SLOANSELECT COLLECTION FALL 2009 - MIT Sloan ... COLLECTION FALL 2009 REPRINT NUMBER OPS1109 Lessons...

SLOANSELECTCOLLECTION

FALL 2009

Lessons in OperationsManagement

A SPECIAL COLLECTION OF BUSINESS OPERATIONS INSIGHTS FROM MIT SLOAN MANAGEMENT REVIEW

LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW i

CONTENTSSLOANSELECTCOLLECTIONFALL 2009

REPRINT NUMBER OPS1109

Lessons in Operations Management

1 The Bullwhip Effect in Supply Chains Spring 1997

11 7 Deadly Sins of Performance Measurement Spring 2007

21 Sharing Global Supply Chain Knowledge Summer 2008

28 Evolving From Value Chain to Value Grid Summer 2006

37 Taking the Measure of Outsourcing Providers Spring 2005

45 Rethinking Procurement in the Era of Globalization Fall 2008

LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 1

93SLOAN MANAGEMENT REVIEW/SPRING 1997 LEE ET AL.

Not long ago, logistics executives at Procter &Gamble (P&G) examined the order pat-terns for one of their best-selling products,

Pampers. Its sales at retail stores were fluctuating, butthe variabilities were certainly not excessive. However,as they examined the distributors’ orders, the execu-tives were surprised by the degree of variability. Whenthey looked at P&G’s orders of materials to their sup-pliers, such as 3M, they discovered that the swingswere even greater. At first glance, the variabilities didnot make sense. While the consumers, in this case,the babies, consumed diapers at a steady rate, the de-mand order variabilities in the supply chain were am-plified as they moved up the supply chain. P&Gcalled this phenomenon the “bullwhip” effect. (Insome industries, it is known as the “whiplash” or the“whipsaw” effect.)

When Hewlett-Packard (HP) executives examinedthe sales of one of its printers at a major reseller, theyfound that there were, as expected, some fluctuations

over time. However, when they examined the ordersfrom the reseller, they observed much bigger swings.Also, to their surprise, they discovered that the ordersfrom the printer division to the company’s integratedcircuit division had even greater fluctuations.

What happens when a supply chain is plagued witha bullwhip effect that distorts its demand informationas it is transmitted up the chain? In the past, withoutbeing able to see the sales of its products at the distri-bution channel stage, HP had to rely on the sales or-ders from the resellers to make product forecasts, plancapacity, control inventory, and schedule production.Big variations in demand were a major problem forHP’s management. The common symptoms of suchvariations could be excessive inventory, poor productforecasts, insufficient or excessive capacities, poor cus-tomer service due to unavailable products or long back-logs, uncertain production planning (i.e., excessive revi-sions), and high costs for corrections, such as for expe-dited shipments and overtime. HP’s product divisionwas a victim of order swings that were exaggerated bythe resellers relative to their sales; it, in turn, createdadditional exaggerations of order swings to suppliers.

In the past few years, the Efficient Consumer Re-sponse (ECR) initiative has tried to redefine how thegrocery supply chain should work.1 One motivationfor the initiative was the excessive amount of invento-ry in the supply chain. Various industry studies foundthat the total supply chain, from when products leavethe manufacturers’ production lines to when they ar-rive on the retailers’ shelves, has more than 100 days of

The Bullwhip Effect in SupplyChains

Hau L. Lee • V. Padmanabhan • Seungjin Whang

Hau L. Lee is the Kleiner Perkins, Mayfield, Sequoia Capital Professorin Industrial Engineering and Engineering Management, and professorof operations management at the Graduate School of Business, StanfordUniversity. V. Padmanabhan is an associate professor of marketing, andSeungjin Whang is an associate professor of operations information andtechnology, also at Stanford.

Distorted information from one end

of a supply chain to the other can

lead to tremendous inefficiencies:

excessive inventory investment, poor

customer service, lost revenues,

misguided capacity plans, ineffective

transportation, and missed

production schedules. How do

exaggerated order swings occur? What

can companies do to mitigate them?


inventory supply. Distorted information has led everyentity in the supply chain — the plant warehouse, amanufacturer’s shuttle warehouse, a manufacturer’smarket warehouse, a distributor’s central warehouse,the distributor’s regional warehouses, and the retailstore’s storage space — to stockpile because of thehigh degree of demand uncertainties and variabili-

ties. It’s no wonder that the ECR reports estimated apotential $30 billion opportunity from streamliningthe inefficiencies of the grocery supply chain.2

Other industries are in a similar position. Computerfactories and manufacturers’ distribution centers, the

distributors’ warehouses, and store warehouses alongthe distribution channel have inventory stockpiles.And in the pharmaceutical industry, there are duplicat-ed inventories in a supply chain of manufacturers suchas Eli Lilly or Bristol-Myers Squibb, distributors suchas McKesson, and retailers such as Longs Drug Stores.Again, information distortion can cause the total in-ventory in this supply chain to exceed 100 days of sup-ply. With inventories of raw materials, such as integrat-ed circuits and printed circuit boards in the computerindustry and antibodies and vial manufacturing in thepharmaceutical industry, the total chain may containmore than one year’s supply.

In a supply chain for a typical consumer product,even when consumer sales do not seem to vary much,there is pronounced variability in the retailers’ ordersto the wholesalers (see Figure 1). Orders to the manu-facturer and to the manufacturers’ supplier spike evenmore. To solve the problem of distorted information,companies need to first understand what creates thebullwhip effect so they can counteract it. Innovativecompanies in different industries have found that they

94 LEE ET AL. SLOAN MANAGEMENT REVIEW/SPRING 1997

Figure 1 Increasing Variability of Orders up the Supply Chain

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The ordering patterns share acommon, recurring theme: thevariabilities of an upstream

site are always greater than those of the downstream site.


can control the bullwhip effect and improve their sup-ply chain performance by coordinating informationand planning along the supply chain.

Causes of the Bullwhip Effect

Perhaps the best illustration of the bullwhip effect isthe well-known “beer game.”3 In the game, partici-pants (students, managers, analysts, and so on) playthe roles of customers, retailers, wholesalers, and sup-pliers of a popular brand of beer. The participantscannot communicate with each other and must makeorder decisions based only on orders from the nextdownstream player. The ordering patterns share acommon, recurring theme: the variabilities of an up-stream site are always greater than those of the down-stream site, a simple, yet powerful illustration of thebullwhip effect. This amplified order variability maybe attributed to the players’ irrational decision making.Indeed, Sterman’s experiments showed that human be-havior, such as misconceptions about inventory anddemand information, may cause the bullwhip effect.4

In contrast, we show that the bullwhip effect is aconsequence of the players’ rational behavior withinthe supply chain’s infrastructure. This important dis-tinction implies that companies wanting to control thebullwhip effect have to focus on modifying the chain’sinfrastructure and related processes rather than the de-cision makers’ behavior.

We have identified four major causes of the bull-whip effect:1. Demand forecast updating 2. Order batching 3. Price fluctuation4. Rationing and shortage gaming

Each of the four forces in concert with the chain’sinfrastructure and the order managers’ rational deci-sion making create the bullwhip effect. Understandingthe causes helps managers design and develop strate-gies to counter it.5

Demand Forecast UpdatingEvery company in a supply chain usually does productforecasting for its production scheduling, capacity plan-ning, inventory control, and material requirementsplanning. Forecasting is often based on the order histo-ry from the company’s immediate customers.

The outcomes of the beer game are the conse-quence of many behavioral factors, such as the players’perceptions and mistrust. An important factor is eachplayer’s thought process in projecting the demand pat-tern based on what he or she observes. When a down-stream operation places an order, the upstream man-ager processes that piece of information as a signalabout future product demand. Based on this signal,the upstream manager readjusts his or her demandforecasts and, in turn, the orders placed with the sup-pliers of the upstream operation. We contend that de-mand signal processing is a major contributor to thebullwhip effect.

For example, if you are a manager who has to de-termine how much to order from a supplier, you use asimple method to do demand forecasting, such as ex-ponential smoothing. With exponential smoothing,future demands are continuously updated as the newdaily demand data become available. The order yousend to the supplier reflects the amount you need toreplenish the stocks to meet the requirements of futuredemands, as well as the necessary safety stocks. The fu-ture demands and the associated safety stocks are up-dated using the smoothing technique. With long leadtimes, it is not uncommon to have weeks of safetystocks. The result is that the fluctuations in the orderquantities over time can be much greater than those inthe demand data.

Now, one site up the supply chain, if you are themanager of the supplier, the daily orders from the man-ager of the previous site constitute your demand. If youare also using exponential smoothing to update yourforecasts and safety stocks, the orders that you placewith your supplier will have even bigger swings. For anexample of such fluctuations in demand, see Figure 2.As we can see from the figure, the orders placed by thedealer to the manufacturer have much greater variabili-ty than the consumer demands. Because the amount ofsafety stock contributes to the bullwhip effect, it is in-tuitive that, when the lead times between the resupplyof the items along the supply chain are longer, the fluc-tuation is even more significant.

Order BatchingIn a supply chain, each company places orders with anupstream organization using some inventory monitor-ing or control. Demands come in, depleting inven-



tory, but the company may not immediately placean order with its supplier. It often batches or accu-mulates demands before issuing an order. There aretwo forms of order batching: periodic ordering andpush ordering.

Instead of ordering frequently, companies mayorder weekly, biweekly, or even monthly. There aremany common reasons for an inventory system basedon order cycles. Often the supplier cannot handle fre-quent order processing because the time and cost ofprocessing an order can be substantial. P&G estimat-ed that, because of the many manual interventionsneeded in its order, billing, and shipment systems,each invoice to its customers cost between $35 and$75 to process.6 Many manufacturers place purchaseorders with suppliers when they run their material re-quirements planning (MRP) systems. MRP systemsare often run monthly, resulting in monthly orderingwith suppliers. A company with slow-moving itemsmay prefer to order on a regular cyclical basis becausethere may not be enough items consumed to warrantresupply if it orders more frequently.

Consider a company that orders once a monthfrom its supplier. The supplier faces a highly erraticstream of orders. There is a spike in demand at onetime during the month, followed by no demands forthe rest of the month. Of course, this variability ishigher than the demands the company itself faces.Periodic ordering amplifies variability and contributesto the bullwhip effect.

One common obstacle for a company that wantsto order frequently is the economics of transportation.There are substantial differences between full truck-

load (FTL) and less-than-truckload rates, so compa-nies have a strong incentive to fill a truckload whenthey order materials from a supplier. Sometimes, sup-pliers give their best pricing for FTL orders. For mostitems, a full truckload could be a supply of a monthor more. Full or close to full truckload ordering wouldthus lead to moderate to excessively long order cycles.

In push ordering, a company experiences regularsurges in demand. The company has orders “pushed”on it from customers periodically because salespeopleare regularly measured, sometimes quarterly or annu-ally, which causes end-of-quarter or end-of-year ordersurges. Salespersons who need to fill sales quotas may“borrow” ahead and sign orders prematurely. TheU.S. Navy’s study of recruiter productivity foundsurges in the number of recruits by the recruiters on aperiodic cycle that coincided with their evaluationcycle.7 For companies, the ordering pattern from theircustomers is more erratic than the consumption pat-terns that their customers experience. The “hockeystick” phenomenon is quite prevalent.

When a company faces periodic ordering by itscustomers, the bullwhip effect results. If all customers’order cycles were spread out evenly throughout the

week, the bullwhip effect would be minimal. The pe-riodic surges in demand by some customers would beinsignificant because not all would be ordering at thesame time. Unfortunately, such an ideal situation rarelyexists. Orders are more likely to be randomly spreadout or, worse, to overlap. When order cycles overlap,most customers that order periodically do so at thesame time. As a result, the surge in demand is evenmore pronounced, and the variability from the bull-whip effect is at its highest.

If the majority of companies that do MRP or dis-tribution requirement planning (DRP) to generatepurchase orders do so at the beginning of the month(or end of the month), order cycles overlap. Periodic


Although some companies claim to thrive on high-low buying

practices,most suffer.

Figure 2 Higher Variability in Orders from Dealer toManufacturer than Actual Sales

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execution of MRPs contributes to the bullwhip effect,or “MRP jitters” or “DRP jitters.”

Price FluctuationEstimates indicate that 80 percent of the transactionsbetween manufacturers and distributors in the groceryindustry were made in a “forward buy” arrangementin which items were bought in advance of require-ments, usually because of a manufacturer’s attractiveprice offer.8 Forward buying constitutes $75 billion to$100 billion of inventory in the grocery industry.9

Forward buying results from price fluctuations inthe marketplace. Manufacturers and distributors peri-odically have special promotions like price discounts,quantity discounts, coupons, rebates, and so on. Allthese promotions result in price fluctuations. Addi-tionally, manufacturers offer trade deals (e.g., specialdiscounts, price terms, and payment terms) to the dis-tributors and wholesalers, which are an indirect formof price discounts. For example, Kotler reports thattrade deals and consumer promotion constitute 47percent and 28 percent, respectively, of their total pro-motion budgets.10 The result is that customers buy inquantities that do not reflect their immediate needs;they buy in bigger quantities and stock up for the fu-ture.

Such promotions can be costly to the supply chain.11

What happens if forward buying becomes the norm?When a product’s price is low (through direct discountor promotional schemes), a customer buys in biggerquantities than needed. When the product’s price re-turns to normal, the customer stops buying until it hasdepleted its inventory. As a result, the customer’s buy-ing pattern does not reflect its consumption pattern,and the variation of the buying quantities is much big-ger than the variation of the consumption rate — thebullwhip effect.

When high-low pricing occurs, forward buyingmay well be a rational decision. If the cost of holdinginventory is less than the price differential, buying inadvance makes sense. In fact, the high-low pricingphenomenon has induced a stream of research onhow companies should order optimally to take ad-vantage of the low price opportunities.

Although some companies claim to thrive onhigh-low buying practices, most suffer. For example,a soup manufacturer’s leading brand has seasonal

sales, with higher sales in the winter (see Figure 3).However, the shipment quantities from the manufac-turer to the distributors, reflecting orders from thedistributors to the manufacturer, varied more widely.When faced with such wide swings, companies oftenhave to run their factories overtime at certain timesand be idle at others. Alternatively, companies mayhave to build huge piles of inventory to anticipate bigswings in demand. With a surge in shipments, theymay also have to pay premium freight rates to trans-port products. Damage also increases from handlinglarger than normal volumes and stocking inventoriesfor long periods. The irony is that these variations areinduced by price fluctuations that the manufacturersand the distributors set up themselves. It’s no wonderthat such a practice was called “the dumbest market-ing ploy ever.”12

Using trade promotions can backfire because of theimpact on the manufacturers’ stock performance. Agroup of shareholders sued Bristol-Myers Squibbwhen its stock plummeted from $74 to $67 as a resultof a disappointing quarterly sales performance; its ac-tual sales increase was only 5 percent instead of the an-ticipated 13 percent. The sluggish sales increase wasreportedly due to the company’s trade deals in a previ-ous quarter that flooded the distribution channel withforward-buy inventories of its product.13

Rationing and Shortage GamingWhen product demand exceeds supply, a manufactureroften rations its product to customers. In one scheme,the manufacturer allocates the amount in proportionto the amount ordered. For example, if the total supplyis only 50 percent of the total demand, all customers


Figure 3 Bullwhip Effect due to Seasonal Sales of Soup

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receive 50 percent of what they order. Knowing thatthe manufacturer will ration when the product is inshort supply, customers exaggerate their real needswhen they order. Later, when demand cools, orderswill suddenly disappear and cancellations pour in. Thisseeming overreaction by customers anticipating short-ages results when organizations and individuals makesound, rational economic decisions and “game” thepotential rationing.14 The effect of “gaming” is thatcustomers’ orders give the supplier little informationon the product’s real demand, a particularly vexingproblem for manufacturers in a product’s early stages.The gaming practice is very common. In the 1980s,on several occasions, the computer industry perceiveda shortage of DRAM chips. Orders shot up, not be-cause of an increase in consumption, but because ofanticipation. Customers place duplicate orders withmultiple suppliers and buy from the first one that candeliver, then cancel all other duplicate orders.15

More recently, Hewlett-Packard could not meet thedemand for its LaserJet III printer and rationed theproduct. Orders surged, but HP managers could notdiscern whether the orders genuinely reflected realmarket demands or were simply phantom orders fromresellers trying to get better allocation of the product.When HP lifted its constraints on resupply of theLaserJets, many resellers canceled their orders. HP’scosts in excess inventory after the allocation periodand in unnecessary capacity increases were in the mil-lions of dollars.16

During the Christmas shopping seasons in 1992and 1993, Motorola could not meet consumer de-mand for handsets and cellular phones, forcing manydistributors to turn away business. Distributors likeAirTouch Communications and the Baby Bells, an-ticipating the possibility of shortages and acting de-fensively, drastically overordered toward the end of1994.17 Because of such overzealous ordering by retaildistributors, Motorola reported record fourth-quarterearnings in January 1995. Once Wall Street realizedthat the dealers were swamped with inventory andnew orders for phones were not as healthy before,Motorola’s stock tumbled almost 10 percent.

In October 1994, IBM’s new Aptiva personal com-puter was selling extremely well, leading resellers tospeculate that IBM might run out of the product be-fore the Christmas season. According to some analysts,

IBM, hampered by an overstock problem the previousyear, planned production too conservatively. Other an-alysts referred to the possibility of rationing: “Retailers— apparently convinced Aptiva will sell well and afraidof being left with insufficient stock to meet holidayseason demand — increased their orders with IBM,believing they wouldn’t get all they asked for.”18 It wasunclear to IBM how much of the increase in orderswas genuine market demand and how much was dueto resellers placing phantom orders when IBM had toration the product.

How to Counteract the Bullwhip Effect

Understanding the causes of the bullwhip effect canhelp managers find strategies to mitigate it. Indeed,many companies have begun to implement innovativeprograms that partially address the effect. Next we ex-amine how companies tackle each of the four causes.We categorize the various initiatives and other possibleremedies based on the underlying coordination mech-anism, namely, information sharing, channel align-ment, and operational efficiency. With informationsharing, demand information at a downstream site istransmitted upstream in a timely fashion. Channelalignment is the coordination of pricing, transporta-tion, inventory planning, and ownership between theupstream and downstream sites in a supply chain.Operational efficiency refers to activities that improveperformance, such as reduced costs and lead time. Weuse this topology to discuss ways to control the bull-whip effect (see Table 1).

Avoid Multiple Demand Forecast UpdatesOrdinarily, every member of a supply chain conductssome sort of forecasting in connection with its plan-ning (e.g., the manufacturer does the production plan-ning, the wholesaler, the logistics planning, and so on).Bullwhip effects are created when supply chain mem-bers process the demand input from their immediatedownstream member in producing their own forecasts.Demand input from the immediate downstream mem-ber, of course, results from that member’s forecasting,with input from its own downstream member.

One remedy to the repetitive processing of consump-tion data in a supply chain is to make demand data at adownstream site available to the upstream site. Hence,



both sites can update their forecastswith the same raw data. In the com-puter industry, manufacturers requestsell-through data on withdrawn stocksfrom their resellers’ central warehouse.Although the data are not as completeas point-of-sale (POS) data from theresellers’ stores, they offer significantlymore information than was availablewhen manufacturers didn’t know whathappened after they shipped theirproducts. IBM, HP, and Apple all re-quire sell-through data as part of theircontract with resellers.

Supply chain partners can use elec-tronic data interchange (EDI) to sharedata. In the consumer products indus-try, 20 percent of orders by retailers ofconsumer products was transmittedvia EDI in 1990.19 In 1992, that fig-ure was close to 40 percent and, in1995, nearly 60 percent. The increas-ing use of EDI will undoubtedly fa-cilitate information transmission andsharing among chain members.

Even if the multiple organizationsin a supply chain use the same source demand data toperform forecast updates, the differences in forecastingmethods and buying practices can still lead to unnec-essary fluctuations in the order data placed with theupstream site. In a more radical approach, the up-stream site could control resupply from upstream todownstream. The upstream site would have access tothe demand and inventory information at the down-stream site and update the necessary forecasts and re-supply for the downstream site. The downstream site,in turn, would become a passive partner in the supplychain. For example, in the consumer products indus-try, this practice is known as vendor-managed inven-tory (VMI) or a continuous replenishment program(CRP). Many companies such as Campbell Soup,M&M/Mars, Nestlé, Quaker Oats, Nabisco, P&G,and Scott Paper use CRP with some or most of theircustomers. Inventory reductions of up to 25 percent arecommon in these alliances. P&G uses VMI in its dia-per supply chain, starting with its supplier, 3M, and itscustomer, Wal-Mart. Even in the high-technology sec-

tor, companies such as Texas Instruments, HP, Motorola,and Apple use VMI with some of their suppliers and, insome cases, with their customers.

Inventory researchers have long recognized thatmulti-echelon inventory systems can operate betterwhen inventory and demand information from down-stream sites is available upstream. Echelon inventory— the total inventory at its upstream and downstreamsites — is key to optimal inventory control.20

Another approach is to try to get demand informa-tion about the downstream site by bypassing it. AppleComputer has a “consumer direct” program, i.e., itsells directly to consumers without going through thereseller and distribution channel. A benefit of the pro-gram is that it allows Apple to see the demand patternsfor its products. Dell Computers also sells its productsdirectly to consumers without going through the dis-tribution channel.

Finally, as we noted before, long resupply lead timescan aggravate the bullwhip effect. Improvements inoperational efficiency can help reduce the highly vari-


Table 1 A Framework for Supply Chain Coordination Initiatives

Causes of Information Channel OperationalBullwhip Sharing Alignment Efficiency

Demand • Understanding • Vendor-managed • Lead-time reductionForecast system dynamics inventory (VMI) • Echelon-basedUpdate • Use point-of-sale • Discount for infor- inventory control

(POS) data mation sharing• Electronic data • Consumer direct

interchange (EDI)• Internet• Computer-assisted

ordering (CAO)

Order • EDI • Discount for truck- • Reduction in fixedBatching • Internet ordering load assortment cost of ordering by

• Delivery appoint- EDI or electronicments commerce

• Consolidation • CAO• Logistics out-

sourcing

Price • Continuous • Everyday low priceFluctuations replenishment (EDLP)

program (CRP) • Activity-based• Everyday low cost costing (ABC)

(EDLC)

Shortage • Sharing sales, • Allocation based Gaming capacity, and on past sales

inventory data


able demand due to multiple forecast updates. Hence,just-in-time replenishment is an effective way to miti-gate the effect.

Break Order BatchesSince order batching contributes to the bullwhip effect,companies need to devise strategies that lead to smallerbatches or more frequent resupply. In addition, thecounterstrategies we described earlier are useful. Whenan upstream company receives consumption data on afixed, periodic schedule from its downstream cus-tomers, it will not be surprised by an unusually largebatched order when there is a demand surge.

