Are we harming Supply Chain Relationships by Jumping to Conclusions?

Many of us I’m sure have been involved in interviewing potential new employees and have been told that we should make sure we don’t jump to conclusions about their suitability in the first five minutes of the interview. I’m also equally sure, that many of us have in fact made up our minds in the first few minutes of the interview. But is this a bad thing; many of those hires that we made based on the first five minutes of the interview probably turned out to be okay. Is the same propensity to jump to conclusions at play when we are looking at potential supply chain partners? In setting up new arrangements with supply chain partners we spend a lot of time engaged in data gathering and analysis. But as with the employee interviews are we just reinforcing our first impressions?

In looking at the problem of people going with their first impressions behavioural scientists conducted a study where they compared the accuracy of lay people versus trained psychologists in looking at very short videos of people with scoulrophobiaome form of psychosis plus a control group. These short episodes of information were called “Thin Slices”. What they found when comparing the lay people with the trained psychologists was that the lay people were very close to the experts in their ability to detect the psychosis. This accuracy was increased where the person in the thin slice was likely to be a source of potential harm to the assessor in the real world. This might be the basis for coulrophobia otherwise known as the fear of clowns.

So how does the concept of thin slices relate to us in the business world? Further research has been done into predicting the outcome of negotiations and interestingly it has been found that similarly to interviews participants in a negotiation are able to predict with some accuracy within a very short period of time whether the negotiation can reach a successful conclusion. Again people were found to be able to make reasonable assessments based on very scant information. So perhaps the warning not to jump to conclusions too early in the supply chain relationship is not such a good suggestion. In fact we should make sure that we are paying particular attention in the first moments of an interaction with a new supply chain partner. Those first feelings may very well prevent us from investing too much time where success is not likely. At the same time we should properly take advice from President Reagan and his statement “Trust, but verify.”

But what is meant by verify? There are a number of elements that we should consider in verifying whether somebody is a good fit as a supply chain partner. Firstly do you share common objectives with the potential partner, is there a good cultural fit and importantly do you have a common view of how the benefits to be gained from the relationship will be shared? So first impressions are probably a good filter for removing those that wouldn’t make a good partner; however a lot more work must be put into building the relationship so that it is protected from opportunism and simple failure through neglect. A good model to consider is the Vested Outsourcing approach to developing collaborative and outcomes based relationships (www.vestedway.com).

If you would like help with setting up collaborative and outcomes based relationships (Vested) then don’t hesitate to contact us at andrew.downard@adsupplychain.com.au or call +61 (0) 419581705.

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Creative Destruction and Business Relationships

In previous blogs I have argued that better and more collaborative relationships with your business partners are a relatively untapped source of competitive advantage.  If this is the case, why would we need to consider bringing a close and collaborative relationship to an end?  There are several reasons, not the least of these is that ‘business happens!’ We may have every intention to continue the relationship but circumstances make it redundant.  While we might mourn the loss of a great business relationship, the story is not all negative.

Firstly the macro story, the term ‘creative destruction’ was coined by the economist Joseph Schumpeter (1942) to describe the incessant product and process innovation activities where out-dated production methods are replaced by newer and more efficient ones.  It has been stated that ‘creative destruction’ accounts for over 50% of productivity growth.  The destructive process acts to free up the factors of production so that they can be used in the newer and more efficient processes.  If the process of creative destruction is held back, by labour market regulation for example, then this imposes a cost in forgone efficiency on the economy.

It is easy to see the same mechanism at play in business relationships.  Should partners persist in retaining an outmoded relationship, they will suffer a decline as a result.  Take for example an arrangement where a customer for steel components is facing a market where lighter and lower cost plastic components are entering.  Even if the relationship is a long and close one, it is in both parties’ interests to bring it to an end.  The customer, if persisting with outmoded steel, will likely lose market share and potentially fail.  The supplier will retain the diminishing business with the customer and will likely miss the opportunity to seek out new markets and customers as they work to support their long term customer.  Both would benefit from a managed end to the relationship and a focus on realising new opportunities.

