Aligning Incentives in Supply Chains
On April 16, 2001, the world's largest network-equipment maker, Cisco, shocked its investors when it told them that it would soon scrap around $2.5 billion of surplus raw materials. This would go down as one of the largest inventory write-offs in U.S. business history and gave Cisco a net loss of $2.69 billion for the month of May alone. A supply chain works well if its companies' incentives are aligned-that is, if the risks, costs, and rewards of doing business are distributed fairly across the network. If incentives aren't in line, the companies' actions won't optimize the chain's performance.
There are three reasons why incentive issues occur within a supply chain. First, when one company can’t see what another firm is doing, they have trouble persuading the firms to work their hardest for the supply chain. Second, it’s hard to share interests when one company has information that other companies in the supply chain do not. And Third, incentive schemes are poorly designed most of the time.
In order for supply chains to run smoothly, the companies within the chains must align their incentives in three stages. First, Executives of the companies need to come to terms that having your incentives out of alignment is a very big problem. They need to understand the operational details of other firms more. Second, the executives need to find the root of the problem. They can hire a consulting firm to do this form them. This way they can choose the best approach in getting incentives realigned. And third, companies can use one of three systems (Contract based, information based, or trust based) to get their supply chains back into alignment.
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