One reason that order batches are large or order fre-quencies low is the relatively high cost of placing anorder and replenishing it. EDI can reduce the cost ofthe paperwork in generating an order. Using EDI,companies such as Nabisco perform paperless, com-puter-assisted ordering (CAO), and, consequently, cus-tomers order more frequently. McKesson’s Economostordering system uses EDI to lower the transactioncosts from orders by drugstores and other retailers.21

P&G has introduced standardized ordering termsacross all business units to simplify the process and dra-matically cut the number of invoices.22 And GeneralElectric is electronically matching buyers and suppliersthroughout the company. It expects to purchase at least$1 billion in materials through its internally developedTrading Process Network. A paper purchase order thattypically cost $50 to process is now $5.23

Another reason for large order batches is the cost oftransportation. The differences in the costs of fulltruckloads and less-than-truckloads are so great thatcompanies find it economical to order full truckloads,even though this leads to infrequent replenishmentsfrom the supplier. In fact, even if orders are made withlittle effort and low cost through EDI, the improve-ments in order efficiency are wasted due to the full-truckload constraint. Now some manufacturers inducetheir distributors to order assortments of different prod-ucts. Hence a truckload may contain different prod-ucts from the same manufacturer (either a plant ware-house site or a manufacturer’s market warehouse)instead of a full load of the same product. The effect isthat, for each product, the order frequency is muchhigher, the frequency of deliveries to the distributorsremains unchanged, and the transportation efficiency

is preserved. P&G has given discounts to distributorsthat are willing to order mixed-SKU (stock-keepingunit) loads of any of its products.24 Manufacturerscould also prepare and ship mixed SKUs to the distrib-utors’ warehouses that are ready to deliver to the stores.

“Composite distribution” for fresh produce andchilled products uses the same mixed-SKU concept tomake resupply more frequent. Since fresh produce andchilled foods need to be stored at different tempera-tures, trucks to transport them need to have varioustemperatures. British retailers like Tesco and Sainsburyuse trucks with separate compartments at differenttemperatures so that they can transport many productson the same truck.25

The use of third-party logistics companies also helpsmake small batch replenishments economical.26 Thesecompanies allow economies of scale that were not fea-sible in a single supplier-customer relationship. Byconsolidating loads from multiple suppliers locatednear each other, a company can realize full truckloadeconomies without the batches coming from the samesupplier. Of course, there are additional handling and

administrative costs for such consolidations or multi-ple pickups, but the savings often outweigh the costs.

Similarly, a third-party logistics company can utilizea truckload to deliver to customers who may be com-petitors, such as neighboring supermarkets. If eachcustomer is supplied separately via full truckloads,using third-party logistics companies can mean mov-ing from weekly to daily replenishments. For smallcustomers whose volumes do not justify frequent fulltruckload replenishments independently, this is espe-cially appealing. Some grocery wholesalers that receiveFTL shipments from manufacturers and then shipmixed loads to wholesalers’ independent stores use lo-


The simplest way to control thebullwhip effect caused by

forward buying and diversionsis to reduce both the frequency and the level of wholesale price

discounting.


gistics companies. In the United Kingdom, Sainsburyand Tesco have long used National Freight Companyfor logistics. As a result of the heightened awarenessdue to the ECR initiative in the grocery industry, weexpect to see third-party logistics companies that fore-cast orders, transport goods, and replenish stores withmixed-SKU pallets from the manufacturers.

When customers spread their periodic orders or re-plenishments evenly over time, they can reduce thenegative effect of batching. Some manufacturers coor-dinate their resupply with their customers. For exam-ple, P&G coordinates regular delivery appointmentswith its customers. Hence, it spreads the replenish-ments to all the retailers evenly over a week.

Stabilize PricesThe simplest way to control the bullwhip effect causedby forward buying and diversions is to reduce both thefrequency and the level of wholesale price discounting.The manufacturer can reduce the incentives for retailforward buying by establishing a uniform wholesalepricing policy. In the grocery industry, major manufac-turers such as P&G, Kraft, and Pillsbury have movedto an everyday low price (EDLP) or value pricing strat-egy. During the past three years, P&G has reduced itslist prices by 12 percent to 24 percent and aggressivelyslashed the promotions it offers to trade customers. In1994, P&G reported its highest profit margins in twenty-one years and showed increases in market share.27 Simi-larly, retailers and distributors can aggressively negotiatewith their suppliers to give them everyday low cost(EDLC). From 1991 to 1994, the percentage of tradedeals in the total promotion budget of grocery productsdropped from 50 percent to 47 percent.

From an operational perspective, practices such asCRP together with a rationalized wholesale pricingpolicy can help to control retailers’ tactics, such as di-version. Manufacturers’ use of CAO for sending or-ders also minimizes the possibility of such a practice.

Activity-based costing (ABC) systems enable com-panies to recognize the excessive costs of forward buy-ing and diversions. When companies run regionalpromotions, some retailers buy in bulk in the areawhere the promotions are held, then divert the prod-ucts to other regions for consumption. The costs ofsuch practices are huge but may not show up in con-ventional accounting systems. ABC systems provide

explicit accounting of the costs of inventory, storage,special handling, premium transportation, and so onthat previously were hidden and often outweigh thebenefits of promotions. ABC therefore helps compa-nies implement the EDLP strategy.28

Eliminate Gaming in Shortage SituationsWhen a supplier faces a shortage, instead of allocatingproducts based on orders, it can allocate in proportionto past sales records. Customers then have no incentiveto exaggerate their orders. General Motors has longused this method of allocation in cases of short supply,and other companies, such as Texas Instruments andHewlett-Packard, are switching to it.

“Gaming” during shortages peaks when customershave little information on the manufacturers’ supplysituation. The sharing of capacity and inventory infor-mation helps to alleviate customers’ anxiety and, conse-quently, lessen their need to engage in gaming. Butsharing capacity information is insufficient when thereis a genuine shortage. Some manufacturers work withcustomers to place orders well in advance of the salesseason. Thus they can adjust production capacity orscheduling with better knowledge of product demand.

Finally, the generous return policies that manufac-turers offer retailers aggravate gaming. Without apenalty, retailers will continue to exaggerate theirneeds and cancel orders. Not surprisingly, some com-puter manufacturers are beginning to enforce morestringent cancellation policies.

�

We contend that the bullwhip effect results from ration-al decision making by members in the supply chain.Companies can effectively counteract the effect by thor-oughly understanding its underlying causes. Industryleaders like Procter & Gamble are implementing inno-vative strategies that pose new challenges: integratingnew information systems, defining new organizationalrelationships, and implementing new incentive andmeasurement systems. The choice for companies isclear: either let the bullwhip effect paralyze you or finda way to conquer it. �

References

1. This initiative was engineered by Kurt Salmon Associates but pro-



pelled by executives from a group of innovative companies like Procter& Gamble and Campbell Soup Company. See:Kurt Salmon Associates, “ECR: Enhancing Consumer Value in theGrocery Industry (Washington, D.C.: report, January 1993); andF.A. Crawford, “ECR: A Mandate for Food Manufacturers?” FoodProcessing, volume 55, February 1994, pp. 34-42. 2. J.A. Cooke, “The $30 Billion Promise,” Traffic Management, volume32, December 1993, pp. 57-59. 3. J. Sterman, “Modeling Managerial Behavior: Misperception ofFeedback in a Dynamic Decision-Making Experiment,” ManagementScience, volume 35, number 3, 1989, pp. 321-339. 4. Sterman (1989); andP. Senge, The Fifth Discipline: The Art and Practice of the LearningOrganization (New York: Doubleday/Currency, 1990).5. For a theoretical treatment of this subject, see:H.L. Lee, P. Padmanabhan, and S. Whang, “Information Distortionin a Supply Chain: The Bullwhip Effect,” Management Science, 1997,forthcoming. 6. M. Millstein, “P&G to Restructure Logistics and Pricing,” Super-market News, 27 June 1994, pp. 1, 49.7. V. Carroll, H.L. Lee, and A.G. Rao, “Implications of SalesforceProductivity, Heterogeneity and Demotivation: A Navy Recruiter CaseStudy,” Management Science, volume 32, number 11, 1986, pp. 1371-1388. 8. Salmon (1993).9. P. Sellers, “The Dumbest Marketing Ploy,” Fortune, volume 126, 5October 1992, pp. 88-93. 10. P. Kotler, Marketing Management: Analysis, Planning, Implementation,and Control (Englewood Cliffs, New Jersey: Prentice Hall, 1997).11. R.D. Buzzell, J.A. Quelch, and W.J. Salmon, “The Costly Bargainof Trade Promotion,” Harvard Business Review, volume 68, March-April 1990, pp. 141-148.

12. Sellers (1992).13. Ibid.14. Lee et al. (1997).15. L. Lode, “The Role of Inventory in Delivery Time Competition,”Management Science, volume 38, number 2, 1992, pp. 182-197.16. Personal communication with Hewlett-Packard.17. K. Kelly, “Burned by Busy Signals: Why Motorola Ramped upProduction Way Past Demand,” Business Week, 6 March 1995, p. 36. 18. Rory J. O’Connor, “Rumor Bolsters IBM Shares,” San Jose MercuryNews, 8 October 1994, p. 9D. 19. M. Reid, “Change at the Check-Out,” The Economist, volume334, 4 March 1995, pp. 3-18. 20. A. Clark and H. Scarf, “Optimal Policies for a Multi-EchelonInventory Problem,” Management Science, volume 6, number 4, 1960,pp. 465-490.21. E.K. Clemons and M. Row, “McKesson Drug Company — AStrategic Information System,” Journal of Management InformationSystems, volume 5, Summer 1988, pp. 36-50. 22. Millstein (1994).23. T. Smart, “Jack Welch’s Cyber-Czar,” Business Week, 5 August1996, pp. 82-83. 24. G. Stern, “Retailers of P&G to Get New Plan on Bills, Shipment,”Wall Street Journal, 22 June 1994.25. Reid (1995).26. H.L. Richardson, “How Much Should You Outsource?,” Trans-portation and Distribution, volume 35, September 1994, pp. 61-62. 27. Z. Schiller, “Ed Artzt’s Elbow Grease Has P&G Shining,” BusinessWeek, 10 October 1994, pp. 84-86.28. R. Mathews, “CRP Moves Towards Reality,” Progressive Grocer,volume 73, July 1994, pp. 43-44.

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LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 11SPRING 2007 MIT SLOAN MANAGEMENT REVIEW 19

S P E C I A L R E P O R T: M E A S U R I N G T O M A N A G E

Operational performance measurement remains an unsolved problem. Despite the relatively little attention it gets in the management literature, designing and using metrics to track and improve operating performance is one of the most persist-ent problems that organizations face. In my interactions with companies in virtually every industry, I scarcely ever encounter one that believes it has an effective set of metrics for theiroperations: manufacturing, customer service, marketing, pro-curement and the like. To be sure, companies do have measure-ments for these areas that they employ every day, but few managers or staff believe that these metrics are the right ones or that they help the company improve its performance and achieve its strategic goals. This is remarkable for two reasons: First, operational performance measurement is so fundamental

Michael Hammer is president of Hammer and Company, a management education and research firm based in Cam-bridge, Massachusetts. He is also a Visiting Professor of Engineering Systems at MIT and a Fellow of the Said Business School at Oxford University. He is the author of numerous books and articles on transforming operational performance. His Web site is www.hammerandco.com. Comment on this article or contact the authors through [email protected].

7[and How to Avoid Them]

OF PERFORMANCE MEASUREMENT

THE

SinsDEADLY

By Michael Hammer

LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 1220 MIT SLOAN MANAGEMENT REVIEW SPRING 2007

to basic operational management that it

should presumably have been resolved a

long time ago; second, in the last several

years companies have developed much

more sophisticated strategic measurement

systems, based on such tools as the bal-

anced scorecard, key performance

indicators, computerized dashboards and

the like. Nonetheless, among the hundreds

of managers with whom I have discussed

this matter, there is a widespread consensus

that they measure too much or too little, or

the wrong things, and that in any event

they don’t use their metrics effectively.

The most striking manifestation of

this problem is that many of the opera-

tional metrics that companies commonly

use make little or no sense. I have found

that organizations fall prey to a half

dozen or so recurring mistakes in defin-

ing and using metrics, mistakes that

seriously impede the relevance and use-

fulness of their operating measures and

that help explain the widespread malaise

about measurement that they feel. I call

these the seven deadly sins of perform-

ance measurement, and, like the seven

deadly sins of theology, they present

grave dangers, if not to the prospects for

the immortal soul then to the prospects

for superior business performance.

1 Vanity One of the most wide-

spread mistakes in performance

measurement is to use measures

that will inevitably make the or-

ganization, its people and especially its

managers look good. As one executive

said, “Nobody wants a metric that they

don’t score 95 on.” This is particularly the

case since bonuses and other rewards are

usually tied to results measured in terms

of performance measures. For instance,

in the area of logistics and order fulfill-

ment, it is common for companies to

measure themselves against promise date

— that is, whether they shipped on the

date that they promised the customer. A

moment’s impartial reflection shows that

this sets the bar absurdly low — a com-

pany need only promise delivery dates

that it can easily make in order to look

good on this metric. Even worse, compa-

nies often measure against what is called

last promise date — the final date prom-

ised the customer, after changes may have

been made to the delivery schedule. It

Philosophy of Performance

Measurement

Typically, companies overload

their managers with metrics

that measure personal perfor-

mance rather than process

performance, frequently

missing improvement oppor-

tunities across the process.

Looking at the entire value

stream captures the sequence

and interaction of the pro-

cesses and how they relate to

one another, in terms of in-

puts and outputs.

We took an evolutionary

step toward a process point of

view by implementing

“shared metrics” across our

value stream. Customers are

now involved as part of the

process team when creating

process definition; a process

team that comprises cross-

functions, including the

customer, is more readily

postured for success.

The Deadliest Sin

Unfortunately, all the sins Dr.

Hammer enumerates are

prevalent in today’s business

environment, but Laziness

bears emphasizing. It is a trap

to assume that one inherently

knows what is important to

measure, yet this is how many

companies create metrics.

They often jump to conclu-

sions, or measure what is easy

to measure, or measure what

they have always measured

rather than go through the ef-

fort of ascertaining what is

truly important to the cus-

tomer to measure, thereby

generating misleading data.

It is essential to have the right

data — data that when ana-

lyzed can reveal whether the

process is capable of meeting

customer expectations and

requirements. A process flow

chart will enable the process

owner to determine “trigger”

points in the process, thereby

establishing measures at

those trigger points. This

takes work, the type of work

in which companies generally

do not want to invest time

and resources and which

they don’t appropriately

value. This is why companies

often jump to using correc-

tive and preventative actions

and/or continuous improve-

ment activities that are

inappropriate.

The Key Metric

There is no one key metric,

but at Boeing Rotocraft Mesa

there is definitely a key pro-

cess to follow in defining a

metric:

1. Start with a SIPOC

(an analysis of the supplier-

input-process-output-customer

continuum) and a process

flow chart.

2. Identify process outputs

that are important to the

customer.

3. Determine the type of

measure, for example, in-pro-

cess, process output or

process efficiency.

4. Establish the minimally ac-

cepted performance level. The

customer must be involved in

this determination.

5. Determine if this is a

“shared” metric.

6. Determine the units of

measure, data availability,

analysis method and fre-

quency of data collection

and reporting.

7. Document the measure.

MIND OF THE MANAGER

Carole J. Haney Process Owner — Process Management and Process Performance, The Boeing Company, Integrated Defense Systems, Rotorcraft Division, Mesa, Arizona

SLOANREVIEW.MIT.EDU/SMR



takes real effort not to hit the last promise

date. Moreover, achieving good results on

last promise date has no larger signifi-

cance for company performance; it does

not lead to customer satisfaction or any

other desirable outcome. A far better

metric would be performance against

customer request date — but achieving

that goal would be more difficult and

might lead to managers not getting their

bonuses. When executives at a semi-

conductor manufacturer proposed

shifting from last promise date to cus-

tomer request date, they encountered

widespread pushback and resistance. A

metals refiner had been using yield — the

percentage of raw material that was

turned into salable product — as a key

performance metric, and everyone was

very pleased that this figure was consis-

tently over 95%. An executive new to the

company made the observation that this

figure glossed over the difference between

high-grade and low-grade product; the

refinery was supposed to produce only

high-grade product, but poor processing

sometimes led to low-grade product. The

company then started to measure the

yield of high-grade product and discov-

ered that figure was closer to 70% — and

a much more meaningful representation

of the refinery’s real performance. Not

surprisingly, this insight was not wel-

comed with great enthusiasm.

2Provincialism This is the sin of

letting organizational bound-

aries and concerns dictate

performance metrics. On the

surface, it would seem natural and appro-

priate for a functional department to be

measured on its own performance —

after all, that is what its managers can

control. In reality, however, measuring

narrowly inevitably leads to suboptimiza-

tion and conflict. For instance, one

insurance company chief executive has

complained that he spends half his time

adjudicating disputes between sales and

underwriting. Sales is usually measured in

Philosophy of Perform-

ance Measurement

My view is not unique,

perhaps, but it is undeni-

able: You can’t manage

without measuring, and

what is measured gets

done. Measurement is

the antidote to ambigu-

ity; it forces you to

impose clarity on vague

concepts and to take ac-

tion. What we measure

communicates our prior-

ities and thus has a

powerful link to strategy.

For example, at Tetra

Pak, we had always talked

about the importance of

lowering the operating

cost for our customers

using our equipments and

products — with very little

action. Two years ago,

however, we created a

measure on our Balanced

Scorecard of percent re-

duction of customer

operating cost, which

quickly mobilized the or-

ganization to action. The

first step was to get a de-

tailed understanding of

the components of and in-

fluences on customer cost,

such as labor, down time,

energy, parts, waste and

so on. We then developed

a model for how to reduce

cost systematically and

began to run selected cus-

tomer projects together to

increase efficiency and re-

duce cost in high-impact

areas. Among the things

we learned was the signifi-

cance of the installation

itself on operating cost. As

a result, we designed and

implemented a new proc-

ess — installation to

performance.

The Deadliest Sin

In my career, I have seen

evidence of all Dr. Ham-

mer’s “deadly sins,” but

Provincialism is worth

highlighting. The great-

est counter to

provincialism is process

orientation with an end-

to-end focus on the

customer. For example,

in our machine sales we

used to measure time

from order to dispatch.

However, this is not a

very useful metric from a

customer’s perspective.

From a manufacturing

point of view, the proc-

ess is complete, but

much still has to happen

before product reaches,

and satisfies, the cus-

tomer: transit, inventory,

installation, service. Our

new scope of measure-

ment is from “order to

performance” — mean-

ing the time from when

the customer places the

order until it is installed

and up and running ac-

cording to guaranteed

performance criteria

that we sold them. Need-

less to say, this is

transformational.

The Key Metric

The identity of the most

crucial metric will vary

over time, of course, de-

pending on strategy and

progress against specific

targets in the strategy.

Currently, with the accel-

erated pace in the

competitive landscape,

product development

time is a critical metric

for Tetra Pak. We have set

a target to reduce time to

market by 50% by 2010.

I Recommend

I have been very inspired

by the Balanced Score-

card work of Harvard

Business School’s Robert

S. Kaplan, especially in

terms of linking metrics

to strategy and taking a

holistic view across four

perspectives — finance,

customer, process and or-

ganization. I also find the

research done by Christo-

pher D. Ittner and David F.

Larcker at the Wharton

School of the University of

Pennsylvania very insight-

ful and very important.

They underline the diffi-

culties of capturing

nonfinancial metrics and

highlight common mis-

takes made in that regard.

Their conclusion that

management needs to be

much more rigorous

when working with nonfi-

nancial measures cannot

be stressed enough.

MIND OF THE MANAGER

Anders Wester Vice President, Business Transformation & Strategic Planning, Tetra Pak Group


LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 14SLOANREVIEW.MIT.EDU/SMR22 MIT SLOAN MANAGEMENT REVIEW SPRING 2007

sales volume, which motivates the sales

force to sell to any willing customer.

Underwriting, however, is measured in

quality of risk, which leads personnel to

want to reject all but the best prospects.

The transportation group in a retailer was

measured in terms of freight costs. While

ostensibly reasonable, this led the group

to search out the best deals in shipping,

even if this meant that deliveries to the

distribution centers would sometimes be

early and sometimes late — resulting

either in out-of-stock situations or in

chaos at the receiving dock.

3 Narcissism This is the unpar-

donable offense of measuring

from one’s own point of view,

rather than from the customer’s

perspective. A retailer, for instance, mea-

sured its distribution organization based

on whether the goods in the stores

matched the stock-on-hand levels speci-

fied in the merchandising plan. It had a

satisfying 98% availability when meas-

ured in this way. But when it thought to

measure to what extent the goods in the

stores matched what customers actually

wanted to buy, rather than what the mer-

chandising plan called for, the figure was

only 86%. Another retailer measured

goods-in-stock by whether the goods

had arrived in the store; eventually, the

company realized that simply being in

the store did the customer no good if the

product wasn’t on the shelf — and on-

shelf availability was considerably lower

than in-store availability. Many compa-

nies measure the performance of order

fulfillment in terms of whether the ship-

ment left the dock on the date scheduled.

This is of interest only to the company it-

self — customers care about when they

receive the shipment, not when it leaves

the dock. A major computer systems

manufacturer measured on-time shipping

in terms of individual components; if it

shipped, say, nine of 10 components of a

system on time, it gave itself a 90% score.

The customer, of course, would give the

company a 0% rating, since without all 10

components the system cannot operate.

4 Laziness This is a trap that

even those who avoid narcis-

sism often fall into: assuming

one knows what is important to

measure without giving it adequate

thought or effort. A semiconductor

maker measured many aspects of its

order processing operation, but not the

critical (to customers) issue of how long

it took from the time the customer gave

the order to the time the company con-

firmed the order and provided a delivery

date — simply because it never thought

to ask customers what was really impor-

tant to them. An electric power utility

assumed that customers cared about

speed of installation and so measured

and tried to improve that factor, only to

discover later that customers cared more

about the reliability of the installation

date they were given than about its prox-

imity. Companies often jump to

conclusions, or measure what is easy to

measure or measure what they have al-

ways measured, rather than go through

the effort of ascertaining what is truly im-

portant to measure.

5 Pettiness Too often, compa-

nies measure only a small

component of what matters. A

telecommunications systems

vendor rejected a proposal to have cus-

tomers perform their own repairs because

that would require putting spare parts at

customer premises, which would drive up

spare parts inventory levels — a key met-

ric for the company. It lost sight of the fact

that the broader and more meaningful

metric was total cost of maintenance —

the sum of labor costs and inventory costs

— and that the increase in parts inventory

would be more than offset by a reduction

in labor costs the new approach would re-

alize. It is a basic axiom in the apparel

industry that manufacturing needs to be

done in Asia in order to lower manufac-

turing costs. Zara International Inc., the

phenomenally successful Spanish apparel

company, has recognized that the larger

metric is product profitability, which does

reflect manufacturing costs but is also af-

fected by the timeliness of the product

line and the volume of goods that need to

be sold off at the end of the season. By

doing production in Europe after the sea-

son has started and after new products

have been tested in the field, Zara ensures

that its fashions sell well and that it has lit-

tle left at the end of the season, payoffs

that more than offset the higher produc-

tion costs.

6 Inanity Many companies

seem to implement metrics

without giving any thought to

the consequences of these

metrics on human behavior and ulti-

mately on enterprise performance.