In the above example, the situation put forward is one where the decline is already underway with the entry of plastic components.  Sometimes businesses or even industries face the situation where the most ‘sensible’ thing is to destroy a competitive advantage before it is under threat.  This proposition has been put forward by Clayton Christensen in his book “The Innovator’s Dilemma”.  In essence what Christensen is saying is “destroy your competitive advantage before somebody else does!”  This approach can be very disruptive to a business and its factors of production but even more so to suppliers, particularly when things are going well and there are no signs of decline.

It is therefore clear that such changes must be well managed, not only for the suppliers who must continue, but also those where the relationship is to come to an end.  Managed badly, the ending of the relationships can lead to resentment, legal action and perhaps difficulty in forming or maintaining relationships in the future because of a tarnished image.

So when is the right time to work on the exit management plan for a business relationship?  Somewhat paradoxically, the best time is when the relationship is being formed.  At this time the nature of the relationship is being discussed and a clear eyed view can be taken of how the parties might untwine themselves in the most sensible way.  Recognising this, the Vested® team at the University of Tennessee have included the creation of an exit management plan as Step 9 in their ten step model for creating a truly collaborative Vested* agreement.

The ‘exit management plan’ covers a wide range of issues.  In their book “The Vested Outsourcing Manual” the authors provide a model that can be used as an aid in creating this plan.  The first element is rules around notice of termination.  Ideally the agreement between the parties will have eschewed the lazy “termination for convenience” clauses and given thought as to what conditions would bring the agreement to an end.  These conditions would include persistent service failures but also the “business happens” issues mentioned earlier.  The termination notice would also be defined as to how it is communicated and the details that it contains.  For example, the notice might not cover all the business between the parties, just the portion affected by external events.

Once delivered, the termination notice triggers the remaining elements of the plan.  In putting together the plan the partners would have agreed on a workable exit transition period.  This is because just like when you start a new piece of business, it takes time to wind down.  The work to be completed during the transition period may include:

  • ·         Program management processes
  • ·         Due diligence issues
  • ·         Continuity plans
  • ·         Facilities, tooling or systems handover
  • ·         Human resources issues/transfers
  • ·         Response time agreements for queries
  • ·         Co-ordination with third parties
  • ·         Timelines, responsibilities and communication plans.

As with any well founded business process there should be a governance and reporting  process that engages the right people in monitoring the execution of the ‘exit management plan’.

The next element while developing the plan is to discuss what the parties agree to do if the relationship suffers a catastrophic failure, a complete relationship breakdown.  This is tough to do at the beginning of a relationship but it is easier done then than when things have spiralled out of control.  Again this should be more than agreeing on the legal jurisdiction.  It should ideally be a graduated response that moves through good faith negotiations, mediation and arbitration.  Only when this has failed should the courts be engaged (accepting the fact that legal action can be triggered at any time during a relationship).

The final point to make is that the exit management plan is more than an expression of good intent.  It is a detailed plan (likely based on the transition plan into the business) that can actually be used to transition out of the business.

So, do your agreements include an operable exit management plan?  Should you be sitting down with your most important trading partners and developing such a plan today?

If you would like help in developing an effective ‘Exit Management Plan’, or want to find out more about Vested then contact us at andrew.downard@adsupplychain.com.au or call +61 (0)419 581 705.

 

Posted in Performance Improvement, Supply Chain Best Practice, Supply Chain Collaboration, Supply Chain Innovation, Supply Chain Relationship Management, Supply Chain Risk | Leave a comment

Was Ford Australia making Dumb Decisions or were they just being too sophisticated?

There has been a lot of froth and bubble recently about the dumb decisions, particularly about model choice, that Ford management in Australia has made that has resulted in the decision to close manufacturing operations in 2016.  I recently saw a YouTube video of a Clayton Christensen (http://www.youtube.com/watch?v=35z03U3wugs ) lecture that might justify the opposite being true!  Christensen believes that some of our current problems with fighting our way out of the GFC cam be slated home to the overly sophisticated way that we measure a firms’ performance.  In particular, he questions the use of measures such as ‘Return on Capital Employed’ in a world where the cost of capital is approaching zero.

