the retailers’ shelves, has more than 100 days of called this phenomenon the “bullwhip” effect. (In some industries, it is known as the “whiplash” or the Hau L. Lee is the Kleiner Perkins, Mayfield, Sequoia Capital Professor “whipsaw” effect.) in Industrial Engineering and Engineering Management, and professor When Hewlett-Packard (HP) executives examined of operations management at the Graduate School of Business, Stanford University. V. Padmanabhan is an associate professor of marketing, and the sales of one of its printers at a major reseller, they Seungjin Whang is an associate professor of operations information and found that there were, as expected, some fluctuations technology, also at Stanford.

SLOAN MANAGEMENT REVIEW/SPRING 1997 LEE ET AL. 93 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 1 Figure 1 Increasing Variability of Orders up the Supply Chain

Consumer Sales Retailer's Orders to Manufacturer 20 20

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Order Quantity 5 Order Quantity 5

0 0 Time Time

Wholesaler's Orders to Manufacturer Manufacturer's Orders to Supplier 20 20

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Order Quantity 5 Order Quantity 5

0 0 Time Time inventory supply. Distorted information has led every distributors’ warehouses, and store warehouses along entity in the supply chain — the plant warehouse, a the distribution channel have inventory stockpiles. manufacturer’s shuttle warehouse, a manufacturer’s And in the pharmaceutical industry, there are duplicat- market warehouse, a distributor’s central warehouse, ed inventories in a supply chain of manufacturers such the distributor’s regional warehouses, and the retail as Eli Lilly or Bristol-Myers Squibb, distributors such store’s storage space — to stockpile because of the as McKesson, and retailers such as Longs Drug Stores. high degree of demand uncertainties and variabili- Again, information distortion can cause the total in- ventory in this supply chain to exceed 100 days of sup- ply. With inventories of raw materials, such as integrat- he ordering patterns share a ed circuits and printed circuit boards in the computer common, recurring theme: the industry and antibodies and vial manufacturing in the variabilities of an upstream pharmaceutical industry, the total chain may contain T more than one year’s supply. site are always greater than those In a supply chain for a typical consumer product, of the downstream site. even when consumer sales do not seem to vary much, there is pronounced variability in the retailers’ orders to the wholesalers (see Figure 1). Orders to the manu- ties. It’s no wonder that the ECR reports estimated a facturer and to the manufacturers’ supplier spike even potential $30 billion opportunity from streamlining more. To solve the problem of distorted information, the inefficiencies of the grocery supply chain.2 companies need to first understand what creates the Other industries are in a similar position. Computer bullwhip effect so they can counteract it. Innovative factories and manufacturers’ distribution centers, the companies in different industries have found that they

94 LEE ET AL. SLOAN MANAGEMENT REVIEW/SPRING 1997 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 2 can control the bullwhip effect and improve their sup- The outcomes of the beer game are the conse- ply chain performance by coordinating information quence of many behavioral factors, such as the players’ and planning along the supply chain. perceptions and mistrust. An important factor is each player’s thought process in projecting the demand pat- Causes of the Bullwhip Effect tern based on what he or she observes. When a down- stream operation places an order, the upstream man- Perhaps the best illustration of the bullwhip effect is ager processes that piece of information as a signal the well-known “beer game.”3 In the game, partici- about future product demand. Based on this signal, pants (students, managers, analysts, and so on) play the upstream manager readjusts his or her demand the roles of customers, retailers, wholesalers, and sup- forecasts and, in turn, the orders placed with the sup- pliers of a popular brand of beer. The participants pliers of the upstream operation. We contend that de- cannot communicate with each other and must make mand signal processing is a major contributor to the order decisions based only on orders from the next bullwhip effect. downstream player. The ordering patterns share a For example, if you are a manager who has to de- common, recurring theme: the variabilities of an up- termine how much to order from a supplier, you use a stream site are always greater than those of the down- simple method to do demand forecasting, such as ex- stream site, a simple, yet powerful illustration of the ponential smoothing. With exponential smoothing, bullwhip effect. This amplified order variability may future demands are continuously updated as the new be attributed to the players’ irrational decision making. daily demand data become available. The order you Indeed, Sterman’s experiments showed that human be- send to the supplier reflects the amount you need to havior, such as misconceptions about inventory and replenish the stocks to meet the requirements of future demand information, may cause the bullwhip effect.4 demands, as well as the necessary safety stocks. The fu- In contrast, we show that the bullwhip effect is a ture demands and the associated safety stocks are up- consequence of the players’ rational behavior within dated using the smoothing technique. With long lead the supply chain’s infrastructure. This important dis- times, it is not uncommon to have weeks of safety tinction implies that companies wanting to control the stocks. The result is that the fluctuations in the order bullwhip effect have to focus on modifying the chain’s quantities over time can be much greater than those in infrastructure and related processes rather than the de- the demand data. cision makers’ behavior. Now, one site up the supply chain, if you are the We have identified four major causes of the bull- manager of the supplier, the daily orders from the man- whip effect: ager of the previous site constitute your demand. If you 1. Demand forecast updating are also using exponential smoothing to update your 2. Order batching forecasts and safety stocks, the orders that you place 3. Price fluctuation with your supplier will have even bigger swings. For an 4. Rationing and shortage gaming example of such fluctuations in demand, see Figure 2. Each of the four forces in concert with the chain’s As we can see from the figure, the orders placed by the infrastructure and the order managers’ rational deci- dealer to the manufacturer have much greater variabili- sion making create the bullwhip effect. Understanding ty than the consumer demands. Because the amount of the causes helps managers design and develop strate- safety stock contributes to the bullwhip effect, it is in- gies to counter it.5 tuitive that, when the lead times between the resupply of the items along the supply chain are longer, the fluc- Demand Forecast Updating tuation is even more significant. Every company in a supply chain usually does product forecasting for its production scheduling, capacity plan- Order Batching ning, inventory control, and material requirements In a supply chain, each company places orders with an planning. Forecasting is often based on the order histo- upstream organization using some inventory monitor- ry from the company’s immediate customers. ing or control. Demands come in, depleting inven-

SLOAN MANAGEMENT REVIEW/SPRING 1997 LEE ET AL. 95 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 3 load (FTL) and less-than-truckload rates, so compa- Figure 2 Higher Variability in Orders from Dealer to nies have a strong incentive to fill a truckload when Manufacturer than Actual Sales they order materials from a supplier. Sometimes, sup- pliers give their best pricing for FTL orders. For most 60 items, a full truckload could be a supply of a month 50 or more. Full or close to full truckload ordering would Orders Placed 40 thus lead to moderate to excessively long order cycles. In push ordering, a company experiences regular 30

Quantity surges in demand. The company has orders “pushed” 20 Actual Sales on it from customers periodically because salespeople 10 are regularly measured, sometimes quarterly or annu- 0 ally, which causes end-of-quarter or end-of-year order Time surges. Salespersons who need to fill sales quotas may “borrow” ahead and sign orders prematurely. The tory, but the company may not immediately place U.S. Navy’s study of recruiter productivity found an order with its supplier. It often batches or accu- surges in the number of recruits by the recruiters on a mulates demands before issuing an order. There are periodic cycle that coincided with their evaluation two forms of order batching: periodic ordering and cycle.7 For companies, the ordering pattern from their push ordering. customers is more erratic than the consumption pat- Instead of ordering frequently, companies may terns that their customers experience. The “hockey order weekly, biweekly, or even monthly. There are stick” phenomenon is quite prevalent. many common reasons for an inventory system based When a company faces periodic ordering by its on order cycles. Often the supplier cannot handle fre- customers, the bullwhip effect results. If all customers’ quent order processing because the time and cost of order cycles were spread out evenly throughout the processing an order can be substantial. P&G estimat- ed that, because of the many manual interventions needed in its order, billing, and shipment systems, lthough some companies each invoice to its customers cost between $35 and claim to thrive on $75 to process.6 Many manufacturers place purchase orders with suppliers when they run their material re- A high-low buying quirements planning (MRP) systems. MRP systems practices,most suffer. are often run monthly, resulting in monthly ordering with suppliers. A company with slow-moving items may prefer to order on a regular cyclical basis because week, the bullwhip effect would be minimal. The pe- there may not be enough items consumed to warrant riodic surges in demand by some customers would be resupply if it orders more frequently. insignificant because not all would be ordering at the Consider a company that orders once a month same time. Unfortunately, such an ideal situation rarely from its supplier. The supplier faces a highly erratic exists. Orders are more likely to be randomly spread stream of orders. There is a spike in demand at one out or, worse, to overlap. When order cycles overlap, time during the month, followed by no demands for most customers that order periodically do so at the the rest of the month. Of course, this variability is same time. As a result, the surge in demand is even higher than the demands the company itself faces. more pronounced, and the variability from the bull- Periodic ordering amplifies variability and contributes whip effect is at its highest. to the bullwhip effect. If the majority of companies that do MRP or dis- One common obstacle for a company that wants tribution requirement planning (DRP) to generate to order frequently is the economics of transportation. purchase orders do so at the beginning of the month There are substantial differences between full truck- (or end of the month), order cycles overlap. Periodic

96 LEE ET AL. SLOAN MANAGEMENT REVIEW/SPRING 1997 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 4 execution of MRPs contributes to the bullwhip effect, or “MRP jitters” or “DRP jitters.” Figure 3 Bullwhip Effect due to Seasonal Sales of Soup

Price Fluctuation 800 Estimates indicate that 80 percent of the transactions 700 600 Shipments from between manufacturers and distributors in the grocery 500 Manufacturer to industry were made in a “forward buy” arrangement Distributors Retailers' 400 Sales in which items were bought in advance of require- 300 ments, usually because of a manufacturer’s attractive 200 Weekly Quantity price offer.8 Forward buying constitutes $75 billion to 100 9 0 $100 billion of inventory in the grocery industry. 1 52 Forward buying results from price fluctuations in Weeks the marketplace. Manufacturers and distributors peri- odically have special promotions like price discounts, sales, with higher sales in the winter (see Figure 3). quantity discounts, coupons, rebates, and so on. All However, the shipment quantities from the manufac- these promotions result in price fluctuations. Addi- turer to the distributors, reflecting orders from the tionally, manufacturers offer trade deals (e.g., special distributors to the manufacturer, varied more widely. discounts, price terms, and payment terms) to the dis- When faced with such wide swings, companies often tributors and wholesalers, which are an indirect form have to run their factories overtime at certain times of price discounts. For example, Kotler reports that and be idle at others. Alternatively, companies may trade deals and consumer promotion constitute 47 have to build huge piles of inventory to anticipate big percent and 28 percent, respectively, of their total pro- swings in demand. With a surge in shipments, they motion budgets.10 The result is that customers buy in may also have to pay premium freight rates to trans- quantities that do not reflect their immediate needs; port products. Damage also increases from handling they buy in bigger quantities and stock up for the fu- larger than normal volumes and stocking inventories ture. for long periods. The irony is that these variations are Such promotions can be costly to the supply chain.11 induced by price fluctuations that the manufacturers What happens if forward buying becomes the norm? and the distributors set up themselves. It’s no wonder When a product’s price is low (through direct discount that such a practice was called “the dumbest market- or promotional schemes), a customer buys in bigger ing ploy ever.”12 quantities than needed. When the product’s price re- Using trade promotions can backfire because of the turns to normal, the customer stops buying until it has impact on the manufacturers’ stock performance. A depleted its inventory. As a result, the customer’s buy- group of shareholders sued Bristol-Myers Squibb ing pattern does not reflect its consumption pattern, when its stock plummeted from $74 to $67 as a result and the variation of the buying quantities is much big- of a disappointing quarterly sales performance; its ac- ger than the variation of the consumption rate — the tual sales increase was only 5 percent instead of the an- bullwhip effect. ticipated 13 percent. The sluggish sales increase was When high-low pricing occurs, forward buying reportedly due to the company’s trade deals in a previ- may well be a rational decision. If the cost of holding ous quarter that flooded the distribution channel with inventory is less than the price differential, buying in forward-buy inventories of its product.13 advance makes sense. In fact, the high-low pricing phenomenon has induced a stream of research on Rationing and Shortage Gaming how companies should order optimally to take ad- When product demand exceeds supply, a manufacturer vantage of the low price opportunities. often rations its product to customers. In one scheme, Although some companies claim to thrive on the manufacturer allocates the amount in proportion high-low buying practices, most suffer. For example, to the amount ordered. For example, if the total supply a soup manufacturer’s leading brand has seasonal is only 50 percent of the total demand, all customers

SLOAN MANAGEMENT REVIEW/SPRING 1997 LEE ET AL. 97 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 5 receive 50 percent of what they order. Knowing that IBM, hampered by an overstock problem the previous the manufacturer will ration when the product is in year, planned production too conservatively. Other an- short supply, customers exaggerate their real needs alysts referred to the possibility of rationing: “Retailers when they order. Later, when demand cools, orders — apparently convinced Aptiva will sell well and afraid will suddenly disappear and cancellations pour in. This of being left with insufficient stock to meet holiday seeming overreaction by customers anticipating short- season demand — increased their orders with IBM, ages results when organizations and individuals make believing they wouldn’t get all they asked for.”18 It was sound, rational economic decisions and “game” the unclear to IBM how much of the increase in orders potential rationing.14 The effect of “gaming” is that was genuine market demand and how much was due customers’ orders give the supplier little information to resellers placing phantom orders when IBM had to on the product’s real demand, a particularly vexing ration the product. problem for manufacturers in a product’s early stages. The gaming practice is very common. In the 1980s, How to Counteract the Bullwhip Effect on several occasions, the computer industry perceived a shortage of DRAM chips. Orders shot up, not be- Understanding the causes of the bullwhip effect can cause of an increase in consumption, but because of help managers find strategies to mitigate it. Indeed, anticipation. Customers place duplicate orders with many companies have begun to implement innovative multiple suppliers and buy from the first one that can programs that partially address the effect. Next we ex- deliver, then cancel all other duplicate orders.15 amine how companies tackle each of the four causes. More recently, Hewlett-Packard could not meet the We categorize the various initiatives and other possible demand for its LaserJet III printer and rationed the remedies based on the underlying coordination mech- product. Orders surged, but HP managers could not anism, namely, information sharing, channel align- discern whether the orders genuinely reflected real ment, and operational efficiency. With information market demands or were simply phantom orders from sharing, demand information at a downstream site is resellers trying to get better allocation of the product. transmitted upstream in a timely fashion. Channel When HP lifted its constraints on resupply of the alignment is the coordination of pricing, transporta- LaserJets, many resellers canceled their orders. HP’s tion, inventory planning, and ownership between the costs in excess inventory after the allocation period upstream and downstream sites in a supply chain. and in unnecessary capacity increases were in the mil- Operational efficiency refers to activities that improve lions of dollars.16 performance, such as reduced costs and lead time. We During the Christmas shopping seasons in 1992 use this topology to discuss ways to control the bull- and 1993, Motorola could not meet consumer de- whip effect (see Table 1). mand for handsets and cellular phones, forcing many distributors to turn away business. Distributors like Avoid Multiple Demand Forecast Updates AirTouch Communications and the Baby Bells, an- Ordinarily, every member of a supply chain conducts ticipating the possibility of shortages and acting de- some sort of forecasting in connection with its plan- fensively, drastically overordered toward the end of ning (e.g., the manufacturer does the production plan- 1994.17 Because of such overzealous ordering by retail ning, the wholesaler, the logistics planning, and so on). distributors, Motorola reported record fourth-quarter Bullwhip effects are created when supply chain mem- earnings in January 1995. Once Wall Street realized bers process the demand input from their immediate that the dealers were swamped with inventory and downstream member in producing their own forecasts. new orders for phones were not as healthy before, Demand input from the immediate downstream mem- Motorola’s stock tumbled almost 10 percent. ber, of course, results from that member’s forecasting, In October 1994, IBM’s new Aptiva personal com- with input from its own downstream member. puter was selling extremely well, leading resellers to One remedy to the repetitive processing of consump- speculate that IBM might run out of the product be- tion data in a supply chain is to make demand data at a fore the Christmas season. According to some analysts, downstream site available to the upstream site. Hence,

98 LEE ET AL. SLOAN MANAGEMENT REVIEW/SPRING 1997 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 6 both sites can update their forecasts with the same raw data. In the com- Table 1 A Framework for Supply Chain Coordination Initiatives puter industry, manufacturers request Causes of Information Channel Operational sell-through data on withdrawn stocks Bullwhip Sharing Alignment Efficiency from their resellers’ central warehouse. Although the data are not as complete Demand • Understanding • Vendor-managed • Lead-time reduction Forecast system dynamics inventory (VMI) • Echelon-based as point-of-sale (POS) data from the Update • Use point-of-sale • Discount for infor- inventory control resellers’ stores, they offer significantly (POS) data mation sharing • Electronic data • Consumer direct more information than was available interchange (EDI) when manufacturers didn’t know what • Internet happened after they shipped their • Computer-assisted ordering (CAO) products. IBM, HP, and Apple all re- quire sell-through data as part of their Order • EDI • Discount for truck- • Reduction in fixed contract with resellers. Batching • Internet ordering load assortment cost of ordering by • Delivery appoint- EDI or electronic Supply chain partners can use elec- ments commerce tronic data interchange (EDI) to share • Consolidation • CAO • Logistics out- data. In the consumer products indus- sourcing try, 20 percent of orders by retailers of Price • Continuous • Everyday low price consumer products was transmitted Fluctuations replenishment (EDLP) 19 via EDI in 1990. In 1992, that fig- program (CRP) • Activity-based ure was close to 40 percent and, in • Everyday low cost costing (ABC) (EDLC) 1995, nearly 60 percent. The increas- ing use of EDI will undoubtedly fa- Shortage • Sharing sales, • Allocation based Gaming capacity, and on past sales cilitate information transmission and inventory data sharing among chain members. Even if the multiple organizations in a supply chain use the same source demand data to tor, companies such as Texas Instruments, HP, Motorola, perform forecast updates, the differences in forecasting and Apple use VMI with some of their suppliers and, in methods and buying practices can still lead to unnec- some cases, with their customers. essary fluctuations in the order data placed with the Inventory researchers have long recognized that upstream site. In a more radical approach, the up- multi-echelon inventory systems can operate better stream site could control resupply from upstream to when inventory and demand information from down- downstream. The upstream site would have access to stream sites is available upstream. Echelon inventory the demand and inventory information at the down- — the total inventory at its upstream and downstream stream site and update the necessary forecasts and re- sites — is key to optimal inventory control.20 supply for the downstream site. The downstream site, Another approach is to try to get demand informa- in turn, would become a passive partner in the supply tion about the downstream site by bypassing it. Apple chain. For example, in the consumer products indus- Computer has a “consumer direct” program, i.e., it try, this practice is known as vendor-managed inven- sells directly to consumers without going through the tory (VMI) or a continuous replenishment program reseller and distribution channel. A benefit of the pro- (CRP). Many companies such as Campbell Soup, gram is that it allows Apple to see the demand patterns M&M/Mars, Nestlé, Quaker Oats, Nabisco, P&G, for its products. Dell Computers also sells its products and Scott Paper use CRP with some or most of their directly to consumers without going through the dis- customers. Inventory reductions of up to 25 percent are tribution channel. common in these alliances. P&G uses VMI in its dia- Finally, as we noted before, long resupply lead times per supply chain, starting with its supplier, 3M, and its can aggravate the bullwhip effect. Improvements in customer, Wal-Mart. Even in the high-technology sec- operational efficiency can help reduce the highly vari-

SLOAN MANAGEMENT REVIEW/SPRING 1997 LEE ET AL. 99 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 7 able demand due to multiple forecast updates. Hence, is preserved. P&G has given discounts to distributors just-in-time replenishment is an effective way to miti- that are willing to order mixed-SKU (stock-keeping gate the effect. unit) loads of any of its products.24 Manufacturers could also prepare and ship mixed SKUs to the distrib- Break Order Batches utors’ warehouses that are ready to deliver to the stores. Since order batching contributes to the bullwhip effect, “Composite distribution” for fresh produce and companies need to devise strategies that lead to smaller chilled products uses the same mixed-SKU concept to batches or more frequent resupply. In addition, the make resupply more frequent. Since fresh produce and counterstrategies we described earlier are useful. When chilled foods need to be stored at different tempera- an upstream company receives consumption data on a tures, trucks to transport them need to have various fixed, periodic schedule from its downstream cus- temperatures. British retailers like Tesco and Sainsbury tomers, it will not be surprised by an unusually large use trucks with separate compartments at different batched order when there is a demand surge. temperatures so that they can transport many products One reason that order batches are large or order fre- on the same truck.25 quencies low is the relatively high cost of placing an The use of third-party logistics companies also helps order and replenishing it. EDI can reduce the cost of make small batch replenishments economical.26 These the paperwork in generating an order. Using EDI, companies allow economies of scale that were not fea- companies such as Nabisco perform paperless, com- sible in a single supplier-customer relationship. By puter-assisted ordering (CAO), and, consequently, cus- consolidating loads from multiple suppliers located tomers order more frequently. McKesson’s Economost near each other, a company can realize full truckload ordering system uses EDI to lower the transaction economies without the batches coming from the same costs from orders by drugstores and other retailers.21 supplier. Of course, there are additional handling and P&G has introduced standardized ordering terms across all business units to simplify the process and dra- matically cut the number of invoices.22 And General he simplest way to control the Electric is electronically matching buyers and suppliers throughout the company. It expects to purchase at least bullwhip effect caused by $1 billion in materials through its internally developed forward buying and diversions Trading Process Network. A paper purchase order that T is to reduce both the frequency typically cost $50 to process is now $5.23 Another reason for large order batches is the cost of and the level of wholesale price transportation. The differences in the costs of full discounting. truckloads and less-than-truckloads are so great that companies find it economical to order full truckloads, even though this leads to infrequent replenishments administrative costs for such consolidations or multi- from the supplier. In fact, even if orders are made with ple pickups, but the savings often outweigh the costs. little effort and low cost through EDI, the improve- Similarly, a third-party logistics company can utilize ments in order efficiency are wasted due to the full- a truckload to deliver to customers who may be com- truckload constraint. Now some manufacturers induce petitors, such as neighboring supermarkets. If each their distributors to order assortments of different prod- customer is supplied separately via full truckloads, ucts. Hence a truckload may contain different prod- using third-party logistics companies can mean mov- ucts from the same manufacturer (either a plant ware- ing from weekly to daily replenishments. For small house site or a manufacturer’s market warehouse) customers whose volumes do not justify frequent full instead of a full load of the same product. The effect is truckload replenishments independently, this is espe- that, for each product, the order frequency is much cially appealing. Some grocery wholesalers that receive higher, the frequency of deliveries to the distributors FTL shipments from manufacturers and then ship remains unchanged, and the transportation efficiency mixed loads to wholesalers’ independent stores use lo-