People in an organization will seek to

improve a metric they are told is impor-

tant, especially if they are compensated

for it — even if doing so has counter-

productive consequences. For instance,

a regional fast-food chain specializing

in chicken decided to improve financial

performance by reducing waste — waste

being defined as chicken that had been


People will seek to improve a metric they are told is important, especially if

they are compensated for it — even if doing so is

counterproductive.

LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 15SPRING 2007 MIT SLOAN MANAGEMENT REVIEW 23SLOANREVIEW.MIT.EDU/SMR

cooked but unsold at the end of the day

and thus discarded. Restaurant man-

agers throughout the chain obediently

responded by driving out waste — in

many cases, by telling their staff not to

cook any chicken until it had been or-

dered. This had the unfortunate and

perverse consequence of turning a fast-

food chain into a slow-food chain; waste

declined but sales declined even more.

Similarly, the common practice of meas-

uring warehouse inventory at the end of

the month encourages the warehouse

manager to clear goods out just before

the end of the month and then rush to

replace them at the beginning of the

next month, thereby creating chaos and

higher costs.

7 Frivolity This may be the most

serious sin of all; it is the sin of

not being serious about meas-

urement in the first place. It is

manifested by arguing about metrics in-

stead of taking them to heart, by finding

excuses for poor performance instead of

tracking root causes, by looking for ways

to pass the blame to others rather than


Measurement

Two common viewpoints heard

in corporate hallways are “You

get what you measure” and

“You can’t measure what you

can’t see.” But it is also true that

if you have the wrong measure,

you may drive an undesired be-

havior and consequence. For

example, focusing only on the

line fill rate or completed orders

causes the supply chain organi-

zation efforts to stop when the

product transfers to the retailer,

but if the product does not

make it to the shelf and the

shelves become empty, both

the retailer and the manufac-

turer lose sales and, most

importantly, the shopper walks

away disappointed.

For a number of years, The

Procter & Gamble Company

used an internal measure of

service — percentage of orders

filled — and tracked, reported,

acted on and so forth. And the

result looked quite good at

99.5%. But when we decided

to extend our view to the store

shelf, we found a very different

picture. In fact, we found that

certain products were out of

stock 10%-14% of the time —

a big difference from the

internal 99.5% rate.

Now, our supply network is

designed from the shelf back:

We begin by focusing on the

optimal end result and align

our processes to deliver that

result. We know that we must

win at the “two moments of

truth” if we are to drive sus-

tainable growth. The first

moment of truth is when the

shopper is at the shelf and

chooses which product to buy.

The second is when the con-

sumer uses the product.

The Deadliest Sin

Dr. Hammer cautions us against

“Provincialism” — the func-

tional focus within organi-

zations that suboptimizes

overall results. In the end, what

the consumer thinks is the ulti-

mate scorecard. We have

focused on key partnerships

with our retail partners to cre-

ate shared value and delight

the consumer. To drive real

partnership, our metrics in-

clude joint success for P&G and

retailers. For example, we seek

to reduce overall supply chain

time by one-third. What is un-

usual about this metric is that it

is not an internal P&G measure

of supply chain time, but rather

spans from our suppliers

through to our retailers. In

other words, the reductions

might not even occur within

the “walls” of P&G. However,

achieving this metric will result

in more agility, improved re-

sponse time and better service.

The Key Metric

Business has become fast-

paced and complex. The

inclination to focus on just one

metric over others is danger-

ous. But how do you balance

multiple priorities and metrics

in this new environment? In the

past, we focused on low-cost,

supply-chain-friendly products;

having long production runs of

one type of unit was consid-

ered optimum. Today, we look

at broader metrics in addition

to low cost. Are we fast to shelf?

Do we enable our retailers with

winning products? Are we agile

— able to change products,

schedules and formats as our

consumer needs change?

Unfortunately, too often we

are faced with scorecard data

telling us what happened last

month and are frustrated that

the metric was not at target. So

P&G has begun identifying,

measuring and controlling

forward-looking or “in-process”

metrics to manage the ultimate

result. For example, case fill rate

or out-of-stocks are critical met-

rics for any business, but

discovering you have an out-of-

stock does not allow you to

prevent it. Therefore, we move

further upstream and measure

the percentage of stock-keeping

units within the minimum/maxi-

mum buffer. Finding out we are

dipping into the minimum

range allows us to intercede

while still maintaining customer

service, preventing the out-of-

stock. Another example is

monitoring our suppliers’ deliv-

ery time and ensuring that this

measure remains on target.

Monitoring on-time rates allows

us to react earlier, streamlining

the supply chain and keeping all

parts synchronized. This allows

for the best deployment of valu-

able resources.

I Recommend

There are so many excellent

books on the market today, but

I would suggest titles from

Peter Drucker, the “Innovation”

series from Clayton Christensen

and Chris Zook and James Al-

len’s Profit From the Core:

Growth Strategy in an Era of

Turbulence as good starting

points.

MIND OF THE MANAGER

Rick Ciccone Director, Global Supply Chain Operations, Procter & Gamble

LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 1624 MIT SLOAN MANAGEMENT REVIEW SPRING 2007 SLOANREVIEW.MIT.EDU/SMR

shouldering the responsibility for im-

proving performance. If the other errors

are sins of the intellect, this is a sin of

character and corporate culture. An oft-

heard phrase at one financial services

company is, “The decision has been made,

let the debates begin.” When self-interest,

hierarchical position and loudness of

voice carry more weight than objective

data, then even the most carefully de-

signed and implemented metrics are of

little value.

These categories overlap and are re-

lated; a single metric may be evidence of

several sins. A company that commits

these sins will find itself unable to use its

metrics to drive improvements in operat-

ing performance, which is the key to


Measurement

I do believe measurement is an

essential ingredient for reliable

performance. You can improve

performance without measure-

ment, for example, by gut feel,

by experience, by recognizing

patterns and so on, but you

cannot do so reliably or in a re-

peatable way (and eventually

you run out of tricks). It is es-

sential, however, to avoid what

I call the “tyranny of the partial

view” or what Michael Hammer

calls “Provincialism.” At the

same time, efforts to defeat

Provincialism must be based

on the customer (or to use

Michael’s terminology, you

must avoid Narcissism). Accom-

plishing both — eliminating

silos and basing performance

management on the customer

view — is, I believe, an essen-

tial element of sound

performance management.

To improve performance in

the retail supply chain at Staples,

it was essential to implement a

common, customer-centric

measure that cut across func-

tional boundaries. For Staples,

this became “customer-facing

in-stock,” a measure of what was

for sale as the customer saw it:

actually on a shelf in a retail

store, available for sale (not in

the back room, on a high shelf,

in a warehouse, in transit to a

store and so on). Making this

number visible and credible and

creating a performance man-

agement system in which all

participants could see and un-

derstand their personal impact

on that measure was critical to

improving the overall system.

The Deadliest Sin

The most resonant “deadly sin”

for me is what Michael labels

“Provincialism” and what many

others refer to as the problem

of organizational “silos.” I think

this sin shows up in many firms

in a number of ways. In my ex-

perience, the most common is

departmental or functional ex-

pense metrics (for example,

warehouse operating expense

as a percent of sales). Unfortu-

nately, it is the measure on

which many functional man-

agers have built their careers as

expert cost managers in their

particular discipline. It creates

an environment within which

many individuals can be “suc-

cessful,” but the firm succeeds

only marginally (or may even

fail). I have found this to be true

because the larger customer-

value equation in almost any

enterprise often can be ex-

panded significantly only

through investments in im-

proved service. This commonly

involves increasing a particular

function’s marginal expense for

the opportunity to sell higher-

value goods to the customer.

At Staples, we worked to

show functional managers the

profit flow-through of in-

creased service and gave them

“permission” to exceed budg-

eted expense rates for specific

service enhancements. We

demonstrated, first on a pro

forma and then on an actual

basis, how investments in ser-

vice translated into faster sales

growth of higher-margin prod-

uct. We then engaged in

prolific, public praise of man-

agers who failed in their siloed

expense measures but who, in

doing so, delivered substan-

tially more profits in other

shared measures.

The Key Metric

In the retail business, the key

metric has to be customer sat-

isfaction. Unfortunately, you

have to work hard to break cus-

tomer satisfaction down into

the small handful of key drivers

that people can actually take

action on, which turn out to be

goods in-stock, helpfulness of

store staff, ease of finding

products and quick checkout.

There is a lot of evidence

that highly satisfied customers

are more profitable and drive

additional profitable cus-

tomers into an enterprise.

Again, I think the important

thing is to break down satis-

faction into some actionable

levers that (1) are critically

linked to the overall satisfac-

tion number, and (2) can be

affected through operational

change. For example, measur-

ing customer-facing in-stock

drives improvements in cus-

tomer perception of in-stock;

changing hiring profiles for

helpfulness improves actual

helpfulness; and so on. Even

though customer satisfaction

as a measure trumps a number

of the “deadly sins,” it unfortu-

nately ends up being too

abstract to operationalize.

Starting, however, from that

“sin-free” measure, you then

can discover additional “sin-

free” measures at the very

next layer of the operation

that can make a difference.

I Recommend

Pat Lencioni’s Silos, Politics, and

Turf Wars: A Leadership Fable

About Destroying the Barriers

That Turn Colleagues Into Com-

petitors. This book explains

why crises often help people

overcome the sin of Provincial-

ism. Leaders shouldn’t have to

wait for a crisis.

MIND OF THE MANAGER

Paul Gaffney Chief Operating Officer, Desktone Inc.Former Executive Vice President, Supply Chain for Staples Inc.



improved enterprise performance. It is

hardly surprising that an enterprise that

does not have the right measures of op-

erating performance will be hard-pressed

to improve that performance; bad meas-

urement systems are at best useless and

at worst positively harmful. As the old

saying goes, “That which is measured

improves”; but if you are measuring the

wrong thing, making it better will do lit-

tle or no good. Remarkably, these sins are

not committed only by poorly managed

or unsuccessful organizations; they are

rampant in even well-managed compa-

nies that are leaders in their industries.

Such companies manage to succeed de-

spite their measurement systems, rather

than with them.

Why has such a vital area been ig-

nored and allowed to drift into such

comical errors? Most often, it is because

senior executives have not demonstrated

a serious commitment to operational

performance improvement. Either be-

cause they are far removed from the

operational fray or because they don’t

recognize the opportunities for perform-

ance improvement and the central role

that metrics play in it, too many leaders

pay scant attention to metrics. As one

manager said: “Our executives don’t take

measurement seriously because they were

turned off by accounting in business

school.” As a result, too many companies

simply do not give operational measure-

ment the attention it needs. They follow

the path of least resistance, using meas-

ures they have inherited from the past or

the first metrics that pop into their heads.

A serious commitment to performance

improvement demands an equally serious

commitment to designing and using ef-

fective operational metrics.

RedemptionThere are four steps to redeeming an or-

ganization from measurement hell,

purging it of the seven deadly sins and

setting it on the path to sustained perfor-

mance improvement. The first is to select

the right things to measure, those aspects

of organizational performance that are

both controllable and important to

achieving enterprise success; the second is

to measure these things in the right ways,

through metrics that capture their essence

in usable forms; the third is to embed

these metrics in a disciplined process for

performance improvement, to use them

for treatment rather than autopsy; and the

last is to create an organizational culture

and value system that encourages the dis-

ciplined use of metrics for ongoing

performance improvement rather than re-

gard them as threats to be feared or

opponents to be vanquished.

Deciding what to measure. There are two

related keys to ensuring that a perform-

ance measurement system is focused on

the right things. The first is to emphasize

end-to-end business processes, the cross-

organizational sequences of activities

that create all customer value. Processes

transcend functions and other organiza-

tional units and are the mechanisms by

which the myriad activities performed in

an enterprise are integrated to realize re-

sults. Typically, an enterprise of any size

has five to 10 primary business processes,

each of which may be decomposed into a

similar number of subprocesses. By fo-

cusing its measurement system on

processes rather than functions, an en-

terprise helps create alignment and a

common focus across disparate units; in-

stead of each seeking to optimize its own

unique metric, departments are encour-

aged to work together to improve the

performance of the process(es) of which

they are part. Thus, metrics for order ful-

fillment should dominate metrics for

logistics or production or order entry;

metrics for product development are

more important than metrics for market

research or engineering; and so on.

The second key to ensuring that the

right metrics are selected is to determine

the drivers of enterprise results in terms

of these processes. An example will help

clarify this concept.

A fashion retailer sought to increase

revenues; since most of the management

team had backgrounds in merchandising,

executives immediately assumed that the

key would be improving the company’s ad-

vertising program in order to attract more

shoppers into the stores. However, the chief

operating officer had recently joined the

company from a different industry and was

unwilling to jump to this conclusion. In-

stead, he led an exercise to determine what

factors were most critical to the company’s

success and to identify metrics that cap-

tured them. A simplified version of this

analysis goes as follows: Increasing sales re-

quires attracting more shoppers into the

stores and selling more to those shoppers;

thus measures of traffic and of what is

called conversion ratio (the percentage of

customers who actually make a purchase)

are important. But these are outcome met-

rics: desirable goals but not ones that can

be achieved directly. The next step was to

determine the drivers of these outcomes,

the factors needed to get more customers

into the stores and to increase the conver-

sion ratio. Advertising effectiveness and

product quality were identified as the key

drivers of increasing traffic and therefore as

There are two keys to useful

performance measurement: an emphasis on

end-to-end business processes

and a focus on the drivers of

enterprise results.

LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 1826 MIT SLOAN MANAGEMENT REVIEW SPRING 2007 SLOANREVIEW.MIT.EDU/SMR

important phenomena to measure as well.

The factors needed to increase the conver-

sion ratio were ensuring that products were

on the shelf (since customers can’t buy

what isn’t there) and having enough sales-

people available to help customers decide

what to buy; thus on-shelf availability and

customer coverage (the ratio of salespeople

to customers) were recognized as impor-

tant metrics as well.

In this case, the assumption that the

key to improving revenues lay through im-

proved advertising turned out to be false.

When measured, customer traffic, adver-

tising effectiveness and product quality

were at levels that ranged from acceptable

to high. The problem lay in the conversion

ratio — not enough shoppers were be-

coming buyers. The root of this problem

was twofold: Neither on-shelf availability

nor customer coverage were as high as

they should have been. These were the

areas, not advertising, which needed atten-

tion. But how can on-shelf availability and

customer coverage be improved? This is

where the connection to the processes is

made. For each of the factors that is meas-

ured, the processes that affect that factor

must be identified; the factor becomes a

key metric for each of these processes, and

the improvement of this metric is to be ac-

complished through process management:

effective execution, ongoing improvement

and holistic redesign when necessary.

In this case, on-shelf availability was

recognized as being shaped by the supply

chain process and so became a key, over-

arching metric for that process; customer

coverage was seen as determined by the

employee scheduling process. (This ap-

proach has similarities with Kaplan’s and

Norton’s strategy maps, except with a

more operational focus and an explicit

linkage to end-to-end processes.)

Changes were made to each of these

processes in order to improve these mea-

sures, which in turn increased the

conversion ratio, which in turn led to the

desired improvement in revenues. In par-

ticular, this analysis led to the recognition

of a very deep-seated problem with the

employee scheduling process. In the past,

it had been driven by when employees

found it convenient to work, rather than

when customers were coming into the

stores. Consequently, there were too

many people working on weekday after-

noons, and not enough on weekends. The

new metrics and the process redesign

effort they spawned soon changed that.

Measuring the right way. Knowing what

needs to be measured is just the first

step; finding the right way to do so is the

next. As outlined above, deciding what

needs to be measured is something of a

science; deciding how to measure, how-

ever, remains an art, since, in general,

there are many different ways of putting

a number on a phenomenon that has

been determined to be worthy of mea-

surement. For instance, how should

customer satisfaction be measured? One

common approach is through customer

surveys. However, this is costly and

slow; it is also often uncertain how well

customer responses on surveys correlate

with desired behaviors. Measuring com-

plaint volumes may not capture the full

spectrum of customer attitudes and is

subject to manipulation — not answering

the complaint line guarantees a higher

reading of customer satisfaction. Mea-

suring attrition and repeat buying

comes too late to do anything about it.

The point is not that these or any

other specific measures of customer

satisfaction are good or bad, but that

virtually every metric has some advan-

tages and drawbacks, and that in

designing metrics one must balance

the following considerations.

Precision. A metric must be carefully and

exactly well defined, so that there can be

no doubt or dispute about it. Thus, “on-

time delivery” can be interpreted in

numerous ways, depending on what the

target is (first promise date, last promise

date, request date and so on) and what it

means to be “on time” (on the date,

within 24 hours, within 48 hours and so

forth). It should come as no surprise that

when a metric is not unambiguously de-

fined, people will interpret it in ways that

work well for them. For instance, the

manufacturing organization at a con-

sumer goods company used an imprecise

definition of productivity as an opportu-

nity to take downtime and turnover time

out of the equation. The definition of a

metric should also include the units

being employed and the range and scale

of the measurement.

Accuracy. In many situations, a company

needs to measure what amounts to a Pla-

tonic ideal (customer satisfaction,

advertising effectiveness, product quality

and so on). Any actual metric will inevi-

tably represent only an approximation of

this ideal. It is necessary to keep in mind

the distinction between reality and what

is being measured and to close the gap

between the two, subject to the limita-

tions imposed by these other

considerations.

Overhead. Organizations often fall prey

to the temptation to construct a complex


Organizations often construct

a complex mechanism for

calculating a metric, when, in many cases, a far simpler

one would suffi ce.


mechanism for calculating a metric, when

a far simpler one would suffice. For in-

stance, the fashion retailer discussed

above needed a way of determining the

conversion ratio at its stores (the percent-

age of shoppers who bought something).

Various complex schemes were proposed,

involving the use of radio frequency

identification tags and various types of

sensors. In the end, the company decided

on the low-tech approach of hiring high

school students to sit outside stores and

count the numbers of people who went

into the store and the number coming

out carrying shopping bags. The more in-

expensive and convenient it is to calculate

a metric, the better. The periodicity of the

metric — how often it needs to be calcu-

lated — must also be taken into account.

Robustness. The designer of a metric

must be conscious of the extent to which

the metric can be manipulated or gamed

by people with something at stake, or the

extent to which the metric can encourage

undesired behaviors. At a telecommuni-

cations company, for instance, using call

duration to measure the performance of

customer service representatives led

CSRs to rush through calls.

A particularly valuable tactic to avoid

suboptimization, undesired behaviors

and the manipulation of metrics is to in-

sist on the use of multiple rather than

single metrics. For instance, measuring

just the speed of product development

can lead to cost overruns; measuring just

transportation costs can lead to missing

promised delivery dates. Individual met-

rics must be used as part of a system of

related measurements, rather than in iso-

lation. Competing process metrics (such

as speed, quality and cost) should be bal-

anced against one another, and process

metrics should be used in conjunction

with narrower-gauge, functional metrics.

Thus, a shipping department should be

held accountable for shipping costs (over

which it has full control) as well as for

on-time delivery (which it does not solely

control), even though — or perhaps es-

pecially because — these two metrics can

conflict with each other. Should people

object, they need to be reminded that the

world is not unidimensional, that the en-

terprise must serve constituencies with

conflicting objectives and that balancing

multiple metrics rather than overdosing

on one is what success demands.

Using metrics systematically. Even the

best-designed metrics are of little value

unless they are embedded in a disci-

plined process that uses them. Otherwise,

they become afterthoughts, employed to

assess blame or reward, but not really

utilized to drive improved performance.

A prerequisite for such a process is

someone to perform it. In other words,

every metric must have one or more indi-

viduals who are personally responsible

and accountable for it; these individuals

must realize that it is their job to ensure

that their metrics achieve the target levels

that have been set for them. Since many

of the metrics that really matter in an en-

terprise do not line up neatly with the

existing organizational structure, respon-

sibility for end-to-end process metrics

needs to rest both with the process owner

(a senior manager with overall authority

for the process) as well as with managers

of the various functions involved in the

process. The old saw that one cannot be

held responsible for what one does not

fully control has outlived its usefulness; it

is both reasonable and necessary to hold

everyone with some influence over a met-

ric jointly accountable for it.

The starting point for using metrics to

drive performance improvements is to

have a target performance level for each

metric. These targets can be derived in a

variety of ways. In some cases, customers

will be explicit about the performance

level they require of a process — how

long they will find it acceptable to wait

for confirmation of an order, for instance.

In other situations, it is the company’s

own financial requirements or competi-

tor performance that dictate required

performance levels. Whatever the origin

of the target, the person(s) responsible

for the metric must regularly compare

the actual value of the metric against the

target level. If there is a meaningful gap

between the two, particularly on a sus-

tained basis, then the source of the gap

must be determined. Broadly speaking,

there are two kinds of reasons why some

aspect of operations is not meeting the

required performance level: a design flaw

or an execution problem. It may be the

case that the design of the operating proc-

ess or system simply does not allow it to

operate at the target level. For instance,

an electric power company found that no

matter how hard people worked, no mat-

ter what tools or training it provided

them, it could not connect electric power

for new customers in less than 180 days;

the process for establishing such new

connections was so fragmented that it in-

evitably required multiple iterations to

converge on an acceptable solution. The

design of a process establishes an upper

limit on its performance; no process can

perform better on a sustained basis than

its design allows. Managers may discover

that a process was designed to meet lower

performance targets, or was designed

with a now-obsolete set of assumptions

or has become so burdened with special

cases and accreted complexity that its

performance has degraded. In such situa-

tions, a holistic redesign of the process is

called for. Conversely, even a well-de-

signed process is not guaranteed to

deliver the performance of which it is

theoretically capable. The electric power

company just cited redesigned its process

so that new connections could be made

in 20 days. However, poorly trained or

unmotivated workers, unreliable equip-

ment or other exogenous factors could

create execution problems that would

lower performance beneath target levels.

In such situations, redesign will not help.

Rather, a disciplined analysis of the un-

derperformance of the process must be


used to highlight its root cause, so that

appropriate remediation — training, per-

sonnel changes, equipment repair or any

of a host of other activities — can be

taken in order to solve the problem and

restore performance to needed levels.

The fundamental point is that measure-

ment is not a thing unto itself. The point

of measurement is not to measure but to

enable improvement and, as such, mea-

surement must be an integral part of an

ongoing program of performance analy-

sis and improvement.

Creating a measurement-friendly culture. Even the best metrics and the best proc-

ess for using them will not flourish in an

inhospitable environment. In too many

organizations, the disciplined use of mea-

surement is not part of the basic value

system. Metrics are regarded as matters of

opinion or as tools for political infight-

ing; or metrics and their use are perceived

as frightening, because they are used for

the assignment of blame and subsequent

punishment. Often, metrics are seen as

pettifogging details only of interest to

“bean counters” and similarly small-

minded folks. The folk hero in too many

organizations is the executive who flies by

the seat of the pants and uses intuition

and guts to make decisions, rather than

the measurement-oriented analytic man-

ager who is scrupulous about establishing

the facts. Even worse, the prevailing cul-

ture in many organizations is to pass the

buck when a problem is identified, lest

one be caught without a seat when the

music stops. In such contexts, the deadly

sins of measurement are an inevitability

that no technical solution can prevent.