 Christensen tells the story of the decline of the Integrated Steel Mills in the USA where the ‘mini mills’, who remelted scrap, had a 20% cost advantage over the traditional integrated mills.  At first the only product that the mini mills could produce was reinforcing bar for concrete construction.  With a cost advantage, the mini mills took market share which the integrated mills were glad to give up.  Their sophisticated analysis told them that they were better off exiting the reo bar business because it made their company performance look better.  Once the market for reo bar was only made up of mini mills there was an immediate drop of about 20% in the price for reo bar.  Christensen points out that for a ‘low cost’ strategy to work you need a ‘high cost’ competitor!  The mini mills were obviously looking for the next steel commodity to target to improve margins.  This required a step up in quality which was achieved with an approximate 20% cost advantage.  The integrated mills gladly gave up this next category because their sophisticated performance measurements showed they were better off exiting.  Once the category was only supplied by mini mills there was an immediate 20% drop in prices, which provided the incentive for the mini mills to target the next steel category.  This pattern continued until the integrated mills became unviable and exited steel production entirely.

So how does this relate to Ford in Australia?  Firstly some points about the direct costs of producing large cars and small cars, direct costs being the assembly, labour, components and raw materials.  It may surprise some but the direct cost to product a large car versus a small car of similar specifications may be measured in the hundreds of dollars, not thousands.  Yet the large car can be sold for $10,000 to $15,000 more – a welcome contribution to margin!

Faced with making a decision on where to apply their capital, Ford would find it hard to go past a decision to build the large car.  Their sophisticated measures would have made it clear that this was the ‘smartest’ decision (making a decision that flew in the face of the sophisticated measures was unlikely, they probably used up all their favours just to be allowed to continue building cars in Australia).

Ford, like the integrated steel mills, was also trapped by their specific investments in this market.  Based on my experience at Nissan Australia when we closed down manufacturing, I would estimate that this move will cost Ford in the order of $1.5 billion to their bottom line in direct costs and write-offs.  Again, based on the Nissan Australia experience, market share is likely to drop to around 4% to 5%.  This of course is very bad news for dealerships and Ford back office people.

So, using Christensen’s theory, Ford was not making dumb decisions, but rather being too sophisticated in their analysis.  Perhaps an old fashioned bottom line profit analysis might have led them to a different decision!

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Zen and the Art of Negotiation

It is always worth recalibrating yourself regarding your approach to negotiation on a regular basis.  Regular negotiation training is a useful way to do this but a simple period of introspection can deliver the same value.  This was brought home to me recently when someone re-told the ‘Story of the Orange’ and how it describes the difference between ‘Positional’ and ‘Interests’ negotiation strategies.  For those that need reminding, the story goes something like this:

Jenny and Jimmy are arguing about who should get the last orange.  The ‘negotiation’ was being conducted on a ‘Win/Lose’ basis where one of them was going to miss out.  Each presented their ‘Position’ as being the only acceptable solution, ie “I get the orange”.  Even if they bring in an arbitrator (Mum) the result from a positional negotiation strategy is either Win/Lose, Lose/Win, or if the arbitrator pulls rang, Lose/Lose.

If Jenny and Jimmy were to adopt an ‘Interests’ based strategy we might find that Jenny was looking for the zest for a cake she was baking while Jimmy was interested in the pulp to eat.  Tackling the task of what to do with the last orange from an ‘interests’ point of view can therefore deliver a Win/Win solution that is closed to those adopting a ‘positional’ approach.  Even if the arbitrator dictates a half each solution, the participants only get 50% of what they were looking for.

The power of this simple story is that it conveys a complex idea in an easily understood way.  It also provides a catalyst for your ‘thinking about negotiation’ quiet time.  During this time you can pose questions to yourself such as:

  1. Did I really get to understand who the other party was & what they were looking for?
  2. Did I communicate clearly to them what I was looking for from the negotiation?

*These questions are loosely based on the ideas of Professor Stuart Diamond author of “Getting More”

While there are a range of approaches with multiple stages, most of which start quite correctly with planning, they don’t necessarily promote self-awareness and introspection as a key step.  This is unfortunate because one of the unsung skills of good negotiators is situational awareness.  If you are too focused on your process of negotiation you might very well miss the important cues that are being sent out to help you answer Question 1.