100 LEE ET AL. SLOAN MANAGEMENT REVIEW/SPRING 1997 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 8 gistics companies. In the United Kingdom, Sainsbury explicit accounting of the costs of inventory, storage, and Tesco have long used National Freight Company special handling, premium transportation, and so on for logistics. As a result of the heightened awareness that previously were hidden and often outweigh the due to the ECR initiative in the grocery industry, we benefits of promotions. ABC therefore helps compa- expect to see third-party logistics companies that fore- nies implement the EDLP strategy.28 cast orders, transport goods, and replenish stores with mixed-SKU pallets from the manufacturers. Eliminate Gaming in Shortage Situations When customers spread their periodic orders or re- When a supplier faces a shortage, instead of allocating plenishments evenly over time, they can reduce the products based on orders, it can allocate in proportion negative effect of batching. Some manufacturers coor- to past sales records. Customers then have no incentive dinate their resupply with their customers. For exam- to exaggerate their orders. General Motors has long ple, P&G coordinates regular delivery appointments used this method of allocation in cases of short supply, with its customers. Hence, it spreads the replenish- and other companies, such as Texas Instruments and ments to all the retailers evenly over a week. Hewlett-Packard, are switching to it. “Gaming” during shortages peaks when customers Stabilize Prices have little information on the manufacturers’ supply The simplest way to control the bullwhip effect caused situation. The sharing of capacity and inventory infor- by forward buying and diversions is to reduce both the mation helps to alleviate customers’ anxiety and, conse- frequency and the level of wholesale price discounting. quently, lessen their need to engage in gaming. But The manufacturer can reduce the incentives for retail sharing capacity information is insufficient when there forward buying by establishing a uniform wholesale is a genuine shortage. Some manufacturers work with pricing policy. In the grocery industry, major manufac- customers to place orders well in advance of the sales turers such as P&G, Kraft, and Pillsbury have moved season. Thus they can adjust production capacity or to an everyday low price (EDLP) or value pricing strat- scheduling with better knowledge of product demand. egy. During the past three years, P&G has reduced its Finally, the generous return policies that manufac- list prices by 12 percent to 24 percent and aggressively turers offer retailers aggravate gaming. Without a slashed the promotions it offers to trade customers. In penalty, retailers will continue to exaggerate their 1994, P&G reported its highest profit margins in twenty- needs and cancel orders. Not surprisingly, some com- one years and showed increases in market share.27 Simi- puter manufacturers are beginning to enforce more larly, retailers and distributors can aggressively negotiate stringent cancellation policies. with their suppliers to give them everyday low cost (EDLC). From 1991 to 1994, the percentage of trade deals in the total promotion budget of grocery products dropped from 50 percent to 47 percent. We contend that the bullwhip effect results from ration- From an operational perspective, practices such as al decision making by members in the supply chain. CRP together with a rationalized wholesale pricing Companies can effectively counteract the effect by thor- policy can help to control retailers’ tactics, such as di- oughly understanding its underlying causes. Industry version. Manufacturers’ use of CAO for sending or- leaders like Procter & Gamble are implementing inno- ders also minimizes the possibility of such a practice. vative strategies that pose new challenges: integrating Activity-based costing (ABC) systems enable com- new information systems, defining new organizational panies to recognize the excessive costs of forward buy- relationships, and implementing new incentive and ing and diversions. When companies run regional measurement systems. The choice for companies is promotions, some retailers buy in bulk in the area clear: either let the bullwhip effect paralyze you or find where the promotions are held, then divert the prod- a way to conquer it. N ucts to other regions for consumption. The costs of such practices are huge but may not show up in con- References ventional accounting systems. ABC systems provide 1. This initiative was engineered by Kurt Salmon Associates but pro-

SLOAN MANAGEMENT REVIEW/SPRING 1997 LEE ET AL. 101 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 9 pelled by executives from a group of innovative companies like Procter 12. Sellers (1992). & Gamble and Campbell Soup Company. See: 13. Ibid. Kurt Salmon Associates, “ECR: Enhancing Consumer Value in the 14. Lee et al. (1997). Grocery Industry (Washington, D.C.: report, January 1993); and 15. L. Lode, “The Role of Inventory in Delivery Time Competition,” F.A. Crawford, “ECR: A Mandate for Food Manufacturers?” Food Management Science, volume 38, number 2, 1992, pp. 182-197. Processing, volume 55, February 1994, pp. 34-42. 16. Personal communication with Hewlett-Packard. 2. J.A. Cooke, “The $30 Billion Promise,” Traffic Management, volume 17. K. Kelly, “Burned by Busy Signals: Why Motorola Ramped up 32, December 1993, pp. 57-59. Production Way Past Demand,” Business Week, 6 March 1995, p. 36. 3. J. Sterman, “Modeling Managerial Behavior: Misperception of 18. Rory J. O’Connor, “Rumor Bolsters IBM Shares,” San Jose Mercury Feedback in a Dynamic Decision-Making Experiment,” Management News, 8 October 1994, p. 9D. Science, volume 35, number 3, 1989, pp. 321-339. 19. M. Reid, “Change at the Check-Out,” The Economist, volume 4. Sterman (1989); and 334, 4 March 1995, pp. 3-18. P. Senge, The Fifth Discipline: The Art and Practice of the Learning 20. A. Clark and H. Scarf, “Optimal Policies for a Multi-Echelon Organization (New York: Doubleday/Currency, 1990). Inventory Problem,” Management Science, volume 6, number 4, 1960, 5. For a theoretical treatment of this subject, see: pp. 465-490. H.L. Lee, P. Padmanabhan, and S. Whang, “Information Distortion 21. E.K. Clemons and M. Row, “McKesson Drug Company — A in a Supply Chain: The Bullwhip Effect,” Management Science, 1997, Strategic Information System,” Journal of Management Information forthcoming. Systems, volume 5, Summer 1988, pp. 36-50. 6. M. Millstein, “P&G to Restructure Logistics and Pricing,” Super- 22. Millstein (1994). market News, 27 June 1994, pp. 1, 49. 23. T. Smart, “Jack Welch’s Cyber-Czar,” Business Week, 5 August 7. V. Carroll, H.L. Lee, and A.G. Rao, “Implications of Salesforce 1996, pp. 82-83. Productivity, Heterogeneity and Demotivation: A Navy Recruiter Case 24. G. Stern, “Retailers of P&G to Get New Plan on Bills, Shipment,” Study,” Management Science, volume 32, number 11, 1986, pp. 1371- Wall Street Journal, 22 June 1994. 1388. 25. Reid (1995). 8. Salmon (1993). 26. H.L. Richardson, “How Much Should You Outsource?,” Trans- 9. P. Sellers, “The Dumbest Marketing Ploy,” Fortune, volume 126, 5 portation and Distribution, volume 35, September 1994, pp. 61-62. October 1992, pp. 88-93. 27. Z. Schiller, “Ed Artzt’s Elbow Grease Has P&G Shining,” Business 10. P. Kotler, Marketing Management: Analysis, Planning, Implementation, Week, 10 October 1994, pp. 84-86. and Control (Englewood Cliffs, New Jersey: Prentice Hall, 1997). 28. R. Mathews, “CRP Moves Towards Reality,” Progressive Grocer, 11. R.D. Buzzell, J.A. Quelch, and W.J. Salmon, “The Costly Bargain volume 73, July 1994, pp. 43-44. of Trade Promotion,” Harvard Business Review, volume 68, March- April 1990, pp. 141-148. Reprint 3837 Copyright © 1997 by the SLOAN MANAGEMENT REVIEW ASSOCIATION. All rights reserved.

102 LEE ET AL. SLOAN MANAGEMENT REVIEW/SPRING 1997 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 10 SPECIAL REPORT: MEASURING TO MANAGE THE DEADLY 7Sins OF PERFORMANCE MEASUREMENT [and How to Avoid Them] By Michael Hammer

Operational performance measurement remains an unsolved problem. Despite the relatively little attention it gets in the management literature, designing and using metrics to track and improve operating performance is one of the most persist- ent problems that organizations face. In my interactions with companies in virtually every industry, I scarcely ever encounter one that believes it has an effective set of metrics for their operations: manufacturing, customer service, marketing, pro- curement and the like. To be sure, companies do have measure- ments for these areas that they employ every day, but few managers or staff believe that these metrics are the right ones or that they help the company improve its performance and achieve its strategic goals. This is remarkable for two reasons: First, operational performance measurement is so fundamental

Michael Hammer is president of Hammer and Company, a management education and research firm based in Cam- bridge, Massachusetts. He is also a Visiting Professor of Engineering Systems at MIT and a Fellow of the Said Business School at Oxford University. He is the author of numerous books and articles on transforming operational performance. His Web site is www.hammerandco.com. Comment on this article or contact the authors through [email protected].

LESSONS IN OPERATIONS MANAGEMENTSPRING 2007 • MIT MIT SLOAN SLOAN MANAGEMENT MANAGEMENT REVIEW REVIEW 11 19 SPECIAL REPORT: MEASURING TO MANAGE to basic operational management that it dozen or so recurring mistakes in defin- said, “Nobody wants a metric that they should presumably have been resolved a ing and using metrics, mistakes that don’t score 95 on.” This is particularly the long time ago; second, in the last several seriously impede the relevance and use- case since bonuses and other rewards are years companies have developed much fulness of their operating measures and usually tied to results measured in terms more sophisticated strategic measurement that help explain the widespread malaise of performance measures. For instance, systems, based on such tools as the bal- about measurement that they feel. I call in the area of logistics and order fulfill- anced scorecard, key performance these the seven deadly sins of perform- ment, it is common for companies to indicators, computerized dashboards and ance measurement, and, like the seven measure themselves against promise date the like. Nonetheless, among the hundreds deadly sins of theology, they present — that is, whether they shipped on the of managers with whom I have discussed grave dangers, if not to the prospects for date that they promised the customer. A this matter, there is a widespread consensus the immortal soul then to the prospects moment’s impartial reflection shows that that they measure too much or too little, or for superior business performance. this sets the bar absurdly low — a com- the wrong things, and that in any event pany need only promise delivery dates they don’t use their metrics effectively. Vanity One of the most wide- that it can easily make in order to look The most striking manifestation of spread mistakes in performance good on this metric. Even worse, compa- this problem is that many of the opera- measurement is to use measures nies often measure against what is called tional metrics that companies commonly that will inevitably make the or- last promise date — the final date prom- use make little or no sense. I have found 1ganization, its people and especially its ised the customer, after changes may have that organizations fall prey to a half managers look good. As one executive been made to the delivery schedule. It

MIND OF THE MANAGER The Key Metric There is no one key metric, Carole J. Haney but at Boeing Rotocraft Mesa Process Owner — Process Management and Process Performance, The Boeing there is definitely a key pro- Company, Integrated Defense Systems, Rotorcraft Division, Mesa, Arizona cess to follow in defining a metric: 1. Start with a SIPOC Philosophy of Performance team that comprises cross- generating misleading data. (an analysis of the supplier- Measurement functions, including the It is essential to have the right input-process-output-customer Typically, companies overload customer, is more readily data — data that when ana- continuum) and a process their managers with metrics postured for success. lyzed can reveal whether the flow chart. that measure personal perfor- process is capable of meeting 2. Identify process outputs mance rather than process The Deadliest Sin customer expectations and that are important to the performance, frequently Unfortunately, all the sins Dr. requirements. A process flow customer. missing improvement oppor- Hammer enumerates are chart will enable the process 3. Determine the type of tunities across the process. prevalent in today’s business owner to determine “trigger” measure, for example, in-pro- Looking at the entire value environment, but Laziness points in the process, thereby cess, process output or stream captures the sequence bears emphasizing. It is a trap establishing measures at process efficiency. and interaction of the pro- to assume that one inherently those trigger points. This 4. Establish the minimally ac- cesses and how they relate to knows what is important to takes work, the type of work cepted performance level. The one another, in terms of in- measure, yet this is how many in which companies generally customer must be involved in puts and outputs. companies create metrics. do not want to invest time this determination. We took an evolutionary They often jump to conclu- and resources and which 5. Determine if this is a step toward a process point of sions, or measure what is easy they don’t appropriately “shared” metric. view by implementing to measure, or measure what value. This is why companies 6. Determine the units of “shared metrics” across our they have always measured often jump to using correc- measure, data availability, value stream. Customers are rather than go through the ef- tive and preventative actions analysis method and fre- now involved as part of the fort of ascertaining what is and/or continuous improve- quency of data collection process team when creating truly important to the cus- ment activities that are and reporting. process definition; a process tomer to measure, thereby inappropriate. 7. Document the measure.

20 MIT SLOAN MANAGEMENT REVIEW SPRING 2007 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENTSLOANREVIEW.MIT.EDU/SMR REVIEW 12 takes real effort not to hit the last promise date. Moreover, achieving good results on MIND OF THE MANAGER last promise date has no larger signifi- cance for company performance; it does Anders Wester not lead to customer satisfaction or any Vice President, Business Transformation & Strategic Planning, other desirable outcome. A far better Tetra Pak Group metric would be performance against customer request date — but achieving Philosophy of Perform- we learned was the signifi- The Key Metric that goal would be more difficult and ance Measurement cance of the installation The identity of the most might lead to managers not getting their My view is not unique, itself on operating cost. As crucial metric will vary bonuses. When executives at a semi- perhaps, but it is undeni- a result, we designed and over time, of course, de- conductor manufacturer proposed able: You can’t manage implemented a new proc- pending on strategy and without measuring, and ess — installation to progress against specific shifting from last promise date to cus- what is measured gets performance. targets in the strategy. tomer request date, they encountered done. Measurement is Currently, with the accel- widespread pushback and resistance. A the antidote to ambigu- The Deadliest Sin erated pace in the metals refiner had been using yield — the ity; it forces you to In my career, I have seen competitive landscape, percentage of raw material that was impose clarity on vague evidence of all Dr. Ham- product development turned into salable product — as a key concepts and to take ac- mer’s “deadly sins,” but time is a critical metric performance metric, and everyone was tion. What we measure Provincialism is worth for Tetra Pak. We have set very pleased that this figure was consis- communicates our prior- highlighting. The great- a target to reduce time to tently over 95%. An executive new to the ities and thus has a est counter to market by 50% by 2010. company made the observation that this powerful link to strategy. provincialism is process figure glossed over the difference between For example, at Tetra orientation with an end- I Recommend high-grade and low-grade product; the Pak, we had always talked to-end focus on the I have been very inspired refinery was supposed to produce only about the importance of customer. For example, by the Balanced Score- lowering the operating in our machine sales we card work of Harvard high-grade product, but poor processing cost for our customers used to measure time Business School’s Robert sometimes led to low-grade product. The using our equipments and from order to dispatch. S. Kaplan, especially in company then started to measure the products — with very little However, this is not a terms of linking metrics yield of high-grade product and discov- action. Two years ago, very useful metric from a to strategy and taking a ered that figure was closer to 70% — and however, we created a customer’s perspective. holistic view across four a much more meaningful representation measure on our Balanced From a manufacturing perspectives — finance, of the refinery’s real performance. Not Scorecard of percent re- point of view, the proc- customer, process and or- surprisingly, this insight was not wel- duction of customer ess is complete, but ganization. I also find the comed with great enthusiasm. operating cost, which much still has to happen research done by Christo- quickly mobilized the or- before product reaches, pher D. Ittner and David F. Provincialism This is the sin of ganization to action. The and satisfies, the cus- Larcker at the Wharton letting organizational bound- first step was to get a de- tomer: transit, inventory, School of the University of tailed understanding of installation, service. Our Pennsylvania very insight- aries and concerns dictate the components of and in- new scope of measure- ful and very important. performance metrics. On the fluences on customer cost, ment is from “order to They underline the diffi- 2surface, it would seem natural and appro- such as labor, down time, performance” — mean- culties of capturing priate for a functional department to be energy, parts, waste and ing the time from when nonfinancial metrics and measured on its own performance — so on. We then developed the customer places the highlight common mis- after all, that is what its managers can a model for how to reduce order until it is installed takes made in that regard. control. In reality, however, measuring cost systematically and and up and running ac- Their conclusion that narrowly inevitably leads to suboptimiza- began to run selected cus- cording to guaranteed management needs to be tion and conflict. For instance, one tomer projects together to performance criteria much more rigorous insurance company chief executive has increase efficiency and re- that we sold them. Need- when working with nonfi- complained that he spends half his time duce cost in high-impact less to say, this is nancial measures cannot adjudicating disputes between sales and areas. Among the things transformational. be stressed enough. underwriting. Sales is usually measured in

SLOANREVIEW.MIT.EDU/SMR LESSONS IN OPERATIONS MANAGEMENTSPRING 2007 • MIT MIT SLOAN SLOAN MANAGEMENT MANAGEMENT REVIEW 1321 SPECIAL REPORT: MEASURING TO MANAGE sales volume, which motivates the sales company a 0% rating, since without all 10 Pettiness Too often, compa- force to sell to any willing customer. components the system cannot operate. nies measure only a small Underwriting, however, is measured in component of what matters. A quality of risk, which leads personnel to Laziness This is a trap that telecommunications systems want to reject all but the best prospects. even those who avoid narcis- 5vendor rejected a proposal to have cus- The transportation group in a retailer was sism often fall into: assuming tomers perform their own repairs because measured in terms of freight costs. While one knows what is important to that would require putting spare parts at ostensibly reasonable, this led the group measure4 without giving it adequate customer premises, which would drive up to search out the best deals in shipping, thought or effort. A semiconductor spare parts inventory levels — a key met- even if this meant that deliveries to the maker measured many aspects of its ric for the company. It lost sight of the fact distribution centers would sometimes be order processing operation, but not the that the broader and more meaningful early and sometimes late — resulting critical (to customers) issue of how long metric was total cost of maintenance — either in out-of-stock situations or in it took from the time the customer gave the sum of labor costs and inventory costs chaos at the receiving dock. the order to the time the company con- — and that the increase in parts inventory would be more than offset by a reduction Narcissism This is the unpar- in labor costs the new approach would re- donable offense of measuring People will seek alize. It is a basic axiom in the apparel from one’s own point of view, to improve a industry that manufacturing needs to be rather than from the customer’s done in Asia in order to lower manufac- 3perspective. A retailer, for instance, mea- metric they turing costs. Zara International Inc., the sured its distribution organization based are told is phenomenally successful Spanish apparel on whether the goods in the stores company, has recognized that the larger matched the stock-on-hand levels speci- important, metric is product profitability, which does fied in the merchandising plan. It had a especially if reflect manufacturing costs but is also af- satisfying 98% availability when meas- they are fected by the timeliness of the product ured in this way. But when it thought to line and the volume of goods that need to measure to what extent the goods in the compensated be sold off at the end of the season. By stores matched what customers actually for it — even doing production in Europe after the sea- wanted to buy, rather than what the mer- son has started and after new products chandising plan called for, the figure was if doing so is have been tested in the field, Zara ensures only 86%. Another retailer measured counterproductive. that its fashions sell well and that it has lit- goods-in-stock by whether the goods tle left at the end of the season, payoffs had arrived in the store; eventually, the that more than offset the higher produc- company realized that simply being in tion costs. the store did the customer no good if the firmed the order and provided a delivery product wasn’t on the shelf — and on- date — simply because it never thought Inanity Many companies shelf availability was considerably lower to ask customers what was really impor- seem to implement metrics than in-store availability. Many compa- tant to them. An electric power utility without giving any thought to nies measure the performance of order assumed that customers cared about the consequences of these fulfillment in terms of whether the ship- speed of installation and so measured metrics6 on human behavior and ulti- ment left the dock on the date scheduled. and tried to improve that factor, only to mately on enterprise performance. This is of interest only to the company it- discover later that customers cared more People in an organization will seek to self — customers care about when they about the reliability of the installation improve a metric they are told is impor- receive the shipment, not when it leaves date they were given than about its prox- tant, especially if they are compensated the dock. A major computer systems imity. Companies often jump to for it — even if doing so has counter- manufacturer measured on-time shipping conclusions, or measure what is easy to productive consequences. For instance, in terms of individual components; if it measure or measure what they have al- a regional fast-food chain specializing shipped, say, nine of 10 components of a ways measured, rather than go through in chicken decided to improve financial system on time, it gave itself a 90% score. the effort of ascertaining what is truly im- performance by reducing waste — waste The customer, of course, would give the portant to measure. being defined as chicken that had been

