by: Issues: January / February 2007. Tags: Strategy. Categories: Strategy.

In recent years, many companies have been focusing on achieving productivity gains in their internal operations. Most have improved internal processes, reduced overheads and eliminated redundant activities. With TQM, Six Sigma and other related methodologies, they have improved the quality of their products and services and rid their operations of profit-reducing mistakes. Many companies have introduced Enterprise Resource Planning (ERP) systems and other productivity-improving forms of information technology, albeit with sometimes-mixed results. As worthwhile as these initiatives have almost certainly been, however, the 80-20 rule would suggest that companies will ultimately begin to run into declining returns in their further efforts to improve internal operations. For some companies, 20 per cent of the most promising internally oriented initiatives may already be delivering 80 per cent of the potential gains to be had.

Fortunately, realizing productivity improvements at the edge of the enterprise — at the interfaces with customers and suppliers — represents a largely untapped frontier of opportunity. To be sure, there have long been examples of companies that have entered into partnering relationships and, through these efforts, achieved worthwhile results. In this author’s experience, however, companies operating outside of true partnering contexts — almost certainly the majority of the economy — have not fared as well.

New levers for achieving inter-company productivity improvements are beginning to prove themselves, particularly in non-partnering contexts. This article provides an overview of three of them: (1) dealing with inter-company incentive problems, (2) seizing opportunities to improve inter-company business processes and (3) reinforcing inter-company productivity gains with Web services technology.

Lever #1: Deal with inter-company incentive problems

Companies have had decades of experience in working through incentive problems within their own organizations. Management stock options have been the subject of much debate in recent years. New and improved incentive schemes are among sales managers’ most heavily used tools. Employee profit-sharing arrangements have long been popular. While these intra-company incentive arrangements clearly have a role to play, the incentive problems they seek to address are often not all that severe. Most managers are generally already motivated to do a good job. Most salespeople and other front-line employees implicitly understand that they will do well only to the extent that their companies prosper.

Inter-company relationships (i.e., those between adjacent companies in a supply chain) can be a different matter. In most companies, managers and other employees dealing with other supply chain participants are naturally incented to pursue actions that will maximize their own firms’ profits. In pursuing these actions, however, they can sometimes materially impair the aggregate profitability of the supply chains in which their firms participate. While superior market power may allow some firms to defer the impact of this degradation in profitability, a shrinking pie ultimately impacts negatively on all supply chain participants.

Examples of inter-company incentive problems abound: Incentive problems related to batch size and inventory trade-offs are perhaps among the most recognizable. Many suppliers like to build in the largest batch sizes possible. Larger batch sizes help them amortize machine set-up, order processing and other related costs over a larger number of units and to minimize profits lost due to line downtime. Most customers, of course, prefer smaller lot sizes, mostly so that they can reduce inventory investments and the risks associated with holding too much of the wrong types of inventory.

It is perhaps elementary to say that supplier and customer ought to work together to set batch sizes that minimize overall supply chain costs, typically by using economic order quantity (EOQ), newsboy model and other related methodologies. (The EOQ model seeks to set batch sizes so that, over a given period, the aggregate order processing costs and inventory carrying costs throughout a supply chain are minimized. The newsboy model uses probability theory to set profit-maximizing batch sizes in situations in which there is demand uncertainty and in which stock levels can be replenished only on a fixed interval basis (e.g. the replenishment of newspapers at a newsstand which might occur only daily. A more detailed overview of these approaches is available from the author on request.)

In most cases, at least in this author’s experience, it simply does not happen. In cases where the customer exercises the majority of the market power, the supplier is pressed for just-in-time delivery. Where the supplier is dominant, the customer is pressed to hold more inventory than the supply chain’s economics would dictate. Either way, significant value is often destroyed. (Importantly, the argument is not being made here that the progress companies have made in reducing line-change times and otherwise increasing the flexibility of their operations has been a waste of effort, or that efforts in this area ought to be abandoned. Instead, the argument is simply that supply chain participants ought to plan their affairs based on a realistic assessment of the progress that has actually been achieved on this front at a given point in time.)

A second example of an inter-company incentive problem relates to inter-company work inputs. In the course of working together, a number of work inputs typically pass back and forth between customer and supplier. A provider of manufacturing services that the author has been working with has a number of these work inputs in its operations, including customer- engineering documentation and engineering change orders provided by customers from time to time.