So take the time to sit back and reflect on recent negotiations; could you have done a better job answering the two questions above?  Are there other questions you should be asking yourself?  Finally, do you conduct a personal ‘debrief’ at the conclusion of a negotiation?  Disciplined self-reflection is one of the tools of continuous improvement contained within the PDCA cycle which is often missed.

If you need help developing your interests based negotiation strategies or setting up negotiation debriefing processes, don’t hesitate to get in touch at andrew.downard@adsupplychain.com.au or call +61 (0)419 581 705.

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Goldilocks and the KPIs

Can we go too hard in measuring our service providers?  Performance measurement of service providers is a very fraught subject and challenges companies to find their ‘Goldilocks’ zone where performance measures fall neatly between too much measurement and not enough measurement.

We can all imagine the flaws with too little measurement; what the team at Vested* call the ailment of ‘driving blind’.  In this situation the customer has insufficient insight into how the service provider is performing and perhaps the service provider is a little unclear as well!  Research from the Aberdeen Group has highlighted one of the biggest issues for firms that outsource as the challenge of identifying whether projected savings actually hit the bottom line.  In particular, if they don’t, where is the shortfall occurring?

So, too few measures is clearly bad, having lots of performance measures is better…. right?   Well, like fast food, too much of something can be bad as well.  Again, Vested has described an ailment that covers this – ‘Measurement Minutia’.  In this case, firms try to measure everything and end up with spread-sheets with hundreds of performance measures.  Not only is the effort and time to put all these measurements together of questionable value, but they are unlikely to be usable in running the business.

Often firms making this mistake use the ICE model to develop KPIs:

                I               =             identify what is easy to measure

                C             =             collect, measure and report everything that is easy to get to

                E              =             end up confused as to what is really going on!

It is well established that around 5 to 7 KPIs is the optimal amount for an individual to deal with.  Once the number increases above this, measures tend to organise themselves into first tier, second tier and so on.  How often do second tier measures get reviewed?  That’s right – rarely!  Vested has an ailment that describes this situation which they describe as the “saddest ailment of all” – the ‘Power of Not Doing’, not using performance measures, even when established, circles the firm right back to driving blind and the failure to deliver results.

Having absorbed the lessons of too few or too many KPIs and come up with the optimal number, nothing else could go wrong…. could it?  Unfortunately there is still one aspect that can trap unsuspecting players.  KPIs that are arbitrarily imposed have a destructive effect on supply chain relationships.  They tend to say to the other party “we don’t trust you” and often lead to minimalist behaviour; that is, just enough effort to meet the KPI benchmark but no more.  Unsurprisingly Vested has identified an ailment to describe this situation – ‘sandbagging’, which needs little explanation.

Interestingly research indicates that where firms arrive at their performance measures collaboratively, this acts to strengthen the relationship and drives improved performance and compliance with the KPIs.   It has also been found that service providers that are tightly controlled and measured exhibit an extreme reluctance to be flexible and adjust to circumstances if it will show a poor result on the KPIs they are being held to.  This is even the case if the customer requests the flexibility!

So, have you identified your ‘Goldilocks Zone’ for the number of KPIs you put in place to measure your service providers and do you develop these KPIs collaboratively with your service providers?

*Vested 10 Ailments – for more information on the 10 Ailments visit www.vestedway.com/penny-wise-and-pound-foolish/.

If you would like help in developing the right number of KPIs in the right way, or want to find out more about Vested then contact us at andrew.downard@adsupplychain.com.au or call +61 (0)419 581 705.

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Justice and Supply Chain Relationships

Have you thought about Justice recently?  I don’t mean justice in terms of villains getting away with their crimes or the innocent being punished.  When it comes to supply chain relationships, justice is an important concept.  While justice has similarities to ‘fairness’, it is more complex.  It is also of great importance when the relationship is between a powerful and weaker entity.