Creating a measurement-friendly cul-

ture is not merely a matter of producing

some inspiring slogans and printing

them on laminated wallet cards. Chang-

ing the basic value system of an

organization is much more complex than

that; however, despite popular wisdom to

the contrary, it can be done, and rela-

tively quickly at that. The challenge is

that to do so requires the personal time

and engagement of the most senior lead-

ers of the organization; they are the only

ones with the stature and the authority

to undertake such a deep shift. They have

at their disposal a range of tools to help

them accomplish such culture change,

and they must make use of all of them:

Personal role modeling. As Albert Ein-

stein said, “Setting an example is not the

main means of influencing others; it is the

only means.” When senior managers

themselves personally insist on getting and

using carefully designed metrics, and when

that fact is publicized throughout the or-

ganization, attitudes change very quickly.

Reward. Making the use of the right

metrics a part of how managers are eval-

uated and rewarded gets their attention.

Rewarding managers who make use of

the right metrics, even if the subsequent

outcomes do not meet expectations, and

concomitantly not rewarding managers

who achieve desirable results without the

disciplined use of metrics, makes the

point that metrics are important.

Implementation. Rather than just preach

about the use of metrics, senior managers

can ensure their use by deploying metrics-

based improvement and decision-making

processes, making them part of basic

management development training and

conducting postaudits of key decisions to

ensure these processes were used.

Commitment. Public demonstration of

executive commitment to meaningful

metrics is a powerful tonic. For instance,

affirming the importance of using metrics

even when it might be expedient not to

do so drives home the message that meas-

urement cannot be an occasional thing.

Articulation. It can do no harm for

executives to talk about performance im-

provement, fact-based decision-making

and carefully designed and meaningful

metrics, and indeed doing so can help in-

tegrate these other techniques. However,

mere words are not a substitute for more

difficult and demanding steps.

When all these techniques are used to-

gether, the results can be truly impressive.

At a privately held logistics company,

the senior executives were dissatisfied

with the measurement system, despite

the company’s apparent success in the

marketplace. They determined that a key

driver of business performance was filling

orders accurately, on time and with all

needed supporting documentation, and

so established the percentage of such

“perfect orders” as a key operating metric.

They then proceeded to identify their five

key business processes and to find ways

to redesign them so as to increase this fig-

ure. They also engaged people across the

organization in the effort to focus on the

metric and improve it. Over a period of

several months, they managed to increase

perfect orders from its initial value of

only 6% to nearly 80%. As a result, oper-

ations costs have been dramatically

reduced, customer satisfaction increased

significantly and margins enhanced.

The deadly sins of operational meas-

urement are not just measurement

problems; they are symptoms of deeper

cultural shortcomings, of a lack of com-

prehension of what is important to

enterprise success, and of a fundamen-

tally unstructured approach to perform-

ance management and improvement.

Poorly designed metrics cannot be re-

paired on their own, but only as part of a

systematic effort to link operations to

business objectives and to implement a

formal process for operational perform-

ance improvement. The result of such an

effort is much more than better metrics;

it is a better company.



Reprint 48302. For ordering information, see page 1.Copyright © Massachusetts Institute of Technology, 2007. All rights reserved.

LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 21SUMMER 2008 MIT SLOAN MANAGEMENT REVIEW 67

There are two categories of supply chain partners: those that buy and

those that sell. Depending on which group they identify with, manag-

ers have different perspectives on the value of sharing critical knowledge

resources with their supply chain partners. Both groups agree that sharing

knowledge makes for more efficient supply chains (with lower costs and

quicker speeds) and more effective organizations (with higher quality outputs

and enhanced customer service). But the benefits of knowledge

sharing don’t always accrue equally or simultaneously to all participants.

In addition, some managers think that knowledge sharing between buyers

and suppliers has an underappreciated “dark side” that can outweigh the

benefits.1 A common worry is that divulged information regarding technolo-

gies, pricing schedules, client bases and processes can be copied or shared with

competitors. Another worry is that relying on knowledge flows from other

organizations can undermine a company’s flexibility and leave it vulnerable to

changes in its partners’ priorities. Despite these concerns, knowledge sharing

between supply chain partners offers more positives than negatives, provided

that the right kind of knowledge goes back and forth.

What type of information or knowledge should suppliers and buyers share

with each other? How does knowledge sharing provide value to buyers and

suppliers, and under what circumstances can it help both? How do cross-

cultural differences between global buyers and suppliers influence the value of

sharing information? To answer these questions, we studied more than 100

cross-national supply chain partnerships in the industrial chemicals, consumer

durables, industrial packaging, toy and apparel industries in 19 country

locations. (See “About the Research,” p. 68.) We examined how different types

of knowledge sharing can benefit buyers or sellers individually. But more

importantly, we studied how knowledge sharing can enhance the performance

of partnerships and build stronger supply chains in the global marketplace. We

sought to understand not only which companies benefit from cross-border

knowledge sharing but also the conditions that lead to knowledge sharing

in global supply chains. Many people see knowledge sharing as the result of

customer or supplier needs when in fact it is more likely to be influenced by

market structures or organizational similarities and dissimilarities between

buyers and suppliers. (See “What Makes Knowledge Sharing Possible?” p. 69.)

Sharing Global Supply Chain Knowledge

Matthew B. Myers is the Nestle Professor of Marketing and an associate professor at the University of Tennessee in Knoxville. Mee-Shew Cheung is an assistant professor of marketing at Xavier University in Cincinnati, Ohio. Comment on this article or contact the authors through [email protected].

Knowledge sharing

between partners has

more upsides than

downsides, provided

that the right kind of

knowledge goes back

and forth.

Matthew B. Myers

and Mee-Shew Cheung

O P E R AT I O N S

SLOANREVIEW.MIT.EDU

LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 2268 MIT SLOAN MANAGEMENT REVIEW SUMMER 2008 SLOANREVIEW.MIT.EDU

The Value of Knowledge in Global Supply ChainsIn a 2004 study, Hau Lee, a professor of operations, information

and technology at Stanford University, found that top-performing

supply chains had three distinct qualities.2 First, they are agile

enough to react readily to sudden changes in demand or supply.

Second, they adapt over time as market structures and environ-

mental conditions change. And third, they align the interests of

all members of the supply chain network in order to optimize

performance. These characteristics — agility, adaptability and

alignment — are possible only when partners promote knowl-

edge flow between supply chain nodes. In other words, the flow

of knowledge is what enables a supply chain to come together in

a way that creates a true value chain for all stakeholders.

This is a critical point. As global supply chains become less

push-oriented and more demand-driven, organizations can

come together more closely in demand-driven supply net-

works. These networks focus on understanding customer needs

(present and future) and building supply chains based on

actual demand levels as opposed to demand forecasts or

production schedules. This permits a higher level of service to

customers — more on-time deliveries and more accurate order

placement — which, in turn, leads to increased levels of

customer loyalty. Higher service levels actually help supply

chains become more efficient, thanks to fewer product returns,

less need for overnight deliveries to compensate for slow turn-

arounds and fewer dissatisfied customers.

Knowledge flow creates value by making the supply chain

more transparent and by giving everyone a better look at

customer needs and value propositions. According to AMR

Research Inc., a business research company located in Boston,

increased demand visibility (that is, more knowledge about real-

time customer needs and demands throughout the entire supply

chain) increases perfect order rates dramatically.3 What’s more,

broad knowledge about customers and the overall market, as

opposed to just information from order points, can provide other

benefits, including a better understanding of market trends,

resulting in better planning and product development.

Toyota Motor Corp., for example, increasingly involves its Tier

1 suppliers in major market-oriented decisions. According to

Vikram Kirloskar, vice-chairman of Toyota Kirloskar Motor, a

joint venture between India’s Kirloskar Group and Toyota, this

input would not have much value if Toyota and its suppliers

didn’t also share knowledge about markets.4 In several industries,

including chemicals and packaged goods, initiatives are under-

way to facilitate knowledge flows between partners and to enhance

customer value. For example, the European chemical industry

estimates that it can save up to 2% of total industry sales through

increased collaboration, including more knowledge sharing, be-

tween its supply chain members.5 Moreover, research consistently

shows that the most common contributors to supply chain fail-

ures — out-of-stocks, excess inventories, new product failure rates,

increased product markdowns and wasted time in engineering and

O P E R AT I O N S

Our research was conducted over a two-

year period at the University of Tennessee,

in cooperation with five partner compa-

nies and more than 100 of their overseas

suppliers. The five companies represented

the industrial chemical, consumer durable,

industrial packaging, toy and apparel

industries. Both the buyer and seller par-

ticipants are multinational corporations

operating from multiple locations in 19

countries: Argentina, Australia, Brazil,

Chile, China, Czech Republic, Germany,

Holland, India, Italy, Japan, Korea, Malay-

sia, Mexico, Poland, Singapore, South

Africa, Taiwan and the United States. We

conducted extensive telephone interviews

with informants from the companies to

understand their exchange context, the

nature of their tasks and the relevance of

the measures to their industrial experience.

The measures were derived from the

extant literature and adapted to suit the

context of our study. We then launched

a Web survey through a multiple-contact

strategy and collected data from 264

respondents (132 purchasing executives

from the buyer companies and 132

marketing/sales executives from their

corresponding overseas suppliers). The

respondents were prescreened to ensure

that they had significant knowledge

about the exchange relationship we were

studying. The dyads had worked with each

other an average of 12.2 years and pur-

chased more than $400 million annually in

materials. Partial least squares analysis was

then conducted to test the hypothesized

relationships between our proposed ante-

cedents and knowledge sharing and the

effect of knowledge sharing on company

performance. The results were all signifi-

cant at the 5% level. MANOVA estimates

were then generated to test for signifi-

cant differences between benefits of

buyers and sellers relative to knowledge-

sharing activities. Thus, findings

presented in this article are supported

with empirical evidence. Following our

quantitative research, we presented an

executive summary to all participants

and sought their feedback for our post

hoc analysis, which was conducted

through subsequent interviews with

leading toy manufacturers in Hong Kong

and major players in the pharmaceutical

industry in the United States. We grate-

fully acknowledge the research assistance

of the University of Tennessee’s Supply

Chain Forum Partners and all participants

in the surveys and interviews.

About the Research

LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 23SUMMER 2008 MIT SLOAN MANAGEMENT REVIEW 69SLOANREVIEW.MIT.EDU

research and development — are

all addressable by increasing

knowledge flows between supply

chain partners.6 Still, some supply

chain members are reluctant to

participate in knowledge-sharing

activities.

Why Knowledge Sharing Is ControversialThere is a saying that, in the global

marketplace, companies don’t

compete — supply chains do. This

is particularly true for industries in

which there is a high degree of

vertical integration and for specific

markets, such as Japan, where

long-term relationships between

buyers and suppliers can trump

competitive offerings from new

players. Strong, cross-national

supply chain relationships can

create innovative environments

that provide competitive advan-

tages for member companies.

Interorganizational learning and

adaptation to volatile environ-

ments can facilitate symbiotic

relationships between partners. It

can help both suppliers and buyers adjust to diverse demand levels

in multiple marketplaces (including new product launches with no

historical demand levels), increasingly complex trade regulations,

risk pooling and process developments. Recent research shows that

best-in-class companies in supply chain management were three

times more likely than laggard companies to apply “visible

technologies” that offer real-time customer and demand data;

these technologies allow buyers and sellers to share knowledge

more easily across borders.7 These applications, which go beyond

radio-frequency identification and early replenishment programs,

enable supply chain partners to maximize operational efficiencies

and enhance customer value creation.

But intercompany knowledge sharing can have harmful com-

petitive consequences. Many supply chain members we interviewed

had an aversion to participating in activities that could provide

more benefit to partners than to their own company. Increasingly,

supply chain partners see themselves as competing among them-

selves for revenue. The CEO of a major global freight carrier

expressed this concern: “We hear a lot about cooperation in global

supply chains. And while I’m sure we benefit from close relation-

ships with our partners, we feel there are two reasons why knowledge

sharing in the supply chain can work against us. First, whenever

we share knowledge with partners, it seems to leak to competitors,

or potential competitors. Second, as the markets become more

intense, we feel profits are in turn limited, and we compete with

our partners for profit shares. So we want to be careful what we

share. We want our partners to win, but not at our expense.” 8

Managers want to know that they can build equity through

collaborative activities. At a minimum, they want an equitable

piece of the “margin pie” relative to the resources they commit.

Given increasing levels of competition and customer expecta-

tions, many companies believe there is a fundamental conflict of

interest among supply chain members. Players located between

raw materials suppliers and retailers or e-tailers, in particular, see

themselves competing with one another for profits. As a result,

they are less likely to view supply chain partners as allies in

improving operational efficiency or market effectiveness than as

competitors for margins. When margins are thin, knowledge

sharing and true partnership can revert to a more traditional

(and more adversarial) vendor-buyer relationship. As David Yeh,

honorary president of the Toy Manufacturers’ Association of

Hong Kong, noted, “Many toy OEMs are now competing directly

A variety of conditions, both environmental and organizational, facilitate knowledge sharing in

global supply chains.

Conditions Affecting Knowledge Sharing How They Influence Knowledge Sharing

Market structures (economic and regulatory) for both buyers and suppliers

The greater the disparities between the buy-ers’ and suppliers’ market environment, the greater the tendency toward sharing knowl-edge between partners.

Environmental uncertainty in both the buyers’ and suppliers’ home markets

The greater the difficulty in forecasting sales volume, the greater the difficulty in predicting competitor moves; the greater the volatility in sales and market share for supply chain members, the more prone members are to share knowledge across borders.

Idiosyncratic investments or “specialty investments” for a specific supply chain relationship

The more member companies make invest-ments (in the form of material, machinery, human resources, etc.) specific to the partner-ship, the greater their propensity to share knowledge with buyers or suppliers.

Organizational fit between buyers and suppliers

When company resources are complemen-tary (i.e., of value to the partner company) and/or when strategies are compatible (when companies share the same goals and values), companies are more prone to share knowledge.

What Makes Knowledge Sharing Possible?

LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 2470 MIT SLOAN MANAGEMENT REVIEW SUMMER 2008 SLOANREVIEW.MIT.EDU

with toy marketing companies such as Mattel and Hasbro in the

same market. The competition has become more intense. Every-

body is fighting over the same piece of pie.”

Although the concept of “pie sharing” is not new, it is impor-

tant to clarify the different ways that knowledge sharing helps

suppliers and buyers and how the supply chain as a whole

benefits from these activities.

Different Types of Knowledge Knowledge sharing encompasses the

sharing of information, but it doesn’t stop there. Much of the

information that companies share — data on inventory levels,

sales, production schedules and prices — is easy to codify and

transmit. But other types of knowledge are just as important to

exchange and more difficult to codify: know-how, managerial and

communication skills and organizational memory. Intercompany

knowledge sharing is a joint activity between supply chain partners;

the parties share knowledge and then jointly interpret and integrate

it into a relationship-domain-specific memory that influences

relationship-specific behavior.9 We found three types of knowledge

sharing within the supply chain, each offering distinct benefits to

buyers and suppliers: information sharing, joint sense making and

knowledge integration (see “Types of Knowledge Sharing”): ■ Information sharing takes place when companies exchange

important data about sales, customer needs, market structures

and demand levels. ■ Joint sense making occurs when supply chain partners work

together to solve operational problems, analyze and discuss strategic

issues and facilitate communication about the relationship. Since

individual partners often interpret the same information differently,

intercompany teams can help create a common understanding. ■ Knowledge integration occurs when supply chain partners develop

relationship-specific memories, providing everyone with a common

understanding of idiosyncratic routines and procedures governing

the relationship. This often results in collective problem solving that

benefits both the companies and the relationship as a whole.

These knowledge-sharing activities constitute mechanisms

that can make or break supply chain partnerships.

Effective Knowledge Sharing in the Supply ChainThe greater the disparity between the market environments of

buyers and suppliers, the greater the likelihood that partners will

share knowledge. For example, in settings where customer prefer-

ences are changing or local regulations or supply sources are in a

state of flux, cross-border partners rely on each other to serve as

knowledge conduits. In general, market volatility makes compa-

nies more open to sharing knowledge; among other things,

companies want to reduce bullwhip effects up the supply chain

and the resulting stock-outs or overstocks. K.C. Lo, CEO of

Smart Union (Hong Kong) Ltd., a toy manufacturer in Hong

Kong with a global customer base, commented: “As manufactur-

ers, we are also faced with the

marketing challenge downstream.

Our customers’ sales and market-

ing problems directly affect our

bottom line. Our interests are

intertwined with everybody along

the supply chain. If the products

do not sell well and the buyers

have to resort to markdowns, it is

not uncommon in our industry to

see buyers coming back to us and

ask for a rebate. To overcome

problems like this, we need inputs

from the buyers along the value

creation process to do a better job

in meeting market demand. None

of us can operate in isolation.”

Companies with similar phi-

losophies and goals have greater

tendencies to share knowledge.

Although this may seem intuitive,

companies often partner with

organizations that do not share the

same business philosophies; subse-

quently, they are reluctant to share

critical knowledge with each other.

Again, while this may seem logical,

it goes against the findings about

the importance of knowledge sharing in achieving competitive

positions. A company’s commitment to knowledge sharing

is greatly influenced by whether it has made investments (for

example, in special equipment, tools, machines or facilities) to

support the buyer-seller relationship. Such investments tend to

make a company more vested in the relationship and encourage

knowledge sharing between partners.

The Role of Cultural Differences One of the more interesting

findings is that cross-cultural differences between buyers and

sellers rarely matter when it comes to sharing knowledge. We

had assumed that culture and all of its nuances (such as differ-

ences in perceptions of trust, time and risk taking) would play a

major role in whether cross-border partners shared knowledge and

other valuable resources: A Japanese buyer of industrial chemicals,

for example, would have perceptions radically different from his

American supplier about how a partnership should work and

what knowledge can be shared safely. However, cultural differ-

ences between buyer and supplier companies had no impact on

their propensity to share knowledge. Interviews with managers

revealed the reasons. First, cross-cultural differences have always

mattered less in business-to-business relationships than they

O P E R AT I O N S

The greater the

disparity between

the market

environments

of buyers and

suppliers, the

greater the

likelihood that

partners will

share knowledge.


have in business-to-consumer exchanges. Second, the nature

of the businesses themselves is changing, becoming increasingly

diverse both in terms of the employee base and in the number of

markets businesses operate in. For example, one of the purchasing

managers we interviewed was a Ukrainian working for a French

company in Brazil. Identifying which cultural characteristics might

influence his decision to share knowledge (Ukrainian, French

or Brazilian?) would be impossible, and in reality this way of look-

ing at culture proved irrelevant. Instead, there was an emergent

global culture of business; decisions about whether to share knowl-

edge — and how to do it — were driven less by cultural norms

than by more objective decision making and market demands. As

Yeh of TMHK conceded, “Businesses are looking for best practice

and best thinking. We have to put our cultural differences aside.

I am seeing a converging trend in the last 30 years.”

The Benefits of Knowledge SharingIn measuring the performance of supply chain partners, it is

important to recognize that businesses often have to make trade-

offs between market share/sales and profits. Therefore, we

combined four indicators to create an index to measure company

performance: increases in market share, sales, return on sales and

return on investment. Research on how much value buyers and

sellers get from knowledge sharing has been confusing; some

studies show benefits, while others have

shown dangerous repercussions.10 We

found that, for both buyers and sellers,

certain dimensions of knowledge sharing

are critical for improved performance

outcomes. Further, although all members

of the supply chain need to participate in

knowledge sharing, buyers and sellers

do not always benefit equally. (See “Who

Benefits From Sharing Knowledge?” p. 72.)

Both buyers and sellers indicated that

information sharing and knowledge integra-

tion enhanced performance. They said that

sharing information contributed to profit-

ability and operating efficiency, benefiting

both members in cross-national collabora-

tions; they noted as well that frequent process

adjustments and evaluations between part-

ners also led to improved performance. In

particular, knowledge sharing about market

structures (for example, about mergers and

acquisitions or regulatory changes), end-

user preferences and profiles, technological

innovations and financial resources helped

everyone’s bottom line. This was especially

important for supply chain partners operat-

ing globally, due to the complexity of

overseas markets and the difficulty of

obtaining reliable information on their own.

For example, the toy industry constantly

faces regulatory changes and new safety

requirements in overseas markets, as recent

events involving Chinese imports in the

United States illustrate.11 Without coopera-

tion and knowledge sharing from their

overseas customers, manufacturers would

have difficulty responding to these kinds of

challenges in a timely manner.

Knowledge sharing in global supply chains goes beyond information sharing. It is a joint

activity in which supply chain partners strive to create more value together than they

would be able to individually.

Conditions Affecting Knowledge Sharing What Is It?

Information Sharing Exchange of information on successful and unsuccessful experiences with products; exchange of information re-lated to changes in end-user needs, preferences and behavior; exchange of information related to changes in market structure, such as mergers, acquisitions or part-nering; exchange of information related to changes in the technology of the focal products; exchange of information as soon as any unexpected problems arise; exchange of information related to changes in the two organizations’ strategies and policies; exchange of information that is sensitive for both parties, such as financial performance and company know-how.

Joint Sense Making The establishment of joint teams to solve operational problems; joint teams to analyze and discuss strategic issues; development of a relationship philosophy that stimulates productive discussion using both buyer and supplier viewpoints; significant face-to-face communi-cation in the relationship.

Knowledge Integration Frequent adjustment of partners’ common understand-ing of end-user needs, preferences and behavior; frequent adjustment of the common understanding of trends in technology related to the business; frequent evaluation and, if needed, adjustment of routines in order-delivery processes; frequent evaluation and, if needed, updating of the formal contracts in the rela-tionship; frequent refreshment of the personal network in the relationship; frequent evaluation and, if needed, updating of information about the relationship stored in partners’ electronic databases.

Types of Knowledge Sharing

LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 26SLOANREVIEW.MIT.EDU

However, the advantages for buyers and sellers are not always

equal: Suppliers receive significantly greater benefit than buyers

from two types of knowledge sharing — information sharing and

knowledge integration — no matter which partner actually

shares the resources. Indeed, the outcomes are the same whether

it is the buyers who do the information sharing or make the ef-

forts to integrate knowledge bases into the operational protocols,

or the suppliers. Both partners win — but suppliers win more.

In contrast to information sharing and knowledge integra-

tion, joint sense making appears to have different effects. When

suppliers developed teams to work with partners, increase face-

to-face communication and evaluate routines and processes,

both buyers and sellers benefited. More than half of the 132

suppliers surveyed indicated high levels of joint sense-making

activity; for their specific partnerships, both buyers and suppliers

averaged significantly higher performance ratings than other

partnerships. But when buyers promoted the same activities,

suppliers were the ones that reaped most of the benefits. Half of

the buyers indicated high levels of joint sense-making activity, yet

in these partnerships suppliers enjoyed 6% higher performance

ratings than their buyers. The disparity may be due to the

significant time and other resources needed to build intercom-

pany teams: Buyers tended to see this as an investment with few

benefits for them; suppliers saw the potential benefits as well

worth the expense. These findings reinforce the view that when

suppliers are willing to dedicate time and resources to share their

knowledge, the supply chain as a whole benefits.

Knowledge sharing between supply chain partners occurs

with the expectation that both buyers and sellers will see benefits.