22 MIT SLOAN MANAGEMENT REVIEW SPRING 2007 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENTSLOANREVIEW.MIT.EDU/SMR REVIEW 14 MIND OF THE MANAGER the metric was not at target. So P&G has begun identifying, Rick Ciccone measuring and controlling Director, Global Supply Chain Operations, Procter & Gamble forward-looking or “in-process” metrics to manage the ultimate result. For example, case fill rate Philosophy of Performance a big difference from the is not an internal P&G measure or out-of-stocks are critical met- Measurement internal 99.5% rate. of supply chain time, but rather rics for any business, but Two common viewpoints heard Now, our supply network is spans from our suppliers discovering you have an out-of- in corporate hallways are “You designed from the shelf back: through to our retailers. In stock does not allow you to get what you measure” and We begin by focusing on the other words, the reductions prevent it. Therefore, we move “You can’t measure what you optimal end result and align might not even occur within further upstream and measure can’t see.” But it is also true that our processes to deliver that the “walls” of P&G. However, the percentage of stock-keeping if you have the wrong measure, result. We know that we must achieving this metric will result units within the minimum/maxi- you may drive an undesired be- win at the “two moments of in more agility, improved re- mum buffer. Finding out we are havior and consequence. For truth” if we are to drive sus- sponse time and better service. dipping into the minimum example, focusing only on the tainable growth. The first range allows us to intercede line fill rate or completed orders moment of truth is when the The Key Metric while still maintaining customer causes the supply chain organi- shopper is at the shelf and Business has become fast- service, preventing the out-of- zation efforts to stop when the chooses which product to buy. paced and complex. The stock. Another example is product transfers to the retailer, The second is when the con- inclination to focus on just one monitoring our suppliers’ deliv- but if the product does not sumer uses the product. metric over others is danger- ery time and ensuring that this make it to the shelf and the ous. But how do you balance measure remains on target. shelves become empty, both The Deadliest Sin multiple priorities and metrics Monitoring on-time rates allows the retailer and the manufac- Dr. Hammer cautions us against in this new environment? In the us to react earlier, streamlining turer lose sales and, most “Provincialism” — the func- past, we focused on low-cost, the supply chain and keeping all importantly, the shopper walks tional focus within organi- supply-chain-friendly products; parts synchronized. This allows away disappointed. zations that suboptimizes having long production runs of for the best deployment of valu- For a number of years, The overall results. In the end, what one type of unit was consid- able resources. Procter & Gamble Company the consumer thinks is the ulti- ered optimum. Today, we look used an internal measure of mate scorecard. We have at broader metrics in addition I Recommend service — percentage of orders focused on key partnerships to low cost. Are we fast to shelf? There are so many excellent filled — and tracked, reported, with our retail partners to cre- Do we enable our retailers with books on the market today, but acted on and so forth. And the ate shared value and delight winning products? Are we agile I would suggest titles from result looked quite good at the consumer. To drive real — able to change products, Peter Drucker, the “Innovation” 99.5%. But when we decided partnership, our metrics in- schedules and formats as our series from Clayton Christensen to extend our view to the store clude joint success for P&G and consumer needs change? and Chris Zook and James Al- shelf, we found a very different retailers. For example, we seek Unfortunately, too often we len’s Profit From the Core: picture. In fact, we found that to reduce overall supply chain are faced with scorecard data Growth Strategy in an Era of certain products were out of time by one-third. What is un- telling us what happened last Turbulence as good starting stock 10%-14% of the time — usual about this metric is that it month and are frustrated that points.

cooked but unsold at the end of the day declined but sales declined even more. Frivolity This may be the most and thus discarded. Restaurant man- Similarly, the common practice of meas- serious sin of all; it is the sin of agers throughout the chain obediently uring warehouse inventory at the end of not being serious about meas- responded by driving out waste — in the month encourages the warehouse urement in the first place. It is many cases, by telling their staff not to manager to clear goods out just before 7manifested by arguing about metrics in- cook any chicken until it had been or- the end of the month and then rush to stead of taking them to heart, by finding dered. This had the unfortunate and replace them at the beginning of the excuses for poor performance instead of perverse consequence of turning a fast- next month, thereby creating chaos and tracking root causes, by looking for ways food chain into a slow-food chain; waste higher costs. to pass the blame to others rather than

SLOANREVIEW.MIT.EDU/SMR LESSONS IN OPERATIONS MANAGEMENTSPRING 2007 • MIT MIT SLOAN SLOAN MANAGEMENT MANAGEMENT REVIEWREVIEW 1523 SPECIAL REPORT: MEASURING TO MANAGE shouldering the responsibility for im- let the debates begin.” When self-interest, These categories overlap and are re- proving performance. If the other errors hierarchical position and loudness of lated; a single metric may be evidence of are sins of the intellect, this is a sin of voice carry more weight than objective several sins. A company that commits character and corporate culture. An oft- data, then even the most carefully de- these sins will find itself unable to use its heard phrase at one financial services signed and implemented metrics are of metrics to drive improvements in operat- company is, “The decision has been made, little value. ing performance, which is the key to

MIND OF THE MANAGER goods in-stock, helpfulness of store staff, ease of finding Paul Gaffney products and quick checkout. Chief Operating Officer, Desktone Inc. There is a lot of evidence Former Executive Vice President, Supply Chain for Staples Inc. that highly satisfied customers are more profitable and drive additional profitable cus- Philosophy of Performance store, available for sale (not in enterprise often can be ex- tomers into an enterprise. Measurement the back room, on a high shelf, panded significantly only Again, I think the important I do believe measurement is an in a warehouse, in transit to a through investments in im- thing is to break down satis- essential ingredient for reliable store and so on). Making this proved service. This commonly faction into some actionable performance. You can improve number visible and credible and involves increasing a particular levers that (1) are critically performance without measure- creating a performance man- function’s marginal expense for linked to the overall satisfac- ment, for example, by gut feel, agement system in which all the opportunity to sell higher- tion number, and (2) can be by experience, by recognizing participants could see and un- value goods to the customer. affected through operational patterns and so on, but you derstand their personal impact At Staples, we worked to change. For example, measur- cannot do so reliably or in a re- on that measure was critical to show functional managers the ing customer-facing in-stock peatable way (and eventually improving the overall system. profit flow-through of in- drives improvements in cus- you run out of tricks). It is es- creased service and gave them tomer perception of in-stock; sential, however, to avoid what The Deadliest Sin “permission” to exceed budg- changing hiring profiles for I call the “tyranny of the partial The most resonant “deadly sin” eted expense rates for specific helpfulness improves actual view” or what Michael Hammer for me is what Michael labels service enhancements. We helpfulness; and so on. Even calls “Provincialism.” At the “Provincialism” and what many demonstrated, first on a pro though customer satisfaction same time, efforts to defeat others refer to as the problem forma and then on an actual as a measure trumps a number Provincialism must be based of organizational “silos.” I think basis, how investments in ser- of the “deadly sins,” it unfortu- on the customer (or to use this sin shows up in many firms vice translated into faster sales nately ends up being too Michael’s terminology, you in a number of ways. In my ex- growth of higher-margin prod- abstract to operationalize. must avoid Narcissism). Accom- perience, the most common is uct. We then engaged in Starting, however, from that plishing both — eliminating departmental or functional ex- prolific, public praise of man- “sin-free” measure, you then silos and basing performance pense metrics (for example, agers who failed in their siloed can discover additional “sin- management on the customer warehouse operating expense expense measures but who, in free” measures at the very view — is, I believe, an essen- as a percent of sales). Unfortu- doing so, delivered substan- next layer of the operation tial element of sound nately, it is the measure on tially more profits in other that can make a difference. performance management. which many functional man- shared measures. To improve performance in agers have built their careers as I Recommend the retail supply chain at Staples, expert cost managers in their The Key Metric Pat Lencioni’s Silos, Politics, and it was essential to implement a particular discipline. It creates In the retail business, the key Turf Wars: A Leadership Fable common, customer-centric an environment within which metric has to be customer sat- About Destroying the Barriers measure that cut across func- many individuals can be “suc- isfaction. Unfortunately, you That Turn Colleagues Into Com- tional boundaries. For Staples, cessful,” but the firm succeeds have to work hard to break cus- petitors. This book explains this became “customer-facing only marginally (or may even tomer satisfaction down into why crises often help people in-stock,” a measure of what was fail). I have found this to be true the small handful of key drivers overcome the sin of Provincial- for sale as the customer saw it: because the larger customer- that people can actually take ism. Leaders shouldn’t have to actually on a shelf in a retail value equation in almost any action on, which turn out to be wait for a crisis.

24 MIT SLOAN MANAGEMENT REVIEW SPRING 2007 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENTSLOANREVIEW.MIT.EDU/SMR REVIEW 16 improved enterprise performance. It is the right things to measure, those aspects each of which may be decomposed into a hardly surprising that an enterprise that of organizational performance that are similar number of subprocesses. By fo- does not have the right measures of op- both controllable and important to cusing its measurement system on erating performance will be hard-pressed achieving enterprise success; the second is processes rather than functions, an en- to improve that performance; bad meas- to measure these things in the right ways, terprise helps create alignment and a urement systems are at best useless and through metrics that capture their essence common focus across disparate units; in- at worst positively harmful. As the old in usable forms; the third is to embed stead of each seeking to optimize its own saying goes, “That which is measured these metrics in a disciplined process for unique metric, departments are encour- improves”; but if you are measuring the performance improvement, to use them aged to work together to improve the wrong thing, making it better will do lit- for treatment rather than autopsy; and the performance of the process(es) of which tle or no good. Remarkably, these sins are last is to create an organizational culture they are part. Thus, metrics for order ful- not committed only by poorly managed and value system that encourages the dis- fillment should dominate metrics for or unsuccessful organizations; they are ciplined use of metrics for ongoing logistics or production or order entry; rampant in even well-managed compa- performance improvement rather than re- metrics for product development are nies that are leaders in their industries. more important than metrics for market Such companies manage to succeed de- research or engineering; and so on. spite their measurement systems, rather There are two keys The second key to ensuring that the than with them. right metrics are selected is to determine Why has such a vital area been ig- to useful the drivers of enterprise results in terms nored and allowed to drift into such of these processes. An example will help comical errors? Most often, it is because performance clarify this concept. senior executives have not demonstrated measurement: A fashion retailer sought to increase a serious commitment to operational revenues; since most of the management performance improvement. Either be- an emphasis on team had backgrounds in merchandising, cause they are far removed from the executives immediately assumed that the operational fray or because they don’t end-to-end key would be improving the company’s ad- recognize the opportunities for perform- business processes vertising program in order to attract more ance improvement and the central role shoppers into the stores. However, the chief that metrics play in it, too many leaders and a focus on operating officer had recently joined the pay scant attention to metrics. As one the drivers of company from a different industry and was manager said: “Our executives don’t take unwilling to jump to this conclusion. In- measurement seriously because they were enterprise results. stead, he led an exercise to determine what turned off by accounting in business factors were most critical to the company’s school.” As a result, too many companies success and to identify metrics that cap- simply do not give operational measure- gard them as threats to be feared or tured them. A simplified version of this ment the attention it needs. They follow opponents to be vanquished. analysis goes as follows: Increasing sales re- the path of least resistance, using meas- quires attracting more shoppers into the ures they have inherited from the past or Deciding what to measure. There are two stores and selling more to those shoppers; the first metrics that pop into their heads. related keys to ensuring that a perform- thus measures of traffic and of what is A serious commitment to performance ance measurement system is focused on called conversion ratio (the percentage of improvement demands an equally serious the right things. The first is to emphasize customers who actually make a purchase) commitment to designing and using ef- end-to-end business processes, the cross- are important. But these are outcome met- fective operational metrics. organizational sequences of activities rics: desirable goals but not ones that can that create all customer value. Processes be achieved directly. The next step was to Redemption transcend functions and other organiza- determine the drivers of these outcomes, There are four steps to redeeming an or- tional units and are the mechanisms by the factors needed to get more customers ganization from measurement hell, which the myriad activities performed in into the stores and to increase the conver- purging it of the seven deadly sins and an enterprise are integrated to realize re- sion ratio. Advertising effectiveness and setting it on the path to sustained perfor- sults. Typically, an enterprise of any size product quality were identified as the key mance improvement. The first is to select has five to 10 primary business processes, drivers of increasing traffic and therefore as

SLOANREVIEW.MIT.EDU/SMR LESSONS IN OPERATIONS MANAGEMENTSPRING 2007 • MIT MIT SLOAN SLOAN MANAGEMENT MANAGEMENT REVIEWREVIEW 1725 SPECIAL REPORT: MEASURING TO MANAGE important phenomena to measure as well. of a very deep-seated problem with the subject to manipulation — not answering The factors needed to increase the conver- employee scheduling process. In the past, the complaint line guarantees a higher sion ratio were ensuring that products were it had been driven by when employees reading of customer satisfaction. Mea- on the shelf (since customers can’t buy found it convenient to work, rather than suring attrition and repeat buying what isn’t there) and having enough sales- when customers were coming into the comes too late to do anything about it. people available to help customers decide stores. Consequently, there were too The point is not that these or any what to buy; thus on-shelf availability and many people working on weekday after- other specific measures of customer customer coverage (the ratio of salespeople noons, and not enough on weekends. The satisfaction are good or bad, but that to customers) were recognized as impor- new metrics and the process redesign virtually every metric has some advan- tant metrics as well. effort they spawned soon changed that. tages and drawbacks, and that in In this case, the assumption that the designing metrics one must balance key to improving revenues lay through im- Measuring the right way. Knowing what the following considerations. proved advertising turned out to be false. needs to be measured is just the first When measured, customer traffic, adver- step; finding the right way to do so is the Precision. A metric must be carefully and tising effectiveness and product quality exactly well defined, so that there can be were at levels that ranged from acceptable no doubt or dispute about it. Thus, “on- to high. The problem lay in the conversion time delivery” can be interpreted in ratio — not enough shoppers were be- Organizations numerous ways, depending on what the coming buyers. The root of this problem target is (first promise date, last promise was twofold: Neither on-shelf availability often construct date, request date and so on) and what it nor customer coverage were as high as a complex means to be “on time” (on the date, they should have been. These were the within 24 hours, within 48 hours and so areas, not advertising, which needed atten- mechanism for forth). It should come as no surprise that tion. But how can on-shelf availability and when a metric is not unambiguously de- customer coverage be improved? This is calculating fined, people will interpret it in ways that where the connection to the processes is a metric, when, work well for them. For instance, the made. For each of the factors that is meas- manufacturing organization at a con- ured, the processes that affect that factor in many cases, sumer goods company used an imprecise must be identified; the factor becomes a definition of productivity as an opportu- key metric for each of these processes, and a far simpler nity to take downtime and turnover time the improvement of this metric is to be ac- one would suffi ce. out of the equation. The definition of a complished through process management: metric should also include the units effective execution, ongoing improvement being employed and the range and scale and holistic redesign when necessary. of the measurement. In this case, on-shelf availability was next. As outlined above, deciding what recognized as being shaped by the supply needs to be measured is something of a Accuracy. In many situations, a company chain process and so became a key, over- science; deciding how to measure, how- needs to measure what amounts to a Pla- arching metric for that process; customer ever, remains an art, since, in general, tonic ideal (customer satisfaction, coverage was seen as determined by the there are many different ways of putting advertising effectiveness, product quality employee scheduling process. (This ap- a number on a phenomenon that has and so on). Any actual metric will inevi- proach has similarities with Kaplan’s and been determined to be worthy of mea- tably represent only an approximation of Norton’s strategy maps, except with a surement. For instance, how should this ideal. It is necessary to keep in mind more operational focus and an explicit customer satisfaction be measured? One the distinction between reality and what linkage to end-to-end processes.) common approach is through customer is being measured and to close the gap Changes were made to each of these surveys. However, this is costly and between the two, subject to the limita- processes in order to improve these mea- slow; it is also often uncertain how well tions imposed by these other sures, which in turn increased the customer responses on surveys correlate considerations. conversion ratio, which in turn led to the with desired behaviors. Measuring com- desired improvement in revenues. In par- plaint volumes may not capture the full Overhead. Organizations often fall prey ticular, this analysis led to the recognition spectrum of customer attitudes and is to the temptation to construct a complex

26 MIT SLOAN MANAGEMENT REVIEW SPRING 2007 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENTSLOANREVIEW.MIT.EDU/SMR REVIEW 18 mechanism for calculating a metric, when control), even though — or perhaps es- tor performance that dictate required a far simpler one would suffice. For in- pecially because — these two metrics can performance levels. Whatever the origin stance, the fashion retailer discussed conflict with each other. Should people of the target, the person(s) responsible above needed a way of determining the object, they need to be reminded that the for the metric must regularly compare conversion ratio at its stores (the percent- world is not unidimensional, that the en- the actual value of the metric against the age of shoppers who bought something). terprise must serve constituencies with target level. If there is a meaningful gap Various complex schemes were proposed, conflicting objectives and that balancing between the two, particularly on a sus- involving the use of radio frequency multiple metrics rather than overdosing tained basis, then the source of the gap identification tags and various types of on one is what success demands. must be determined. Broadly speaking, sensors. In the end, the company decided there are two kinds of reasons why some on the low-tech approach of hiring high Using metrics systematically. Even the aspect of operations is not meeting the school students to sit outside stores and best-designed metrics are of little value required performance level: a design flaw count the numbers of people who went unless they are embedded in a disci- or an execution problem. It may be the into the store and the number coming plined process that uses them. Otherwise, case that the design of the operating proc- out carrying shopping bags. The more in- they become afterthoughts, employed to ess or system simply does not allow it to expensive and convenient it is to calculate assess blame or reward, but not really operate at the target level. For instance, a metric, the better. The periodicity of the utilized to drive improved performance. an electric power company found that no metric — how often it needs to be calcu- A prerequisite for such a process is matter how hard people worked, no mat- lated — must also be taken into account. someone to perform it. In other words, ter what tools or training it provided every metric must have one or more indi- them, it could not connect electric power Robustness. The designer of a metric viduals who are personally responsible for new customers in less than 180 days; must be conscious of the extent to which and accountable for it; these individuals the process for establishing such new the metric can be manipulated or gamed must realize that it is their job to ensure connections was so fragmented that it in- by people with something at stake, or the that their metrics achieve the target levels evitably required multiple iterations to extent to which the metric can encourage that have been set for them. Since many converge on an acceptable solution. The undesired behaviors. At a telecommuni- of the metrics that really matter in an en- design of a process establishes an upper cations company, for instance, using call terprise do not line up neatly with the limit on its performance; no process can duration to measure the performance of existing organizational structure, respon- perform better on a sustained basis than customer service representatives led sibility for end-to-end process metrics its design allows. Managers may discover CSRs to rush through calls. needs to rest both with the process owner that a process was designed to meet lower A particularly valuable tactic to avoid (a senior manager with overall authority performance targets, or was designed suboptimization, undesired behaviors for the process) as well as with managers with a now-obsolete set of assumptions and the manipulation of metrics is to in- of the various functions involved in the or has become so burdened with special sist on the use of multiple rather than process. The old saw that one cannot be cases and accreted complexity that its single metrics. For instance, measuring held responsible for what one does not performance has degraded. In such situa- just the speed of product development fully control has outlived its usefulness; it tions, a holistic redesign of the process is can lead to cost overruns; measuring just is both reasonable and necessary to hold called for. Conversely, even a well-de- transportation costs can lead to missing everyone with some influence over a met- signed process is not guaranteed to promised delivery dates. Individual met- ric jointly accountable for it. deliver the performance of which it is rics must be used as part of a system of The starting point for using metrics to theoretically capable. The electric power related measurements, rather than in iso- drive performance improvements is to company just cited redesigned its process lation. Competing process metrics (such have a target performance level for each so that new connections could be made as speed, quality and cost) should be bal- metric. These targets can be derived in a in 20 days. However, poorly trained or anced against one another, and process variety of ways. In some cases, customers unmotivated workers, unreliable equip- metrics should be used in conjunction will be explicit about the performance ment or other exogenous factors could with narrower-gauge, functional metrics. level they require of a process — how create execution problems that would Thus, a shipping department should be long they will find it acceptable to wait lower performance beneath target levels. held accountable for shipping costs (over for confirmation of an order, for instance. In such situations, redesign will not help. which it has full control) as well as for In other situations, it is the company’s Rather, a disciplined analysis of the un- on-time delivery (which it does not solely own financial requirements or competi- derperformance of the process must be

SLOANREVIEW.MIT.EDU/SMR LESSONS IN OPERATIONS MANAGEMENTSPRING 2007 • MIT MIT SLOAN SLOAN MANAGEMENT MANAGEMENT REVIEWREVIEW 1927 SPECIAL REPORT: MEASURING TO MANAGE used to highlight its root cause, so that tively quickly at that. The challenge is and carefully designed and meaningful appropriate remediation — training, per- that to do so requires the personal time metrics, and indeed doing so can help in- sonnel changes, equipment repair or any and engagement of the most senior lead- tegrate these other techniques. However, of a host of other activities — can be ers of the organization; they are the only mere words are not a substitute for more taken in order to solve the problem and ones with the stature and the authority difficult and demanding steps. restore performance to needed levels. to undertake such a deep shift. They have at their disposal a range of tools to help When all these techniques are used to- The fundamental point is that measure- them accomplish such culture change, gether, the results can be truly impressive. ment is not a thing unto itself. The point and they must make use of all of them: At a privately held logistics company, of measurement is not to measure but to the senior executives were dissatisfied enable improvement and, as such, mea- Personal role modeling. As Albert Ein- with the measurement system, despite surement must be an integral part of an stein said, “Setting an example is not the the company’s apparent success in the ongoing program of performance analy- main means of influencing others; it is the marketplace. They determined that a key sis and improvement. only means.” When senior managers driver of business performance was filling themselves personally insist on getting and orders accurately, on time and with all Creating a measurement-friendly culture. using carefully designed metrics, and when needed supporting documentation, and Even the best metrics and the best proc- that fact is publicized throughout the or- so established the percentage of such ess for using them will not flourish in an ganization, attitudes change very quickly. “perfect orders” as a key operating metric. inhospitable environment. In too many They then proceeded to identify their five organizations, the disciplined use of mea- Reward. Making the use of the right key business processes and to find ways surement is not part of the basic value metrics a part of how managers are eval- to redesign them so as to increase this fig- system. Metrics are regarded as matters of uated and rewarded gets their attention. ure. They also engaged people across the opinion or as tools for political infight- Rewarding managers who make use of organization in the effort to focus on the ing; or metrics and their use are perceived the right metrics, even if the subsequent metric and improve it. Over a period of as frightening, because they are used for outcomes do not meet expectations, and several months, they managed to increase the assignment of blame and subsequent concomitantly not rewarding managers perfect orders from its initial value of punishment. Often, metrics are seen as who achieve desirable results without the only 6% to nearly 80%. As a result, oper- pettifogging details only of interest to disciplined use of metrics, makes the ations costs have been dramatically “bean counters” and similarly small- point that metrics are important. reduced, customer satisfaction increased minded folks. The folk hero in too many significantly and margins enhanced. organizations is the executive who flies by Implementation. Rather than just preach The deadly sins of operational meas- the seat of the pants and uses intuition about the use of metrics, senior managers urement are not just measurement and guts to make decisions, rather than can ensure their use by deploying metrics- problems; they are symptoms of deeper the measurement-oriented analytic man- based improvement and decision-making cultural shortcomings, of a lack of com- ager who is scrupulous about establishing processes, making them part of basic prehension of what is important to the facts. Even worse, the prevailing cul- management development training and enterprise success, and of a fundamen- ture in many organizations is to pass the conducting postaudits of key decisions to tally unstructured approach to perform- buck when a problem is identified, lest ensure these processes were used. ance management and improvement. one be caught without a seat when the Poorly designed metrics cannot be re- music stops. In such contexts, the deadly Commitment. Public demonstration of paired on their own, but only as part of a sins of measurement are an inevitability executive commitment to meaningful systematic effort to link operations to that no technical solution can prevent. metrics is a powerful tonic. For instance, business objectives and to implement a Creating a measurement-friendly cul- affirming the importance of using metrics formal process for operational perform- ture is not merely a matter of producing even when it might be expedient not to ance improvement. The result of such an some inspiring slogans and printing do so drives home the message that meas- effort is much more than better metrics; them on laminated wallet cards. Chang- urement cannot be an occasional thing. it is a better company. ing the basic value system of an organization is much more complex than Articulation. It can do no harm for Reprint 48302. For ordering information, see page 1. that; however, despite popular wisdom to executives to talk about performance im- Copyright © Massachusetts Institute of Technology, the contrary, it can be done, and rela- provement, fact-based decision-making 2007. All rights reserved.