As covered in previous blogs the importance of trust is well recognised as contributing to effective and continuing supply chain relationships.  We have also discussed the corrosive effect that opportunism has on trust and the continuance of relationships.  Another aspect that is closely related is justice, which has two faces.  Firstly there is ‘Procedural Justice’, which refers to the fairness and transparency of the processes that one party, usually the powerful, uses to manage the relationship and interact with the other party.  The other face is ‘Distributed Justice’ which relates to the outcomes that are experienced by the parties as a result of the application of the policies and procedures.  The lack of either procedural or distributed justice will lead towards dissatisfaction, a reduction in trust and perhaps a move towards passive opportunism by the injured party.  This can easily escalate into a full relationship failure spiral which is hard to reverse once underway.

One of the most common examples of failing to deliver both procedural and distributed justice revolves around the creation and application of invoice payment processes by large corporations.  In the first instance the powerful party may negotiate (demand) extended payment terms and impose stringent and complex processes for submitting invoices.  This situation leads the suppliers to feel there is a lack of fairness and procedural justice in place.  If the powerful party then goes on to further delay payments by rejecting invoices for minor errors, losing invoices or failing to meet their own guidelines, then this delivers feelings that there is a lack of distributed justice.  In both cases one form of justice can be in place but the other missing.  For example, the processes and procedures may be designed to be fair but are not followed or are abused by staff which leads to a lack of distributed justice even though procedural justice can be seen to be in place.  Likewise, a firm may have developed a tough process which is seen to be unfair but suppliers recognise that at least the customer follows the process.  This situation is not confined to powerful buyers dealing with suppliers.  A powerful customer may impose stringent goods return processes for example.

Given that the benefits of good relationships are superior to the results gained when relationships are poor, all organisations should strive to maintain the former.  That by no means indicates that firms need to be soft on trading partners or give up benefits they should be entitled to.  The value that can be released by good relationships is generated by growing the pie through innovation and speed, not through reassessing how the pie is to be cut.

So how should organisations handle this issue of justice?  The first thing to consider is the design of the processes, policies and procedures they apply to dealing with trading partners.  The simple design rule is “Treat others as you would like to be treated yourself”.  Note that the phrase “like to be treated” was used; not how you are actually treated!  Too many industries, such as automotive manufacturing, pass on unfair processes not because they are needed, but because it is the way they are treated.  This ends up poisoning an industry rather than a single relationship.  Added to this approach is a second important step; discuss the proposed process with representative trading partners.  It is well recognised that governance structures that are ‘imposed’ lead to reductions in performance whereas ones arrived at mutually deliver improved performance.

To deliver ‘distributed justice’ is similar to developing trust.  Firstly the other party must believe you intend to follow your procedures and policies.  Secondly you must actually follow them.  When they come to see you are following your own rules, this will add to the atmosphere of certainty which will aid in the development of a good relationship.

It has been said that we get the supply chain relationships we deserve!  To get better and enduring relationships, organisations should consider the issue of Justice as it relates to their dealings with trading partners.  Designing systems that have fairness embedded into them will pay dividends if you then go on to follow these procedures.

 

If you need help to review and develop policies, processes and procedures that deliver Justice and fairness to trading partners then don’t hesitate to contact us at andrew.downard@adsupplychain.com.au or call +61(0)419 581 705.

 

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Regaining Lost Trust

I’ve written a few times about the importance of trust in business relationships and also about what to do in the absence of trust.  It is worth now looking at what to do if trust is lost.

Loss of trust can come about for a range of reasons.  Perhaps one party has engaged in opportunistic behaviour and given their trading partner good reason not to trust them.  This type of behaviour is clearly intentional and is likely to result in an immediate and large reduction in the levels of trust.  Trust can also be eroded unintentionally.  In these circumstances there may be an unintended breach of one party’s expectations; for example, a continuing failure to meet deadlines or other promises.

In the case of opportunistic behaviour the other party comes to believe that they cannot rely on their partner to actually do what they say they will do.  This is a loss of what is known as ‘affective’ trust.  With unintended failures, there is a loss of ‘competency-based’ trust.  Both types of loss of trust can cause the affected party to reconsider their dealings with their trading partner.  Actually exiting the relationship can occur in both cases but is more likely to occur after opportunistic behaviour.  In the case of unintended failure the response may be to reduce the level of business rather than outright exit.  At best, arrangements may continue with increased governance and controls, with a corresponding increase in transaction costs.