And both parties do gain — just not equally. Not surprisingly,

problems can emerge when one party feels it is not benefiting

as much as its partners. Henry Liu, vice president of Starlight

Industrial Ltd., a Hong Kong toy manufacturer, commented,

“Very often when we ask the customers [buyers]

for information, we feel like we are talking to the

wall. We have difficulties getting their commit-

ment to do more knowledge sharing. The

knowledge and information flow along our supply

chain needs to be more effective.” This imbalance

— where managers see relative gains as more

important than absolute gains — can undermine

long-term cooperation within supply chains. In

general, however, both buyers and suppliers felt

that their collective knowledge-sharing efforts en-

hanced the value of their relationships with partner

companies. They felt that knowledge-sharing

activities helped reduce costs, increase product

quality, enhance delivery performance and increase

the overall quality of communication between

companies. In short, whatever the disparities in

bottom-line benefits between buyers and suppliers, both groups

felt that intercompany knowledge sharing was a valuable aspect

of their global supply chain relationships. As Yeh of the TMHK

noted, “Knowledge sharing between buyers and sellers is critical

in a supply chain, even though it is often hard to quantify the

actual size of the pie gained by each individual party. Both sides

have to look at the ultimate picture and be more in sync.”

One question that emerges from the research is: Why do

suppliers generally benefit more than buyers? There are two

factors: the predominance of demand-driven supply chains in

today’s global marketplace and the fact that suppliers have more

room for improvement than buyers, who already tend to be quite

lean. Increased competition has forced supply chain managers to

become more agile and to tie their global models more closely to

real-time consumption (as opposed to capacity or speculative

sales forecasts). As a result, the knowledge that buyers share with

suppliers is more valuable.

Demand-driven supply networks have been implemented by

some of the best supply chains worldwide, including Toyota and

Dell Inc.12 Moreover, many successful suppliers, such as those

supplying the automotive and aerospace industries, are becom-

ing system integrators, producing components and whole

systems for leading manufacturers.13 In the meantime, manu-

facturers (buyers) have had to simplify their approaches to lean

manufacturing processes and become less rigid. A number of

industries have already taken big steps in this direction, includ-

ing U.S. aerospace and defense companies.14 Several major

players, including Boeing, Lockheed Martin and United Tech-

nologies, recently formed the Supplier Excellence Alliance,

comprising original equipment manufacturers and suppliers

working together to accelerate supply chain performance. One

of its primary initiatives is to help companies become effective

participants in demand-driven supply networks.

72 MIT SLOAN MANAGEMENT REVIEW SUMMER 2008

O P E R AT I O N S

Who Benefits From Sharing Knowledge?

Both buyers andsuppliers benefit


Buyers don't benefit,but suppliers do




While both buyers and supplierswin, suppliers benefit morefrom basic exchanges ofinformation between partners.

Knowledge-sharing teams andface-to-face communication areoften time-consuming, butsuppliers benefit from it. Buyerswin when suppliers form teams,but not from their own efforts.

When partners sharedatabases and routines, bothbuyers and suppliers win, butsuppliers win more.

When buyersshare…

When suppliersshare…

…information

…in joint sense making

…in knowledge integration

The Bottom Line


Sharing Knowledge Across BordersSeveral important lessons emerge from this. First, while suppli-

ers may benefit the most from knowledge sharing, buyers also

come out ahead. Frequently, supply chain partners focus too

much on their own share of the benefits pie, forgetting that

unless knowledge resources are shared, no one benefits. A

company may not benefit as much from knowledge-sharing

activities as its partners. But in absolute terms, its performance

will be enhanced significantly. Without participation, knowl-

edge sharing doesn’t occur, and no one wins.

Second, dividing the benefits equally between suppliers and

buyers may sound appealing, but in reality it may not be possible:

One partner will always have more to learn than the other and

thereby have a bigger upside. In most industries, suppliers have

the advantage as global supply chains move toward more

demand-driven models, giving buyers the upper hand. However,

buyers have already seized many efficiencies. Suppliers, who are

furthest removed from the point of final sale (and thus have the

most room for improvement), have the next opportunity.

Suppliers need to realize that any real or perceived dispropor-

tional benefits on their part may cause tension in the relationship,

and they need to be willing to address this problem. Among other

things, they can show good will in the form of more generous

division of profits, support for customers’ R&D programs, dis-

counts or preferred customer status. This would go a long way

toward ensuring future knowledge-sharing benefits.

Third, in order to benefit from their partners’ knowledge,

companies need to participate in the sharing process. Even if a

company feels that sharing certain information or knowledge

resources is more of a potential liability than a benefit, it must

recognize that there is a quid pro quo: A partner’s participation

in the sharing process will likely depend on the original compa-

ny’s willingness to do its part.

Finally, cross-cultural differences rarely matter, at least in the

context of knowledge-sharing value. Managers repeatedly have

heard that the greater the cultural distances between buyers and

their suppliers, the less effective knowledge sharing can be. Our

research found the opposite.

IN THE COMPETITIVE LANDSCAPE of global supply chains, knowl-

edge sharing between buyers and suppliers has never been more

critical. Although there is still a significant amount of hesitancy

on the part of supply chain managers to share critical knowl-

edge resources, experience shows that knowledge sharing can

benefit both buyers and suppliers. If managers can come to

terms with the often-disproportionate gains for suppliers and

understand that some gain is better than no gain at all, both

parties will benefit. Simultaneously, there may be room for sup-

pliers to address the benefit disparities in order to reduce

tensions among supply chain partners. If companies approach

global knowledge sharing constructively, supply chains will

become more competitive — and everyone can win.

REFERENCES

1. E. Anderson and S.D. Jap, “The Dark Side of Close Relationships,” MIT Sloan Management Review 46, no. 3 (spring 2005): 75-82.

2. H.L. Lee, “The Triple-A Supply Chain,” Harvard Business Review (October 2004): 102-112.

3. B. Swanton and D. Hofman, “DDSN: Who Says Reducing Forecast Error Requires Predicting Further Into the Future?” (Boston: AMR Research, 2004). An increase in demand visibility was also found to increase on-time delivery performance by 27.5% and yield an average margin improvement of 3.7%, according to AMR; see C. Saran, “Supply Chain Optimisation Can Deliver ROI Within Four Months, Finds AMR Research,” Computer Weekly, April 25, 2006.

4. K. Giriprakash, “Toyota’s Small Car Likely to Be Ready by 2010-11,” Hindu Business Line, Feb. 15, 2007.

5. I. Young, “Industry Eyes Big Savings From Supply Chain Collabora-tion,” Chemical Week, Nov. 2, 2005; S. Monahan and R. Nardone, “How Unilever Aligned Its Supply Chain and Business Strategies,” Supply Chain Management Review 11, no. 8 (November 2007): 44-50.

6. Many industries besides the chemical industry can benefit from increased supply chain collaboration and knowledge sharing. According to AMR Research, increased knowledge flows and more visible supply chains (meaning more information on customer demand for all supply chain members) lead to a significant reduction in supply chain problems. The combined annual returns for companies in AMR Research’s 2007 top 25 supply chains, an annual ranking that identifies large manufactur-ers and retailers that display superior supply chain performance, capabilities and leadership, was 17.89%, significantly higher than the Dow Jones or S&P 500 returns for the same period. The top companies include Nokia, Apple, Procter & Gamble and IBM. See K. O’Marah, “The Top 25 Supply Chains 2007,” Supply Chain Management Review 11, no. 6 (September 2007): 16-22.

7. “Best-In-Class Firms 2.7 Times More Likely to Use Global Supply Chain Visibility Platforms to Improve Global Trade Management,” Asia Pulse News, June 15, 2007.

8. Author’s interview with U.S. freight company executive, Aug. 26-27, 2007.

9. F. Selnes and J. Sallis, “Promoting Relationship Learning,” Journal of Marketing 67, no. 3 (July 2003): 80-95.

10. For more detailed descriptions regarding how knowledge sharing works and who benefits, see D. Apostolou, N. Sakkas and G. Mentzas, “Knowledge Networking in Supply Chains: A Case Study in the Wood/Furniture Sector,” Information Knowledge Systems Management 1, no. 3-4 (1999): 267-281; for excellent reviews of the dangerous reper-cussions, see Anderson and Jap, “The Dark Side.”

11. “Chinese Toys: No Fun and Games,” Economist, Jan. 12, 2008.

12. R. Kisiel, “Automaker, Supplier Win Supply-Chain Honor,” Automotive News, Dec. 12, 2005.

13. J. Ott, “Chain Reaction: The Supplier Excellence Alliance Is Spreading the Gospel of Lean Manufacturing and the Mechanics of Survival,” Aviation Week, Sept. 19, 2005, 51; for more on the Supplier Excellence Alliance, see www.seaonline.org.

14. “Chain Reaction.”

Reprint 49401.Copyright © Massachusetts Institute of Technology, 2008. All rights reserved.


ention the term value chain, and most managers will have visions of a neat

sequence of value-enhancing activities. In the simplest form of a value chain,

raw materials are formed into components that are assembled into final prod-

ucts, distributed, sold and serviced. Frequently, these activities span multiple

organizations. This orderly progression allows managers to formulate profitable strategies

and coordinate operations. But it can also put a stranglehold on innovation at a time when

the greatest opportunities for value creation (and the most significant threats to long-term

survival) often originate outside the traditional, linear view.

Traditional value chains may have worked well for landline telecommunications and

automobile production during the last century, but innovation today comes in many shapes

and sizes — and often unexpectedly. (See “About the Research,” p. 75.) This argues for see-

ing value creation as multidirectional rather than linear.1 Given the constant tension

between opportunity and threat, companies need to explore opportunities for managing

risks, gaining additional influence over customer demand and generating new ways to cre-

ate customer value. Mobile phone giant Nokia Corp., for example, is legendary for having

had the foresight to lock in critical components that were in short supply, allowing it to

achieve significant market share growth. However, Nokia suffered a setback a few years ago

when competitors used that very same strategy to take advantage of shifts in the demand for

LCD displays.

Protection against such fickle reversals calls for a more complex view of value — one that

is based on a grid as opposed to the traditional chain. The grid approach allows companies

to move beyond traditional linear thinking and industry lines and map out novel opportu-

nities and threats. This permits managers to identify where other companies — perhaps

even those engaged in entirely different value chains — obtain value, line up critical

resources or influence customer demand.

In a value-grid framework, there are a variety of new pathways to enhanced performance.

They can be vertical (as companies explore opportunities upstream or downstream from

the adjacent tiers in their existing value chain), horizontal (as companies identify opportu-

nities from spanning similar tiers in multiple value chains) or even diagonal (as companies

look more integratively across value chains and tiers for prospects to enhance performance

and mitigate risk). Successful companies increasingly develop a multifaceted value-Grid

perspective as they leverage new opportunities and respond to new threats.2 (See “Value-

Grid Dimensions and Strategies,” p. 74.)

Breaking free of linear

chain thinking and

viewing value creation

from a multidimensional

grid perspective provides

the greatest opportunities

for innovation.

Frits K. Pil and

Matthias Holweg

M

Frits K. Pil is an associate professor at the Katz Graduate School of Business and a research scien-tist at the Learning Research Development Center, both at the University of Pittsburgh. Matthias Hol-weg is a senior lecturer at the Judge Business School at the University of Cambridge, UK, and aresearch affiliate at the MIT Center for Technology, Policy, and Industrial Development. They can bereached at [email protected] and [email protected].

72 MIT SLOAN MANAGEMENT REVIEW SUMMER 2006

Evolving From Value Chain to Value Grid


Thinking Nonlinearly Within the Chain Companies seek competitive advantage with value chains by

managing an orderly flow of goods and services across supplier

and customer relationships. In theory at least, reducing the lead

time at each link in the chain allows companies to reduce inven-

tory and deliver the end products using concepts such as just-in-

time manufacturing and supply, continuous replenishment and

quick-response manufacturing. Doing away with decision-mak-

ing tiers in turn cuts coordination costs and improves informa-

tion flow. As the entire chain tightens, the company becomes more

competitive.3

However, there is a catch: How benefits are distributed across

the value chain depends heavily on the balance of power between

suppliers and manufacturers. This is where nonlinear thinking

comes in. The strategy focus needs to shift from lead-time reduc-

tion to the power dynamics between the company and other

players in the chain. Thus, companies need to focus on three

areas: (1) opportunities to influence customer demand both

upstream and downstream, (2) opportunities to modify infor-

mation access in either direction, and (3) opportunities to

explore penetration points in multiple tiers that are not immedi-

ately adjacent. These types of opportunities emerge from think-

ing nonlinearly within the traditional value chain, which

constitutes the vertical dimension of the value grid.

Influencing Demand Companies try to control demand both down-

stream (in the direction of the end-user or customer) and

upstream in their value chain (in the direction of their suppliers

and their suppliers’ suppliers). In controlling downstream

demand, companies essentially control who drives the purchase

decision in the supply chain. Customers typically generate

demand for some intermediate products. Intel Corp., for example,

tries to increase demand and shore up its prices by making com-

puter buyers more aware of its chip sets, while Nokia works hard

to get its logos affixed to the cell phones it sells to wireless service

providers. According to a Nokia executive, the company sees its

brand image as the primary driver of customer retention — even

more than its reputation for technology leadership. Mobile serv-

ice providers such as Verizon and Sprint in the United States,

Japan’s DoCoMo and UK-based Orange push back by giving pref-

erential treatment to handset providers who agree to remove their

logos and customize handsets for the service provider.

The value-grid approach recognizes that companies cannot

always control or influence the customer directly, so it takes a

broader perspective on how to control where the purchase deci-

sion is made. Companies can explore the full value chain, identi-

fying — and sometimes inserting — levers that will shift

decisions from one point to another. The pharmaceutical indus-

try offers a case in point. Clearly, the end-user in this industry is

the patient who takes a drug, but who drives the decision on

which drug to purchase is less obvious. To deal with this ambigu-

ity, pharmaceutical companies often take a three-pronged

approach in targeting key decision points. The first prong is

aimed at consumers. The industry invests more than $2 billion

annually on direct-to-consumer marketing (almost 10% of what

it spends on research and development). But focusing on con-

sumers is only partly effective. The National Institutes of Health

estimates that only about one in 10 consumers who see adver-

tisements for medicines request a specific drug from their physi-

cian. While this figure may seem unimpressive, the advertising

prompts a larger group of patients to discuss their concerns with

their healthcare provider, thus increasing the overall demand for

a particular class of drugs.

The second prong is aimed at physicians, getting them to

become more aware of conditions that specific drugs are

intended to treat. For example, GlaxoSmithKline Inc. lends

LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 3074 MIT SLOAN MANAGEMENT REVIEW SUMMER 2006

spirometers to primary-care practices so that physicians can con-

duct breathing tests themselves rather than referring patients to

pulmonologists for testing. GlaxoSmithKline uses this opportu-

nity to provide doctors with information on inhaled corticos-

teroids. The hope is that greater use of spirometry tests will result

in increased identification of subtle respiratory problems, which

in turn will generate more demand for medications such as those

that the company produces.

When medications from multiple pharmaceutical companies

can be used to treat a condition, drug companies face obstacles in

shifting demand to their particular drug. The last prong involves

incentives for physicians and pharmacies. By strategically manip-

ulating discounts and exclusivity arrangements, pharmaceutical

companies try to persuade physicians to prescribe their products.

Failing that, they attempt to redirect prescriptions to a drug that

they produce, going as far as to insert pharmacy benefit managers

strategically into the value chain. (Pharmacy benefit managers

act on behalf of insurance companies to negotiate discounts for

their plan participants.) Merck & Co., Inc., for example, acquired

Medco Health Solutions in 1993 for this precise purpose.

Medco, which was spun off in 2003 amid complaints about its

role pushing Merck products, currently manages prescription

drug plans representing more than 60 million patients. To qual-

ify for discounts, participants must select from a preferred list

of medicines. In exchange for getting their products on the pre-

ferred list, pharmaceutical companies provide additional

rebates to the pharmacy benefit managers. Pharmacy benefit

managers effectively limit the number of channels and avenues

by which patients can obtain their medications and frequently

cut out traditional pharmacies. For example, Medco negotiates

with clients such as General Motors Corp. to have plan partici-

pants purchase maintenance drugs from a mail-order unit.

Indeed, the GM plan no longer permits plan participants to fill

their prescriptions through pharmacies such as Walgreen Co.’s

Walgreens.

In addition to influencing demand downstream, companies

have opportunities to influence price sensitivity and volume

demand upstream. Consider Pfizer Inc. Its statin drug Lipitor,

which is designed to reduce levels of so-called “bad” cholesterol,

is the world’s top-selling medicine and accounted for sales of

$12.2 billion in 2005. However, in anticipation of the loss of its

patent protection in 2010, Pfizer is testing a new cholesterol drug,

torcetrapib, which is intended to increase the amount of “good”

cholesterol and potentially complement Lipitor’s role in slowing

the development and progression of atherosclerosis.

Pfizer is assessing torcetrapib’s effectiveness and safety — not

as a stand-alone intervention but as used in conjunction with

Lipitor. The company is not testing torcetrapib with the other

well-known statins, which are produced by its competitors. If the

clinical trials are successful, torcetrapib will be available only as

part of an integrated combination pill with Lipitor.

This provides a good example of how companies can look

upstream, in this case to R&D efforts, to identify ways to narrow

customer choice downstream. In this particular instance, there is

also a potential bonus for end-users: By having Lipitor and torce-

trapib in one pill, they may be able to obtain two drugs for a sin-

gle copay.

Modifying Information Access Real opportunities for shifting the buy-

ing decision occur when companies are able to link information

with control. (See “Knowledge-Retention Strategies by Network

Role.”) For example, a company needs to understand its suppliers’

flexibility and pricing structure. Companies can do a better job in

this area by monitoring the market conditions faced by suppliers.

For example, American Honda Motor Co. Inc., unlike some of its

Japanese competitors, offers contracts to suppliers that specify

which second-tier suppliers will furnish components for the sub-

assemblies integrators provide. The greatest value comes when

suppliers view this level of control as being in their own interest as

Upstream

HorizontalDimension

DiagonalDimension

VerticalDimension

End-users

Downstream

Primary Inputs(Raw Materials,Services, etc.)

The grid perspective highlights three dimensions for identi-

fying ways to enhance company performance: the vertical,

horizontal and integrative diagonal dimensions. Within the

vertical dimension, companies explore nonlinear opportuni-

ties in their traditional value chain by looking beyond those

directly connected to them upstream or downstream.

Within the horizontal dimension, companies explore

opportunities in parallel value chains. Within the diagonal

dimension, companies take an integrative approach as

they explore more widely in other tiers and value chains

for opportunities to create value.

For ease of exposition, the value grid figure here is simple

and rendered in two dimensions. It should be noted that

companies undertaking a thorough mapping of the value

grid will find many more cross-linkages and relationships.

After initial opportunities have been exploited, the poten-

tial landscape for identifying opportunities can be continu-

ously enlarged.

Value-Grid Dimensions and Strategies


well. In 2002, the U.S. government’s steel safeguard program

imposed tariffs of up to 30% on certain types of imported steel.

This caused prices of U.S.-produced steel to jump dramatically,

which in turn made it difficult to procure certain grades of steel.

Most automakers now purchase steel in volume, which they resell

to their suppliers at a discount. The benefit to automakers is not

just lower cost but also the ability to learn more about their sup-

pliers’ material costs and control a key input for direct suppliers.

For companies such as Nokia that cannot directly control the

product offering, having information about end-users is critical. It

is standard for mobile network operators to provide phone service

with handsets, tying the price of the phone to the service contract.

In reaction, Nokia developed a mechanism for communication

with its users in Europe, the Middle East and Africa — a Web site

called Club Nokia, where customers get priority support and

exclusive offers and services if they register their phones. Nokia

went so far as to offer special ring tones directly through this site, a

practice it discontinued only after service providers complained.

Exploring Multitier Penetration As companies find ways to control

over-demand, they often assume multiple positions in the value

chain in order to diversify demand and limit a particular buyer’s

power. For example, Bosal International NV, headquartered in

Lummen, Belgium, manufactures original equipment exhaust

systems for auto manufacturers. However, it also sells extensively

in the aftermarket. The company sees its business holistically: By

examining the multiple points in the value chain where it can

participate, it can explore scale economies in design and produc-

tion. In the late 1990s, for example, there was intense pressure

from original equipment manufacturers to reduce costs and

This article is based on a structured investigation of value

chain strategies in a range of industry sectors, supported

by the Cambridge-MIT Institute’s Centre for Competitive-

ness and Innovation, the International Motor Vehicle Pro-

gram at MIT and the Sloan Foundation. Our initial impetus

for undertaking the research was a comprehensive map-

ping of the value chains and value creation strategies of

nine vehicle manufacturers, their suppliers and their logis-

tics operations. The automotive industry is widely noted

for its operational effectiveness, and our initial efforts pro-

vided us with a comprehensive picture of the value chain

strategies at each tier. This enabled us to assess the effec-

tiveness and the risks inherent in the linear thinking asso-

ciated with current value chain strategies.

In a second step, we turned toward the fast-moving

telecommunications sector, where we conducted a series

of structured and semistructured interviews with execu-

tives of hardware manufacturers, software providers and

national telecommunications operators. Contrasting the

automotive and telecom sectors, we developed our basic

framework articulating the three core dimensions of

value-grid thinking.

In a third step, we explored how nonlinear strategies

are used in other sectors. We drew on interviews in health-

care and pharmaceutical-related settings and a host of

other industries to refine and validate our value- grid

model and identify a set of generic strategies for leverag-

ing value-grid thinking.

About the Research

Knowledge-Retention Strategies by Network Role

Dimension Description Exemplar Strategies

Vertical

Horizontal

Diagonal

Companies think nonlinearly about their value chainwhen they look downstream to end-users and upstreamto supply and service providers to find ways to betterunderstand end-users, enhance demand for productsand capitalize on information accessible to other tiersof the value chain.

Within a tier, companies move across value chains toleverage existing competencies, manage risk, seizevalue embedded in other chains and develop novelvalue propositions that are not accessible to actorsoperating in single value chains.

Companies operate diagonally when they operateacross tiers and parallel value chains. They take an inte-grative approach to gaining access to critical informa-tion, and they identify additional opportunities toensure and enhance demand.

• Influencing customer demand, both upstream anddownstream

• Modifying downstream information access• Exploring multitier penetration

• Seizing value• Integrating value• Creating new value propositions

• Pursuing pinch-point mapping• Defining demand enablers


increase the steel quality of exhaust systems. Although supplying

OEMs was important for credibility, the aftermarket offered

Bosal more attractive margins.

The balance is now shifting. Because exhaust systems are built

to last longer, they are replaced later in a vehicle’s life cycle. This has

led to greater price sensitivity in the aftermarket and fewer sales.

However, tighter emission standards and other factors now favor

OEM suppliers such as Bosal that offer integrated solutions. To

leverage its aftermarket experience, Bosal has shifted investment

away from aftermarket exhausts to less-price-sensitive accessories

such as tow and roof bars and the emerging catalytic converter

aftermarket. By supplying more than one tier in the value chain,

Bosal is less vulnerable to specific changes in demand and more

able to capture high-margin opportunities as they emerge.