Often, the way a work input is provided by one party has a big impact on the other party’s costs. In the case of the manufacturing services company, the engineering documentation it received often had to undergo extensive revisions so that it could be utilized on the company’s plant floor. Similarly, its customers were often reluctant to provide engineering change orders in ways that minimized the costs of processing them. This company regularly exhorted its customers to consider more efficient ways of working. The many good intentions expressed by its clients notwithstanding, the company was forced to maintain much larger program management and manufacturing engineering staffs than were truly required.

Several other examples of inter-company incentive problems can be given. Conflicting incentives around the importance of meeting required end-customer service levels often destroy value. The failure to share forecast, cost and actual demand information where doing so would help supply chain performance is typically rooted in incentive problems. Finally, the practice in many companies that have outsourced their manufacturing to retain in-house testing and other QA activities ¯ even though co-locating these activities with the outsourced manufacturing operation would improve supply chain performance ¯ is, at its core, an incentive problem.

Dealing with incentive problems: A two-step approach

As with other problems that impact corporate performance, incentive problems are best dealt with in a two-step process:

(1) identify the most pressing incentive problems at work in a given situation and
(2) define a solution that addresses the incentive problems identified.

To identify incentive problems, it can often be helpful to assemble a cross-functional group with a view to identifying a list of behaviors, whether internal or with customers or suppliers, that may be reducing overall supply chain profitability. Paying careful attention to customer survey results and, where appropriate, conducting in-depth, clarifying interviews with customers, play an important role. An open and honest conversation with suppliers as to the existence of internal behaviors that may be unduly increasing supply chain costs can also often be instructive. Finally, with both customers and suppliers, it can be important to take into account the incentives of individual actors as well as those of their employers.

Once identified, there are a number of approaches that can be harnessed to deal with inter-company incentive problems. (V.G. Narayanan and Ananth Raman, “Aligning Incentives in Supply Chains”, Harvard Business Review, November 2004, provides an overview of a number of additional options. One such approach is described below.)

Activity-based pricing as an incentive alignment tool

In circumstances in which a company finds that its margins are under pressure and where its fixed overhead costs represent a significant proportion of its revenues, Activity-based Pricing (ABP) can be a particularly attractive incentive alignment tool. With ABP, pricing arrangements move away from simpler arrangements based on mark-ups on direct material and labour costs towards subtler arrangements that much more closely reflect the all-in costs incurred in a given buyer-seller relationship.

The manufacturing services firm above again provides an instructive example. Prior to adopting ABP, the company’s pricing consisted of a fixed amount per unit, with a minimum batch size. The price levels were based on a standard mark-up over direct material and labour costs that the company expected would cover overhead and contribute to profits. The company’s management accounting system simply tracked the extent to which the gross margins for a given account or order, defined as revenues less material and direct labour costs, met a predetermined objective. Exhibit A below illustrates a typical pre-ABP pricing arrangement.

company’s move to ABP consisted of two steps. First, the company installed an activity-based costing (ABC) capability. Compared with the old management accounting system, the new system gave the company a much better understanding of individual order and customer profitability by accounting for the actual demands made on the company’s overheads by individual orders and customers. For example, the new system was able to account for the all-in costs (i.e., including purchasing, accounting, program management, etc.) associated with processing individual customer orders. Customers that produced similar levels of gross margin but that had differing ordering patterns were shown, appropriately, to produce different levels of profitability.

The second stage of moving to ABP involved supplementing the company’s existing direct-cost-plus-pricing model with an approach that provided a broader menu of service-oriented pricing. (In its initial roll out of ABP, the company offered its customers a choice between the older pricing system and APB, a practice the author recommends.)

Exhibit B provides an example of APB employed with the same product as was used for Exhibit A. In comparing the pricing in Exhibit A with that in Exhibit B, the per-unit pricing is approximately 27 per cent less with ABP than with the old direct-cost-plus style of pricing. On the other hand, the customer has a range of services to pay for under APB that it did not under the old regime. Importantly, because the customer had to pay for these services, it was much more powerfully incented to economize on their use. In this particular case, by moving to EOQ-driven batch sizes, making fewer demands in terms of rush deliveries and streamlining the way in which it implemented engineering change orders, the customer found that it could reduce its costs by 15 to 20 per cent (a result achieved with no adverse impact on the ABC-determined profitability of the manufacturing services supplier).

Lever #2: Improve inter-company business processes

Following the dramatic collapse of the business process re-engineering movement of the 1990s, many companies are once again paying greater attention to the management of their processes. Unlike many of the efforts from the 1990s, however, companies are taking a much more measured approach, exploiting opportunities for incremental gains wherever these can be achieved. As well, many companies are spending more time looking at inter-company business processes.

