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Squeezing Supply Chains

If one were looking for evidence of structural evolution in an organization where would one look? Well according to Narayanan and Raman (2004) one wouldn’t look at their supply chain – or at least not very closely. “Most companies don’t worry about the behavior of their partners while building supply chains . . . Every firm behaves in ways that maximize its own interests, but companies assume, wrongly, that when they do so, they also maximize the supply chain’s interests” (¶ 4).

Narayanan and Raman (2004) look at the impact of incentives on supply chains and how structuring the right deal can make or break a company’s competitiveness. Cisco, for example, ended up writing off over $2.5B in inventory as a result of sloppy deal with its suppliers in April 2001 (¶ 1). Campbell’s lost control over their ability to normalize production due to discounts offered to distributors who used the opportunity to forward purchase rather than passing the incentive onto their retailers (¶ 27).

These examples provide both good and bad examples of structural evolution at work. Scott (2003) notes of the impact of structural evolution by observing “Weick rejects the notion that evolution necessarily entails improvements in the surviving forms. He points out that successful interlocking of behaviors (that is, organized patterns of action) ‘can occur without any necessary increase in the productivity or viability of the system’ (1979: 179)” (p. 115). Such is the case with Campbell and Cisco. Scott also notes however that

Evolutionary theories assume that change occurs through a continuous cycle of variation, selection, and retention. New elements such as rules or routines arise through random change; selection occurs primarily through the competition for scarce resources, and retention preserves them through some type of copying or reproduction process. (p. 181)

Again, no more so is this readily apparent than in supply chain management. From looking at the examples provided by Narayanan and Raman (2004), it seems apparent that while there are a myriad of ways organizations can be structured the same does not seem to be true for supply chains. This is mainly attributable to three factors

  1. Lack of transparency between the partners,
  2. Lack of key information or shared knowledge between the partners, and
  3. Badly designed incentive schemes.

Also, supply chain management, since it is seldom under the direct control of a single organization, becomes a game of trial and error that follows Weick’s three phases of evolution: variation, selection, and retention (Scott, 2003, p. 98).

One of the key issues influencing this evolutionary process is the level of trust that must be built up between the various partners. Suppliers to the auto industry, for example, are reluctant to be transparent with their financial data for fear of being pressured to reduce margins. The same can be said for a number of other industries and firms including those mega distributors such as Wal-Mart. The problem can be summed up in a single question: who receives the spoils of the surplus produced when margins are squeezed?

From an outside perspective, the Wal-Mart mentality could be summed up as “if you price it right, it will sell”. Price becomes a major competitive edge for mega distributors. But price isn’t always a deciding factor for the consumer. So is it in a supplier’s best interest to produce $3M in widgets with a ROI of 12% or $12M with a ROI of 3%?

By the mega distributor’s standards, producing more for less is good business practice. However from the supplier standpoint this increase in volume is accompanied by an increase in risk to the firm. If there is no corresponding financial offset the benefits of producing more may put it at a strategic disadvantage. There needs to be some surplus available to mitigate chance shocks to the organization. Distributors that squeeze their supplier’s margins in this way while keeping their own margins intact are therefore reaping the benefits that should, in part, rightly go to the supplier.

It would seem then that Narayanan and Raman (2004) utopia of supply chain management is a near impossible state to achieve. Negotiation of supplier relationships must take into account the fair and equitable distribution of profit surpluses across the entire value chain and not simply between the supplier and the distributor. Those negotiations must balance the opportunity for profit with the opportunity for increased markets, provide a reasonable benefit, and minimize the risk inherent in such systems. The evolutionary approach to negotiation of supply chains becomes important therefore as buyers don’t necessarily want to lose good suppliers and suppliers don’t want to lose markets for their goods. The true competitive advantage of supply chains however can only come about when all the partners have transparency and influence across the entire value chain.

Kevin Feenan
Managing Director
Knomaze Corporation

References

Narayanan, V.G. & Raman, A. (2004). Aligning Incentives in Supply Chains. Harvard Business Review, October 2004. Retrieved on January 20, 2005 from http://harvardbusinessonline.hbsp.harvard.edu/b01/en/hbr/hbrsa/current/0411/article/R0411F.jhtml

Scott, W.R. (2003). Organizations: Rational, natural, and open systems (5th ed.). Upper Saddle, NJ: Prentice Hall.

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