28 MIT SLOAN MANAGEMENT REVIEW SPRING 2007 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENTSLOANREVIEW.MIT.EDU/SMR REVIEW 20 OPERATIONS Sharing Global Supply Chain Knowledge

here are two categories of supply chain partners: those that buy and those that sell. Depending on which group they identify with, manag- T ers have different perspectives on the value of sharing critical knowledge resources with their supply chain partners. Both groups agree that sharing knowledge makes for more efficient supply chains (with lower costs and quicker speeds) and more effective organizations (with higher quality outputs and enhanced customer service). But the benefits of knowledge sharing don’t always accrue equally or simultaneously to all participants. In addition, some managers think that knowledge sharing between buyers and suppliers has an underappreciated “dark side” that can outweigh the benefits.1 A common worry is that divulged information regarding technolo- gies, pricing schedules, client bases and processes can be copied or shared with competitors. Another worry is that relying on knowledge flows from other organizations can undermine a company’s flexibility and leave it vulnerable to changes in its partners’ priorities. Despite these concerns, knowledge sharing between supply chain partners offers more positives than negatives, provided that the right kind of knowledge goes back and forth. What type of information or knowledge should suppliers and buyers share with each other? How does knowledge sharing provide value to buyers and suppliers, and under what circumstances can it help both? How do cross- cultural differences between global buyers and suppliers influence the value of sharing information? To answer these questions, we studied more than 100 cross-national supply chain partnerships in the industrial chemicals, consumer durables, industrial packaging, toy and apparel industries in 19 country locations. (See “About the Research,” p. 68.) We examined how different types of knowledge sharing can benefit buyers or sellers individually. But more Knowledge sharing importantly, we studied how knowledge sharing can enhance the performance between partners has of partnerships and build stronger supply chains in the global marketplace. We sought to understand not only which companies benefit from cross-border more upsides than knowledge sharing but also the conditions that lead to knowledge sharing downsides, provided in global supply chains. Many people see knowledge sharing as the result of customer or supplier needs when in fact it is more likely to be influenced by that the right kind of market structures or organizational similarities and dissimilarities between knowledge goes back buyers and suppliers. (See “What Makes Knowledge Sharing Possible?” p. 69.) and forth.

Matthew B. Myers is the Nestle Professor of Marketing and an associate professor at the University of Tennessee in Knoxville. Mee-Shew Cheung is an assistant professor of Matthew B. Myers marketing at Xavier University in Cincinnati, Ohio. Comment on this article or contact the authors through [email protected]. and Mee-Shew Cheung

SLOANREVIEW.MIT.EDU LESSONS IN OPERATIONS MANAGEMENTSUMMER 2008 • MIT MIT SLOAN SLOAN MANAGEMENT MANAGEMENT REVIEWREVIEW 2167 OPERATIONS

The Value of Knowledge in Global Supply Chains Knowledge flow creates value by making the supply chain In a 2004 study, Hau Lee, a professor of operations, information more transparent and by giving everyone a better look at and technology at Stanford University, found that top-performing customer needs and value propositions. According to AMR supply chains had three distinct qualities.2 First, they are agile Research Inc., a business research company located in Boston, enough to react readily to sudden changes in demand or supply. increased demand visibility (that is, more knowledge about real- Second, they adapt over time as market structures and environ- time customer needs and demands throughout the entire supply mental conditions change. And third, they align the interests of chain) increases perfect order rates dramatically.3 What’s more, all members of the supply chain network in order to optimize broad knowledge about customers and the overall market, as performance. These characteristics — agility, adaptability and opposed to just information from order points, can provide other alignment — are possible only when partners promote knowl- benefits, including a better understanding of market trends, edge flow between supply chain nodes. In other words, the flow resulting in better planning and product development. of knowledge is what enables a supply chain to come together in Toyota Motor Corp., for example, increasingly involves its Tier a way that creates a true value chain for all stakeholders. 1 suppliers in major market-oriented decisions. According to This is a critical point. As global supply chains become less Vikram Kirloskar, vice-chairman of Toyota Kirloskar Motor, a push-oriented and more demand-driven, organizations can joint venture between India’s Kirloskar Group and Toyota, this come together more closely in demand-driven supply net- input would not have much value if Toyota and its suppliers works. These networks focus on understanding customer needs didn’t also share knowledge about markets.4 In several industries, (present and future) and building supply chains based on including chemicals and packaged goods, initiatives are under- actual demand levels as opposed to demand forecasts or way to facilitate knowledge flows between partners and to enhance production schedules. This permits a higher level of service to customer value. For example, the European chemical industry customers — more on-time deliveries and more accurate order estimates that it can save up to 2% of total industry sales through placement — which, in turn, leads to increased levels of increased collaboration, including more knowledge sharing, be- customer loyalty. Higher service levels actually help supply tween its supply chain members.5 Moreover, research consistently chains become more efficient, thanks to fewer product returns, shows that the most common contributors to supply chain fail- less need for overnight deliveries to compensate for slow turn- ures — out-of-stocks, excess inventories, new product failure rates, arounds and fewer dissatisfied customers. increased product markdowns and wasted time in engineering and

About the Research

Our research was conducted over a two- The measures were derived from the performance. The results were all signifi- year period at the University of Tennessee, extant literature and adapted to suit the cant at the 5% level. MANOVA estimates in cooperation with five partner compa- context of our study. We then launched were then generated to test for signifi- nies and more than 100 of their overseas a Web survey through a multiple-contact cant differences between benefits of suppliers. The five companies represented strategy and collected data from 264 buyers and sellers relative to knowledge- the industrial chemical, consumer durable, respondents (132 purchasing executives sharing activities. Thus, findings industrial packaging, toy and apparel from the buyer companies and 132 presented in this article are supported industries. Both the buyer and seller par- marketing/sales executives from their with empirical evidence. Following our ticipants are multinational corporations corresponding overseas suppliers). The quantitative research, we presented an operating from multiple locations in 19 respondents were prescreened to ensure executive summary to all participants countries: Argentina, Australia, Brazil, that they had significant knowledge and sought their feedback for our post Chile, China, Czech Republic, Germany, about the exchange relationship we were hoc analysis, which was conducted Holland, India, Italy, Japan, Korea, Malay- studying. The dyads had worked with each through subsequent interviews with sia, Mexico, Poland, Singapore, South other an average of 12.2 years and pur- leading toy manufacturers in Hong Kong Africa, Taiwan and the United States. We chased more than $400 million annually in and major players in the pharmaceutical conducted extensive telephone interviews materials. Partial least squares analysis was industry in the United States. We grate- with informants from the companies to then conducted to test the hypothesized fully acknowledge the research assistance understand their exchange context, the relationships between our proposed ante- of the University of Tennessee’s Supply nature of their tasks and the relevance of cedents and knowledge sharing and the Chain Forum Partners and all participants the measures to their industrial experience. effect of knowledge sharing on company in the surveys and interviews.

68 MIT SLOAN MANAGEMENT REVIEW SUMMER 2008 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENTSLOANREVIEW.MIT.EDU REVIEW 22 research and development — are all addressable by increasing What Makes Knowledge Sharing Possible? knowledge flows between supply chain partners.6 Still, some supply A variety of conditions, both environmental and organizational, facilitate knowledge sharing in chain members are reluctant to global supply chains. participate in knowledge-sharing activities. Conditions Affecting Knowledge Sharing How They Influence Knowledge Sharing Market structures (economic and The greater the disparities between the buy- Why Knowledge Sharing Is regulatory) for both buyers and suppliers ers’ and suppliers’ market environment, the Controversial greater the tendency toward sharing knowl- edge between partners. There is a saying that, in the global marketplace, companies don’t Environmental uncertainty in both the The greater the difficulty in forecasting compete — supply chains do. This buyers’ and suppliers’ home markets sales volume, the greater the difficulty in is particularly true for industries in predicting competitor moves; the greater the volatility in sales and market share for supply which there is a high degree of chain members, the more prone members are vertical integration and for specific to share knowledge across borders. markets, such as Japan, where long-term relationships between Idiosyncratic investments or “specialty The more member companies make invest- investments” for a specific supply chain ments (in the form of material, machinery, buyers and suppliers can trump relationship human resources, etc.) specific to the partner- competitive offerings from new ship, the greater their propensity to share players. Strong, cross-national knowledge with buyers or suppliers. supply chain relationships can Organizational fit between buyers When company resources are complemen- create innovative environments and suppliers tary (i.e., of value to the partner company) that provide competitive advan- and/or when strategies are compatible tages for member companies. (when companies share the same goals Interorganizational learning and and values), companies are more prone to share knowledge. adaptation to volatile environ- ments can facilitate symbiotic relationships between partners. It can help both suppliers and buyers adjust to diverse demand levels sharing in the supply chain can work against us. First, whenever in multiple marketplaces (including new product launches with no we share knowledge with partners, it seems to leak to competitors, historical demand levels), increasingly complex trade regulations, or potential competitors. Second, as the markets become more risk pooling and process developments. Recent research shows that intense, we feel profits are in turn limited, and we compete with best-in-class companies in supply chain management were three our partners for profit shares. So we want to be careful what we times more likely than laggard companies to apply “visible share. We want our partners to win, but not at our expense.” 8 technologies” that offer real-time customer and demand data; Managers want to know that they can build equity through these technologies allow buyers and sellers to share knowledge collaborative activities. At a minimum, they want an equitable more easily across borders.7 These applications, which go beyond piece of the “margin pie” relative to the resources they commit. radio-frequency identification and early replenishment programs, Given increasing levels of competition and customer expecta- enable supply chain partners to maximize operational efficiencies tions, many companies believe there is a fundamental conflict of and enhance customer value creation. interest among supply chain members. Players located between But intercompany knowledge sharing can have harmful com- raw materials suppliers and retailers or e-tailers, in particular, see petitive consequences. Many supply chain members we interviewed themselves competing with one another for profits. As a result, had an aversion to participating in activities that could provide they are less likely to view supply chain partners as allies in more benefit to partners than to their own company. Increasingly, improving operational efficiency or market effectiveness than as supply chain partners see themselves as competing among them- competitors for margins. When margins are thin, knowledge selves for revenue. The CEO of a major global freight carrier sharing and true partnership can revert to a more traditional expressed this concern: “We hear a lot about cooperation in global (and more adversarial) vendor-buyer relationship. As David Yeh, supply chains. And while I’m sure we benefit from close relation- honorary president of the Toy Manufacturers’ Association of ships with our partners, we feel there are two reasons why knowledge Hong Kong, noted, “Many toy OEMs are now competing directly

SLOANREVIEW.MIT.EDU LESSONS IN OPERATIONS MANAGEMENTSUMMER 2008 • MITMIT SLOAN SLOAN MANAGEMENT REVIEW REVIEW 6923 OPERATIONS with toy marketing companies such as Mattel and Hasbro in the ers, we are also faced with the same market. The competition has become more intense. Every- marketing challenge downstream. body is fighting over the same piece of pie.” Our customers’ sales and market- Although the concept of “pie sharing” is not new, it is impor- ing problems directly affect our tant to clarify the different ways that knowledge sharing helps bottom line. Our interests are suppliers and buyers and how the supply chain as a whole intertwined with everybody along benefits from these activities. the supply chain. If the products do not sell well and the buyers Different Types of Knowledge Knowledge sharing encompasses the have to resort to markdowns, it is sharing of information, but it doesn’t stop there. Much of the The greater the not uncommon in our industry to information that companies share — data on inventory levels, see buyers coming back to us and sales, production schedules and prices — is easy to codify and disparity between ask for a rebate. To overcome transmit. But other types of knowledge are just as important to the market problems like this, we need inputs exchange and more difficult to codify: know-how, managerial and from the buyers along the value communication skills and organizational memory. Intercompany environments creation process to do a better job knowledge sharing is a joint activity between supply chain partners; in meeting market demand. None the parties share knowledge and then jointly interpret and integrate of buyers and of us can operate in isolation.” it into a relationship-domain-specific memory that influences suppliers, the Companies with similar phi- relationship-specific behavior.9 We found three types of knowledge losophies and goals have greater sharing within the supply chain, each offering distinct benefits to greater the tendencies to share knowledge. buyers and suppliers: information sharing, joint sense making and Although this may seem intuitive, knowledge integration (see “Types of Knowledge Sharing”): likelihood that companies often partner with ■ Information sharing takes place when companies exchange partners will organizations that do not share the important data about sales, customer needs, market structures same business philosophies; subse- and demand levels. share knowledge. quently, they are reluctant to share ■ Joint sense making occurs when supply chain partners work critical knowledge with each other. together to solve operational problems, analyze and discuss strategic Again, while this may seem logical, issues and facilitate communication about the relationship. Since it goes against the findings about individual partners often interpret the same information differently, the importance of knowledge sharing in achieving competitive intercompany teams can help create a common understanding. positions. A company’s commitment to knowledge sharing ■ Knowledge integration occurs when supply chain partners develop is greatly influenced by whether it has made investments (for relationship-specific memories, providing everyone with a common example, in special equipment, tools, machines or facilities) to understanding of idiosyncratic routines and procedures governing support the buyer-seller relationship. Such investments tend to the relationship. This often results in collective problem solving that make a company more vested in the relationship and encourage benefits both the companies and the relationship as a whole. knowledge sharing between partners. These knowledge-sharing activities constitute mechanisms that can make or break supply chain partnerships. The Role of Cultural Differences One of the more interesting findings is that cross-cultural differences between buyers and Effective Knowledge Sharing in the Supply Chain sellers rarely matter when it comes to sharing knowledge. We The greater the disparity between the market environments of had assumed that culture and all of its nuances (such as differ- buyers and suppliers, the greater the likelihood that partners will ences in perceptions of trust, time and risk taking) would play a share knowledge. For example, in settings where customer prefer- major role in whether cross-border partners shared knowledge and ences are changing or local regulations or supply sources are in a other valuable resources: A Japanese buyer of industrial chemicals, state of flux, cross-border partners rely on each other to serve as for example, would have perceptions radically different from his knowledge conduits. In general, market volatility makes compa- American supplier about how a partnership should work and nies more open to sharing knowledge; among other things, what knowledge can be shared safely. However, cultural differ- companies want to reduce bullwhip effects up the supply chain ences between buyer and supplier companies had no impact on and the resulting stock-outs or overstocks. K.C. Lo, CEO of their propensity to share knowledge. Interviews with managers Smart Union (Hong Kong) Ltd., a toy manufacturer in Hong revealed the reasons. First, cross-cultural differences have always Kong with a global customer base, commented: “As manufactur- mattered less in business-to-business relationships than they

70 MIT SLOAN MANAGEMENT REVIEW SUMMER 2008 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENTSLOANREVIEW.MIT.EDU REVIEW 24 have in business-to-consumer exchanges. Second, the nature Yeh of TMHK conceded, “Businesses are looking for best practice of the businesses themselves is changing, becoming increasingly and best thinking. We have to put our cultural differences aside. diverse both in terms of the employee base and in the number of I am seeing a converging trend in the last 30 years.” markets businesses operate in. For example, one of the purchasing managers we interviewed was a Ukrainian working for a French The Benefits of Knowledge Sharing company in Brazil. Identifying which cultural characteristics might In measuring the performance of supply chain partners, it is influence his decision to share knowledge (Ukrainian, French important to recognize that businesses often have to make trade- or Brazilian?) would be impossible, and in reality this way of look- offs between market share/sales and profits. Therefore, we ing at culture proved irrelevant. Instead, there was an emergent combined four indicators to create an index to measure company global culture of business; decisions about whether to share knowl- performance: increases in market share, sales, return on sales and edge — and how to do it — were driven less by cultural norms return on investment. Research on how much value buyers and than by more objective decision making and market demands. As sellers get from knowledge sharing has been confusing; some studies show benefits, while others have shown dangerous repercussions.10 We Types of Knowledge Sharing found that, for both buyers and sellers, certain dimensions of knowledge sharing Knowledge sharing in global supply chains goes beyond information sharing. It is a joint are critical for improved performance activity in which supply chain partners strive to create more value together than they outcomes. Further, although all members would be able to individually. of the supply chain need to participate in Conditions Affecting knowledge sharing, buyers and sellers Knowledge Sharing What Is It? do not always benefit equally. (See “Who Benefits From Sharing Knowledge?” p. 72.) Information Sharing Exchange of information on successful and unsuccessful experiences with products; exchange of information re- Both buyers and sellers indicated that lated to changes in end-user needs, preferences and information sharing and knowledge integra- behavior; exchange of information related to changes in tion enhanced performance. They said that market structure, such as mergers, acquisitions or part- sharing information contributed to profit- nering; exchange of information related to changes in ability and operating efficiency, benefiting the technology of the focal products; exchange of both members in cross-national collabora- information as soon as any unexpected problems arise; exchange of information related to changes in the two tions; they noted as well that frequent process organizations’ strategies and policies; exchange of adjustments and evaluations between part- information that is sensitive for both parties, such as ners also led to improved performance. In financial performance and company know-how. particular, knowledge sharing about market structures (for example, about mergers and Joint Sense Making The establishment of joint teams to solve operational acquisitions or regulatory changes), end- problems; joint teams to analyze and discuss strategic user preferences and profiles, technological issues; development of a relationship philosophy that stimulates productive discussion using both buyer and innovations and financial resources helped supplier viewpoints; significant face-to-face communi- everyone’s bottom line. This was especially cation in the relationship. important for supply chain partners operat- ing globally, due to the complexity of Knowledge Integration Frequent adjustment of partners’ common understand- overseas markets and the difficulty of ing of end-user needs, preferences and behavior; obtaining reliable information on their own. frequent adjustment of the common understanding of trends in technology related to the business; frequent For example, the toy industry constantly evaluation and, if needed, adjustment of routines in faces regulatory changes and new safety order-delivery processes; frequent evaluation and, if requirements in overseas markets, as recent needed, updating of the formal contracts in the rela- events involving Chinese imports in the tionship; frequent refreshment of the personal network United States illustrate.11 Without coopera- in the relationship; frequent evaluation and, if needed, updating of information about the relationship stored tion and knowledge sharing from their in partners’ electronic databases. overseas customers, manufacturers would have difficulty responding to these kinds of challenges in a timely manner.

SLOANREVIEW.MIT.EDU LESSONS IN OPERATIONS MANAGEMENTSUMMER 2008 • MIT MIT SLOAN SLOAN MANAGEMENT REVIEW REVIEW 7125 OPERATIONS

“Very often when we ask the customers [buyers] Who Benefits From Sharing Knowledge? for information, we feel like we are talking to the wall. We have difficulties getting their commit- When buyers When suppliers ment to do more knowledge sharing. The share… share… The Bottom Line knowledge and information flow along our supply …information While both buyers and suppliers chain needs to be more effective.” This imbalance Both buyers and Both buyers and win, suppliers benefit more suppliers benefit suppliers benefit from basic exchanges of — where managers see relative gains as more information between partners. important than absolute gains — can undermine …in joint sense making Knowledge-sharing teams and long-term cooperation within supply chains. In Buyers don't benefit, Both buyers and face-to-face communication are but suppliers do suppliers benefit often time-consuming, but general, however, both buyers and suppliers felt suppliers benefit from it. Buyers win when suppliers form teams, that their collective knowledge-sharing efforts en- but not from their own efforts. hanced the value of their relationships with partner …in knowledge integration When partners share companies. They felt that knowledge-sharing Both buyers and Both buyers and databases and routines, both suppliers benefit suppliers benefit buyers and suppliers win, but activities helped reduce costs, increase product suppliers win more. quality, enhance delivery performance and increase the overall quality of communication between companies. In short, whatever the disparities in However, the advantages for buyers and sellers are not always bottom-line benefits between buyers and suppliers, both groups equal: Suppliers receive significantly greater benefit than buyers felt that intercompany knowledge sharing was a valuable aspect from two types of knowledge sharing — information sharing and of their global supply chain relationships. As Yeh of the TMHK knowledge integration — no matter which partner actually noted, “Knowledge sharing between buyers and sellers is critical shares the resources. Indeed, the outcomes are the same whether in a supply chain, even though it is often hard to quantify the it is the buyers who do the information sharing or make the ef- actual size of the pie gained by each individual party. Both sides forts to integrate knowledge bases into the operational protocols, have to look at the ultimate picture and be more in sync.” or the suppliers. Both partners win — but suppliers win more. One question that emerges from the research is: Why do In contrast to information sharing and knowledge integra- suppliers generally benefit more than buyers? There are two tion, joint sense making appears to have different effects. When factors: the predominance of demand-driven supply chains in suppliers developed teams to work with partners, increase face- today’s global marketplace and the fact that suppliers have more to-face communication and evaluate routines and processes, room for improvement than buyers, who already tend to be quite both buyers and sellers benefited. More than half of the 132 lean. Increased competition has forced supply chain managers to suppliers surveyed indicated high levels of joint sense-making become more agile and to tie their global models more closely to activity; for their specific partnerships, both buyers and suppliers real-time consumption (as opposed to capacity or speculative averaged significantly higher performance ratings than other sales forecasts). As a result, the knowledge that buyers share with partnerships. But when buyers promoted the same activities, suppliers is more valuable. suppliers were the ones that reaped most of the benefits. Half of Demand-driven supply networks have been implemented by the buyers indicated high levels of joint sense-making activity, yet some of the best supply chains worldwide, including Toyota and in these partnerships suppliers enjoyed 6% higher performance Dell Inc.12 Moreover, many successful suppliers, such as those ratings than their buyers. The disparity may be due to the supplying the automotive and aerospace industries, are becom- significant time and other resources needed to build intercom- ing system integrators, producing components and whole pany teams: Buyers tended to see this as an investment with few systems for leading manufacturers.13 In the meantime, manu- benefits for them; suppliers saw the potential benefits as well facturers (buyers) have had to simplify their approaches to lean worth the expense. These findings reinforce the view that when manufacturing processes and become less rigid. A number of suppliers are willing to dedicate time and resources to share their industries have already taken big steps in this direction, includ- knowledge, the supply chain as a whole benefits. ing U.S. aerospace and defense companies.14 Several major Knowledge sharing between supply chain partners occurs players, including Boeing, Lockheed Martin and United Tech- with the expectation that both buyers and sellers will see benefits. nologies, recently formed the Supplier Excellence Alliance, And both parties do gain — just not equally. Not surprisingly, comprising original equipment manufacturers and suppliers problems can emerge when one party feels it is not benefiting working together to accelerate supply chain performance. One as much as its partners. Henry Liu, vice president of Starlight of its primary initiatives is to help companies become effective Industrial Ltd., a Hong Kong toy manufacturer, commented, participants in demand-driven supply networks.