Thinking nonlinearly about demand also helps companies

identify customer solutions that fall outside the traditional value

chain. In the auto sector, for example, steel providers typically ship

steel coils to vehicle manufacturers, which stamp them into auto

body components that get welded and painted. Prior to painting,

the assembled auto body receives an electrocoat to protect it

against corrosion. Dusseldorf, Germany–based steel producer

ThyssenKrupp AG has developed a new coating that protects steel

against both chipping and corrosion. This coating has the poten-

tial to eliminate a significant chunk of the painting process at

assembly plants, thereby allowing manufacturers to operate

smaller, more flexible factories and produce finished vehicles at

lower cost. In the automotive market, where product life cycles are

getting shorter and product variety continues to increase, this

change has the potential of offering a considerable advantage.

Exploiting Parallel Value Chains Within the value grid’s vertical dimension, companies often look

for new opportunities within a single value chain as they seek

new ways to influence demand, obtain critical information or

penetrate the value chain at multiple points. By contrast, the

opportunities for change in the horizontal dimension typically

By moving beyond the linear value chain, companies can gen-

erate value for the customer by joining or integrating addi-

tional value chains. There are several ways in which this type

of integration is playing out in the telecom sector. (See “The

Convergence of Voice Services.”)

Although mobile phone use has taken off, mobile calls are

traditionally much more expensive than landline calls. Land-

line manufacturers are working on mobile handsets that link

into the landline at home and into the global system for

mobile communication (GSM) network outside the home, thus

providing a novel value proposition for consumers. BT Group’s

BT Fusion, offered in collaboration with mobile provider Voda-

fone Group, is a mobile handset that functions as a normal

mobile phone but links at home to a landline, using Bluetooth

short-range radio (see option A in the figure). The customer

needs only one handset and pays low landline charges in addi-

tion to mobile network charges.

Voice over Internet Protocol (VoIP) companies like Luxem-

bourg-based Skype Ltd. and New Jersey–based Vonage offer

Internet telephony to households by providing voice commu-

nication between users of the Internet and landline telephone

infrastructure — seizing part of the landline infrastructure’s

value in the process. Corporations have embraced VoIP as a

way to save on landline phone calls, but they are still faced

with the high cost of cell phone calls.

As wireless Internet access becomes more ubiquitous, the

solution will be to integrate VoIP and wireless fidelity (WiFi). A

voice signal sent over IP is transmitted through a WiFi connec-

tion (VoWiFi). With current collaborations between VoIP and

WiFi providers, individuals can make calls wirelessly much

more cheaply than over traditional mobile networks. Dublin-

based Cicero Networks combines a VoWiFi capability in

hotspots coupled with a GSM capability for its business cus-

tomers, as most mobile phone calls originate from business

premises (see option B in the figure). Using dual-mode

GSM/WiFi handsets or pocket PCs, customers can make calls

over the cheaper WiFi base stations when these are available

and not congested by other WiFi users, and over GSM other-

wise. WiFi networks increasingly threaten mobile network

operators in urban areas, where WiFi density is high. A further

boost to voice service convergence may occur with WiMAX, a

variant on WiFi, which spans several square miles.

Yet another opportunity to integrate value is found by

linking the fixed and VoIP communication value chains to

enhance options and cost propositions. The USB DUALphone,

made by wireless communication supplier RTX, based in

Noerresundby, Denmark, is a cordless phone for home use

that can be used either as an IP or a traditional public

switched telephone network (PSTN) phone (see option C in

the figure). Still absent from the market is a handset that

integrates VoWiFi, GSM and landline access (see option D in

the figure). With GSM capability now integrated in a single

chip and increasing coverage of WiFi base stations, however,

this is a viable proposition. Instant text and video messaging,

interactive gaming and other interactive applications, cash

equivalency storage, streaming Internet access, browsing and

data sharing further enrich the potential to integrate value in

this particular arena.

Integrating Value in the Telecom Sector


reside in multiple value chains. This dimension provides oppor-

tunities for companies to leverage economies of scale across mul-

tiple sources of demand. Consider the case of an auto supplier

that makes flexible printed circuit boards. If the supplier is able

to sell its circuit boards to companies making medical and office

automation equipment, it can generate greater sales across which

to spread its costs. The potential of the value grid’s horizontal

dimension goes beyond economies of scale and scope in that it

enables companies to manage risk, seize existing value, integrate

sources of existing value and explore novel ways to create value.

Managing Risk In most industries, demand patterns tend to be

cyclical. Fluctuations are fairly common, which might cause

companies to underuse capacity or fail to supply demand, thus

prompting customers to look at competing products.

Looking across value chains provides companies with an

opportunity to explore countercyclical demand patterns. For

example, Honda is famous for its high-quality engines, but

demand for some motor vehicles, such as motorcycles, is sea-

sonal. To stabilize demand for motorcycle engines, Honda uses

those engines in counterseasonal products, such as lawnmowers,

go-carts and snowblowers. Similarly, the engines that power the

Honda Accord, CR-V and Element also power Honda’s 135HP

outboard motors. Honda leverages its core expertise in engine

design and benefits by achieving economies of scale in engine

production and design. It spreads the demand and development

risks for a component across multiple value chains and level

demand by operating in value chains with orthogonal (for exam-

ple, offsetting) demand and risk patterns.

Seizing Value In order to build more value, companies are becom-

ing more aggressive about moving horizontally into the value

chains of other companies in their industry. This entails using a

similar production or service stage in other value chains as a pen-

etration point into those chains. Toyota, for example, is the world

leader in hybrid powertrain technology, yet it has chosen to

license this technology to Ford and Nissan — two direct com-

petitors — even though demand for its own hybrid vehicles out-

paces its production capacity.

According to traditional linear thinking about value, Toyota

is unwise because its engines are key to differentiating some of

its products downstream and enabling the company to charge

premium prices. From a horizontal perspective, however, the

engine is a product in its own right. Toyota is more than a vehi-

cle purveyor; it is an influential supplier to other vehicle pro-

ducers. By supplying others, Toyota not only gains economies of

scale but also helps to establish and control the technological

framework for future hybrid vehicle development across the

industry.

The greatest opportunities — and perhaps the greatest threats

— occur when companies think horizontally in an attempt to

control value. This often takes place when a company identifies a

component or service that yields disproportionate profitability

and then introduces that element into other companies’ value

chains. Disposable printer cartridges are a good example of this.

Many printer manufacturers sell their printers at or near cost in

the hope that ink, toner cartridges and paper will generate a rev-

enue stream later on. Like the proverbial razor company, they

count on being able to sell disposable cartridges at regular inter-

vals. However, this scenario was threatened when small busi-

nesses began offering refilled cartridges at substantial discounts.

Traditional printer manufacturers, including Hewlett-Packard

Co. and Lexmark International Inc., took defensive steps to com-

bat the challenge. Lexmark added to its toner cartridges an elec-

tronic chip that can communicate with the printer as a way to

ensure that the replacement cartridges would be Lexmark prod-

ucts. The company offered discounts on cartridges with embed-

ded chips, believing that only Lexmark would be able to refill or

remanufacture them. However, the company was wrong, and

independent companies succeeded in supplying compatible car-

tridges. After pursuing legal challenges that ultimately failed, Lex-

mark changed its strategy and began supplying printer cartridges

for other brands of printers.

Lexmark’s solution raises an interesting point about horizon-

tal thinking: When companies in or across industries modularize

a particular component or service in the value chain, other com-

Packet Signal

Switched Signal

Packet Signal

A.Bluetooth

&GSM

B.VoWiFi

&GSM

C.VoIP

&Landline

D.VoIP,

Landline& GSM

Landline (PSTN)

Cell phone network

Data line (Voice over IP)

NetworkInfrastructure

Combinatory Options atthe Customer Interface

PC

Cell phone

Landline

Breaking free of linear mind-sets is enabling the

telecommunications sector to identify a number of novel

opportunities for delivering value to its customers. By inte-

grating the value proposition across the three basic value

chains associated with the landline telephone, the cell phone

and the Internet, companies are developing a number of per-

mutations of service and price bundles for end-users.

The Convergence of Voice Services


panies may begin to act in a similar fashion and provide compet-

itive components or services.

Integrating Value Breaking free of linear mind-sets helps companies

see opportunities to create value for customers by participating

more actively in new value chains. The telecom industry provides

an excellent example. Landline telephone services and mobile net-

works historically have been viewed as separate enterprises, leading

large telecom operators like AT&T Inc. and BT to spin off their

mobile components into independent companies. However, as

more consumers are abandoning their landlines in favor of mobile

service, fixed-line operators are coming up with novel ways to inte-

grate value with other value chains. As a first step, the companies

are integrating the value of landline and mobile services by linking

voice communications across data and voice networks. (See “Inte-

grating Value in the Telecom Sector,” p. 76.)

Creating New Value Propositions Horizontal thinking allows com-

panies to create value propositions that would be impossible with

a traditional linear view. For example, airlines and hotels want to

be able to distinguish price-sensitive budget travelers seeking a

last-minute deal from business travelers looking for convenience

and comfort. Which customers are willing to pay a premium to

stay in a specific hotel, and which would be happy with any

accommodation? Priceline.com Inc. and Hotwire.com (owned by

Expedia Inc.) allow customers to choose travel dates and destina-

tions, but the airline carriers and hotels are not identified until

the flight or room has been paid for. Thus, large airlines and hotel

chains are able to identify bargain hunters without undermining

their pricing structure for customers who value them. By span-

ning value chains within an industry, these companies create a

service that generates new value for companies in each chain.

Although Priceline.com started out by spanning value chains

within the airline industry, the travel reservations industry has

evolved into the sale of integrated (and discounted) hotel, airline

and car-rental packages. This is based on a strategy of spanning

the value chains of multiple industries. Companies like Cendant

Corp., which owns Orbitz, make money on bundling packages

from their own car-rental and hotel chains (Avis, Budget, Days

Inn, Ramada Inn, etc.) with airline tickets. By integrating the

value chains from these industries, they can offer package and

price combinations that would not be possible within a single

value chain. They also foil the efforts of companies looking to

gain market share in electronic price gathering and comparison

across distribution channels, such as Yahoo! Inc.’s FareChase.

Expedia Inc., Travelocity.com LP and other companies have used

similar strategies, often through agreements rather than direct

ownership of hotel, airline or car-rental agencies.

The resulting rapid proliferation of potential sales channels

has created new opportunities for eking value from crossing mul-

tiple value chains. Cendant, for example, is trying to leverage its

software development to provide turnkey software solutions for

inventory and rate management to hotel chains.

Exploiting Value Chains Across TiersIn addition to the value grid’s horizontal and vertical dimensions,

further opportunities for increasing control over inputs and cus-

tomers can be found by exploring the grid in an integrative fashion.

This includes exploring means of controlling the supply of critical

components and uncovering new ways of boosting customer

demand by looking upstream and downstream in other value

chains. Two strategies that take advantage of this diagonal, integra-

tive approach are pinch-point mapping (which involves identifying

potential bottlenecks and threats) and demand enabling.

Pursuing Pinch-Point Mapping In theory, at least, most companies

recognize the importance of knowing which suppliers produce

the key upstream inputs for their products. For example, auto-

motive companies that produce diesel engines rely heavily on a

ceramic particulate filter that is supplied by only two companies

in the world: Ibiden Co. Ltd., headquartered in Ogaki, Japan, and

NGK Insulators Ltd., headquartered in Nagoya, Japan.

When Ibiden experienced quality problems in early 2005,

Ford Motor Co. and PSA Peugeot Citroen were unable to pro-

duce thousands of vehicles. To avoid such problems, it makes

sense for companies to monitor key component supplies and

negotiate alternative sources of components that, if unavailable,

could shut down significant parts of the operation.

Arranging alternative sourcing within one industry is rela-

Expertise in one value chain may be a source of advantage in another. For example, UPS has evolvedfrom providing transportation services to offering a range of value-added, logistics-intensive services.


tively straightforward, but it is more complex when the compo-

nents are used across different industry sectors. Pinch points that

span different industries are particularly tricky to monitor

because it is difficult to anticipate demand or use for a compo-

nent or service in another industry. Companies should pay spe-

cial attention to components that take time to come on stream

and where the producer can allocate capacity across a variety of

applications. For example, producers of memory chips have reor-

ganized production to meet the dramatic increase in demand for

flash memory for camera cell phones, digital cameras and per-

sonal music players; in the process, the supply of other types of

memory chips has dwindled, posing threats to computer man-

ufacturers and other companies that rely on those chips.

Companies that fail to follow and manage pinch points can

run into serious problems. For example, a fire at a key Philips

semiconductor factory in 2000 caused a worldwide shortage of

the radio frequency chips used by both Nokia and Ericsson.

Nokia immediately lined up another source and redesigned other

chips so they could be produced elsewhere. However, Ericsson

responded more slowly and lost an estimated $400 million in

mobile phone handset sales. By acting quickly, Nokia was able to

gain a stronger position in the handset market, at least for a time.

History shows that such advantages can be short-lived.

Recently, for example, Nokia failed to monitor developments in

the market for color screens. Because producers of the film-trans-

fer screens were already committed to supplying makers of com-

puter monitors and television displays, Nokia was caught short.

This enabled Samsung Group, which produces its own screens, to

achieve significant gains in the market: Samsung’s global market

share in 2004 surged from 4% to 14%, while Nokia’s share

dropped by 2%.

In addition to helping companies avoid supply problems, mon-

itoring other value chains can help them identify potential rivals.

This is evident in the video games industry. As video game players

seek high-end graphics processors, wireless and wired Internet

capabilities, Windows XP and full multimedia drives, consoles like

the Xbox 360 and PlayStation are becoming well suited to audio-

video management. Indeed, the consoles could serve as hubs for

home entertainment, displacing traditional audio-video devices

(MP3, CD and DVD players) and perhaps becoming gateways for

audiovisual entertainment sales in their own right.

Defining Demand Enablers Examining value chains in other indus-

tries can reveal new opportunities to leverage key competitive

advantages. Companies that have a particular expertise in a given

value chain may find that that source of advantage is also relevant

in other value chains. For example, United Parcel Service of

America Inc. has evolved from providing transportation services

to offering corporate clients a range of value-added services that

are logistics intensive. One such client is Toshiba Corp. UPS man-


ages Toshiba’s laptop computer service business, which includes

overseeing the availability of parts, transporting broken equip-

ment to a service center, repairing the equipment and expediting

it back to the customer. By bundling repair with logistics, UPS

can provide a cost-effective solution, within a time frame that is

half what Toshiba could otherwise offer.

By reaching outside their established value chains, companies

can create new threats. In entering the computer repair business,

for example, UPS poses a new threat to companies such as Unisys

Corp. that have played an important role in this market.

Companies often can find new opportunities to leverage other

value chains to enhance the appeal of products that originate

within their own chain. Such was the case with Apple Computer

Inc., which in 2002 negotiated an unprecedented agreement with

major and independent music labels to sell music over the Web.

Most music labels had tried to launch similar ventures but had

been unsuccessful, in part because their musical selection was

limited and prices were high. Apple went with low prices in hopes

of locking users into its iPod music players. The company now

has the opportunity to develop new products that use its propri-

etary software and designs. Apple drew on the music industry as

a demand enabler for its hardware, and currently it is looking to

video and other content services to further lock in that demand.

Life Within the GridShifting from a value chain focus to a grid focus requires man-

agers to rethink the organization’s value proposition and associ-

ated structures from three perspectives: the impact on existing

operations; innovations outside of existing operational spheres;

and dynamic shifts in the value grid landscape. At the operational

level, a company uses the value-grid to leverage information that

directly benefits its existing operations.

Understanding the anatomy of purchasing decisions, for

example, empowers a company to adjust its provision of services

or products to more accurately match customer needs. This

directly benefits existing operations and thus ensures minimal

resistance because it does not threaten existing modes of think-

ing and operating. With a deep understanding of what drives a

purchasing decision, a company can make better decisions about

ways to shift control over the demand and manage risk.

Starting from an operational standpoint also makes sense for

pinch-point mapping because tracking and manipulating pinch

points ensures an uninterrupted flow of critical components and

services. Further, companies can leverage their understanding

strategically to lock out competitors.

Operating with a grid perspective also makes it easier for com-

panies to explore innovative strategies that do not directly benefit

operations, such as demand enablers. Such exploration is best done

through new organizational initiatives. It requires a more system-

atic and conscious effort because it lacks a natural operational

champion, such as a purchasing director or operations manager.

Value grids are inherently complex and dynamic, enabling a

nearly limitless web of opportunities. Because of this, vigilant

monitoring of the value-grid landscape must become an integral

part of ongoing corporate decision-making processes. This

includes both identifying new opportunities as well as monitor-

ing emerging dangers from other players in the value grid. Some

early warning signs of shifting opportunities and potential

threats are straightforward, such as the simplification or stan-

dardization of information, which often comes with the decision

to modularize a product or service. But many more opportuni-

ties and challenges are idiosyncratic and far more difficult to

identify. Thus, on a dynamic level, companies must continually

explore, evaluate and map the broad competitive landscape,

rethinking the value grid in terms of their critical activities.

REFERENCES

1. Jay W. Forrester provided one of the first systematic explorationsof the complex dynamics underlying information and material flow inmultiechelon systems; see J.W. Forrester, “Industrial Dynamics” (Cam-bridge, Massachusetts: MIT Press, 1961). It set the stage for exploringthe linkages across parts of the value chain from an operations stand-point. Among other things, it provided an early look at the root causefor dynamic distortions in value chains, which was later expanded andrelabeled as the bullwhip effect; see, for example, H.L. Lee, V. Pad-manabhan and S. Whang, “The Bullwhip Effect in Supply Chains,”Sloan Management Review 38, no. 3 (spring 1997): 93-102. Sincethen, value chain dynamics have become widely explored, asresearchers try to understand value creation and the sources of value.The “value chain” concept gained prominence in the mid-1980s asresearchers looked for cost optimization and new sources for competi-tive advantage; see J.B. Houlihan, “International Supply Chain Man-agement,” International Journal of Physical Distribution and MaterialsManagement 15, no. 1 (1985): 22-38; and M.E. Porter, “CompetitiveAdvantage: Creating and Sustaining Superior Performance” (NewYork: The Free Press, 1985). The efforts to understand value chains’dynamics as a source of core competence and competitive advantagecontinue to this day. A key concern in our previous research hasbeen, from an operations standpoint, how holistic value chain strate-gies can be leveraged to enhance responsiveness to customer needs;see M. Holweg and F.K. Pil, “Successful Build-to-Order StrategiesStart With the Customer,” MIT Sloan Management Review 43, no. 1(fall 2001): 74-83; and M. Holweg and F.K. Pil, “The Second Century:Reconnecting Customer and Value Chain Through Build-to-Order”(Cambridge, Massachusetts: MIT Press, 2004).

2. Martin Christopher observed that competition increasingly occursbetween entire value chains, not individual companies; see M. Christo-pher, “Logistics and Supply Chain Management” (London: PitmanPublishing, 1992).

3. An approach that was developed jointly with Audi AG and Daimler-Chrysler Corp., currently under pilot testing. For a more general dis-cussion on the advantage of small-scale operations in the value chain,see F.K. Pil and M. Holweg, “Exploring Scale: The Advantages ofThinking Small,” MIT Sloan Management Review 44, no. 2 (winter2003): 33-39.



enior executives frequently express dissatisfaction with back-office processes and func-

tions in areas such as human resources, information technology, indirect procurement,

finance and accounting, perceiving them as too costly to operate, limited in their capabilities

and frustratingly slow. Some of the largest companies — particularly those that have grown

through mergers and acquisitions — are saddled with disparate and poorly performing

processes that only major investments in dollars and management capacity can correct. Even

if senior executives agree to commit the necessary management time and other resources,

many are skeptical about creating the proper environment for back-office success.

Not surprisingly, rather than address these challenges themselves, many companies are

choosing to outsource some functions and areas — in some cases, even their entire global

back offices — to business-process outsourcing providers. One example of a BPO provider

is call centers; increasing numbers of companies are outsourcing their service support func-

tion to either local or offshore providers that can handle it more efficiently and at lower

cost. More recently, companies including BP Plc and Bank of

America NA have decided to outsource the transactional side of

their human resources activity.1 This trend toward outsourcing of

business processes continues to gather steam as companies seek

alternative and improved ways of leveraging their assets.

Some BPO providers speak of the “transformational” impacts

that upgraded processes can have on client business perform-

ance.2 Suppliers can furnish companies with more than simply

expertise. Some provide upfront capital to convert cumbersome,

decentralized human resources and administrative systems into

shared utilities, which they then deliver through new offices, new

business processes and Web-enabled technology. In addition to

setting the stage for internal efficiencies, BPOs can provide

opportunities for other benefits. Recently, for example, the Lon-

don-based Society of Lloyd’s, the global underwriting group,

worked closely with London-based Xchanging, a major business-

process outsourcing firm, to revamp its policy administration

and claims processing capabilities. The subsequent changes

allowed Lloyd’s to achieve substantial cost savings and service

Taking the Measure of Outsourcing Providers

David Feeny is a Fellow of Templeton College and director of the OxfordInstitute of Information Management at Oxford University. Mary Lacity isprofessor of information systems at the University of Missouri–St. Louis.Leslie P. Willcocks is professor of information systems at WarwickBusiness School, University of Warwick, Coventry. Contact them [email protected], [email protected] and [email protected].

SSuccessful outsourcing

of back-office business

functions requires

knowing not only your

company’s needs but also

the 12 core capabilities

that are key criteria for

screening suppliers.

David Feeny, Mary Lacity

and Leslie P. Willcocks


improvements; it has since partnered with Xchanging to sell

services that grew out of their business relationship to external

customers, creating a new stream of profits.

BPO has become a large and diverse market in recent years,

populated by an increasing number of providers. Organizations

interested in exploring the potential benefits of outsourcing

business processes need to look carefully at their own goals and

be clear about what supplier capabilities they need. Over the

course of 15 years of research, initially focused on IT outsourcing

but more recently expanded to include other types of BPO, we

have described ways to analyze appropriate outsourcing goals

and have provided a widely used model for identifying the capa-

bilities that need to be retained in-house.3 (See “About the

Research.”) This article identifies and describes what BPO

providers can bring to outsourcing relationships. Finding the

right suppliers is essential to BPO success.

Understanding Supplier CompetenciesRegardless of their specific areas of expertise, every BPO

supplier operates in three domains. To greater or lesser extents,

they possess competencies in delivery, transformation and

relationships.

■ Delivery competency encompasses how well a supplier can

respond to the client’s requirement for day-to-day operational

services. It reflects the supplier’s scope and complexity of serv-

ices: What levels of cost, quality, robustness and flexibility are

the supplier able to meet? Few companies will be eager to out-

source their business processes unless they are confident that

their minimum required standards of service can be met dur-

ing the life of the contract.

■ Increasingly, clients expect that the services they outsource will

improve over time and provide them with some combination

of cost, quality and functionality improvements. Transforma-

tion competency represents how well a supplier can deliver on

these formal or informal expectations. Suppliers use several

potential levers for achieving radical change and improvement,

and competing suppliers can vary greatly in this domain.