So, how can trust be regained if it has been lost?  In the case of unintended failures and ongoing business, the party that needs to regain trust must show exemplary performance on an ongoing basis.  Stephen M.R. Covey in his book ‘The Speed of Trust’ suggests following and living by the following 13 key behaviours:

1 Talk Straight 7 Get Better
2 Demonstrate Respect 8 Confront Reliability
3 Create Transparency 9 Clarify Expectations
4 Right Wrongs 10 Practice Accountability
5 Show Loyalty 11 Listen First
6 Deliver Results 12 Keep Commitments
    13 Extend Trust

 

By following these tenets you can both regain lost trust or build trust in an emerging relationship.

But what to do if you have acted opportunistically and lost the trust of your trading partner?  Assuming that you want to maintain the relationship, then the task is more difficult than with unintended failures.  One suggestion is to make an extraordinary commitment that binds you,  the promisor, to a very significant loss if you fail to meet your commitment, the business version of offering up hostages!  The concept being that the promisor has made a commitment that only a trustworthy and honest person would make.  Obviously the promisor would need to be sure that no ‘unintended’ failures could intrude on their promise!

 

If you would like to know more about how to manage your business relationships or how to recover from a low trust situation then don’t hesitate to contact us on +61 (0)419 581 705 or email andrew.downard@adsupplychain.com.au .

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Why Collaborating with Sub-1st tier Suppliers (and Customers) Makes Sense

Smart Supply Chain Managers know that it is important to monitor what is happening with their supply chain partners.  The big question is which partners should they monitor?

It is tempting to use Vilfredo Pareto’s principle and focus on the 20% of suppliers or customers that make up 80% of expenditure or income.  While there is certainly good support for keeping an eye on these ‘big fish’, there is good theory behind taking a different path, or at least including others in the net of partners that are kept under review.  So while it is certainly important to stay close to those supply chain partners that make up most of the firm’s activities at the same time there are also a number of reasons to go deeper into the supply network.

High volume suppliers or customers are the source of a large proportion of a firm’s business and any loss or failure of these players is going to have a serious impact.  Such large entities are also quite likely to be strong and resilient businesses in their own right.  As such, they are unlikely to provide an early warning of problems in the broader economy.  These larger players are quite likely to exhibit signs of distress about the same time as your own business (or perhaps after  as your difficulties impact negatively on them).

So why focus on second or third tier suppliers or customers who are a much smaller part of a firm’s business?  The answer lies precisely in their status as small and insignificant members of the supply chain.  As smaller players they have less buffers and protections against the problems of an economy.  Larger suppliers are like the frog in the slowly boiling water; they fail to identify the change in their environment because of their scale.  Small suppliers or customers have less resilience and a change in the economy is immediately obvious to them.

The use of the term smaller is also relative.  A well-documented example of a supply chain failure that could have been moderated if the focal company had tighter linkages with suppliers further back in the supply chain, involves the Boeing 787 program delays.  In essence, Boeing failed to identify a number of significant events/changes that were occurring in its supply chain for specialist fasteners, in particular the concentration of fastener manufacturers and the constraints on titanium supply.  This resulted in a delay to the 787 program by several years.  The organisations that failed in Boeing’s fastener supply chain were not insignificant in size, but they were not tier 1 suppliers to Boeing, so did not feature on the radar.

Thomas Choi and Tom Linton in a Harvard Business Review Blog “Don’t Let Your Supply Chain Control Your Business” highlighted the above points along with several others:

  • By having relationships further back into the supply chain firms are better able to control costs.
  • Smaller more innovative suppliers (and customers) are likely to be more innovative and be the source of new ideas.
  • In a world where ‘Stewardship’ of a firm’s supply chain is expected sustainability and social responsibility risks reside with smaller suppliers further back in the supply chain.  Ask Mattel (lead paint), Apple (worker suicide) or various clothing manufacturers (child labour).