In many of the publicized examples of inter-company business processes change, the relevant parties are engaged in what appear to be partnering-type relationships. (Michael Hammer, “The Super efficient Company”, Harvard Business Review, September 2001, provides several interesting examples.) In this author’s view, however, companies involved in more transactional contexts can produce similar results by following the four steps below.

Step #1 – Map the existing set of shared processes. Most companies have no more than 7 to 10 main processes they share with both customers and suppliers. The manufacturing services company identified five main processes: (1) product design, (2) new product introduction, (3) supply chain planning, (4) order execution and (5) returns processing. Once the main processes have been identified, they need to be mapped, at least at a high level. Conversations with representative sets of customers and suppliers can usually help to ensure that the critical tasks, work and information flows and storage areas have been identified.

Step #2 – Articulate clearly how the processes need to improve. Many people talk about improving processes without being specific about how the process needs to improve. People often tend to think of process improvement as being synonymous with cost reduction. To be sure, cost reduction will, in many cases, be the most important outcome to achieve. In other cases, however, closer scrutiny will suggest that other outcomes, such as improving process speed, flexibility or quality, will make greater contributions to increased end-customer value.

Step #3 – Identify specific process improvement opportunities. The main kinds of process improvement opportunities found in internal operations tend to be prevalent in inter-company processes. In somewhat rare cases, there will be opportunities to redesign entire processes with a view to unlocking considerable new value. In many more cases, there will be opportunities to improve processes by eliminating areas of duplicated work, inefficient work flows or low value-added activities. Dealing with poorly performing inter-company hand-offs will in many cases also produce worthwhile gains.

Step #4 – Pay careful attention to implementation. Perhaps even more so than with intra-company process changes in which adherence can often be mandated, great care must be given to the way that changes to inter-company processes are implemented. On the customer side, a carefully designed set of incentives will almost always be critical to success. In some cases, there will be opportunities to design new service offerings that support inter-company process change. The manufacturing services company above, for example, is working on a set of on-line design aids that it expects will streamline the product design process it shares with its customers. On the supplier side, there is often easier access to the general management level, which can be helpful in facilitating change. As with customers, tying changes to improvements in the supplier’s profitability will typically be very important.

Lever #3: Consider Web services technology

A new set of technologies has come onto the scene over the last three to five years that promises to reinforce the gains made through incentive alignment and business process improvement initiatives. The technology is commonly referred to as Web services.

Their best efforts to the contrary, both technology visionaries and technology vendors often create impenetrable descriptions of their Web services. Fortunately, anyone who has used Google as a search engine, has obtained directions using MapQuest or has ordered a book on Amazon has had first-hand experience with Web services. In a nutshell, a Web service is a URL-addressable (i.e., it is available on the Internet) piece of software that performs functions and provides answers. A Web service is made by taking a piece of software functionality and wrapping it up so that the services it performs are visible and accessible to other software applications over the Internet.

So much for the definition. What can it do? The answer, interestingly, is somewhat boring for most technology visionaries, but quite interesting for the business executive. Essentially, the technology is being used to build low-cost and flexible connections between diverse applications already installed in companies.

A few examples might help illustrate. A company will often receive fax or e-mail purchase orders that must be entered manually into an ERP system. With an appropriate Web services application, customers could use their own ERP systems to interact directly with the company’s systems, over the Internet, eliminating the need for manual entry. Similarly, a customer’s order might require the company’s purchaser to place manual purchase orders with a number of suppliers. With appropriate Web services connections, the company’s purchasing application could, without manual intervention, interact with the ERP systems of its various suppliers. Finally, the company might wish to confirm product availability with a supplier before firming its order, a process requiring at least a couple of telephone calls and a manual computer search. With an appropriate Web services application, an automated set of queries and responses could be developed to do the job automatically, further reducing costs and increasing speed.

Although Web services technology is still very much in its early days and is still the subject of an enormous amount of hype, the successful experiences of Dell, GM and others suggest that the technology is likely worth exploring in the context of an inter-company productivity improvement effort.

While the implementation of some of the ideas outlined in this article will vary from company to company, it will often be advantageous to consider how the three levers outlined can be pulled in an integrated manner. New technology will often not go very far without the use of appropriate incentives. Offering appropriate incentives alone will miss significant opportunity where companies are working with inefficient inter-company processes. Companies that pull all three levers together can often achieve steady improvements in bottom-line performance.

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