72 MIT SLOAN MANAGEMENT REVIEW SUMMER 2008 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENTSLOANREVIEW.MIT.EDU REVIEW 26 Sharing Knowledge Across Borders global knowledge sharing constructively, supply chains will Several important lessons emerge from this. First, while suppli- become more competitive — and everyone can win. ers may benefit the most from knowledge sharing, buyers also come out ahead. Frequently, supply chain partners focus too REFERENCES much on their own share of the benefits pie, forgetting that 1. E. Anderson and S.D. Jap, “The Dark Side of Close Relationships,” unless knowledge resources are shared, no one benefits. A MIT Sloan Management Review 46, no. 3 (spring 2005): 75-82. company may not benefit as much from knowledge-sharing 2. H.L. Lee, “The Triple-A Supply Chain,” Harvard Business Review activities as its partners. But in absolute terms, its performance (October 2004): 102-112. will be enhanced significantly. Without participation, knowl- 3. B. Swanton and D. Hofman, “DDSN: Who Says Reducing Forecast edge sharing doesn’t occur, and no one wins. Error Requires Predicting Further Into the Future?” (Boston: AMR Second, dividing the benefits equally between suppliers and Research, 2004). An increase in demand visibility was also found to increase on-time delivery performance by 27.5% and yield an average buyers may sound appealing, but in reality it may not be possible: margin improvement of 3.7%, according to AMR; see C. Saran, “Supply One partner will always have more to learn than the other and Chain Optimisation Can Deliver ROI Within Four Months, Finds AMR Research,” Computer Weekly, April 25, 2006. thereby have a bigger upside. In most industries, suppliers have the advantage as global supply chains move toward more 4. K. Giriprakash, “Toyota’s Small Car Likely to Be Ready by 2010-11,” Hindu Business Line, Feb. 15, 2007. demand-driven models, giving buyers the upper hand. However, 5. I. Young, “Industry Eyes Big Savings From Supply Chain Collabora- buyers have already seized many efficiencies. Suppliers, who are tion,” Chemical Week, Nov. 2, 2005; S. Monahan and R. Nardone, furthest removed from the point of final sale (and thus have the “How Unilever Aligned Its Supply Chain and Business Strategies,” most room for improvement), have the next opportunity. Supply Chain Management Review 11, no. 8 (November 2007): 44-50. Suppliers need to realize that any real or perceived dispropor- 6. Many industries besides the chemical industry can benefit from increased supply chain collaboration and knowledge sharing. According tional benefits on their part may cause tension in the relationship, to AMR Research, increased knowledge flows and more visible supply and they need to be willing to address this problem. Among other chains (meaning more information on customer demand for all supply things, they can show good will in the form of more generous chain members) lead to a significant reduction in supply chain problems. The combined annual returns for companies in AMR Research’s 2007 division of profits, support for customers’ R&D programs, dis- top 25 supply chains, an annual ranking that identifies large manufactur- counts or preferred customer status. This would go a long way ers and retailers that display superior supply chain performance, toward ensuring future knowledge-sharing benefits. capabilities and leadership, was 17.89%, significantly higher than the Dow Jones or S&P 500 returns for the same period. The top companies Third, in order to benefit from their partners’ knowledge, include Nokia, Apple, Procter & Gamble and IBM. See K. O’Marah, “The companies need to participate in the sharing process. Even if a Top 25 Supply Chains 2007,” Supply Chain Management Review 11, company feels that sharing certain information or knowledge no. 6 (September 2007): 16-22. resources is more of a potential liability than a benefit, it must 7. “Best-In-Class Firms 2.7 Times More Likely to Use Global Supply Chain Visibility Platforms to Improve Global Trade Management,” Asia recognize that there is a quid pro quo: A partner’s participation Pulse News, June 15, 2007. in the sharing process will likely depend on the original compa- 8. Author’s interview with U.S. freight company executive, Aug. 26-27, ny’s willingness to do its part. 2007. Finally, cross-cultural differences rarely matter, at least in the 9. F. Selnes and J. Sallis, “Promoting Relationship Learning,” Journal of context of knowledge-sharing value. Managers repeatedly have Marketing 67, no. 3 (July 2003): 80-95. heard that the greater the cultural distances between buyers and 10. For more detailed descriptions regarding how knowledge sharing their suppliers, the less effective knowledge sharing can be. Our works and who benefits, see D. Apostolou, N. Sakkas and G. Mentzas, “Knowledge Networking in Supply Chains: A Case Study in the Wood/ research found the opposite. Furniture Sector,” Information Knowledge Systems Management 1, no. 3-4 (1999): 267-281; for excellent reviews of the dangerous reper- cussions, see Anderson and Jap, “The Dark Side.” IN THE COMPETITIVE LANDSCAPE of global supply chains, knowl- edge sharing between buyers and suppliers has never been more 11. “Chinese Toys: No Fun and Games,” Economist, Jan. 12, 2008. critical. Although there is still a significant amount of hesitancy 12. R. Kisiel, “Automaker, Supplier Win Supply-Chain Honor,” Automotive News, Dec. 12, 2005. on the part of supply chain managers to share critical knowl- 13. J. Ott, “Chain Reaction: The Supplier Excellence Alliance Is Spreading edge resources, experience shows that knowledge sharing can the Gospel of Lean Manufacturing and the Mechanics of Survival,” Aviation benefit both buyers and suppliers. If managers can come to Week, Sept. 19, 2005, 51; for more on the Supplier Excellence Alliance, terms with the often-disproportionate gains for suppliers and see www.seaonline.org. understand that some gain is better than no gain at all, both 14. “Chain Reaction.” parties will benefit. Simultaneously, there may be room for sup- pliers to address the benefit disparities in order to reduce Reprint 49401. Copyright © Massachusetts Institute of Technology, 2008. All rights reserved. tensions among supply chain partners. If companies approach

SLOANREVIEW.MIT.EDU LESSONS IN OPERATIONS MANAGEMENTSUMMER 2008 • MITMIT SLOAN SLOAN MANAGEMENT REVIEW REVIEW 7327 Evolving From Value Chain to Value Grid

Breaking free of linear chain thinking and ention the term value chain, and most managers will have visions of a neat sequence of value-enhancing activities. In the simplest form of a value chain, viewing value creation raw materials are formed into components that are assembled into final prod- M ucts, distributed, sold and serviced. Frequently, these activities span multiple from a multidimensional organizations. This orderly progression allows managers to formulate profitable strategies and coordinate operations. But it can also put a stranglehold on innovation at a time when grid perspective provides the greatest opportunities for value creation (and the most significant threats to long-term survival) often originate outside the traditional, linear view. the greatest opportunities Traditional value chains may have worked well for landline telecommunications and automobile production during the last century, but innovation today comes in many shapes for innovation. and sizes — and often unexpectedly. (See “About the Research,” p. 75.) This argues for see- ing value creation as multidirectional rather than linear.1 Given the constant tension between opportunity and threat, companies need to explore opportunities for managing Frits K. Pil and risks, gaining additional influence over customer demand and generating new ways to cre- Matthias Holweg ate customer value. Mobile phone giant Nokia Corp., for example, is legendary for having had the foresight to lock in critical components that were in short supply, allowing it to achieve significant market share growth. However, Nokia suffered a setback a few years ago when competitors used that very same strategy to take advantage of shifts in the demand for LCD displays. Protection against such fickle reversals calls for a more complex view of value — one that is based on a grid as opposed to the traditional chain. The grid approach allows companies to move beyond traditional linear thinking and industry lines and map out novel opportu- nities and threats. This permits managers to identify where other companies — perhaps even those engaged in entirely different value chains — obtain value, line up critical resources or influence customer demand. In a value-grid framework, there are a variety of new pathways to enhanced performance. They can be vertical (as companies explore opportunities upstream or downstream from the adjacent tiers in their existing value chain), horizontal (as companies identify opportu- nities from spanning similar tiers in multiple value chains) or even diagonal (as companies look more integratively across value chains and tiers for prospects to enhance performance and mitigate risk). Successful companies increasingly develop a multifaceted value-Grid perspective as they leverage new opportunities and respond to new threats.2 (See “Value- Grid Dimensions and Strategies,” p. 74.)

Frits K. Pil is an associate professor at the Katz Graduate School of Business and a research scien- tist at the Learning Research Development Center, both at the University of Pittsburgh. Matthias Hol- weg is a senior lecturer at the Judge Business School at the University of Cambridge, UK, and a research affiliate at the MIT Center for Technology, Policy, and Industrial Development. They can be reached at [email protected] and [email protected].

72 MIT SLOAN MANAGEMENT REVIEW SUMMER 2006 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 28 players in the chain. Thus, companies need to focus on three areas: (1) opportunities to influence customer demand both upstream and downstream, (2) opportunities to modify infor- mation access in either direction, and (3) opportunities to explore penetration points in multiple tiers that are not immedi- ately adjacent. These types of opportunities emerge from think- ing nonlinearly within the traditional value chain, which constitutes the vertical dimension of the value grid.

Influencing Demand Companies try to control demand both down- stream (in the direction of the end-user or customer) and upstream in their value chain (in the direction of their suppliers and their suppliers’ suppliers). In controlling downstream demand, companies essentially control who drives the purchase decision in the supply chain. Customers typically generate demand for some intermediate products. Intel Corp., for example, tries to increase demand and shore up its prices by making com- puter buyers more aware of its chip sets, while Nokia works hard to get its logos affixed to the cell phones it sells to wireless service providers. According to a Nokia executive, the company sees its brand image as the primary driver of customer retention — even more than its reputation for technology leadership. Mobile serv- ice providers such as Verizon and Sprint in the United States, Japan’s DoCoMo and UK-based Orange push back by giving pref- erential treatment to handset providers who agree to remove their logos and customize handsets for the service provider. The value-grid approach recognizes that companies cannot always control or influence the customer directly, so it takes a broader perspective on how to control where the purchase deci- sion is made. Companies can explore the full value chain, identi- fying — and sometimes inserting — levers that will shift decisions from one point to another. The pharmaceutical indus- try offers a case in point. Clearly, the end-user in this industry is the patient who takes a drug, but who drives the decision on Thinking Nonlinearly Within the Chain which drug to purchase is less obvious. To deal with this ambigu- Companies seek competitive advantage with value chains by ity, pharmaceutical companies often take a three-pronged managing an orderly flow of goods and services across supplier approach in targeting key decision points. The first prong is and customer relationships. In theory at least, reducing the lead aimed at consumers. The industry invests more than $2 billion time at each link in the chain allows companies to reduce inven- annually on direct-to-consumer marketing (almost 10% of what tory and deliver the end products using concepts such as just-in- it spends on research and development). But focusing on con- time manufacturing and supply, continuous replenishment and sumers is only partly effective. The National Institutes of Health quick-response manufacturing. Doing away with decision-mak- estimates that only about one in 10 consumers who see adver- ing tiers in turn cuts coordination costs and improves informa- tisements for medicines request a specific drug from their physi- tion flow. As the entire chain tightens, the company becomes more cian. While this figure may seem unimpressive, the advertising competitive.3 prompts a larger group of patients to discuss their concerns with However, there is a catch: How benefits are distributed across their healthcare provider, thus increasing the overall demand for the value chain depends heavily on the balance of power between a particular class of drugs. suppliers and manufacturers. This is where nonlinear thinking The second prong is aimed at physicians, getting them to comes in. The strategy focus needs to shift from lead-time reduc- become more aware of conditions that specific drugs are tion to the power dynamics between the company and other intended to treat. For example, GlaxoSmithKline Inc. lends

LESSONS IN OPERATIONS MANAGEMENTSUMMER 2006 • MIT MIT SLOAN SLOAN MANAGEMENT REVIEW REVIEW 7329 spirometers to primary-care practices so that physicians can con- Medco Health Solutions in 1993 for this precise purpose. duct breathing tests themselves rather than referring patients to Medco, which was spun off in 2003 amid complaints about its pulmonologists for testing. GlaxoSmithKline uses this opportu- role pushing Merck products, currently manages prescription nity to provide doctors with information on inhaled corticos- drug plans representing more than 60 million patients. To qual- teroids. The hope is that greater use of spirometry tests will result ify for discounts, participants must select from a preferred list in increased identification of subtle respiratory problems, which of medicines. In exchange for getting their products on the pre- in turn will generate more demand for medications such as those ferred list, pharmaceutical companies provide additional that the company produces. rebates to the pharmacy benefit managers. Pharmacy benefit When medications from multiple pharmaceutical companies managers effectively limit the number of channels and avenues can be used to treat a condition, drug companies face obstacles in by which patients can obtain their medications and frequently shifting demand to their particular drug. The last prong involves cut out traditional pharmacies. For example, Medco negotiates incentives for physicians and pharmacies. By strategically manip- with clients such as General Motors Corp. to have plan partici- ulating discounts and exclusivity arrangements, pharmaceutical pants purchase maintenance drugs from a mail-order unit. companies try to persuade physicians to prescribe their products. Indeed, the GM plan no longer permits plan participants to fill Failing that, they attempt to redirect prescriptions to a drug that their prescriptions through pharmacies such as Walgreen Co.’s they produce, going as far as to insert pharmacy benefit managers Walgreens. strategically into the value chain. (Pharmacy benefit managers In addition to influencing demand downstream, companies act on behalf of insurance companies to negotiate discounts for have opportunities to influence price sensitivity and volume their plan participants.) Merck & Co., Inc., for example, acquired demand upstream. Consider Pfizer Inc. Its statin drug Lipitor, which is designed to reduce levels of so-called “bad” cholesterol, is the world’s top-selling medicine and accounted for sales of Value-Grid Dimensions and Strategies $12.2 billion in 2005. However, in anticipation of the loss of its patent protection in 2010, Pfizer is testing a new cholesterol drug, The grid perspective highlights three dimensions for identi- torcetrapib, which is intended to increase the amount of “good” fying ways to enhance company performance: the vertical, cholesterol and potentially complement Lipitor’s role in slowing horizontal and integrative diagonal dimensions. Within the the development and progression of atherosclerosis. vertical dimension, companies explore nonlinear opportuni- Pfizer is assessing torcetrapib’s effectiveness and safety — not ties in their traditional value chain by looking beyond those directly connected to them upstream or downstream. as a stand-alone intervention but as used in conjunction with Within the horizontal dimension, companies explore Lipitor. The company is not testing torcetrapib with the other opportunities in parallel value chains. Within the diagonal well-known statins, which are produced by its competitors. If the dimension, companies take an integrative approach as clinical trials are successful, torcetrapib will be available only as they explore more widely in other tiers and value chains part of an integrated combination pill with Lipitor. for opportunities to create value. This provides a good example of how companies can look For ease of exposition, the value grid figure here is simple upstream, in this case to R&D efforts, to identify ways to narrow and rendered in two dimensions. It should be noted that customer choice downstream. In this particular instance, there is companies undertaking a thorough mapping of the value grid will find many more cross-linkages and relationships. also a potential bonus for end-users: By having Lipitor and torce- After initial opportunities have been exploited, the poten- trapib in one pill, they may be able to obtain two drugs for a sin- tial landscape for identifying opportunities can be continu- gle copay. ously enlarged. Modifying Information Access Real opportunities for shifting the buy- Upstream ing decision occur when companies are able to link information Primary Inputs (Raw Materials, with control. (See “Knowledge-Retention Strategies by Network Services, etc.) Role.”) For example, a company needs to understand its suppliers’ Downstream flexibility and pricing structure. Companies can do a better job in this area by monitoring the market conditions faced by suppliers. For example, American Honda Motor Co. Inc., unlike some of its Vertical Japanese competitors, offers contracts to suppliers that specify Dimension Horizontal which second-tier suppliers will furnish components for the sub- Dimension End-users assemblies integrators provide. The greatest value comes when Diagonal Dimension suppliers view this level of control as being in their own interest as

74 MIT SLOAN MANAGEMENT REVIEW SUMMER 2006 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 30 well. In 2002, the U.S. government’s steel safeguard program imposed tariffs of up to 30% on certain types of imported steel. About the Research This caused prices of U.S.-produced steel to jump dramatically, which in turn made it difficult to procure certain grades of steel. This article is based on a structured investigation of value Most automakers now purchase steel in volume, which they resell chain strategies in a range of industry sectors, supported to their suppliers at a discount. The benefit to automakers is not by the Cambridge-MIT Institute’s Centre for Competitive- just lower cost but also the ability to learn more about their sup- ness and Innovation, the International Motor Vehicle Pro- gram at MIT and the Sloan Foundation. Our initial impetus pliers’ material costs and control a key input for direct suppliers. for undertaking the research was a comprehensive map- For companies such as Nokia that cannot directly control the ping of the value chains and value creation strategies of product offering, having information about end-users is critical. It nine vehicle manufacturers, their suppliers and their logis- is standard for mobile network operators to provide phone service tics operations. The automotive industry is widely noted with handsets, tying the price of the phone to the service contract. for its operational effectiveness, and our initial efforts pro- In reaction, Nokia developed a mechanism for communication vided us with a comprehensive picture of the value chain with its users in Europe, the Middle East and Africa — a Web site strategies at each tier. This enabled us to assess the effec- called Club Nokia, where customers get priority support and tiveness and the risks inherent in the linear thinking asso- exclusive offers and services if they register their phones. Nokia ciated with current value chain strategies. went so far as to offer special ring tones directly through this site, a In a second step, we turned toward the fast-moving practice it discontinued only after service providers complained. telecommunications sector, where we conducted a series of structured and semistructured interviews with execu- Exploring Multitier Penetration As companies find ways to control tives of hardware manufacturers, software providers and national telecommunications operators. Contrasting the over-demand, they often assume multiple positions in the value automotive and telecom sectors, we developed our basic chain in order to diversify demand and limit a particular buyer’s framework articulating the three core dimensions of power. For example, Bosal International NV, headquartered in value-grid thinking. Lummen, Belgium, manufactures original equipment exhaust In a third step, we explored how nonlinear strategies systems for auto manufacturers. However, it also sells extensively are used in other sectors. We drew on interviews in health- in the aftermarket. The company sees its business holistically: By care and pharmaceutical-related settings and a host of examining the multiple points in the value chain where it can other industries to refine and validate our value- grid participate, it can explore scale economies in design and produc- model and identify a set of generic strategies for leverag- tion. In the late 1990s, for example, there was intense pressure ing value-grid thinking. from original equipment manufacturers to reduce costs and

Knowledge-Retention Strategies by Network Role

Dimension Description Exemplar Strategies Vertical Companies think nonlinearly about their value chain • Influencing customer demand, both upstream and when they look downstream to end-users and upstream downstream to supply and service providers to find ways to better • Modifying downstream information access understand end-users, enhance demand for products • Exploring multitier penetration and capitalize on information accessible to other tiers of the value chain.

Horizontal Within a tier, companies move across value chains to • Seizing value leverage existing competencies, manage risk, seize • Integrating value value embedded in other chains and develop novel • Creating new value propositions value propositions that are not accessible to actors operating in single value chains.

Diagonal Companies operate diagonally when they operate • Pursuing pinch-point mapping across tiers and parallel value chains. They take an inte- • Defining demand enablers grative approach to gaining access to critical informa- tion, and they identify additional opportunities to ensure and enhance demand.