So what should firms do about the challenge of collaborating back into their supply chain?  The first step is to understand “who is involved”?  All too often firms can reliably talk about customers two and three tiers forward from their own business but only one or two tiers backward into the supply base.  There are a number of reasons for this including that tier one suppliers are unwilling to pass this information on for fear of being eliminated from the chain.  A collaborative ‘Supply Chain Mapping’ project focused on making the supply chain more reliable for all participants may overcome this reluctance.  Then like Honda has done identify participants that it makes sense to interact with (you obviously can’t have a relationship with all).  Then decide whether you want to formalise the relationship; Honda will have contracts with sub-tier suppliers for quality, appearance or cost control purposes.  But again this approach presupposes a trusting and collaborative supply chain ……… a subject for a later Blog perhaps!

 

If you would like to know more about how to collaborate with sub-tier suppliers, please feel free to contact us at andrew.downard@adsupplychain.com.au or call +61 (0)419 581 705.

 

Posted in Performance Improvement, Supply Chain Best Practice, Supply Chain Collaboration, Supply Chain Innovation, Supply Chain Partner Segmentation, Supply Chain Relationship Management | Leave a comment

Failure to Use Market Power is Waste: Welcome to the Dark Side

Having worked for an organisation where failure to use market power was considered as a form of waste, I have seen the dark side of business relationships and contracting.  This form of aggressive dealings with trading partners was described by Oliver Williamson, the Nobel Prize winning economist, as taking a “muscular approach” to contracting.  Williamson also described this approach as “myopic” as it will always drive up costs in the long run.  Partners subjected to this use (misuse?) of market power will find overt or covert ways of protecting themselves from their powerful partners.  As the powerful players “use up” their partners they also fine that it is harder to find people that will deal with them on these terms which can lead to cost increases,  constraints on business growth or even continuity of supply.

The companies that use muscular methods don’t always see the problem.  They often argue that they have fine “collaborative” arrangements with their trading partners.  An example cited by the authors of “Unpacking Oliver”[i] showed that when powerful customers arbitrarily imposed extensions in payment terms (30 → 60 → 90 days) they reported that collaboration was alive and well in their relationships.  The suppliers on the receiving end reported that collaboration was going backwards.  Part of the problem is that the powerful customers were applying “megaphone collaboration” (named after the complaints about some countries’ diplomacy efforts where lecturing replaces discussion).  This approach was described by Dapiran & Hogarth-Scott (2003)[ii] as mistaking collaboration with compliance.

Sometimes we find ourselves setting up business relationships where both parties in the discussions truly believe in a win/win result.  This lasts right up to the point when the corporate lawyers become involved with their “standard” contract with the “boiler-plate” clauses.  All of a sudden the conversation shifts to who is going to hold who harmless and who can exit the arrangement for convenience (and who must give long notice with penalties).  We do this though because “it’s the law” – Right?  Wrong! Most of these types of clauses are included in contracts because we choose to.  As emphasised in Unpacking Oliver, we need to not only negotiate “win/win” but also contract “win/win”.

Unpacking Oliver is about identifying 10 lessons from the work of Oliver Williamson to be applied to developing strategic business partnerships.  While they are all important, several have been highlighted for particular focus for those in the trenches negotiating agreements:

  1. Outsourcing is a continuum, not a destination.
  2. Develop contracts that create “Mutuality of Advantage”.
  3. Understand the Transaction Attributes & their Impact on Risk & Price.
  4. The greater the Bilateral Dependencies, the greater the need for Preserving Continuity.
  5. Use a contract as a framework, not a legal weapon.
  6. Develop safeguards to prevent Defection.
  7. Predicted Alignments can minimise Transaction Costs.
  8. Your Style of contracting matters; be credible.
  9. Build Trust, leave money on the table.
  10. Keep it simple.

Whoops, they all got highlighted!  So if you want to read more about the work of Oliver Williamson and the 10 Lessons, then download your copy of “Unpacking Oliver” from the Vested Outsourcing website http://www.vestedway.com/vested-library/ .

You will also find other useful resources around this subject at this website.

If you need more information about setting up strategic  business relationships or want help to do so, don’t hesitate to contact us at andrew.downard@adsupplychain.com.au or call +61(0)419 581 705.