■ Most outsourcing deals are made up of “fee-for-service” con-

tracts, which separate the price the client pays from the costs

the supplier incurs in providing the services. This seemingly

straightforward arrangement can lead to serious conflicts,

especially when the contracts extend for many years. Clients

typically use their bargaining power to negotiate the best price

they can, but their position weakens once the contract has

been signed and the supplier seeks control. For this reason,

savvy clients attempt to gauge the supplier’s relationship com-

petency — the extent to which the supplier is willing and able

to cultivate a “win-win” relationship that will align client and

supplier goals and incentives over time.

We have been researching outsourcing

arrangements for 15 years, and we have

drawn on multiple research bases for

this article. The first research base con-

sists of 112 sourcing case histories

(mainly in the area of IT), studied longi-

tudinally from 1990 to 2001.i The sec-

ond is a 2001–2004 longitudinal study

of business-process outsourcing prac-

tices, with a particular focus on four

cases in aerospace and insurance.ii We

also draw upon a study of 10 applica-

tion-service provision outsourcing

arrangementsiii and two studies of off-

shore outsourcing arrangements.iv The

approach in all cases has been to inter-

view multiple stakeholders — senior

business executives, functional leaders

and operational staff in both client and

vendor organizations — and to review

related internal documentation. For

example, the BPO case research referred

to involved more than 40 formal inter-

views and analysis of over 120 original

documents, including contracts. We

studied practices and progress over time

and assessed these against outcomes.

Outsourcing success typically was meas-

ured by comparing objectives against

outcomes, cost savings (most deals

demanded some degree of cost saving)

and reported levels of satisfaction. The

satisfaction measure varied with stake-

holders from deal to deal, but examples

include service levels, end-customer

opinion, speed of conflict resolution,

innovation achieved and number of

times that penalty clauses were invoked.

i. M.C. Lacity, L.P. Willcocks and D.F. Feeny, “TheValue of Selective IT Sourcing,” Sloan Manage-

ment Review 37, no. 3 (spring 1996): 13-25; T.Kern and L. Willcocks, “The Relationship Advan-tage: Information Technologies, Sourcing, andManagement” (Oxford: Oxford University Press,2002); and M.C. Lacity and L.P. Willcocks,“Global Information Technology Outsourcing:Search for Business Advantage” (Chichester,U.K.: John Wiley & Sons, 2001).

ii. L.P. Willcocks, M.C. Lacity and D. Feeny,“Transforming a Back-Office Function: LessonsFrom BAE Systems’ Experience With an Enter-prise Partnership,” MIS Quarterly Executive 2, no.2 (2003): 86-103; and D. Feeny, L. Willcocks andM. Lacity, “Business Process Outsourcing: ThePromise of the ‘Enterprise Partnership’ Model,”Templeton College, Oxford University, 2003.

iii. T. Kern, M.C. Lacity and L.P. Willcocks, “Net-sourcing: Renting Business Applications andServices Over a Network” (New York: PrenticeHall, 2002).

iv. K. Kumar and L. Willcocks, “Offshore Outsourc-ing: A Country Too Far?” Proceedings of the 4thEuropean Conference in Information Systems,1996; and J.W. Rottman and M.C. Lacity, “TwentyPractices for Offshore Sourcing,” MIS QuarterlyExecutive 3, no. 3 (September 2004): 117-130.

About the Research


The first step in identifying potential suppliers is for a company

to consider its own requirements. (See “Client Needs and Sup-

plier Competencies.”) Does the company need a supplier who

can deliver the highest level of service, or will a moderate level be

sufficient? Is the present service in need of radical change? Or is

the company looking to phase out an internal service that is per-

forming satisfactorily in order to free up more management time

to address core activities? Does the company want a services ven-

dor that can be replaced easily if its performance is unsatisfac-

tory? Or would it like to have a long-term partner whose business

success over time will be closely tied to its own (recognizing, of

course, that this means higher switching costs should it need to

make a change)? A common mistake in outsourcing is choosing

a partner through a procurement process that encourages a bid-

ding war. This often leads to a “winner’s curse,” in which the sup-

plier that gets the contract almost immediately feels pressure to

restore profitability to a flawed business model.4

At the same time, client companies must determine which

suppliers have the appropriate level of ability in each area of

need. A common pitfall is that client executives have a tendency

to overemphasize supplier resources, such as physical facilities,

technology and workforce composition, while overlooking the

critical capabilities and resources that will be deployed for the

customer’s benefit. An executive at a company that has identified

technology as a key driver for transformation might ask a

prospective supplier for evidence that it has first-rate employees

in the technology area. Realistically, all credible suppliers will

have excellent technology people. Understanding the cultural dif-

ferences among competing suppliers may be more valuable:

Which ones have a culture of rapid and regular delivery of bene-

fits to client businesses through component-based platform

architecture, and which prefer to bundle system requirements

into large infrastructure projects?

Evaluating a supplier involves understanding the infrastruc-

ture, values and methodologies it brings to its area of expertise.

Successful evaluation also requires an awareness of the range of

processes the supplier uses and its available skills. The following

section examines 12 capabilities that support these supplier com-

petencies, drawn from case studies of BPO suppliers working

with major corporate clients. The supplier capabilities model

serves as a tool for helping clients assess potential service

providers, but it may also prove useful to suppliers who wish to

assess their relative strengths versus their competition.

12 Supplier CapabilitiesDepending on their specific needs and circumstances, companies

will look to BPO suppliers for different capabilities. Some capa-

bilities will support a single element of supplier competency,

while others will contribute to two or even three different

domains. (See “12 Supplier Capabilities,” p. 45.)

1. Domain Expertise The first and most obvious capability to

evaluate is the supplier’s capacity to apply and retain sufficient

professional knowledge of the target process to meet the user

requirements. Many supplier organizations acquire domain

expertise from clients through employee transfers. For example,

Barclays Plc, the financial services company, transferred its

check-processing staff to Unisys Corp.; conversely, Hewitt Asso-

ciates Inc. and Xchanging acquired human resource expertise

by transferring people from Bank of America and BAE Systems

Plc, respectively. This method of building expertise has two

potential advantages from the client’s point of view. First, it

becomes the supplier’s responsibility rather than the client’s

responsibility to adjust capacity, eliminate poor performers and

leverage the untapped potential of the best people; second, both

parties are assured that the staff operating the service are famil-

iar both with the functional domain (such as HR) and the

specifics and idiosyncrasies of the client’s existing service. As

the suppliers grow their own critical mass of expertise in the

target domain and become less reliant on transferees, new

clients should consider whether suppliers have enough knowl-

edge to operate in their specific context.

Depending on their goals, clients will view domain expertise

differently. A client seeking to build external capacity to handle

periodic variations in service demand will want a commitment

from the supplier that it is prepared to build expertise specific to

that specific context. On the other hand, a company seeking to

reduce labor costs through offshore outsourcing might be wary

of going too far: “It has become very clear [to us] that in order for

offshore to succeed, we need to groom, reward and retain our

own subject matter experts,” says a senior vice president of a For-

tune 500 financial services company.

Long-TermViability Needs

Relevance ofDelivery,Transformation,RelationshipCompetencies

OperationalService Needs

ServiceImprovementNeeds

In selecting potential suppliers, companies must begin by

assessing their requirements and the level of service they

seek. They must decide if they are looking to fix an existing

function, free up management time or establish a long-term

partnership.

Client Needs and Supplier Competencies


2. Business Management The second requirement of any BPO

arrangement is that the supplier consistently be able to meet both

client service-level agreements and its own business plans.

Clients must understand that failure on one front inevitably leads

to failure on the other. In some adversarial client-supplier rela-

tionships, clients focus on the high-priced items within the sup-

plier’s bundle of services and threaten to erode the supplier’s

margin by scaling back on or eliminating these items. They fre-

quently fail to give their suppliers credit for other items in the

bundle that are priced quite favorably compared to external

benchmarks of unit price. In successful relationships, business

managers on both sides are able to have frank discussions about

the supplier’s business returns and service performance.

Another example of business management in action is the

procurement deal BAE Systems developed with Xchanging. The

issue here was not pricing but volume. During the first year of

their contract, Xchanging realized that there was a significant

shortfall in the expected value of the transactions it handled.

The two parties collaborated over several months to identify

additional categories of business they could add to the contract,

thereby allowing Xchanging to get back on track with its busi-

ness plan while also providing BAE Systems with ways to

achieve new savings.

As the contract manager of an Australian public sector agency

explains: “Suppliers have to make a reasonable margin to stay in

business. You don’t want them to lose money because the worse

their business gets, the worse your business gets.”

3. Behavior Management When considering outsourcing serv-

ices, clients often seek qualitative as well as quantitative

improvements. For example, some managers worry about

whether morale will suffer if employees are transferred to the

supplier’s organization or whether employees will find a new

sense of purpose. Every major BPO supplier has employees with

impressive experience, skill and knowledge. However, clients

also should evaluate the supplier’s track records in motivating

and managing people to deliver superior service. This involves

looking for signs that the supplier understands training, man-

aging and motivating people.

Different suppliers use different methods. For example, CGI

Group Inc. of Montreal puts employees slated for transfer

through a process it calls “harmonization” even before the final

contracts with client companies are signed. “This is much more

than an orientation,” says Ed Standridge, a CGI partner. “We

want to show every employee — not just a subset — this is what

we do, how we do it, the timing. We want to set the stage for

good behavior management beforehand, not react to bad

behavior afterwards.”

Other BPO suppliers also place significant emphasis on

making sure that transitions are handled effectively, and man-

agers at some client companies have been pleased by the results.

Since 2001, for example, Xchanging has provided third-party

HR services to BAE Systems, running former employees

through its extensive orientation program. As a result of the

program, people have become “a lot more professional,” says

Kim Reid, divisional HR director at BAE Systems. “They have a

lot more understanding of what drives a business. They under-

stand the cost base and how you actually get value out of a busi-

ness. It has been quite a nice surprise to see that happen, and

happen so quickly.”

4. Sourcing Another potentially critical factor in meeting client

goals is the supplier’s capacity to tap the resources needed to

meet service targets. Clearly, client needs will vary depending

on the nature of the service and how much change the client is

looking to generate. Some clients may want access to economies

of scale or lower labor costs; others may need specialized pro-

fessional skills, improved infrastructure or help with supply

management. The procurement services deal between BAE Sys-

tems and Xchanging, for example, was based on two considera-

tions: Xchanging’s superior ability to attract high-level

professional skills for procurement of supply categories such as

office supplies, health plans and training; and its ability to take

advantage of scale by aggregating BAE’s part-time needs with

those of other clients.

AT&T Corp.’s desire to access the high skills and low costs of

India’s IT sector provides a contrasting example of the role of

sourcing. Rather than building a new service center itself, the com-

pany’s CIO managed to persuade IBM Corp. — which has a long

history as AT&T’s BPO and IT supplier — to open a service facil-

ity in India with all of the capabilities it needed. In effect, AT&T

was able to trade some of the potential cost savings it would have

garnered, if it had set up its own center, for reduced risk (both

management and political). Up to 40% of AT&T’s application

“Suppliers have to make a reasonable margin to stay in business. You don’t want them to lose money, because the worse their business gets, the worse your business gets.”


development work is done offshore

through IBM’s captive center, with

reported cost savings of around 30%.

5. Technology Exploitation Many com-

panies know that they are very out

of date when it comes to investing

in back-office processes that could

transform their services’ cost, quality

and functionality. At the same time,

top management is increasingly wary

about embarking on costly new tech-

nology initiatives they aren’t able to

manage closely. As they contemplate

outsourcing, many clients want to

know how swiftly and effectively

suppliers will be able to deploy tech-

nology to support critical service

improvement targets. This capability

requires careful evaluation, looking

beyond the purely technical skills that

all major suppliers have and assessing

the supplier’s approach. What values

and behaviors does the supplier bring to technology exploitation?

What processes does it employ? And what existing infrastructure

does it plan to use as a base? As some BPO suppliers are finding,

the ability to deliver improved business processes such as “e-

enabled” HR services directly to the end-user’s desktop can sur-

prise and delight their clients.

Technology is expensive, and clients will want it to be the ser-

vant of the business, not the master. The role of a good technol-

ogy supplier is to help client companies find cost-effective

business solutions. For example, CGI works with each client to

develop an annual technology plan that identifies the mutually

agreed-upon investments and projects the client intends to pur-

sue within the existing contractual framework.

6. Process Re-Engineering Another powerful lever for service trans-

formation is the ability to design and implement changes to the

service process to meet improvement targets. Capability in this

area is well established for many major BPOs. Given the promi-

nence of General Electric Co.’s corporate initiatives during the

1990s, many clients are familiar with Six Sigma and the Capability

Maturity Models. But it is important to look beyond well-known

tools to consider the human and behavioral factors. Who has the

critical skills? Who will own the change process? Who defines what

qualifies as an improvement? And who benefits? There are many

cases, particularly in IT outsourcing, in which process improve-

ments seem to have been designed more for the convenience of the

supplier than for the benefit of the client and the end user.

7. Customer Development “When I became the Accenture partner

responsible for the London Stock Exchange,” recalls David

Andrews (now CEO of Xchanging), “I found I had 200 users who

complained about everything. A critical task was to change their

mind-sets so that they became customers.” This points to one of

the fundamental challenges confronting both suppliers and clients.

Rather than thinking of those who avail themselves of internally

provided services as “users,” suppliers need to think of them as

“customers” — people who make informed choices about service

level, functionality and costs. The senior management of client

organizations and BPOs typically negotiate outsourcing deals, but

it’s the business units and end users who must live with the day-to-

day effects. To maximize chances for success, clients need to iden-

tify suppliers who can manage the user-to-customer transition.

Suppliers should take three steps to achieve the re-orientation

from user to customer. First, the supplier should have personal

contact with a large number of end users in order to build a real

understanding of how they want to use the service. This will help

create a climate of trust. Second, the supplier should work with

client managers to gain agreement on a detailed definition of the

required service, which everyone involved with providing the serv-

ice must understand. This will become the basis for regular reviews

of performance and user satisfaction. And third, the supplier

should work to create a business relationship in which the end user

becomes a customer who feels fully informed of service options,

potential enhancements and cost impacts; the customer then can

make new choices to meet the changing needs of the business.

Governance

Leadership

Sourcing

RelationshipCompetencyCapabilities thatdetermine thesupplier’s willingnessand ability to alignwith client needs andgoals over time.

Planning &Contracting

OrganizationalDesign

BusinessManagement

CustomerDevelopment

DomainExpertise

ProgramManagement

BehaviorManagement

TechnologyExploitation

ProcessRe-Engineering

DeliveryCompetencyCapabilities thatdetermine thesupplier’s abilityto respond tothe client’srequirement forday-to-dayoperationalservices.

TransformationCompetency

Capabilities thatdetermine the supplier’sability to meet theclient’s need for serviceimprovement.

Evaluating business-outsourcing providers requires understanding a supplier’s range of

business expertise and skills. Depending on their particular needs, companies will need to

look to suppliers for different capabilities.

12 Supplier Capabilities


Although these suggestions might sound rather obvious, they

are not easy to achieve under most fee-for-service contracts. Sup-

pliers typically set out to provide a centrally specified service level

and price package, but this often differs from what the user

claims to be receiving. As a result, a significant amount of the

supplier’s management time is consumed by extensive (and cen-

tral) negotiation over long lists of “anomalies” that pre-contract

due diligence failed to identify. The net result is that the user feels

neglected and taken advantage of, rather than developing trust.

Even though the supplier’s capability to develop customers is

considered part of its transformation competency, in practice this

is tied more closely to the supplier’s relationship competency.

8. Planning and Contracting A supplier’s relationship competency

starts with its ability to develop and execute business plans that

can deliver win-win results for both customers and suppliers

over time. The planning component involves creating a vision

of the potential prize and a coherent process for achieving it.

The details of this vision and process should be shared openly

with the client in order to build trust. A few years ago, a client

and a supplier were reporting disappointment with lack of

progress in the strategic partnership they had announced six

months earlier. The breakthrough came when a manager for the

supplier agreed to reveal his company’s revenue goal, which it

had thus far been unwilling to specify. To the manager’s sur-

prise, the client’s response was extremely favorable; the client

even stated that unless the supplier achieved at least that level of

revenue, he would consider the partnership a failure. As they

worked together to identify additional projects to support this

goal, the supplier gained sufficient confidence to invest more

resources in the effort.

Presenting the plan upfront clarifies the expectations for all

parties. For example, a recent procurement services deal between

Deutsche Bank AG and Accenture Ltd. spells out the vision, the

rewards and the plan for their achievement. It commits Accen-

ture to funding and creating a new platform for procurement,

with 200 people assigned to its development. Accenture receives

a substantial new revenue stream from Deutsche Bank and an

opportunity to attract other clients to the new service. In turn,

the plan is slated to deliver 15% to 20% in savings for Deutsche

Bank through consolidation, standardization and retooling of its

existing 14 procurement units.

Beyond the importance of planning, suppliers should be well

versed in the art of contracting. Among other things, this requires

understanding options for sharing rewards between themselves

and their clients as the plan is delivered. Many variations are pos-

sible. When Bank of America arranged to outsource HR services

from Exult Inc. (now part of Hewitt), it negotiated to take an

equity stake in the supplier as well as a share of the supplier’s rev-

enues from external clients;5 Xchanging structures its major deals

as profit-sharing arrangements, with open-book accounting. The

essential principle is that if the supplier and client do their parts

to make the business plans successful, both parties will win.

9. Organization Design Business plans are executed through orga-

nizational structures and processes. Clients need to assess

whether suppliers have the capability to deliver the necessary

resources to achieve the stated business plan. Suppliers vary

greatly in terms of their organizational approach, the choices

they make and their flexibility. Some emphasize a “thin” front-

end client team, interfacing with consolidated service units

that have profit responsibility and ownership of most of the

resources. Although such arrangements take advantage of

economies of scale, they can constrain a supplier’s ability to

deliver the business plan for a specific client. By contrast, other

suppliers allocate most of their resources to “enterprise part-

nership” units that are created for each major deal. The units

have their own chief executives, full executive teams and dedi-

cated core resources. They are responsible and accountable for

delivery of the business plan.

A critical issue in supplier organizational design is resource

allocation. Clients seeking to achieve service transformation

must evaluate this area with particular care. A potential supplier

may have impressive capabilities in all of the important ele-

ments of transformation, such as sourcing, technology and

process re-engineering, but the need for many of these capabil-

ities will fluctuate dramatically during the life of the contract.

Clients thus need to select suppliers who will be responsive to

their needs (and the needs of the shared business plan) as they

change over time.

10. Governance Every supplier points to some type of service

review committee or board that defines, tracks and evaluates

how well they have performed over time. Large relationship-

Although suppliers were consistent in the way they contracted and governed, the main differentiatorbetween success and failure was the individual leading the supplier account teams.


oriented deals, such as Accenture and Deutsche Bank or

Xchanging and BAE Systems, typically include a joint board of

directors, which underscores the expectation that clients will be

active partners in the enterprise.

Having previous experience with jointly staffed governance

mechanisms is helpful, but clients need to ask suppliers impor-

tant follow-up questions. What kind of reporting processes

does the supplier envision to ensure that each part of the gover-

nance structure remains properly informed? What procedures

does it intend to institute for dealing with escalating problems?

What powers and sanctions will be available through the gover-

nance structure?

Having joint boards of directors can lead to managerial schiz-

ophrenia.6 There may be confusion over exactly which hat the

client executives wear when they sit on the board of the service

business. Should they press for more services at lower cost to ben-

efit their own employer? Or should they encourage the service

business to maximize external revenues by taking on more

clients, even when this might divert attention from their own

service needs? The best way to deal with potentially competing

objectives is to have multiple joint boards to provide checks and

balances. For example, Lloyd’s, the International Underwriting

Association of London and Xchanging have developed a three-

way insurance services deal; they established a joint board of

directors that is focused on achieving revenue and profit growth

for the enterprise partnership. Xchanging, which owns 50%, has

a majority on this board to ensure operational control. But to

protect the service quality, there is a separate service review board

on which clients have equal membership with the supplier. When

a service problem escalates to this board, a remedial action plan

must be worked out within a maximum of three months. The

service review board also has the power to reduce prices. The ulti-

mate sanction for continual poor performance is the removal of

the enterprise partnership CEO.

11. Program Management A BPO supplier cannot survive without

highly developed project management and change management

capabilities. But clients interested in service transformation and a

long-term relationship should look beyond the supplier’s project-

level capabilities and evaluate its program management capability.

Program management involves prioritizing, coordinating, mobi-

lizing the organization and promoting a series of interrelated

change projects. As discussed earlier, it is important to provide

multilevel orientation and support for transferees, to think of

end users as customers, to have technology- and process-based

projects that deliver service improvements over time and to have

an overarching business plan. Managing change at this level is not

for the faint of heart; it demands sophisticated methodologies,

processes and professional skills. However, clients also should

assess potential suppliers based on their values and motivations.

Is the supplier so proud of the apparatus it uses for program

management, for example, that it risks operating a bureaucracy

that is unable to adjust to the client’s particular needs?

An experienced practitioner described program management

this way: “[Program management] is guided by a healthy para-

dox. It blends the rigorous project management disciplines

exemplified by world-class consultants with the practicality and

pragmatism that is only gained from running operations. … It

requires intellectual flexibility to vary or reverse a traditional

approach according to circumstance. … As a result there are no

rules, only guidelines.”

12. Leadership Although governance provides a structural and

procedural context for leadership, effective suppliers exercise

leadership more directly. They know how to identify, communi-

cate and deliver the balance of the activities required to achieve

success, both for the client and the supplier. Management litera-

ture generally credits individual leaders with a surprising degree

of influence over business results. Our research into the effec-

tiveness of services suppliers confirms this overall view. In rela-

tionships in IT outsourcing, we found that the individuals

fulfilling supplier leadership roles had a considerable impact on

relationship success.7 Although individual supplier firms were

consistent in the way they contracted and governed, 76% of the

deals under study were judged by participants to be successful,

and 24% were seen as unsuccessful. The main differentiator

between success and failure was the individual leading the sup-

plier account teams. When examining how these leaders make a

difference, three patterns emerge:

■ In unsuccessful cases, the leader of the supplier team was

often seen as too focused on delivery, meeting contractual

service levels while delivering the required margin to the

host supplier company. These issues clearly are important,

but they seem more a matter of business management than

leadership.

■ The quality of the supplier leader’s personal relationship with

the client leader is usually a driver. This can have an important

impact on the wider relationship between client and supplier

organizations.

■ Least obvious but perhaps most important, the relationship

between the leader who the supplier assigns to the client and

the top management of the supplier’s organization can be a

critical factor in success. Because most suppliers tend to create

more of a front-end team to serve the client rather than a full-

function business unit, the local team is extremely dependent

on its leader’s clout with headquarters to gain access to key

resources and approval for client-aligned business policies.


The recent experience of a large corporate client highlights the

importance of leadership in selecting suppliers. The company

negotiated a $200 million outsourcing contract with Supplier A.