LESSONS IN OPERATIONS MANAGEMENTSUMMER 2006 • MIT MIT SLOAN SLOAN MANAGEMENT MANAGEMENT REVIEWREVIEW 3175 increase the steel quality of exhaust systems. Although supplying body components that get welded and painted. Prior to painting, OEMs was important for credibility, the aftermarket offered the assembled auto body receives an electrocoat to protect it Bosal more attractive margins. against corrosion. Dusseldorf, Germany–based steel producer The balance is now shifting. Because exhaust systems are built ThyssenKrupp AG has developed a new coating that protects steel to last longer, they are replaced later in a vehicle’s life cycle. This has against both chipping and corrosion. This coating has the poten- led to greater price sensitivity in the aftermarket and fewer sales. tial to eliminate a significant chunk of the painting process at However, tighter emission standards and other factors now favor assembly plants, thereby allowing manufacturers to operate OEM suppliers such as Bosal that offer integrated solutions. To smaller, more flexible factories and produce finished vehicles at leverage its aftermarket experience, Bosal has shifted investment lower cost. In the automotive market, where product life cycles are away from aftermarket exhausts to less-price-sensitive accessories getting shorter and product variety continues to increase, this such as tow and roof bars and the emerging catalytic converter change has the potential of offering a considerable advantage. aftermarket. By supplying more than one tier in the value chain, Bosal is less vulnerable to specific changes in demand and more Exploiting Parallel Value Chains able to capture high-margin opportunities as they emerge. Within the value grid’s vertical dimension, companies often look Thinking nonlinearly about demand also helps companies for new opportunities within a single value chain as they seek identify customer solutions that fall outside the traditional value new ways to influence demand, obtain critical information or chain. In the auto sector, for example, steel providers typically ship penetrate the value chain at multiple points. By contrast, the steel coils to vehicle manufacturers, which stamp them into auto opportunities for change in the horizontal dimension typically

Integrating Value in the Telecom Sector

By moving beyond the linear value chain, companies can gen- WiFi providers, individuals can make calls wirelessly much erate value for the customer by joining or integrating addi- more cheaply than over traditional mobile networks. Dublin- tional value chains. There are several ways in which this type based Cicero Networks combines a VoWiFi capability in of integration is playing out in the telecom sector. (See “The hotspots coupled with a GSM capability for its business cus- Convergence of Voice Services.”) tomers, as most mobile phone calls originate from business Although mobile phone use has taken off, mobile calls are premises (see option B in the figure). Using dual-mode traditionally much more expensive than landline calls. Land- GSM/WiFi handsets or pocket PCs, customers can make calls line manufacturers are working on mobile handsets that link over the cheaper WiFi base stations when these are available into the landline at home and into the global system for and not congested by other WiFi users, and over GSM other- mobile communication (GSM) network outside the home, thus wise. WiFi networks increasingly threaten mobile network providing a novel value proposition for consumers. BT Group’s operators in urban areas, where WiFi density is high. A further BT Fusion, offered in collaboration with mobile provider Voda- boost to voice service convergence may occur with WiMAX, a fone Group, is a mobile handset that functions as a normal variant on WiFi, which spans several square miles. mobile phone but links at home to a landline, using Bluetooth Yet another opportunity to integrate value is found by short-range radio (see option A in the figure). The customer linking the fixed and VoIP communication value chains to needs only one handset and pays low landline charges in addi- enhance options and cost propositions. The USB DUALphone, tion to mobile network charges. made by wireless communication supplier RTX, based in Voice over Internet Protocol (VoIP) companies like Luxem- Noerresundby, Denmark, is a cordless phone for home use bourg-based Skype Ltd. and New Jersey–based Vonage offer that can be used either as an IP or a traditional public Internet telephony to households by providing voice commu- switched telephone network (PSTN) phone (see option C in nication between users of the Internet and landline telephone the figure). Still absent from the market is a handset that infrastructure — seizing part of the landline infrastructure’s integrates VoWiFi, GSM and landline access (see option D in value in the process. Corporations have embraced VoIP as a the figure). With GSM capability now integrated in a single way to save on landline phone calls, but they are still faced chip and increasing coverage of WiFi base stations, however, with the high cost of cell phone calls. this is a viable proposition. Instant text and video messaging, As wireless Internet access becomes more ubiquitous, the interactive gaming and other interactive applications, cash solution will be to integrate VoIP and wireless fidelity (WiFi). A equivalency storage, streaming Internet access, browsing and voice signal sent over IP is transmitted through a WiFi connec- data sharing further enrich the potential to integrate value in tion (VoWiFi). With current collaborations between VoIP and this particular arena.

76 MIT SLOAN MANAGEMENT REVIEW SUMMER 2006 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 32 reside in multiple value chains. This dimension provides oppor- The Convergence of Voice Services tunities for companies to leverage economies of scale across mul- tiple sources of demand. Consider the case of an auto supplier that makes flexible printed circuit boards. If the supplier is able Breaking free of linear mind-sets is enabling the to sell its circuit boards to companies making medical and office telecommunications sector to identify a number of novel opportunities for delivering value to its customers. By inte- automation equipment, it can generate greater sales across which grating the value proposition across the three basic value to spread its costs. The potential of the value grid’s horizontal chains associated with the landline telephone, the cell phone dimension goes beyond economies of scale and scope in that it and the Internet, companies are developing a number of per- enables companies to manage risk, seize existing value, integrate mutations of service and price bundles for end-users. sources of existing value and explore novel ways to create value.

Managing Risk In most industries, demand patterns tend to be Combinatory Options at the Customer Interface cyclical. Fluctuations are fairly common, which might cause A. B. C. D. companies to underuse capacity or fail to supply demand, thus Network Bluetooth VoWiFi VoIP VoIP, Infrastructure & & & Landline prompting customers to look at competing products. GSM GSM Landline & GSM Landline (PSTN) Looking across value chains provides companies with an Switched Signal opportunity to explore countercyclical demand patterns. For Landline example, Honda is famous for its high-quality engines, but Cell phone network demand for some motor vehicles, such as motorcycles, is sea- Packet Signal sonal. To stabilize demand for motorcycle engines, Honda uses Cell phone those engines in counterseasonal products, such as lawnmowers, Data line (Voice over IP) go-carts and snowblowers. Similarly, the engines that power the Packet Signal

Honda Accord, CR-V and Element also power Honda’s 135HP PC outboard motors. Honda leverages its core expertise in engine design and benefits by achieving economies of scale in engine — occur when companies think horizontally in an attempt to production and design. It spreads the demand and development control value. This often takes place when a company identifies a risks for a component across multiple value chains and level component or service that yields disproportionate profitability demand by operating in value chains with orthogonal (for exam- and then introduces that element into other companies’ value ple, offsetting) demand and risk patterns. chains. Disposable printer cartridges are a good example of this. Many printer manufacturers sell their printers at or near cost in Seizing Value In order to build more value, companies are becom- the hope that ink, toner cartridges and paper will generate a rev- ing more aggressive about moving horizontally into the value enue stream later on. Like the proverbial razor company, they chains of other companies in their industry. This entails using a count on being able to sell disposable cartridges at regular inter- similar production or service stage in other value chains as a pen- vals. However, this scenario was threatened when small busi- etration point into those chains. Toyota, for example, is the world nesses began offering refilled cartridges at substantial discounts. leader in hybrid powertrain technology, yet it has chosen to Traditional printer manufacturers, including Hewlett-Packard license this technology to Ford and Nissan — two direct com- Co. and Lexmark International Inc., took defensive steps to com- petitors — even though demand for its own hybrid vehicles out- bat the challenge. Lexmark added to its toner cartridges an elec- paces its production capacity. tronic chip that can communicate with the printer as a way to According to traditional linear thinking about value, Toyota ensure that the replacement cartridges would be Lexmark prod- is unwise because its engines are key to differentiating some of ucts. The company offered discounts on cartridges with embed- its products downstream and enabling the company to charge ded chips, believing that only Lexmark would be able to refill or premium prices. From a horizontal perspective, however, the remanufacture them. However, the company was wrong, and engine is a product in its own right. Toyota is more than a vehi- independent companies succeeded in supplying compatible car- cle purveyor; it is an influential supplier to other vehicle pro- tridges. After pursuing legal challenges that ultimately failed, Lex- ducers. By supplying others, Toyota not only gains economies of mark changed its strategy and began supplying printer cartridges scale but also helps to establish and control the technological for other brands of printers. framework for future hybrid vehicle development across the Lexmark’s solution raises an interesting point about horizon- industry. tal thinking: When companies in or across industries modularize The greatest opportunities — and perhaps the greatest threats a particular component or service in the value chain, other com-

LESSONS IN OPERATIONS MANAGEMENTSUMMER 2006 • MIT MIT SLOAN SLOAN MANAGEMENT REVIEW REVIEW 7733 Expertise in one value chain may be a source of advantage in another. For example, UPS has evolved from providing transportation services to offering a range of value-added, logistics-intensive services.

panies may begin to act in a similar fashion and provide compet- gain market share in electronic price gathering and comparison itive components or services. across distribution channels, such as Yahoo! Inc.’s FareChase. Expedia Inc., Travelocity.com LP and other companies have used Integrating Value Breaking free of linear mind-sets helps companies similar strategies, often through agreements rather than direct see opportunities to create value for customers by participating ownership of hotel, airline or car-rental agencies. more actively in new value chains. The telecom industry provides The resulting rapid proliferation of potential sales channels an excellent example. Landline telephone services and mobile net- has created new opportunities for eking value from crossing mul- works historically have been viewed as separate enterprises, leading tiple value chains. Cendant, for example, is trying to leverage its large telecom operators like AT&T Inc. and BT to spin off their software development to provide turnkey software solutions for mobile components into independent companies. However, as inventory and rate management to hotel chains. more consumers are abandoning their landlines in favor of mobile service, fixed-line operators are coming up with novel ways to inte- Exploiting Value Chains Across Tiers grate value with other value chains. As a first step, the companies In addition to the value grid’s horizontal and vertical dimensions, are integrating the value of landline and mobile services by linking further opportunities for increasing control over inputs and cus- voice communications across data and voice networks. (See “Inte- tomers can be found by exploring the grid in an integrative fashion. grating Value in the Telecom Sector,” p. 76.) This includes exploring means of controlling the supply of critical components and uncovering new ways of boosting customer Creating New Value Propositions Horizontal thinking allows com- demand by looking upstream and downstream in other value panies to create value propositions that would be impossible with chains. Two strategies that take advantage of this diagonal, integra- a traditional linear view. For example, airlines and hotels want to tive approach are pinch-point mapping (which involves identifying be able to distinguish price-sensitive budget travelers seeking a potential bottlenecks and threats) and demand enabling. last-minute deal from business travelers looking for convenience and comfort. Which customers are willing to pay a premium to Pursuing Pinch-Point Mapping In theory, at least, most companies stay in a specific hotel, and which would be happy with any recognize the importance of knowing which suppliers produce accommodation? Priceline.com Inc. and Hotwire.com (owned by the key upstream inputs for their products. For example, auto- Expedia Inc.) allow customers to choose travel dates and destina- motive companies that produce diesel engines rely heavily on a tions, but the airline carriers and hotels are not identified until ceramic particulate filter that is supplied by only two companies the flight or room has been paid for. Thus, large airlines and hotel in the world: Ibiden Co. Ltd., headquartered in Ogaki, Japan, and chains are able to identify bargain hunters without undermining NGK Insulators Ltd., headquartered in Nagoya, Japan. their pricing structure for customers who value them. By span- When Ibiden experienced quality problems in early 2005, ning value chains within an industry, these companies create a Ford Motor Co. and PSA Peugeot Citroen were unable to pro- service that generates new value for companies in each chain. duce thousands of vehicles. To avoid such problems, it makes Although Priceline.com started out by spanning value chains sense for companies to monitor key component supplies and within the airline industry, the travel reservations industry has negotiate alternative sources of components that, if unavailable, evolved into the sale of integrated (and discounted) hotel, airline could shut down significant parts of the operation. and car-rental packages. This is based on a strategy of spanning Arranging alternative sourcing within one industry is rela- the value chains of multiple industries. Companies like Cendant Corp., which owns Orbitz, make money on bundling packages from their own car-rental and hotel chains (Avis, Budget, Days Inn, Ramada Inn, etc.) with airline tickets. By integrating the value chains from these industries, they can offer package and price combinations that would not be possible within a single value chain. They also foil the efforts of companies looking to

78 MIT SLOAN MANAGEMENT REVIEW SUMMER 2006 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 34 tively straightforward, but it is more complex when the compo- nents are used across different industry sectors. Pinch points that span different industries are particularly tricky to monitor because it is difficult to anticipate demand or use for a compo- nent or service in another industry. Companies should pay spe- cial attention to components that take time to come on stream and where the producer can allocate capacity across a variety of applications. For example, producers of memory chips have reor- ganized production to meet the dramatic increase in demand for flash memory for camera cell phones, digital cameras and per- sonal music players; in the process, the supply of other types of memory chips has dwindled, posing threats to computer man- ufacturers and other companies that rely on those chips. Companies that fail to follow and manage pinch points can run into serious problems. For example, a fire at a key Philips semiconductor factory in 2000 caused a worldwide shortage of the radio frequency chips used by both Nokia and Ericsson. Nokia immediately lined up another source and redesigned other chips so they could be produced elsewhere. However, Ericsson responded more slowly and lost an estimated $400 million in mobile phone handset sales. By acting quickly, Nokia was able to gain a stronger position in the handset market, at least for a time. History shows that such advantages can be short-lived. Recently, for example, Nokia failed to monitor developments in the market for color screens. Because producers of the film-trans- fer screens were already committed to supplying makers of com- puter monitors and television displays, Nokia was caught short. This enabled Samsung Group, which produces its own screens, to achieve significant gains in the market: Samsung’s global market share in 2004 surged from 4% to 14%, while Nokia’s share dropped by 2%. In addition to helping companies avoid supply problems, mon- itoring other value chains can help them identify potential rivals. This is evident in the video games industry. As video game players seek high-end graphics processors, wireless and wired Internet capabilities, Windows XP and full multimedia drives, consoles like the Xbox 360 and PlayStation are becoming well suited to audio- video management. Indeed, the consoles could serve as hubs for home entertainment, displacing traditional audio-video devices (MP3, CD and DVD players) and perhaps becoming gateways for audiovisual entertainment sales in their own right.

Defining Demand Enablers Examining value chains in other indus- tries can reveal new opportunities to leverage key competitive advantages. Companies that have a particular expertise in a given value chain may find that that source of advantage is also relevant in other value chains. For example, United Parcel Service of America Inc. has evolved from providing transportation services to offering corporate clients a range of value-added services that are logistics intensive. One such client is Toshiba Corp. UPS man-

LESSONS IN OPERATIONS MANAGEMENTSUMMER 2006 • MIT MIT SLOAN SLOAN MANAGEMENT MANAGEMENT REVIEWREVIEW 3579 ages Toshiba’s laptop computer service business, which includes champion, such as a purchasing director or operations manager. overseeing the availability of parts, transporting broken equip- Value grids are inherently complex and dynamic, enabling a ment to a service center, repairing the equipment and expediting nearly limitless web of opportunities. Because of this, vigilant it back to the customer. By bundling repair with logistics, UPS monitoring of the value-grid landscape must become an integral can provide a cost-effective solution, within a time frame that is part of ongoing corporate decision-making processes. This half what Toshiba could otherwise offer. includes both identifying new opportunities as well as monitor- By reaching outside their established value chains, companies ing emerging dangers from other players in the value grid. Some can create new threats. In entering the computer repair business, early warning signs of shifting opportunities and potential for example, UPS poses a new threat to companies such as Unisys threats are straightforward, such as the simplification or stan- Corp. that have played an important role in this market. dardization of information, which often comes with the decision Companies often can find new opportunities to leverage other to modularize a product or service. But many more opportuni- value chains to enhance the appeal of products that originate ties and challenges are idiosyncratic and far more difficult to within their own chain. Such was the case with Apple Computer identify. Thus, on a dynamic level, companies must continually Inc., which in 2002 negotiated an unprecedented agreement with explore, evaluate and map the broad competitive landscape, major and independent music labels to sell music over the Web. rethinking the value grid in terms of their critical activities. Most music labels had tried to launch similar ventures but had been unsuccessful, in part because their musical selection was limited and prices were high. Apple went with low prices in hopes REFERENCES of locking users into its iPod music players. The company now 1. Jay W. Forrester provided one of the first systematic explorations has the opportunity to develop new products that use its propri- of the complex dynamics underlying information and material flow in etary software and designs. Apple drew on the music industry as multiechelon systems; see J.W. Forrester, “Industrial Dynamics” (Cam- bridge, Massachusetts: MIT Press, 1961). It set the stage for exploring a demand enabler for its hardware, and currently it is looking to the linkages across parts of the value chain from an operations stand- video and other content services to further lock in that demand. point. Among other things, it provided an early look at the root cause for dynamic distortions in value chains, which was later expanded and relabeled as the bullwhip effect; see, for example, H.L. Lee, V. Pad- Life Within the Grid manabhan and S. Whang, “The Bullwhip Effect in Supply Chains,” Shifting from a value chain focus to a grid focus requires man- Sloan Management Review 38, no. 3 (spring 1997): 93-102. Since agers to rethink the organization’s value proposition and associ- then, value chain dynamics have become widely explored, as researchers try to understand value creation and the sources of value. ated structures from three perspectives: the impact on existing The “value chain” concept gained prominence in the mid-1980s as operations; innovations outside of existing operational spheres; researchers looked for cost optimization and new sources for competi- and dynamic shifts in the value grid landscape. At the operational tive advantage; see J.B. Houlihan, “International Supply Chain Man- agement,” International Journal of Physical Distribution and Materials level, a company uses the value-grid to leverage information that Management 15, no. 1 (1985): 22-38; and M.E. Porter, “Competitive directly benefits its existing operations. Advantage: Creating and Sustaining Superior Performance” (New York: The Free Press, 1985). The efforts to understand value chains’ Understanding the anatomy of purchasing decisions, for dynamics as a source of core competence and competitive advantage example, empowers a company to adjust its provision of services continue to this day. A key concern in our previous research has or products to more accurately match customer needs. This been, from an operations standpoint, how holistic value chain strate- gies can be leveraged to enhance responsiveness to customer needs; directly benefits existing operations and thus ensures minimal see M. Holweg and F.K. Pil, “Successful Build-to-Order Strategies resistance because it does not threaten existing modes of think- Start With the Customer,” MIT Sloan Management Review 43, no. 1 ing and operating. With a deep understanding of what drives a (fall 2001): 74-83; and M. Holweg and F.K. Pil, “The Second Century: Reconnecting Customer and Value Chain Through Build-to-Order” purchasing decision, a company can make better decisions about (Cambridge, Massachusetts: MIT Press, 2004). ways to shift control over the demand and manage risk. 2. Martin Christopher observed that competition increasingly occurs Starting from an operational standpoint also makes sense for between entire value chains, not individual companies; see M. Christo- pinch-point mapping because tracking and manipulating pinch pher, “Logistics and Supply Chain Management” (London: Pitman Publishing, 1992). points ensures an uninterrupted flow of critical components and 3. An approach that was developed jointly with Audi AG and Daimler- services. Further, companies can leverage their understanding Chrysler Corp., currently under pilot testing. For a more general dis- strategically to lock out competitors. cussion on the advantage of small-scale operations in the value chain, Operating with a grid perspective also makes it easier for com- see F.K. Pil and M. Holweg, “Exploring Scale: The Advantages of Thinking Small,” MIT Sloan Management Review 44, no. 2 (winter panies to explore innovative strategies that do not directly benefit 2003): 33-39. operations, such as demand enablers. Such exploration is best done through new organizational initiatives. It requires a more system- Reprint 47414. For ordering information, see page 1. atic and conscious effort because it lacks a natural operational Copyright © Massachusetts Institute of Technology, 2006. All rights reserved.

80 MIT SLOAN MANAGEMENT REVIEW SUMMER 2006 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 36 Taking the Measure of Outsourcing Providers Successful outsourcing of back-office business enior executives frequently express dissatisfaction with back-office processes and func- Stions in areas such as human resources, information technology, indirect procurement, functions requires finance and accounting, perceiving them as too costly to operate, limited in their capabilities knowing not only your and frustratingly slow. Some of the largest companies — particularly those that have grown company’s needs but also through mergers and acquisitions — are saddled with disparate and poorly performing processes that only major investments in dollars and management capacity can correct. Even the 12 core capabilities if senior executives agree to commit the necessary management time and other resources, that are key criteria for many are skeptical about creating the proper environment for back-office success. screening suppliers. Not surprisingly, rather than address these challenges themselves, many companies are choosing to outsource some functions and areas — in some cases, even their entire global back offices — to business-process outsourcing providers. One example of a BPO provider David Feeny, Mary Lacity is call centers; increasing numbers of companies are outsourcing their service support func- and Leslie P. Willcocks tion to either local or offshore providers that can handle it more efficiently and at lower cost. More recently, companies including BP Plc and Bank of America NA have decided to outsource the transactional side of their human resources activity.1 This trend toward outsourcing of business processes continues to gather steam as companies seek alternative and improved ways of leveraging their assets. Some BPO providers speak of the “transformational” impacts that upgraded processes can have on client business perform- ance.2 Suppliers can furnish companies with more than simply expertise. Some provide upfront capital to convert cumbersome, decentralized human resources and administrative systems into shared utilities, which they then deliver through new offices, new business processes and Web-enabled technology. In addition to setting the stage for internal efficiencies, BPOs can provide opportunities for other benefits. Recently, for example, the Lon- don-based Society of Lloyd’s, the global underwriting group, worked closely with London-based Xchanging, a major business- process outsourcing firm, to revamp its policy administration and claims processing capabilities. The subsequent changes allowed Lloyd’s to achieve substantial cost savings and service

David Feeny is a Fellow of Templeton College and director of the Oxford Institute of Information Management at Oxford University. Mary Lacity is professor of information systems at the University of Missouri–St. Louis. Leslie P. Willcocks is professor of information systems at Warwick Business School, University of Warwick, Coventry. Contact them at [email protected], [email protected] and Leslie. [email protected].

LESSONS IN OPERATIONS MANAGEMENTSPRING 2005 • MIT MIT SLOAN SLOAN MANAGEMENT MANAGEMENT REVIEW REVIEW 3741 improvements; it has since partnered with Xchanging to sell ices: What levels of cost, quality, robustness and flexibility are services that grew out of their business relationship to external the supplier able to meet? Few companies will be eager to out- customers, creating a new stream of profits. source their business processes unless they are confident that BPO has become a large and diverse market in recent years, their minimum required standards of service can be met dur- populated by an increasing number of providers. Organizations ing the life of the contract. interested in exploring the potential benefits of outsourcing business processes need to look carefully at their own goals and ■ Increasingly, clients expect that the services they outsource will be clear about what supplier capabilities they need. Over the improve over time and provide them with some combination course of 15 years of research, initially focused on IT outsourcing of cost, quality and functionality improvements. Transforma- but more recently expanded to include other types of BPO, we tion competency represents how well a supplier can deliver on have described ways to analyze appropriate outsourcing goals these formal or informal expectations. Suppliers use several and have provided a widely used model for identifying the capa- potential levers for achieving radical change and improvement, bilities that need to be retained in-house.3 (See “About the and competing suppliers can vary greatly in this domain. Research.”) This article identifies and describes what BPO providers can bring to outsourcing relationships. Finding the ■ Most outsourcing deals are made up of “fee-for-service” con- right suppliers is essential to BPO success. tracts, which separate the price the client pays from the costs the supplier incurs in providing the services. This seemingly Understanding Supplier Competencies straightforward arrangement can lead to serious conflicts, Regardless of their specific areas of expertise, every BPO especially when the contracts extend for many years. Clients supplier operates in three domains. To greater or lesser extents, typically use their bargaining power to negotiate the best price they possess competencies in delivery, transformation and they can, but their position weakens once the contract has relationships. been signed and the supplier seeks control. For this reason, savvy clients attempt to gauge the supplier’s relationship com- ■ Delivery competency encompasses how well a supplier can petency — the extent to which the supplier is willing and able respond to the client’s requirement for day-to-day operational to cultivate a “win-win” relationship that will align client and services. It reflects the supplier’s scope and complexity of serv- supplier goals and incentives over time.