Further Reading:



[i] Vitasek K et al “Unpacking Oliver: 10 Lessons to Improve Collaborative Outsourcing” http://www.vestedway.com/vested-library/

 

[ii] Dapiran, G P, Hogarth-Scott, S, 2003, Are Cooperation and Trust being confused with power? An analysis of food retailing in Australia and the UK, International Journal of Retail & Distribution Management, Vol 31, No 5, pp 256-267

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Cost Savings Bias & Corporate Mental Accounting

Those of us that have been involved in corporate cost reduction programs will no doubt have been exposed to the bias and sometimes illogical nature of decisions made.  To understand the reasons behind these sometimes odd decisions we can look to a corporate version of what in the individual is called “Mental Accounting”.

Mental Accounting is a set of cognitive processes individuals use to rationalise money they have, use and save.  People tend to group expenditures into groups such as “rent/food/essentials” or “entertainment/holidays/non-essentials”.  One group might be seen as having priority over another if funds are constrained.  A similar approach as suggested by Richard Thaler ¤ is taken with income.  Funds coming to an individual is categorised by their source.  So, income from salary or wages are treated differently from income from gambling, the latter being seen as a “windfall” gain.  With a windfall the usual care taken with expenditure might be ignored.  An example provided by Thaler describes the treatment of casino winnings by a successful gambler.  Winnings are habitually placed in a different pocket/location from seed money.  This amount, often called “house money” is freely gambled away without concern because of its windfall status.  Cutting into seed money might well be treated differently.

Mental accounting also causes us to make apparently illogical decisions.  Again, an example describes how a shopper when told they can get a $5 discount on a $15 calculator, will drive across town to get their saving.  The same individual will probably pass up a $5 saving and not drive across town when purchasing a $250 jacket.  The question is why?  In both cases the saving is $5 and each $5 would have the same monetary value. 

So what has “mental accounting” to do with corporate cost reduction programs?  Based on the writer’s experience, cost reduction opportunities are often treated differently depending on where they lie in the organisation.  A saving of a few cents per product in manufacturing operations, which may impact on quality or customer satisfaction, and which may only amount to a few tens of thousands in total savings, will be pursued aggressively.  Whereas a larger saving in an overhead area such as Marketing spend or advertising may be seen as “off-limits”.  Why the difference?

Perhaps one area of difference that might explain this apparent paradox is the degree to which each area can be measured.  In manufacturing, direct costs are usually known with some precision.  Likewise the reduction of a certain input or charge to a lower cost item can also be defined in a measureable way.  While the ability to measure does not equate to a proper risk analysis, it does often provide business leaders with a feeling of confidence, justified or otherwise.

In the case of overhead costs the picture is less clear because of the difficulty with measurement.  Expenditure on overheads is usually clear cut, but benefits are not so certain.  An old anecdote about expenditure on advertising provides an illustration – “A Sales Marketing manager states that 50% of his advertising expenditure is a complete waste; – trouble is, he doesn’t know which half is which”.  This comment could also be made about expenditure on training, auditors or insurances.

Mental Accounting also impacts on “sunk costs”.  Thaler provides an example where you buy a pair of shoes; when you wear them for the first time you find they don’t fit well.  He goes on to predict the following:

a.       The more expensive the shoes, the more times you will persist in wearing them.

b.      When you cease to wear them, the more expensive the shoes, the longer they will stay in your wardrobe.

Anyone who has been involved in an expensive but failed software implementation will recognise the “corporate mental accounting” version of this story!  Failed capital equipment investment projects would also provide a similar example.

How can we eliminate or at least manage the impact of “corporate mental accounting?”  The following steps can be seen as providing a start:

1.       Treat every dollar of expenditure as being equal in value and importance.

2.       Be focused on measuring the benefit of each dollar of expenditure regardless of where in the business it is spent.

3.       Ensure all functional areas recognise that the money they get to spend is not “free”.

4.       Finally, cost reduction programs should focus on eliminating waste, regardless of where it is found, rather than on cutting costs because you can.

 

If you need help putting together your waste elimination program and avoiding the negative impacts of “corporate mental accounting” then don’t hesitate to contact us at at andrew.downard@adsupplychain.com.au or call +61 (0)419 581 705.

 

 ¤Richard H Thaler “Mental Accounting Matters” Journal of Behavioural Decision Making (1999)

 

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