V Pattabhi Ram and A V Vedpuriswar
Wafers had attended the morning class on “Just in time” (JIT) management. The good professor had sounded out that the world had long ago moved out of the EOQ model and was today dating JIT. Wafers wasn’t willing to buy that argument. Her logic was simple: In JIT, the manufacturer was merely pushing his problem on to the supplier who in turn was pushing it on to his supplier. The buck had to stop somewhere. Wafers did not have the heart to voice her concerns to the professor because the class was too busy cracking some quantitative problem on JIT.
That evening as the gang met up at the Chennai Coffee Pub, she aired her concerns to China, her smart pal who studied at IIT. “Oh, you mean the crisis on the supply chain front,” he cracked. “Wow! These guys can give fancy names to mundane stuff” thought Wafers. She did not know what she was getting into. At the end she would realize that she hadn’t really bargained for what was to follow. China explained, “You are right. A supply chain must be very responsive to changes in market demand. Otherwise companies can be left with unsold inventory which may severely dent the bottom line.” China had read Wafers’ mind. It stumped her no end.
Rinku, the journalist, looking disheveled after chasing a breaking story, quoted the case of a global company famous for its supply chain management. “In April 2005, the company had surprised the world, when it wrote off a whopping $4 billion dollars of surplus raw materials. It was amazing that the global major had misread demand by such a mile.
China explained how the trouble had arisen: “The problem lay in the behavior of the supply chain partners. The company out-sources a massive part of the production activity to contract manufacturers. Before the crisis erupted, the contractors had piled semi-finished products because demand for the company’s products had always exceeded supply. Remember, the company rewarded the contractors for prompt delivery. So the contractors had an incentive to build buffer stocks. Many contractors did bulk purchases from component suppliers to pick volume discount and thereby increase their profits. Therefore, both the contractors and component makers had everything to gain by building excess inventory.”
When demand slowed in 2005, the problem which had remained hidden so long, now surfaced. Most contractors simply assumed that the company would buy everything they could produce. Since the company had not stipulated the responsibilities of its contractors and component suppliers, much of the excess inventory ended up in the company’s warehouses. The company landed in trouble because its partners acted in ways that were not in the best interests of the supply chain.
Rinku took over to explain the lessons. “While building supply chains to deliver goods to consumers, one must understand the behavior of the various firms in the chain. Every firm seeks to maximize its own interests thus undermining the functioning of the entire supply chain. The risks, costs and rewards of doing business must be distributed fairly across the network. Misaligned rewards cause excess inventory, stock-outs, incorrect forecasts, inadequate sales efforts and sometimes poor customer service.”
China explained that incentive-related issues arose in supply chains arose mainly because incentive schemes were also badly designed. He then decided to illustrate with an example.
“There is this ferroalloy exporter operating from Visakhapatnam port. The ferroalloy is manufactured at a factory 150 km away from the port. Movement of the ferroalloy takes place by truck. This job is outsourced to a transporter who hires trucks. The transportation contract is fixed on a per ton basis which would be unaltered for a year. The transporter, however, goes into the market daily and hires trucks based on the prevailing market rate. If the rate is not lucrative, he doesn’t hire any truck. Because of the inability to move cargo, shipments get delayed. So it makes sense for the exporter to pay the transporter on the basis of a spot rate plus mark up”.
“But truck contracts are never structured this way because there is lack of trust. Like, there are difficulties in verifying the rate at which the transporter places the truck. So managers want to play it safe and offer long term contracts.” As China sipped into his 4th cup of coffee, Rinku took over. “A second point is that since transporters are paid on a per ton basis, they have no incentive to place a truck if there is a part load. This is because the truck owner (the third one in the supply chain) will charge for a full truck even if it is only partially loaded. So the transporter doesn’t carry out the customer’s instruction to hire trucks immediately. Rather, he would wait for a few days to ensure that enough stock has accumulated.”
Wafers asked, “How does one crack the conundrum?” China replied, “Firstly companies must acknowledge that there is misalignment in incentives. They must then redesign incentives to obtain the behaviour they desire from their partners. Only managers who understand the motivations of other companies in their supply chain can tackle incentive-related issues. Since alignment also requires an understanding of functions such as marketing, manufacturing, logistics, and finance, senior managers must get involved in the process”.
Wafers wasn’t convinced: “But how do you think alignment of incentives is possible?” Rinku responded, “Contracts can be framed that reward or penalize partners based on outcomes. Thus transporters can be penalized heavily if they do not place trucks on time and rewarded handsomely if they do so.”
Wafers wasn’t sure whether she was any the wiser but realized that there was a lot more to business than what her CA program had taught her.