About the Research

We have been researching outsourcing related internal documentation. For ment Review 37, no. 3 (spring 1996): 13-25; T. arrangements for 15 years, and we have example, the BPO case research referred Kern and L. Willcocks, “The Relationship Advan- tage: Information Technologies, Sourcing, and drawn on multiple research bases for to involved more than 40 formal inter- Management” (Oxford: Oxford University Press, this article. The first research base con- views and analysis of over 120 original 2002); and M.C. Lacity and L.P. Willcocks, “Global Information Technology Outsourcing: sists of 112 sourcing case histories documents, including contracts. We Search for Business Advantage” (Chichester, (mainly in the area of IT), studied longi- studied practices and progress over time U.K.: John Wiley & Sons, 2001). i tudinally from 1990 to 2001. The sec- and assessed these against outcomes. ii. L.P. Willcocks, M.C. Lacity and D. Feeny, ond is a 2001–2004 longitudinal study Outsourcing success typically was meas- “Transforming a Back-Office Function: Lessons From BAE Systems’ Experience With an Enter- of business-process outsourcing prac- ured by comparing objectives against prise Partnership,” MIS Quarterly Executive 2, no. tices, with a particular focus on four outcomes, cost savings (most deals 2 (2003): 86-103; and D. Feeny, L. Willcocks and cases in aerospace and insurance.ii We demanded some degree of cost saving) M. Lacity, “Business Process Outsourcing: The Promise of the ‘Enterprise Partnership’ Model,” also draw upon a study of 10 applica- and reported levels of satisfaction. The Templeton College, Oxford University, 2003. tion-service provision outsourcing satisfaction measure varied with stake- iii. T. Kern, M.C. Lacity and L.P. Willcocks, “Net- arrangementsiii and two studies of off- holders from deal to deal, but examples sourcing: Renting Business Applications and iv Services Over a Network” (New York: Prentice shore outsourcing arrangements. The include service levels, end-customer Hall, 2002). approach in all cases has been to inter- opinion, speed of conflict resolution, iv. K. Kumar and L. Willcocks, “Offshore Outsourc- view multiple stakeholders — senior innovation achieved and number of ing: A Country Too Far?” Proceedings of the 4th business executives, functional leaders times that penalty clauses were invoked. European Conference in Information Systems, 1996; and J.W. Rottman and M.C. Lacity, “Twenty and operational staff in both client and i. M.C. Lacity, L.P. Willcocks and D.F. Feeny, “The Practices for Offshore Sourcing,” MIS Quarterly vendor organizations — and to review Value of Selective IT Sourcing,” Sloan Manage- Executive 3, no. 3 (September 2004): 117-130.

42 MIT SLOAN MANAGEMENT REVIEW SPRING 2005 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 38 The first step in identifying potential suppliers is for a company 1. Domain Expertise The first and most obvious capability to to consider its own requirements. (See “Client Needs and Sup- evaluate is the supplier’s capacity to apply and retain sufficient plier Competencies.”) Does the company need a supplier who professional knowledge of the target process to meet the user can deliver the highest level of service, or will a moderate level be requirements. Many supplier organizations acquire domain sufficient? Is the present service in need of radical change? Or is expertise from clients through employee transfers. For example, the company looking to phase out an internal service that is per- Barclays Plc, the financial services company, transferred its forming satisfactorily in order to free up more management time check-processing staff to Unisys Corp.; conversely, Hewitt Asso- to address core activities? Does the company want a services ven- ciates Inc. and Xchanging acquired human resource expertise dor that can be replaced easily if its performance is unsatisfac- by transferring people from Bank of America and BAE Systems tory? Or would it like to have a long-term partner whose business Plc, respectively. This method of building expertise has two success over time will be closely tied to its own (recognizing, of potential advantages from the client’s point of view. First, it course, that this means higher switching costs should it need to becomes the supplier’s responsibility rather than the client’s make a change)? A common mistake in outsourcing is choosing responsibility to adjust capacity, eliminate poor performers and a partner through a procurement process that encourages a bid- leverage the untapped potential of the best people; second, both ding war. This often leads to a “winner’s curse,”in which the sup- parties are assured that the staff operating the service are famil- plier that gets the contract almost immediately feels pressure to iar both with the functional domain (such as HR) and the restore profitability to a flawed business model.4 specifics and idiosyncrasies of the client’s existing service. As At the same time, client companies must determine which the suppliers grow their own critical mass of expertise in the suppliers have the appropriate level of ability in each area of target domain and become less reliant on transferees, new need. A common pitfall is that client executives have a tendency clients should consider whether suppliers have enough knowl- to overemphasize supplier resources, such as physical facilities, edge to operate in their specific context. technology and workforce composition, while overlooking the Depending on their goals, clients will view domain expertise critical capabilities and resources that will be deployed for the differently. A client seeking to build external capacity to handle customer’s benefit. An executive at a company that has identified periodic variations in service demand will want a commitment technology as a key driver for transformation might ask a from the supplier that it is prepared to build expertise specific to prospective supplier for evidence that it has first-rate employees that specific context. On the other hand, a company seeking to in the technology area. Realistically, all credible suppliers will reduce labor costs through offshore outsourcing might be wary have excellent technology people. Understanding the cultural dif- of going too far: “It has become very clear [to us] that in order for ferences among competing suppliers may be more valuable: offshore to succeed, we need to groom, reward and retain our Which ones have a culture of rapid and regular delivery of bene- own subject matter experts,”says a senior vice president of a For- fits to client businesses through component-based platform tune 500 financial services company. architecture, and which prefer to bundle system requirements into large infrastructure projects? Evaluating a supplier involves understanding the infrastruc- Client Needs and Supplier Competencies ture, values and methodologies it brings to its area of expertise. Successful evaluation also requires an awareness of the range of In selecting potential suppliers, companies must begin by processes the supplier uses and its available skills. The following assessing their requirements and the level of service they section examines 12 capabilities that support these supplier com- seek. They must decide if they are looking to fix an existing function, free up management time or establish a long-term petencies, drawn from case studies of BPO suppliers working partnership. with major corporate clients. The supplier capabilities model serves as a tool for helping clients assess potential service Operational providers, but it may also prove useful to suppliers who wish to Service Needs assess their relative strengths versus their competition. Relevance of 12 Supplier Capabilities Service Delivery, Improvement Transformation, Depending on their specific needs and circumstances, companies Needs Relationship will look to BPO suppliers for different capabilities. Some capa- Competencies bilities will support a single element of supplier competency, Long-Term while others will contribute to two or even three different Viability Needs domains. (See “12 Supplier Capabilities,” p. 45.)

LESSONS IN OPERATIONS MANAGEMENTSPRING 2005 • MIT MIT SLOANSLOAN MANAGEMENT REVIEW REVIEW 43 39 “Suppliers have to make a reasonable margin to stay in business. You don’t want them to lose money, because the worse their business gets, the worse your business gets.”

2. Business Management The second requirement of any BPO contracts with client companies are signed. “This is much more arrangement is that the supplier consistently be able to meet both than an orientation,” says Ed Standridge, a CGI partner. “We client service-level agreements and its own business plans. want to show every employee — not just a subset — this is what Clients must understand that failure on one front inevitably leads we do, how we do it, the timing. We want to set the stage for to failure on the other. In some adversarial client-supplier rela- good behavior management beforehand, not react to bad tionships, clients focus on the high-priced items within the sup- behavior afterwards.” plier’s bundle of services and threaten to erode the supplier’s Other BPO suppliers also place significant emphasis on margin by scaling back on or eliminating these items. They fre- making sure that transitions are handled effectively, and man- quently fail to give their suppliers credit for other items in the agers at some client companies have been pleased by the results. bundle that are priced quite favorably compared to external Since 2001, for example, Xchanging has provided third-party benchmarks of unit price. In successful relationships, business HR services to BAE Systems, running former employees managers on both sides are able to have frank discussions about through its extensive orientation program. As a result of the the supplier’s business returns and service performance. program, people have become “a lot more professional,” says Another example of business management in action is the Kim Reid, divisional HR director at BAE Systems. “They have a procurement deal BAE Systems developed with Xchanging. The lot more understanding of what drives a business. They under- issue here was not pricing but volume. During the first year of stand the cost base and how you actually get value out of a busi- their contract, Xchanging realized that there was a significant ness. It has been quite a nice surprise to see that happen, and shortfall in the expected value of the transactions it handled. happen so quickly.” The two parties collaborated over several months to identify additional categories of business they could add to the contract, 4. Sourcing Another potentially critical factor in meeting client thereby allowing Xchanging to get back on track with its busi- goals is the supplier’s capacity to tap the resources needed to ness plan while also providing BAE Systems with ways to meet service targets. Clearly, client needs will vary depending achieve new savings. on the nature of the service and how much change the client is As the contract manager of an Australian public sector agency looking to generate. Some clients may want access to economies explains: “Suppliers have to make a reasonable margin to stay in of scale or lower labor costs; others may need specialized pro- business. You don’t want them to lose money because the worse fessional skills, improved infrastructure or help with supply their business gets, the worse your business gets.” management. The procurement services deal between BAE Sys- tems and Xchanging, for example, was based on two considera- 3. Behavior Management When considering outsourcing serv- tions: Xchanging’s superior ability to attract high-level ices, clients often seek qualitative as well as quantitative professional skills for procurement of supply categories such as improvements. For example, some managers worry about office supplies, health plans and training; and its ability to take whether morale will suffer if employees are transferred to the advantage of scale by aggregating BAE’s part-time needs with supplier’s organization or whether employees will find a new those of other clients. sense of purpose. Every major BPO supplier has employees with AT&T Corp.’s desire to access the high skills and low costs of impressive experience, skill and knowledge. However, clients India’s IT sector provides a contrasting example of the role of also should evaluate the supplier’s track records in motivating sourcing. Rather than building a new service center itself, the com- and managing people to deliver superior service. This involves pany’s CIO managed to persuade IBM Corp. — which has a long looking for signs that the supplier understands training, man- history as AT&T’s BPO and IT supplier — to open a service facil- aging and motivating people. ity in India with all of the capabilities it needed. In effect, AT&T Different suppliers use different methods. For example, CGI was able to trade some of the potential cost savings it would have Group Inc. of Montreal puts employees slated for transfer garnered, if it had set up its own center, for reduced risk (both through a process it calls “harmonization” even before the final management and political). Up to 40% of AT&T’s application

44 MIT SLOAN MANAGEMENT REVIEW SPRING 2005 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 40 development work is done offshore through IBM’s captive center, with 12 Supplier Capabilities reported cost savings of around 30%. Evaluating business-outsourcing providers requires understanding a supplier’s range of 5. Technology Exploitation Many com- business expertise and skills. Depending on their particular needs, companies will need to panies know that they are very out look to suppliers for different capabilities. of date when it comes to investing in back-office processes that could transform their services’ cost, quality Organizational Relationship Design Competency and functionality. At the same time, Planning & Contracting Capabilities that top management is increasingly wary determine the Delivery Governance supplier’s willingness about embarking on costly new tech- and ability to align Competency with client needs and nology initiatives they aren’t able to Capabilities that goals over time. determine the Leadership Customer manage closely. As they contemplate supplier’s ability Development to respond to Program Business outsourcing, many clients want to the client’s Management requirement for Management know how swiftly and effectively day-to-day suppliers will be able to deploy tech- operational Process services. Behavior Domain Management Re-Engineering nology to support critical service Expertise Transformation Competency improvement targets. This capability Sourcing Technology Capabilities that requires careful evaluation, looking Exploitation determine the supplier’s ability to meet the beyond the purely technical skills that client’s need for service improvement. all major suppliers have and assessing the supplier’s approach. What values and behaviors does the supplier bring to technology exploitation? 7. Customer Development “When I became the Accenture partner What processes does it employ? And what existing infrastructure responsible for the London Stock Exchange,” recalls David does it plan to use as a base? As some BPO suppliers are finding, Andrews (now CEO of Xchanging), “I found I had 200 users who the ability to deliver improved business processes such as “e- complained about everything. A critical task was to change their enabled” HR services directly to the end-user’s desktop can sur- mind-sets so that they became customers.” This points to one of prise and delight their clients. the fundamental challenges confronting both suppliers and clients. Technology is expensive, and clients will want it to be the ser- Rather than thinking of those who avail themselves of internally vant of the business, not the master. The role of a good technol- provided services as “users,” suppliers need to think of them as ogy supplier is to help client companies find cost-effective “customers” — people who make informed choices about service business solutions. For example, CGI works with each client to level, functionality and costs. The senior management of client develop an annual technology plan that identifies the mutually organizations and BPOs typically negotiate outsourcing deals, but agreed-upon investments and projects the client intends to pur- it’s the business units and end users who must live with the day-to- sue within the existing contractual framework. day effects. To maximize chances for success, clients need to iden- tify suppliers who can manage the user-to-customer transition. 6. Process Re-Engineering Another powerful lever for service trans- Suppliers should take three steps to achieve the re-orientation formation is the ability to design and implement changes to the from user to customer. First, the supplier should have personal service process to meet improvement targets. Capability in this contact with a large number of end users in order to build a real area is well established for many major BPOs. Given the promi- understanding of how they want to use the service. This will help nence of General Electric Co.’s corporate initiatives during the create a climate of trust. Second, the supplier should work with 1990s, many clients are familiar with Six Sigma and the Capability client managers to gain agreement on a detailed definition of the Maturity Models. But it is important to look beyond well-known required service, which everyone involved with providing the serv- tools to consider the human and behavioral factors. Who has the ice must understand. This will become the basis for regular reviews critical skills? Who will own the change process? Who defines what of performance and user satisfaction. And third, the supplier qualifies as an improvement? And who benefits? There are many should work to create a business relationship in which the end user cases, particularly in IT outsourcing, in which process improve- becomes a customer who feels fully informed of service options, ments seem to have been designed more for the convenience of the potential enhancements and cost impacts; the customer then can supplier than for the benefit of the client and the end user. make new choices to meet the changing needs of the business.

LESSONS IN OPERATIONS MANAGEMENTSPRING 2005 • MIT MIT SLOANSLOAN MANAGEMENT REVIEW REVIEW 45 41 Although suppliers were consistent in the way they contracted and governed, the main differentiator between success and failure was the individual leading the supplier account teams.

Although these suggestions might sound rather obvious, they Beyond the importance of planning, suppliers should be well are not easy to achieve under most fee-for-service contracts. Sup- versed in the art of contracting. Among other things, this requires pliers typically set out to provide a centrally specified service level understanding options for sharing rewards between themselves and price package, but this often differs from what the user and their clients as the plan is delivered. Many variations are pos- claims to be receiving. As a result, a significant amount of the sible. When Bank of America arranged to outsource HR services supplier’s management time is consumed by extensive (and cen- from Exult Inc. (now part of Hewitt), it negotiated to take an tral) negotiation over long lists of “anomalies” that pre-contract equity stake in the supplier as well as a share of the supplier’s rev- due diligence failed to identify. The net result is that the user feels enues from external clients;5 Xchanging structures its major deals neglected and taken advantage of, rather than developing trust. as profit-sharing arrangements, with open-book accounting. The Even though the supplier’s capability to develop customers is essential principle is that if the supplier and client do their parts considered part of its transformation competency, in practice this to make the business plans successful, both parties will win. is tied more closely to the supplier’s relationship competency. 9. Organization Design Business plans are executed through orga- 8. Planning and Contracting A supplier’s relationship competency nizational structures and processes. Clients need to assess starts with its ability to develop and execute business plans that whether suppliers have the capability to deliver the necessary can deliver win-win results for both customers and suppliers resources to achieve the stated business plan. Suppliers vary over time. The planning component involves creating a vision greatly in terms of their organizational approach, the choices of the potential prize and a coherent process for achieving it. they make and their flexibility. Some emphasize a “thin” front- The details of this vision and process should be shared openly end client team, interfacing with consolidated service units with the client in order to build trust. A few years ago, a client that have profit responsibility and ownership of most of the and a supplier were reporting disappointment with lack of resources. Although such arrangements take advantage of progress in the strategic partnership they had announced six economies of scale, they can constrain a supplier’s ability to months earlier. The breakthrough came when a manager for the deliver the business plan for a specific client. By contrast, other supplier agreed to reveal his company’s revenue goal, which it suppliers allocate most of their resources to “enterprise part- had thus far been unwilling to specify. To the manager’s sur- nership” units that are created for each major deal. The units prise, the client’s response was extremely favorable; the client have their own chief executives, full executive teams and dedi- even stated that unless the supplier achieved at least that level of cated core resources. They are responsible and accountable for revenue, he would consider the partnership a failure. As they delivery of the business plan. worked together to identify additional projects to support this A critical issue in supplier organizational design is resource goal, the supplier gained sufficient confidence to invest more allocation. Clients seeking to achieve service transformation resources in the effort. must evaluate this area with particular care. A potential supplier Presenting the plan upfront clarifies the expectations for all may have impressive capabilities in all of the important ele- parties. For example, a recent procurement services deal between ments of transformation, such as sourcing, technology and Deutsche Bank AG and Accenture Ltd. spells out the vision, the process re-engineering, but the need for many of these capabil- rewards and the plan for their achievement. It commits Accen- ities will fluctuate dramatically during the life of the contract. ture to funding and creating a new platform for procurement, Clients thus need to select suppliers who will be responsive to with 200 people assigned to its development. Accenture receives their needs (and the needs of the shared business plan) as they a substantial new revenue stream from Deutsche Bank and an change over time. opportunity to attract other clients to the new service. In turn, the plan is slated to deliver 15% to 20% in savings for Deutsche 10. Governance Every supplier points to some type of service Bank through consolidation, standardization and retooling of its review committee or board that defines, tracks and evaluates existing 14 procurement units. how well they have performed over time. Large relationship-

46 MIT SLOAN MANAGEMENT REVIEW SPRING 2005 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 42 oriented deals, such as Accenture and Deutsche Bank or Is the supplier so proud of the apparatus it uses for program Xchanging and BAE Systems, typically include a joint board of management, for example, that it risks operating a bureaucracy directors, which underscores the expectation that clients will be that is unable to adjust to the client’s particular needs? active partners in the enterprise. An experienced practitioner described program management Having previous experience with jointly staffed governance this way: “[Program management] is guided by a healthy para- mechanisms is helpful, but clients need to ask suppliers impor- dox. It blends the rigorous project management disciplines tant follow-up questions. What kind of reporting processes exemplified by world-class consultants with the practicality and does the supplier envision to ensure that each part of the gover- pragmatism that is only gained from running operations. … It nance structure remains properly informed? What procedures requires intellectual flexibility to vary or reverse a traditional does it intend to institute for dealing with escalating problems? approach according to circumstance. … As a result there are no What powers and sanctions will be available through the gover- rules, only guidelines.” nance structure? Having joint boards of directors can lead to managerial schiz- 12. Leadership Although governance provides a structural and ophrenia.6 There may be confusion over exactly which hat the procedural context for leadership, effective suppliers exercise client executives wear when they sit on the board of the service leadership more directly. They know how to identify, communi- business. Should they press for more services at lower cost to ben- cate and deliver the balance of the activities required to achieve efit their own employer? Or should they encourage the service success, both for the client and the supplier. Management litera- business to maximize external revenues by taking on more ture generally credits individual leaders with a surprising degree clients, even when this might divert attention from their own of influence over business results. Our research into the effec- service needs? The best way to deal with potentially competing tiveness of services suppliers confirms this overall view. In rela- objectives is to have multiple joint boards to provide checks and tionships in IT outsourcing, we found that the individuals balances. For example, Lloyd’s, the International Underwriting fulfilling supplier leadership roles had a considerable impact on Association of London and Xchanging have developed a three- relationship success.7 Although individual supplier firms were way insurance services deal; they established a joint board of consistent in the way they contracted and governed, 76% of the directors that is focused on achieving revenue and profit growth deals under study were judged by participants to be successful, for the enterprise partnership. Xchanging, which owns 50%, has and 24% were seen as unsuccessful. The main differentiator a majority on this board to ensure operational control. But to between success and failure was the individual leading the sup- protect the service quality, there is a separate service review board plier account teams. When examining how these leaders make a on which clients have equal membership with the supplier. When difference, three patterns emerge: a service problem escalates to this board, a remedial action plan must be worked out within a maximum of three months. The ■ In unsuccessful cases, the leader of the supplier team was service review board also has the power to reduce prices. The ulti- often seen as too focused on delivery, meeting contractual mate sanction for continual poor performance is the removal of service levels while delivering the required margin to the the enterprise partnership CEO. host supplier company. These issues clearly are important, but they seem more a matter of business management than 11. Program Management A BPO supplier cannot survive without leadership. highly developed project management and change management capabilities. But clients interested in service transformation and a ■ The quality of the supplier leader’s personal relationship with long-term relationship should look beyond the supplier’s project- the client leader is usually a driver. This can have an important level capabilities and evaluate its program management capability. impact on the wider relationship between client and supplier Program management involves prioritizing, coordinating, mobi- organizations. lizing the organization and promoting a series of interrelated change projects. As discussed earlier, it is important to provide ■ Least obvious but perhaps most important, the relationship multilevel orientation and support for transferees, to think of between the leader who the supplier assigns to the client and end users as customers, to have technology- and process-based the top management of the supplier’s organization can be a projects that deliver service improvements over time and to have critical factor in success. Because most suppliers tend to create an overarching business plan. Managing change at this level is not more of a front-end team to serve the client rather than a full- for the faint of heart; it demands sophisticated methodologies, function business unit, the local team is extremely dependent processes and professional skills. However, clients also should on its leader’s clout with headquarters to gain access to key assess potential suppliers based on their values and motivations. resources and approval for client-aligned business policies.