Supplier A assigned an individual who one client executive

described as “a great person” to lead the account team, but the

leader had no clout with headquarters and could not get any-

thing done. The client terminated the contract and hired Sup-

plier B, who assigned an account leader with an impressive track

record in managing previous large contracts. Unfortunately,

having recently been recruited from a rival supplier, this leader

also had very little influence with the head office. The client

eventually called Supplier B’s CEO and asked him to “send

someone who can act on your behalf.” The CEO complied and

assigned a person from the head office, who brought 18 of the

supplier’s best people to the client team. The contract with Sup-

plier B has now been in effect for more than a year and is con-

sidered by both sides to be a great success.

From Capabilities to PerformanceThe objective of this article is to provide a framework for helping

client companies evaluate which suppliers possess the competen-

cies required to address their BPO requirements. However,

choosing capable suppliers is not enough to ensure performance.

The research suggests three imperatives for companies wishing to

add value through use of the BPO services market:

■ To identify which competencies to assess in the BPO market-

place, client firms should think carefully about each of the

processes they eventually may want to outsource. This will

involve evaluating the roles individual processes play within

their overall business model and then assessing what

improvement goals — measured in terms of cost, quality,

functionality or flexibility — will be most valuable to the busi-

ness over time. As clients conduct this type of in-depth analy-

sis, they should decide what combination of delivery,

transformation and relationship competencies would be most

important in light of their particular needs. The research con-

firms the value of the “selective” approach we presented in

1996,8 with the added refinement that multiple relationships

with a single supplier can be effective.

■ The decision to choose a particular supplier (or extend the

relationship with an existing one) should then be guided by a

thorough evaluation of relevant strengths in the 12 capabili-

ties. Capabilities, not skills and resources or brand name,

determine the right choice.

■ Finally, even with outsourcing it is essential for client firms

to remain involved with business processes rather than step

aside and assume that “it’s now up to the supplier.” The

actual level of client involvement and the extent and nature

of the resources needed will be a function of the specific con-

text.9 Part of understanding that context is identifying the

particular supplier capabilities that are most important and

the client-side involvement required for their successful

deployment.

For too many companies, outsourcing has been a case of “marry

in haste, repent at leisure.” As one senior executive of a major

supplier recently observed, “Outsourcing contracts are agreed to

in concept but delivered in detail, and that’s why they can break

down.” By benchmarking supplier capabilities against strategic

and operational intent, companies have an opportunity to estab-

lish relationships that are properly calibrated with the business

objectives they seek to accomplish.

REFERENCES

1. For an account of Bank of America’s outsourcing of HR activity toExult (which agreed to a merger with Hewitt Associates in June 2004),see P. Adler, “Making the HR Outsourcing Decision,” MIT Sloan Man-agement Review 45, no. 1 (fall 2003): 53-59. For a broader discussionof theory and practice in HR outsourcing, see D. Dell and H. Munson,“Outsourcing HR in the Power Utilities and Energy Industry,” researchreport E-0006-04-RR, Conference Board, New York, June 2004.

2. For an introduction to the transformational approach, see J. Linder,M. Cole and A. Jacobson, “Business Transformation Through Out-sourcing,” Strategy & Leadership 30, no. 4 (2002): 23-28; and J. Lin-der, “Transformational Outsourcing,” MIT Sloan Management Review45, no. 2 (winter 2004): 52-58.

3. See, for example, M. Lacity, L. Willcocks and D. Feeny, “The Valueof Selective IT Sourcing,” Sloan Management Review 37, no. 3 (spring1996): 13-25; and D. Feeny and L. Willcocks, “Core IS Capabilities forExploiting Information Technology,” Sloan Management Review 39, no.3 (spring 1998): 9-21.

4. For definition and analysis of the “winner’s curse” phenomenonacross 85 outsourcing contracts, see T. Kern, L.Willcocks and E. VanHeck, “The Winner’s Curse In IT Outsourcing: Strategies for AvoidingRelational Trauma,” California Management Review 44, no. 2 (winter2002): 47-69.

5. Exult quickly won significant add-on contracts, including a $700 mil-lion deal with Prudential Financial Inc. and a $600 million deal withInternational Paper Co. See M.L. Cagle and K. Campbell, “Taking HRfrom Cost Center to Revenue Generator at Bank of America” (presen-tation at the 2002 Outsourcing World Summit, Orlando, Florida, Febru-ary 18, 2002).

6. For discussion, see M. Lacity, D. Feeny, and L. Willcocks, “Trans-forming a Back-Office Function: Lessons from BAE Systems’ Experi-ence With an Enterprise Partnership,” MIS Quarterly Executive 2, no.2 (September 2003): 86-103.

7. M. Lacity and L. Willcocks, “Global Information Technology Out-sourcing: In Search of Business Advantage” (Chichester, U.K.: JohnWiley & Sons, 2001).

8. Lacity, Willcocks and Feeny, “Value of Selective IT Sourcing.”

9. Feeny and Willcocks, “Core IS Capabilities.”


LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 4576 MIT SLOAN MANAGEMENT REVIEW FALL 2008

S U P P LY C H A I N

Rethinking Procurement in the Era of Globalization

Over the past 25 years, the role of procurement within companies has changed

dramatically from that of simply buying goods and services to overseeing an

integrated set of management functions. Procurement has crept into every aspect

of management, from category management to managing supplier relationships, contracts

and payments, and strategy. As companies look beyond short-term costs and the scope

of procurement-related issues has grown, procurement professionals are paying more

attention not just to what they spend on goods and services but to the broader costs of

operating, maintaining and replacing the items and resources they purchase over time.

Despite procurement’s increased level of importance, it has yet to achieve the high-level

recognition it deserves. There are two main reasons for this. First, it is often difficult to document

procurement’s specific contributions: Were the cost savings the result of skillful negotiations

with vendors or a fortuitous shift in the market? The financial benefits of a favorable procure-

ment deal often extend beyond the initial purchase price to other aspects of performance (for

example, improved working capital or reduced financing costs), so there is more than one

bottom line to consider. Second, the line between the responsibilities of procurement and those

of other stakeholders can be ambiguous. The result: Procurement often shares whatever

successes it achieves with other groups; in failure, however, it typically gets all the blame.

The need to place procurement in a broader strategic context has become all the more press-

ing in the current era of increasing globalization. Global sourcing links procurement decisions

to strategic decisions. “Make or buy” decisions — for example, whether to move production

offshore to your own subsidiaries or outsource it to outside producers and subcontractors —

are typically made at the senior executive levels. However, other important decisions (such as

where to buy, from whom and under what conditions) are usually handled by procurement

professionals. The reality is that these decisions are no longer based entirely on an understand-

ing of direct purchase costs or on easily observable transaction costs, such as transport expenses

and import duties, but on many other types of transaction costs as well, including those related

to cultural, institutional and political differences. In this article, we will explore the role of these

other transaction costs in sourcing decisions and offer a new framework for evaluating costs

associated with sourcing and procurement in an increasingly globalized market.

The Role of Transaction Costs Traditional economic theory ignored transaction costs and assumed that trade was friction-

less. However, trade transactions, by their very nature, involve transaction costs.1 A necessary

condition for exchange is that one can commit ex ante to being able and willing to fulfill

Frank A.G. den Butter is a professor of economics at Vrije Universiteit Amsterdam, The Netherlands. Kees A. Linse is director of common infrastructure management at Royal Dutch Shell plc. Comment on this article or contact the authors at [email protected].

What used to be a

matter of finding

and purchasing goods

and services at the

most favorable price

has changed. At some

companies, procurement

has become closely

intertwined with

strategic decision

making and board policy

at the highest levels

of the organization.

Frank A.G. den Butter

and Kees A. Linse

SLOANREVIEW.MIT.EDU

LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 46FALL 2008 MIT SLOAN MANAGEMENT REVIEW 77SLOANREVIEW.MIT.EDU

contractual obligations ex post. Neither buyers nor sellers will enter

into exchange relationships unless they are confident that the other

party will fulfill the contractual obligations. The problem can be

solved in different ways.2 The exchange can be defined institution-

ally (for example, in a legally binding contract), but it can also

be defined by trust and by providing incentives for trustworthy

behavior (for example, through bonding networks, where not

fulfilling the contractual obligation leads to a costly exclusion from

the network).

This fundamental problem of exchange triggers various types

of transaction costs, which can vary based on the way the problem

is solved. Practically speaking, transaction costs consist of all the

costs incurred in the course of acquiring goods and services, either

by exchanging property rights in a market transaction or by

exchanging responsibilities: all the expenses and time spent coor-

dinating the purchase of goods and services. The “hard” costs

are relatively easy to quantify — they relate to items such as trans-

port charges, import levies and tariffs. “Soft” costs, on the other

hand, are less accessible and less clearly defined. They include

the costs of creating and checking contracts, information costs,

costs resulting from cultural differences and

communication failures, knowledge of legal

procedures, costs incurred in building trust

and reputation, network building, costs asso-

ciated with risk (including regulation) and

security requirements.3

As distances between trading partners grow

and economic, cultural, political and social

systems converge in a globalized market,

the soft costs become more important and

procurement becomes a more strategically

important area. Indeed, the ability to purchase

goods or services at the lowest possible price is

often less critical than developing effective

ways of bridging cultural differences and over-

coming informal trade barriers.4 However,

transaction costs cannot be reduced by deci-

sions of the procurement department alone.

Because of the wide range of costs and their

effects, it requires strategic decisions by top

management. As procurement managers look

beyond traditional cost considerations, top

managers must define their priorities and

deal with different cost categories.

Strategic Transaction Management The ongoing trend of globalization has

brought about increased movement toward

specialization and fragmentation of produc-

tion as manifested by growth in outsourcing,

global sourcing and direct foreign investments. Dramatic growth

rates in countries with lower production costs (including India and

China) have given rise to a sense of urgency within companies

operating internationally about how they can continue to create

value through trade. One option is to switch from captive produc-

tion to become a leader in orchestrating production — developing

expertise regarding where to produce, assemble and sell. It requires

changing the way companies go about managing transactions and

how international trade relationships are established. In doing this,

companies can acquire critical knowledge about how transaction

costs can be reduced. In fact, it works in two ways. Lower transac-

tion costs will enable further fragmentation of production and

outsourcing of specialized tasks because they make outsourcing

profitable.5 At the same time, enhanced knowledge about the costs

of outsourcing (in particular, knowing when outsourcing isn’t

profitable due to unexpectedly high soft transaction costs) can lead

to further reductions in transaction costs.

Knowledge of transaction costs is a critical part of trade and

investment decisions. It allows companies to reduce their overall

costs, thereby making existing trade more profitable and opening

LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 4778 MIT SLOAN MANAGEMENT REVIEW FALL 2008 SLOANREVIEW.MIT.EDU

the door to higher volumes of trade. Knowing how to keep trans-

action costs low is something we call transaction management.

Effective transaction management can create value for both

individual companies and society as a whole.

As transaction costs are reduced, they become a smaller part of

the total supply cost in current trade. But there are compelling rea-

sons for companies to remain focused on this area. Good transaction

management and lower transaction costs will increase the number

of profitable trade transactions and lead to further fragmentation

of supply chains. In the process, production processes will undergo

changes; with increased outsourcing, there will be fewer direct

production costs and more transaction costs. On balance, new

trade (from outsourcing more parts of the supply chain) will have

higher transaction costs in relation to the total supply costs.

The strategic character of transaction management is high-

lighted by the fact that institutions, including the legal

infrastructure, the banking system and the regulatory and politi-

cal systems, are all highly influential in how transactions are

managed. Different institutions shape transactions in different

ways — for example, whether the transactions are handled for-

mally (with legal contracts) or informally (through trust-based

relationships). Although globalization has spurred significant

convergence in the institutional environment, cultural, legal and

social differences continue to be barriers in some countries and

regions. For example, the trading norms that are accepted in

continental Europe and the English-speaking world do not

always line up with how things are done in the Middle East and

Asia. For managers seeking to reduce transaction costs, under-

standing the cultural, legal and social differences is critical.

Transaction Management for ProcurementProcurement professionals have an essential role to play in

managing the complex interface between companies and stake-

holders to maximize value. In today’s transparent global

economy, procurement managers will not only have to identify

and manage the different sources of transaction costs. They will

need to do this in areas where they have varying degrees of

control or influence. To assist management in understanding its

cost exposure, it is helpful to consider transaction costs along

two dimensions: (1) in terms of objective and subjective issues

and (2) in terms of internal and external influences.

Objective and Subjective Issues Objective issues are tied to measur-

able factors and are of a technical or professional nature. They

are usually linked to financial issues such as direct costs, improved

quality, on time delivery, transportation cost and life cycle cost.

Subjective factors, by contrast, are related to emotional, religious

or intuitive views of the world and how it connects with the orga-

nization. Although not overtly related to finance, such issues (for

example, unethical business behavior, diminished confidence in

a brand or adversarial labor relations) can result in significant

transaction costs and have major financial implications.

Internal and External Factors By internal factors, we mean factors

related to the specific business: its market position and its

reputation and brand. These are distinct from external factors,

which are tied to developments outside the company in areas

such as regulation, labor costs and currencies.

The combinations of internal, external, objective and subjective

factors create a complex spectrum of exposures that can affect the

financial health of a company, if not its very existence. In a global

economy, knowing the risks and opportunities of the different

exposures is a critical management competence. (See “Classifica-

tion of Costs in Procurement.”) Although management decisions

will originate in many different parts of the company, procurement

managers will need to keep a close eye on the various cost expo-

sures and flag concerns as they arise. Procurement, therefore, will

need to become more closely connected with strategic decisions

throughout the company.

Companies strive to minimize the total cost of ownership.

Based on our analysis of cost factors, the total cost of ownership

consists of:

1. The direct cost of acquisition, which is the original pur-

chase cost

2. The further cost, which is related to owning the equip-

ment or business, such as installation, maintenance, energy

consumption, disposal, etc.

3. All transaction costs related to acquisition and further cost

The direct cost of acquisition and the further cost are the two

factors that typically drive purchase decisions. They are largely


This research combines two different perspectives: govern-

ment policy making and corporate decision making. Prof.

den Butter was responsible for the report “The Netherlands

As a Trading Nation,” published in 2003, which recom-

mended increasing trade through low transaction costs.i

As formal trade barriers disappear, the report pointed out,

soft transaction costs will become increasingly important,

requiring countries to make knowledge investments. Dr.

Linse, who organized a conference for procurement officers

in late 2007, worked with Prof. den Butter to evaluate how

areas such as sustainable development and ethical behavior

should be reflected in transaction costs.

i. Scientific Council for Government Policy (WRR), “Nederland Handelsland: het Perspectief van de Transactiekosten (The Netherlands As a Trading Nation: The Transac-tion Costs Perspective),” “Reports to the Government” no. 66 (The Hague, Netherlands: Sdu Uitgevers, 2003).

About the Research

LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 48FALL 2008 MIT SLOAN MANAGEMENT REVIEW 79SLOANREVIEW.MIT.EDU

related to objective costs (as noted in “Classification of Costs in

Procurement”). The first step in extending the purchaser’s deci-

sion framework is to identify transaction costs as a cost category

that needs to be managed separately. The second step is to give

subjective costs the same level of attention as objective costs.

Finally, purchasers must acknowledge that many of the soft issues

do not just operate within the decision framework of procure-

ment but are integral to the strategic position of the company;

hence they need to be addressed by a wider management group.

An alternative way to view procurement is to look at the

day-to-day activities procurement professionals manage. (See

“Transaction Costs By Stage of Procurement,” p. 80.) This adds

the time dimension of decision making to our objective/subjec-

tive and internal/external framework. However, it would be a

mistake to conclude that the day-to-day activities will reflect the

variety of transaction costs covered by our framework. In par-

ticular, procurement professionals must be prepared to address

issues of accountability, optimization and compliance to ensure

that transaction costs are identified and properly addressed.

Accountability Procurement professionals need to assume

accountability not only for purchasing but also for managing

the complete transaction. Although procurement specialists

are often familiar with various types of transaction costs,

many lack a full appreciation of the effects some costs have on

the overall economics.

Optimization Once the transaction costs are known, the

challenge is figuring out how to optimize them in relation to the total

cost of ownership. This means knowing where costs can be mini-

mized and knowing where they are necessary to achieve optimal

procurement results. For example, transaction costs may be accept-

able in a situation where innovative or key strategic goods or services

of very high value to the company are being procured and where

security of supply is of prime importance. On the other hand, for

routine or commodity goods or services, the cost is of prime impor-

tance and transaction cost will need to be avoided or minimized.

Compliance Even if transaction costs are properly identified for

every stage of the procurement life cycle, their benefits may not be

realized due to noncompliance during the implementation of the

acquisition process. In today’s global market, compliance manage-

ment is more important than ever.

Managing the Soft Side of Procurement The importance of detailing and managing hard costs on

a category-by-category basis cannot be overstated. However, a

major part of the globalization challenge is figuring out how to

conduct business both profitably and ethically, which requires a

more comprehensive understanding of how to manage the soft

issues (for example, the trade-offs between the environment and

profits). Decisions to source products offshore — for example,

outsourcing parts production and services — often lead to higher

The table lists the various types of costs that managers of global companies need to consider in making procurement decisions.

It emphasizes the role of transaction costs, especially “soft” transaction costs. Such costs are becoming increasingly important and

have made procurement an essential part of strategic decision making.

Classification of Costs in Procurement

Objective (“Hard”) Factors Subjective (“Soft”) Factors

Internal Factors (decisions within company control)

External Factors (decisions controlled by others)

Internal Factors(decisions within company control)

External Factors(decisions controlled by others)

• Search and information costs connected with identifying suppliers

•Direct costs of acquisition

•Transport costs

•Quality assurance

• Installation and maintenance costs

•Intellectual property costs

•Training

• Legislation in relation to trade

•Currency effects

• Import/export permits, levies

• Labor costs and safety standards

• Government rules and regulations

• The effects of sourcing decisions on existing jobs

• The effects on reputation and brand value

• Corporate culture: Will staff support new suppliers?

• Sustainability trade-offs inside the company

• Risk aversion: Will staff be able to deal with the risks associated with new supply options?

• Sustainability considerations in relation to local and global economic environments

• Cultural differences con-nected with doing business

• Political differences concern-ing democratic rights, distribution of wealth, unions and political stability

• Customer views on desirable sources/suppliers

•Labor circumstances

•Environment

LESSONS IN OPERATIONS MANAGEMENT • MIT SLOAN MANAGEMENT REVIEW 4980 MIT SLOAN MANAGEMENT REVIEW FALL 2008 SLOANREVIEW.MIT.EDU


transaction costs than originally expected. This has implications

for regional employment and economic growth because these

transaction costs may affect the profitability of outsourcing and

reduce economic activity. It may, moreover, lead to social unrest

at home and a loss of trust in the company, which can give rise to

a new set of transaction costs.

Decisions to address issues of environmental sustainability

in a responsible way or to create attractive working conditions

for employees may result in higher transaction costs in the

short term (in the form of higher production costs or more

expensive training). In the long run, however, these investments

may lead to lower transaction costs (resulting from a good

reputation and the ability to attract the most motivated work-

ers). Therefore, in balancing the trade-offs between short-term

and long-term costs, ethical corporate behavior can be rational.

Different companies will make these decisions in different ways,

depending on how they value the risk and costs of a reputation

loss and how managers are emotionally or politically positioned

in relation to these issues.

SENIOR MANAGERS AT global companies need to recognize that the

role of procurement professionals is changing. What used to be a

matter of finding and purchasing goods and services at a favorable

price has become closely intertwined with strategic decision

making and board policy at the highest levels of the organization.

Global sourcing creates many new opportunities for value creation,

which well-run companies must learn to take advantage of.

REFERENCES

1. Ronald Coase, winner of the Nobel Memorial Prize for economics in 1991, introduced the concept of transaction costs in economic theory: See R.H. Coase, “The Nature of the Firm,” Economica 4 (1937): 386-405; and R.H. Coase, “The Institutional Structure of Production,” American Economic Review 82, no. 4 (September 1992): 713-719. Nowadays, transaction cost economics has become a major field: See O.E. William-son, “Transaction Cost Economics: How It Works; Where It Is Headed,” De Economist 146, no. 1 (1998): 23-58; and D.C. North and J.J. Wallis, “Mea-suring the Transaction Sector in the American Economy, 1870-1970,” in “Long-Term Factors in American Economic Growth,” ed. S.L. Engerman and R.E. Gallman (Chicago: University of Chicago Press, 1986): 95-161.

2. Greif elaborates the fundamental problem of exchange by showing how various institutions provide different solutions to the problem. That brings about different types of transaction costs: See A. Greif, “The Fundamental Problem of Exchange: A Research Agenda in Historical Institutional Analy-sis,” European Review of Economic History 4, no. 3 (December 2000): 251-284. For instance, the belief that the contract will be fulfilled may stem from a formal legal obligation, but it can also be based on the reputation of trustworthiness of the trading partner. In the first case, transaction costs will mainly depend on the quality of the legal system, and in the second case they will depend on the bonding of the trust relation.

3. A particularly noteworthy factor on the “soft” side of procurement is trust. On one hand, building trust and developing a reputation require investment, which leads to higher transaction costs. However, once suppliers and clients have established trust, they can anticipate lower transaction costs. Building trust and encouraging trustworthy behavior also has benefits for society as a whole, creating positive externalities. Damaged trust and reputation not only hurt companies in the form of high transaction costs; they harm society as a whole. See F.A.G. den Butter and R.H.J. Mosch, “Trade, Trust and Transaction Cost,” dis-cussion paper TI 03-082/3, Tinbergen Institute, Amsterdam, Oct. 13, 2003.

4. Informal trade barriers relate to red tape, tacit knowledge of how institutions work, uncertain and hazardous interpretation of rules and regulations, etc.

5. In this respect, Grossman and Rossi-Hansberg argue that the theory of international trade should consider the comparative advantages of trade in tasks rather than of trade in products and services: See G.M. Grossman and E. Rossi-Hansberg, “Trading Tasks: A Simple Theory of Offshoring,” NBER working paper W12721, December 2006.

Reprint 50117. Copyright © Massachusetts Institute of Technology, 2008. All rights reserved.

Transaction costs can be grouped into three categories that are aligned with potential trade transactions: costs associated with contact, costs associated with contract and costs associated with control.

Contact In the contact phase, the buyer seeks information about the preferred product (price and quality), potential suppliers, or, if the product does not yet exist, which producer might be able to develop and/or produce it. The seller devotes marketing effort to looking for a buyer. At this stage, the transaction costs are mainly for search and information. However, they are sunk costs — occurring even if a trade relationship (purchase) is not established.

Contract The contract phase starts immediately after the potential trading partners have found each other and begun working toward a deal. The costs in this period revolve around negotiating the terms of the contract. Parties have to decide how to divide expected rents of the transaction and how to protect their respective interests.

Control The control phase involves monitoring and enforcing the contract. Both monitoring and enforcement involve high transaction costs, especially when large distances separate the trading partners and suppliers from each other. Now that physi-cal distances have become less important through reduced transportation costs and fast communication, cultural and institutional distances can be large. Business partners need to monitor the terms of their agreements to verify whether the other party is doing what it promised to do. If there are prob-lems, the next step is enforcement of the contract. The most common response is to start a legal procedure. Especially in international trading relationships, legal actions take both time and money. Moreover, foreigners often have difficulties in national courts when they file claims against a local company.

Transaction Costs By Stage of Procurement

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