The Impact of Incentives When Outsourcing

As companies have outsourced more supply chain activities, it has become harder to align the goals of all parties involved. The misalignment of incentives often hurts supply chain perfor­mance. The $2.5 billion writedown of inventory by Cisco in 2001 is an example of the cost of misaligned incentives. Cisco outsourced production to contract manufacturers and rewarded them for rapid deliveries. The suppliers stockpiled semifinished products for Cisco because the availability of this inventory allowed suppliers to react quickly during an extended period when demand had exceeded supply. When demand slowed in 2000, it took a while before the inflow of components could be curtailed. A reward for rapid deliveries without any negative consequence for inventories led suppliers to build $2.5 billion of inventory, which became useless when demand slowed. This example is a cautionary tale of the importance of understanding the impact of incentives in a supply chain. Understanding the impact of incentives is important whenever the third party’s actions are not fully observable or when the third party has information that is not available to the firm. In either case, it is difficult to design incentives that induce the third party to do what is right for the supply chain.

A good example of the lack of visibility of the third party’s actions arises in the automotive supply chain. Consider the case in which Chrysler sells cars through a dealer. The dealer is an agent acting on behalf of the auto company, which is referred to as the principal. The dealer also sells other brands and used cars. Every month, the dealer allocates its sales effort (e.g., sales people, promotions) across all types of cars it sells. Earnings for Chrysler are based on sales of its brands, which in turn are affected by the effort exerted by the dealer. The challenge in this setting is that although Chrysler can observe sales directly, dealer effort is hard to observe and measure. Thus, when sales are high in a given month, it is difficult for Chrysler to infer whether the increase resulted from better market conditions or greater sales effort. In general, Chrysler would like to encourage greater effort from its dealers.

It is well known that incentives offered by the principal can encourage greater effort from the agent. Well-designed incentives can be strong communicators of desired performance. Poorly designed incentives, however, can backfire and hurt supply chain performance. A commonly used performance incentive sets “thresholds” for minimum performance below which there are no rewards. Chrysler offered such an incentive to its dealers in the first quarter of 2001. The rough structure of the incentive was as follows: Dealers would keep the margin made from cus­tomers if sales for the month were less than 75 percent of an agreed-upon target. However, if sales reached or exceeded 75 percent but were less than 100 percent of the target, the dealer would get an additional $150 per car sold. If sales reached or exceeded 100 percent but were less than 110 percent, the dealer would get an additional $250 per car sold. If sales reached or exceeded 110 percent of the target, the dealer would get an additional $500 per car sold. Chrys- ler’s hope was that by increasing the margin for higher thresholds, the dealer would have an incentive to increase effort on sales of Chrysler cars.

In the first month after the new contract was announced, the U.S. car industry saw a decrease in sales. Chrysler, however, saw sales drop by twice the industry average. There are three potential causes for this behavior, all related to the structure of the incentive. First, the tar­get set may have been too high. Given that the target was not achievable, dealers decided to sup­press effort. Second, under the incentive, the dealer makes more money selling 900 cars one month and 1,100 the next month compared with selling 1,000 cars each month. The dealer has an incentive to shift demand over time to achieve such an outcome, thus increasing information distortion and observed demand variation. The third cause is that within the first week of the month, the dealer has an idea of the threshold range it is likely to reach. For example, if the dealer believes that it can easily cross the 75 percent threshold but has little chance of crossing the 100 percent threshold, it will decrease its effort for the month and save it for later, because the marginal benefit of selling an additional car is only $150. In contrast, if demand for the month is high and the dealer believes it can easily cross the 100 percent threshold, it is likely to exert addi­tional effort to reach the 110 percent threshold because the marginal benefit from reaching that threshold is high. Thus, Chrysler’s incentive increases variation in dealer effort, further exagger­ating any existing market variation.

The following approaches can help dampen the distortion introduced by threshold incen­tives such as Chrysler’s. It is important to ensure that the target set is not too high or too low because the dealer reduces the effort exerted in either case. Even when the target is set fairly, a problem arises if the target is a fixed number that does not vary with market conditions. A rea­sonable target may become too easy if the market is strong and too difficult if the market is weak. It is better to set a target that adjusts based on market conditions. The challenge, however, is to identify market conditions. One approach used is to adjust the target after sales are observed, based on average sales across all dealers. Thus, when the auto market was down by 8 percent (industry sales are a good measure of market conditions), Chrysler could have lowered the target for its dealers by the same amount. Assuming the original target was fairly set and the dealers were aware of the planned adjustment of the target based on market conditions, they would have continued to exert steady effort. Threshold incentives for which the target is adjusted based on market conditions are more likely to result in steady effort from the third party.

Information distortion is also observed in threshold incentives offered by companies to their sales staff. Under these incentives, staff is offered rewards for crossing sales thresholds during a specified period of time (e.g., a quarter). The problem observed is that sales effort and orders peak during the last few weeks of the quarter, as salespeople try to cross the threshold. This pattern, in which sales peak close to the end of the evaluation period, is referred to as the hockey stick phe­nomenon. This information distortion arises because the incentive is offered over a fixed time period, making the last few weeks of each quarter a period of intense activity for all sales staff.

One approach that firms can take to address the hockey stick phenomenon is to offer threshold incentives over a rolling horizon. For example, if a firm offers its sales staff weekly incentives based on sales over the past 13 weeks, each week becomes the last week of a 13-week period. Sales effort thus becomes more even compared with when the entire sales staff has the same last week for their bonus evaluation. Given the presence of enterprise resource planning (ERP) systems, implementing a rolling horizon incentive is much easier today than it once was. Another approach to address this issue is to recognize that although higher sales benefit supply chain performance, higher variation of sales hurts performance. Incentives can then be designed to reward total sales over a given time period while punishing variation of sales. Even though designing incentives that account for multiple dimensions of performance is difficult, it is impor­tant if the goals of the third party and the firm are to be aligned.

Source: Chopra Sunil, Meindl Peter (2014), Supply Chain Management: Strategy, Planning, and Operation, Pearson; 6th edition.

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