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Reprint: R0411F
Most companies don’t worry about the behavior of their supply chain partners. Instead, they expect the supply chain to work efficiently without interference, as if guided by Adam Smith’s famed invisible hand. In their study of more than 50 supply networks, V.G. Narayanan and Ananth Raman found that companies often looked out for their own interests and ignored those of their network partners. Consequently, supply chains performed poorly.
Those results aren’t shocking when you consider that supply chains extend across several functions and many companies, each with its own priorities and goals. Yet all those functions and firms must pull in the same direction for a chain to deliver goods and services to consumers quickly and cost-effectively.
According to the authors, a supply chain works well only if the risks, costs, and rewards of doing business are distributed fairly across the network. In fact, misaligned incentives are often the cause of excess inventory, stock-outs, incorrect forecasts, inadequate sales efforts, and even poor customer service. The fates of all supply chain partners are interlinked: If the firms work together to serve consumers, they will all win. However, they can do that only if incentives are aligned.
Companies must acknowledge that the problem of incentive misalignment exists and then determine its root cause and align or redesign incentives. They can improve alignment by, for instance, adopting revenue-sharing contracts, using technology to track previously hidden information, or working with intermediaries to build trust among network partners. It’s also important to periodically reassess incentives, because even top-performing networks find that changes in technology or business conditions alter the alignment of incentives.
Excess inventory. Stock-outs. Wildly off-base demand forecasts. Are you plagued by these supply-chain headaches? If so, you may be unwittingly rewarding your supply-chain partners for advancing their own interests—not yours or those of the entire supply chain. Cisco did this when it rewarded its contract manufacturers for delivering supplies quickly. So manufacturers built buffer stocks to ensure speedy deliveries. But when a recession slashed demand, these vendors stuck Cisco with $2.5 billion worth of surplus raw materials.
A supply chain works well only when its players equally share the risks, costs, and rewards of doing business together. How to encourage that sharing? Ensure that all supply-chain partners’ incentives are aligned. First, acknowledge that incentive problems exist. Second, determine their causes. For example, do your retailers benefit more from pushing another company’s products instead of yours? Third, realign incentives so that everyone’s pulling in the same direction. For instance, write contracts enabling you to track retailers’ efforts on your behalf and reward them for enhanced sales.
When each firm in your supply chain acts in the overall chain’s best interests, everyone benefits. Like Whirlpool, Campbell Soup, and other leading firms, you can align incentives to create wins for every organization in your supply chain.
The Idea in Practice
How to Realign Incentives in Your Supply Chain
Acknowledge incentive problems. Facilitate discussions among managers about how incentive misalignments affect your company’s supply chains. Educate managers about your supply-chain partners’ operations, so they understand how incentives can get out of whack.
Identify root causes. Incentive misalignment has three causes:
Hidden actions:
- You can’t see what your partners are doing, so you can’t create incentives that induce them to do what’s best for the entire supply chain.
Hidden information:
- One partner has information that other partners don’t. For example, automotive parts suppliers fear that if they share their cost data, the “Big Three” U.S. auto manufacturers will use that information to squeeze their margins. So they don’t participate in improvement initiatives that require such data. Result? Because of information hoarding, the Big Three’s supply chains function inefficiently.
Badly designed incentive schemes:
- Incentives intended to spur supply-chain efficiency don’t have the expected impact.
Align or redesign incentives. Select one or more of these solutions:
Change contracts.
- Create contracts that reward or penalize partners based on measurable outcomes. A Canadian bread maker altered its contracts with deliverymen to prevent them from overstocking shelves during rivals’ promotions. It introduced penalties for stale loaves as well as commissions based on sales. The combination motivated deliverymen to keep the shelves full—except on days when rivals offered shoppers deep discounts on competing products.
Uncover hidden information.
- Track more business variables that affect supply-chain effectiveness. Campbell Soup realized that 40% of its chicken noodle soup manufactured one year was sold to distributors during a six-week period when Campbell offered discounts on the product. The uptick had strained the company’s supply chain. Campbell began gathering data on distributors’ sales to retailers and gave distributors discounts based on their sales—eliminating the incentive to forward-buy.
Promote trust.
- Use intermediaries to prevent supply chains from breaking down because of mutual misgivings among chain partners. Hong Kong-based supply-chain intermediary Li & Fung enforces a code of ethics precluding Asian network members from using child labor or bribing government officials. It also denies multinational companies access to its network if they make frivolous demands on suppliers or refuse to take delivery of products at contracted prices. Li & Fung’s reputation for integrity reduces the need for formal contracts.
Wall Street still remembers the day it heard that Cisco’s much-vaunted supply chain had snapped. On a mad Monday, April 16, 2001, the world’s largest network-equipment maker shocked investors when it warned them that it would soon scrap around $2.5 billion of surplus raw materials—one of the largest inventory write-offs in U.S. business history. The company reported in May a net loss of $2.69 billion for the quarter, and its share price tumbled by approximately 6% on the day it made that announcement. Cisco was perhaps blindsided by the speed with which the United States had advanced into recession, but how could this paragon of supply chain management have misread demand by $2.5 billion, almost half as much as its sales in the quarter? Experts blamed the company’s new forecasting software, and analysts accused senior executives of burying their heads in sockets, but those experts and analysts were mostly wrong.