LESSONS IN OPERATIONS MANAGEMENTSPRING 2005 • MIT MIT SLOANSLOAN MANAGEMENT REVIEW REVIEW 47 43 The recent experience of a large corporate client highlights the actual level of client involvement and the extent and nature importance of leadership in selecting suppliers. The company of the resources needed will be a function of the specific con- negotiated a $200 million outsourcing contract with Supplier A. text.9 Part of understanding that context is identifying the Supplier A assigned an individual who one client executive particular supplier capabilities that are most important and described as “a great person” to lead the account team, but the the client-side involvement required for their successful leader had no clout with headquarters and could not get any- deployment. thing done. The client terminated the contract and hired Sup- plier B, who assigned an account leader with an impressive track For too many companies, outsourcing has been a case of “marry record in managing previous large contracts. Unfortunately, in haste, repent at leisure.” As one senior executive of a major having recently been recruited from a rival supplier, this leader supplier recently observed, “Outsourcing contracts are agreed to also had very little influence with the head office. The client in concept but delivered in detail, and that’s why they can break eventually called Supplier B’s CEO and asked him to “send down.” By benchmarking supplier capabilities against strategic someone who can act on your behalf.” The CEO complied and and operational intent, companies have an opportunity to estab- assigned a person from the head office, who brought 18 of the lish relationships that are properly calibrated with the business supplier’s best people to the client team. The contract with Sup- objectives they seek to accomplish. plier B has now been in effect for more than a year and is con- sidered by both sides to be a great success. REFERENCES 1. For an account of Bank of America’s outsourcing of HR activity to From Capabilities to Performance Exult (which agreed to a merger with Hewitt Associates in June 2004), The objective of this article is to provide a framework for helping see P. Adler, “Making the HR Outsourcing Decision,” MIT Sloan Man- agement Review 45, no. 1 (fall 2003): 53-59. For a broader discussion client companies evaluate which suppliers possess the competen- of theory and practice in HR outsourcing, see D. Dell and H. Munson, cies required to address their BPO requirements. However, “Outsourcing HR in the Power Utilities and Energy Industry,” research choosing capable suppliers is not enough to ensure performance. report E-0006-04-RR, Conference Board, New York, June 2004. The research suggests three imperatives for companies wishing to 2. For an introduction to the transformational approach, see J. Linder, M. Cole and A. Jacobson, “Business Transformation Through Out- add value through use of the BPO services market: sourcing,” Strategy & Leadership 30, no. 4 (2002): 23-28; and J. Lin- der, “Transformational Outsourcing,” MIT Sloan Management Review 45, no. 2 (winter 2004): 52-58. ■ To identify which competencies to assess in the BPO market- place, client firms should think carefully about each of the 3. See, for example, M. Lacity, L. Willcocks and D. Feeny, “The Value of Selective IT Sourcing,” Sloan Management Review 37, no. 3 (spring processes they eventually may want to outsource. This will 1996): 13-25; and D. Feeny and L. Willcocks, “Core IS Capabilities for involve evaluating the roles individual processes play within Exploiting Information Technology,” Sloan Management Review 39, no. their overall business model and then assessing what 3 (spring 1998): 9-21. improvement goals — measured in terms of cost, quality, 4. For definition and analysis of the “winner’s curse” phenomenon across 85 outsourcing contracts, see T. Kern, L.Willcocks and E. Van functionality or flexibility — will be most valuable to the busi- Heck, “The Winner’s Curse In IT Outsourcing: Strategies for Avoiding ness over time. As clients conduct this type of in-depth analy- Relational Trauma,” California Management Review 44, no. 2 (winter sis, they should decide what combination of delivery, 2002): 47-69. transformation and relationship competencies would be most 5. Exult quickly won significant add-on contracts, including a $700 mil- lion deal with Prudential Financial Inc. and a $600 million deal with important in light of their particular needs. The research con- International Paper Co. See M.L. Cagle and K. Campbell, “Taking HR firms the value of the “selective” approach we presented in from Cost Center to Revenue Generator at Bank of America” (presen- 1996,8 with the added refinement that multiple relationships tation at the 2002 Outsourcing World Summit, Orlando, Florida, Febru- ary 18, 2002). with a single supplier can be effective. 6. For discussion, see M. Lacity, D. Feeny, and L. Willcocks, “Trans- forming a Back-Office Function: Lessons from BAE Systems’ Experi- ■ The decision to choose a particular supplier (or extend the ence With an Enterprise Partnership,” MIS Quarterly Executive 2, no. relationship with an existing one) should then be guided by a 2 (September 2003): 86-103. thorough evaluation of relevant strengths in the 12 capabili- 7. M. Lacity and L. Willcocks, “Global Information Technology Out- sourcing: In Search of Business Advantage” (Chichester, U.K.: John ties. Capabilities, not skills and resources or brand name, Wiley & Sons, 2001). determine the right choice. 8. Lacity, Willcocks and Feeny, “Value of Selective IT Sourcing.” 9. Feeny and Willcocks, “Core IS Capabilities.” ■ Finally, even with outsourcing it is essential for client firms

to remain involved with business processes rather than step Reprint 46310. For ordering information, see page 1. aside and assume that “it’s now up to the supplier.” The Copyright © Massachusetts Institute of Technology, 2005. All rights reserved.

48 MIT SLOAN MANAGEMENT REVIEW SPRING 2005 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 44 SUPPLY CHAIN Rethinking Procurement in the Era of Globalization

What used to be a matter of finding ver the past 25 years, the role of procurement within companies has changed and purchasing goods dramatically from that of simply buying goods and services to overseeing an integrated set of management functions. Procurement has crept into every aspect and services at the O of management, from category management to managing supplier relationships, contracts most favorable price and payments, and strategy. As companies look beyond short-term costs and the scope has changed. At some of procurement-related issues has grown, procurement professionals are paying more attention not just to what they spend on goods and services but to the broader costs of companies, procurement operating, maintaining and replacing the items and resources they purchase over time. has become closely Despite procurement’s increased level of importance, it has yet to achieve the high-level recognition it deserves. There are two main reasons for this. First, it is often difficult to document intertwined with procurement’s specific contributions: Were the cost savings the result of skillful negotiations strategic decision with vendors or a fortuitous shift in the market? The financial benefits of a favorable procure- making and board policy ment deal often extend beyond the initial purchase price to other aspects of performance (for example, improved working capital or reduced financing costs), so there is more than one at the highest levels bottom line to consider. Second, the line between the responsibilities of procurement and those of the organization. of other stakeholders can be ambiguous. The result: Procurement often shares whatever successes it achieves with other groups; in failure, however, it typically gets all the blame. The need to place procurement in a broader strategic context has become all the more press- Frank A.G. den Butter ing in the current era of increasing globalization. Global sourcing links procurement decisions and Kees A. Linse to strategic decisions. “Make or buy” decisions — for example, whether to move production offshore to your own subsidiaries or outsource it to outside producers and subcontractors — are typically made at the senior executive levels. However, other important decisions (such as where to buy, from whom and under what conditions) are usually handled by procurement professionals. The reality is that these decisions are no longer based entirely on an understand- ing of direct purchase costs or on easily observable transaction costs, such as transport expenses and import duties, but on many other types of transaction costs as well, including those related to cultural, institutional and political differences. In this article, we will explore the role of these other transaction costs in sourcing decisions and offer a new framework for evaluating costs associated with sourcing and procurement in an increasingly globalized market.

The Role of Transaction Costs Traditional economic theory ignored transaction costs and assumed that trade was friction- less. However, trade transactions, by their very nature, involve transaction costs.1 A necessary condition for exchange is that one can commit ex ante to being able and willing to fulfill

Frank A.G. den Butter is a professor of economics at Vrije Universiteit Amsterdam, The Netherlands. Kees A. Linse is director of common infrastructure management at Royal Dutch Shell plc. Comment on this article or contact the authors at [email protected].

76 MIT SLOAN MANAGEMENT REVIEW FALL 2008 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENTSLOANREVIEW.MIT.EDU REVIEW 45 costs resulting from cultural differences and communication failures, knowledge of legal procedures, costs incurred in building trust and reputation, network building, costs asso- ciated with risk (including regulation) and security requirements.3 As distances between trading partners grow and economic, cultural, political and social systems converge in a globalized market, the soft costs become more important and procurement becomes a more strategically important area. Indeed, the ability to purchase goods or services at the lowest possible price is often less critical than developing effective ways of bridging cultural differences and over- coming informal trade barriers.4 However, transaction costs cannot be reduced by deci- sions of the procurement department alone. Because of the wide range of costs and their effects, it requires strategic decisions by top management. As procurement managers look beyond traditional cost considerations, top managers must define their priorities and deal with different cost categories.

Strategic Transaction Management The ongoing trend of globalization has brought about increased movement toward specialization and fragmentation of produc- tion as manifested by growth in outsourcing, contractual obligations ex post. Neither buyers nor sellers will enter global sourcing and direct foreign investments. Dramatic growth into exchange relationships unless they are confident that the other rates in countries with lower production costs (including India and party will fulfill the contractual obligations. The problem can be China) have given rise to a sense of urgency within companies solved in different ways.2 The exchange can be defined institution- operating internationally about how they can continue to create ally (for example, in a legally binding contract), but it can also value through trade. One option is to switch from captive produc- be defined by trust and by providing incentives for trustworthy tion to become a leader in orchestrating production — developing behavior (for example, through bonding networks, where not expertise regarding where to produce, assemble and sell. It requires fulfilling the contractual obligation leads to a costly exclusion from changing the way companies go about managing transactions and the network). how international trade relationships are established. In doing this, This fundamental problem of exchange triggers various types companies can acquire critical knowledge about how transaction of transaction costs, which can vary based on the way the problem costs can be reduced. In fact, it works in two ways. Lower transac- is solved. Practically speaking, transaction costs consist of all the tion costs will enable further fragmentation of production and costs incurred in the course of acquiring goods and services, either outsourcing of specialized tasks because they make outsourcing by exchanging property rights in a market transaction or by profitable.5 At the same time, enhanced knowledge about the costs exchanging responsibilities: all the expenses and time spent coor- of outsourcing (in particular, knowing when outsourcing isn’t dinating the purchase of goods and services. The “hard” costs profitable due to unexpectedly high soft transaction costs) can lead are relatively easy to quantify — they relate to items such as trans- to further reductions in transaction costs. port charges, import levies and tariffs. “Soft” costs, on the other Knowledge of transaction costs is a critical part of trade and hand, are less accessible and less clearly defined. They include investment decisions. It allows companies to reduce their overall the costs of creating and checking contracts, information costs, costs, thereby making existing trade more profitable and opening

SLOANREVIEW.MIT.EDU LESSONS IN OPERATIONS MANAGEMENTFALL 2008 • MITMIT SLOAN SLOAN MANAGEMENT REVIEW REVIEW 7746 SUPPLY CHAIN the door to higher volumes of trade. Knowing how to keep trans- Transaction Management for Procurement action costs low is something we call transaction management. Procurement professionals have an essential role to play in Effective transaction management can create value for both managing the complex interface between companies and stake- individual companies and society as a whole. holders to maximize value. In today’s transparent global As transaction costs are reduced, they become a smaller part of economy, procurement managers will not only have to identify the total supply cost in current trade. But there are compelling rea- and manage the different sources of transaction costs. They will sons for companies to remain focused on this area. Good transaction need to do this in areas where they have varying degrees of management and lower transaction costs will increase the number control or influence. To assist management in understanding its of profitable trade transactions and lead to further fragmentation cost exposure, it is helpful to consider transaction costs along of supply chains. In the process, production processes will undergo two dimensions: (1) in terms of objective and subjective issues changes; with increased outsourcing, there will be fewer direct and (2) in terms of internal and external influences. production costs and more transaction costs. On balance, new trade (from outsourcing more parts of the supply chain) will have Objective and Subjective Issues Objective issues are tied to measur- higher transaction costs in relation to the total supply costs. able factors and are of a technical or professional nature. They The strategic character of transaction management is high- are usually linked to financial issues such as direct costs, improved lighted by the fact that institutions, including the legal quality, on time delivery, transportation cost and life cycle cost. infrastructure, the banking system and the regulatory and politi- Subjective factors, by contrast, are related to emotional, religious cal systems, are all highly influential in how transactions are or intuitive views of the world and how it connects with the orga- managed. Different institutions shape transactions in different nization. Although not overtly related to finance, such issues (for ways — for example, whether the transactions are handled for- example, unethical business behavior, diminished confidence in mally (with legal contracts) or informally (through trust-based a brand or adversarial labor relations) can result in significant relationships). Although globalization has spurred significant transaction costs and have major financial implications. convergence in the institutional environment, cultural, legal and social differences continue to be barriers in some countries and Internal and External Factors By internal factors, we mean factors regions. For example, the trading norms that are accepted in related to the specific business: its market position and its continental Europe and the English-speaking world do not reputation and brand. These are distinct from external factors, always line up with how things are done in the Middle East and which are tied to developments outside the company in areas Asia. For managers seeking to reduce transaction costs, under- such as regulation, labor costs and currencies. standing the cultural, legal and social differences is critical. The combinations of internal, external, objective and subjective factors create a complex spectrum of exposures that can affect the financial health of a company, if not its very existence. In a global economy, knowing the risks and opportunities of the different About the Research exposures is a critical management competence. (See “Classifica- tion of Costs in Procurement.”) Although management decisions This research combines two different perspectives: govern- will originate in many different parts of the company, procurement ment policy making and corporate decision making. Prof. managers will need to keep a close eye on the various cost expo- den Butter was responsible for the report “The Netherlands sures and flag concerns as they arise. Procurement, therefore, will As a Trading Nation,” published in 2003, which recom- need to become more closely connected with strategic decisions mended increasing trade through low transaction costs.i throughout the company. As formal trade barriers disappear, the report pointed out, Companies strive to minimize the total cost of ownership. soft transaction costs will become increasingly important, Based on our analysis of cost factors, the total cost of ownership requiring countries to make knowledge investments. Dr. consists of: Linse, who organized a conference for procurement officers 1. The direct cost of acquisition, which is the original pur- in late 2007, worked with Prof. den Butter to evaluate how chase cost areas such as sustainable development and ethical behavior 2. The further cost, which is related to owning the equip- should be reflected in transaction costs. ment or business, such as installation, maintenance, energy

i. Scientific Council for Government Policy (WRR), “Nederland Handelsland: het consumption, disposal, etc. Perspectief van de Transactiekosten (The Netherlands As a Trading Nation: The Transac- 3. All transaction costs related to acquisition and further cost tion Costs Perspective),” “Reports to the Government” no. 66 (The Hague, Netherlands: Sdu Uitgevers, 2003). The direct cost of acquisition and the further cost are the two factors that typically drive purchase decisions. They are largely

78 MIT SLOAN MANAGEMENT REVIEW FALL 2008 LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENTSLOANREVIEW.MIT.EDU REVIEW 47 Classification of Costs in Procurement

The table lists the various types of costs that managers of global companies need to consider in making procurement decisions. It emphasizes the role of transaction costs, especially “soft” transaction costs. Such costs are becoming increasingly important and have made procurement an essential part of strategic decision making.

Objective (“Hard”) Factors Subjective (“Soft”) Factors Internal Factors External Factors Internal Factors External Factors (decisions within (decisions controlled (decisions within (decisions controlled company control) by others) company control) by others) • Search and information • Legislation in relation •The effects of sourcing • Sustainability considerations costs connected with to trade decisions on existing jobs in relation to local and global identifying suppliers •Currency effects •The effects on reputation economic environments •Direct costs of acquisition • Import/export permits, and brand value • Cultural differences con- •Transport costs levies •Corporate culture: Will staff nected with doing business •Quality assurance • Labor costs and safety support new suppliers? • Political differences concern- ing democratic rights, •Installation and standards •Sustainability trade-offs inside the company distribution of wealth, maintenance costs • Government rules and unions and political stability •Intellectual property costs regulations •Risk aversion: Will staff be able to deal with the risks • Customer views on desirable •Training associated with new supply sources/suppliers options? •Labor circumstances •Environment

related to objective costs (as noted in “Classification of Costs in Optimization Once the transaction costs are known, the Procurement”). The first step in extending the purchaser’s deci- challenge is figuring out how to optimize them in relation to the total sion framework is to identify transaction costs as a cost category cost of ownership. This means knowing where costs can be mini- that needs to be managed separately. The second step is to give mized and knowing where they are necessary to achieve optimal subjective costs the same level of attention as objective costs. procurement results. For example, transaction costs may be accept- Finally, purchasers must acknowledge that many of the soft issues able in a situation where innovative or key strategic goods or services do not just operate within the decision framework of procure- of very high value to the company are being procured and where ment but are integral to the strategic position of the company; security of supply is of prime importance. On the other hand, for hence they need to be addressed by a wider management group. routine or commodity goods or services, the cost is of prime impor- An alternative way to view procurement is to look at the tance and transaction cost will need to be avoided or minimized. day-to-day activities procurement professionals manage. (See “Transaction Costs By Stage of Procurement,” p. 80.) This adds Compliance Even if transaction costs are properly identified for the time dimension of decision making to our objective/subjec- every stage of the procurement life cycle, their benefits may not be tive and internal/external framework. However, it would be a realized due to noncompliance during the implementation of the mistake to conclude that the day-to-day activities will reflect the acquisition process. In today’s global market, compliance manage- variety of transaction costs covered by our framework. In par- ment is more important than ever. ticular, procurement professionals must be prepared to address issues of accountability, optimization and compliance to ensure Managing the Soft Side of Procurement that transaction costs are identified and properly addressed. The importance of detailing and managing hard costs on a category-by-category basis cannot be overstated. However, a Accountability Procurement professionals need to assume major part of the globalization challenge is figuring out how to accountability not only for purchasing but also for managing conduct business both profitably and ethically, which requires a the complete transaction. Although procurement specialists more comprehensive understanding of how to manage the soft are often familiar with various types of transaction costs, issues (for example, the trade-offs between the environment and many lack a full appreciation of the effects some costs have on profits). Decisions to source products offshore — for example, the overall economics. outsourcing parts production and services — often lead to higher

SLOANREVIEW.MIT.EDU LESSONS IN OPERATIONS MANAGEMENTFALL 2008 • MITMIT SLOAN SLOAN MANAGEMENT REVIEW REVIEW 7948 SUPPLY CHAIN transaction costs than originally expected. This has implications Different companies will make these decisions in different ways, for regional employment and economic growth because these depending on how they value the risk and costs of a reputation transaction costs may affect the profitability of outsourcing and loss and how managers are emotionally or politically positioned reduce economic activity. It may, moreover, lead to social unrest in relation to these issues. at home and a loss of trust in the company, which can give rise to a new set of transaction costs. SENIOR MANAGERS AT global companies need to recognize that the Decisions to address issues of environmental sustainability role of procurement professionals is changing. What used to be a in a responsible way or to create attractive working conditions matter of finding and purchasing goods and services at a favorable for employees may result in higher transaction costs in the price has become closely intertwined with strategic decision short term (in the form of higher production costs or more making and board policy at the highest levels of the organization. expensive training). In the long run, however, these investments Global sourcing creates many new opportunities for value creation, may lead to lower transaction costs (resulting from a good which well-run companies must learn to take advantage of. reputation and the ability to attract the most motivated work- ers). Therefore, in balancing the trade-offs between short-term REFERENCES and long-term costs, ethical corporate behavior can be rational. 1. Ronald Coase, winner of the Nobel Memorial Prize for economics in 1991, introduced the concept of transaction costs in economic theory: See R.H. Coase, “The Nature of the Firm,” Economica 4 (1937): 386-405; Transaction Costs By Stage of Procurement and R.H. Coase, “The Institutional Structure of Production,” American Economic Review 82, no. 4 (September 1992): 713-719. Nowadays, transaction cost economics has become a major field: See O.E. William- Transaction costs can be grouped into three categories that are son, “Transaction Cost Economics: How It Works; Where It Is Headed,” De Economist 146, no. 1 (1998): 23-58; and D.C. North and J.J. Wallis, “Mea- aligned with potential trade transactions: costs associated with suring the Transaction Sector in the American Economy, 1870-1970,” in contact, costs associated with contract and costs associated “Long-Term Factors in American Economic Growth,” ed. S.L. Engerman with control. and R.E. Gallman (Chicago: University of Chicago Press, 1986): 95-161.

Contact In the contact phase, the buyer seeks information 2. Greif elaborates the fundamental problem of exchange by showing how about the preferred product (price and quality), potential various institutions provide different solutions to the problem. That brings suppliers, or, if the product does not yet exist, which producer about different types of transaction costs: See A. Greif, “The Fundamental might be able to develop and/or produce it. The seller devotes Problem of Exchange: A Research Agenda in Historical Institutional Analy- marketing effort to looking for a buyer. At this stage, the sis,” European Review of Economic History 4, no. 3 (December 2000): 251-284. For instance, the belief that the contract will be fulfilled may stem transaction costs are mainly for search and information. from a formal legal obligation, but it can also be based on the reputation of However, they are sunk costs — occurring even if a trade trustworthiness of the trading partner. In the first case, transaction costs will relationship (purchase) is not established. mainly depend on the quality of the legal system, and in the second case Contract The contract phase starts immediately after the they will depend on the bonding of the trust relation. potential trading partners have found each other and begun 3. A particularly noteworthy factor on the “soft” side of procurement working toward a deal. The costs in this period revolve around is trust. On one hand, building trust and developing a reputation negotiating the terms of the contract. Parties have to decide require investment, which leads to higher transaction costs. However, how to divide expected rents of the transaction and how to once suppliers and clients have established trust, they can anticipate protect their respective interests. lower transaction costs. Building trust and encouraging trustworthy behavior also has benefits for society as a whole, creating positive Control The control phase involves monitoring and enforcing externalities. Damaged trust and reputation not only hurt companies in the contract. Both monitoring and enforcement involve high the form of high transaction costs; they harm society as a whole. See F.A.G. transaction costs, especially when large distances separate the den Butter and R.H.J. Mosch, “Trade, Trust and Transaction Cost,” dis- cussion paper TI 03-082/3, Tinbergen Institute, Amsterdam, Oct. 13, 2003. trading partners and suppliers from each other. Now that physi- cal distances have become less important through reduced 4. Informal trade barriers relate to red tape, tacit knowledge of how transportation costs and fast communication, cultural and institutions work, uncertain and hazardous interpretation of rules and institutional distances can be large. Business partners need regulations, etc. to monitor the terms of their agreements to verify whether the 5. In this respect, Grossman and Rossi-Hansberg argue that the theory other party is doing what it promised to do. If there are prob- of international trade should consider the comparative advantages of lems, the next step is enforcement of the contract. The most trade in tasks rather than of trade in products and services: See G.M. common response is to start a legal procedure. Especially in Grossman and E. Rossi-Hansberg, “Trading Tasks: A Simple Theory international trading relationships, legal actions take both time of Offshoring,” NBER working paper W12721, December 2006. and money. Moreover, foreigners often have difficulties in national courts when they file claims against a local company. Reprint 50117. Copyright © Massachusetts Institute of Technology, 2008. All rights reserved.

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