A version of this article appeared in the November 2004 issue of Harvard Business Review.
By identifying key business activities that could be affected by disruptions to your supply chain, you can prepare a plan of action with a focus on your bottom line.
This resource looks at steps in supply chains, explores possible risks and links to the business continuity plan to manage these risks.
On this page
A supply chain is a network of individuals and companies that produce and deliver a product or service to a consumer.
Supply chains are important to keep shelves stocked and items available for trade. Any disruption in the supply chain can cause problems in providing goods and services to your customers on time and within budget.
To manage risk in supply chains:
- identify supply chain risks within your business
- identify what is within your control or outside your control
- understand the impact on your business if there are disruptions
- develop a risk management plan to account for disruptions.
Why it's important to check your supply chain
When one element of your supply chain fails to deliver their product or service to the next business in the chain, the entire supply chain can be disrupted.
This can result in:
- delays
- reduced revenues
- inflated costs
- disruptions to your production or continuity of service
- damaged business reputation and customer confidence from delays, quality or ethical issues.
A business with a resilient and responsive supply chain has a competitive advantage over other businesses that do not.
Identify your supply chain
There are many steps and processes involved in developing goods and services.
A supply chain may include the following:
- individuals, businesses, and organisations that make products, components or raw materials (e.g. beekeepers produce honey which may be marketed by a beekeeper's cooperative to a larger company)
- businesses that produce packaging materials (e.g. boxes, bottles)
- logistics and/or transport businesses that transport the raw or manufactured products (e.g. tankers, goods trucks)
- businesses that supply IT software (e.g. online shopping portals, customer relationship databases, logistics, project management, telephones)
- businesses that provide marketing services (e.g. design, labels, online and traditional marketing)
- businesses that fill packaging materials (e.g. bottling lines)
- businesses that purchase, distribute, or sell the product (e.g. wholesalers, distributors, retail, and online retail shops).
Preparing for supply chain disruptions
The best way to manage a supply chain disruption is to prepare for it in advance.
A business impact analysis helps prepare your business for the impact of a supply chain disruption.
A business impact analysis:
- identifies your key business processes, procedures and standards
- examines key activities and resources you need to operate your business
- assesses how these would be affected by supply chain interruptions highlighted in your risk management plan.
A business impact analysis is part of a business continuity plan.
This template includes 2 sections:
- risk management plan
- business impact analysis.
Use this page to consider your risk of a supply chain disruption, then complete the 2 sections of the template.
Download the business continuity planning template.
The level of impact on your business would depend on the severity and length of the disruption, but significant disruptions are likely to have a financial impact.
Completing a business impact analysis allows you to consider how a supply chain disruption would affect business activities, including financial management, and help to identify the ways you might prevent, or minimise the impact.
If vital machinery breaks down and disrupts production, the impacts on various business activities could include the need to:
- focus resources on fixing the problem
- reduce or reallocate staff from the production area
- contact suppliers and let them know
- contact your downstream customers
- manage your inventory of raw materials and finished goods
- review orders and purchasing
- reveiw the impact on sales, revenue and cashflow
- increase marketing activities to improve customer relations and business reputation.
Risks around your supply chain are either within your own control, or outside your control. Developing and reviewing your risk management and analysing the business impact as part of your business continuity plan ensures your business is prepared for any potential business disruptions.
While supply chain risk may seem straightforward, it can be easy to overlook potential risk areas. There may be several ways to prepare for a supplier disruption but often, sourcing an alternate supplier may be the best solution.
Consider these types of supply chain risks and their possible risk preparation or reduction strategies.
Human resources
- Train internal staff in different roles as part of a development program
- Recruit staff with the skills you need (or have potential to learn the role or activity)
- Meet with the supplier and establish relationship with new key account holder
- Assess the change and consider exploring new supplier options
- Source alternative local suppliers
- Consider overseas suppliers if the risk is widespread and ongoing
Product, and packaging materials
- Use alternative packaging
- Increase sales in other product lines
- Seek and engage an alternative supplier
- Source local or national suppliers
Logistics delays
- Source alternative logistics from other countries or states
- Increase order volumes and local stock holding
- Check if covered by business insurance
Decrease in standards
- Check all products supplied
- Raise issues with suppliers and clarify standards
- Increase quality assurance checks
- Source potential alternative suppliers
Insolvency and bankruptcy
- Communicate with customers
- Explore the opportunity to buy any remaining inventory from the supplier
- Seek alternative suppliers
Manufacturing risks
- Check and service equipment regularly
- Check with other businesses to borrow or lease equipment
- Consider purchasing backup equipment for critical tasks
- Consider changing the way something is made as a short term workaround
With any supplier-related risks, knowing your suppliers and reducing reliance on a sole provider can help to reduce impacts on your business.
Also consider...
- Last reviewed: 24 Nov 2022
- Last updated: 24 Nov 2022