Monday, April 25, 2011

Freaks in the Supply Chain

In our Vested Outsourcing work, we talk a lot about managing incentives.  We often refer to the book “Freakonomics” by Steven Levitt and Stephen Dubner.  In their work, they delight in putting the spotlight of incentive analysis onto urban myths, business lore and conventional wisdom.




Most supply chain professionals have by now had some exposure to the wonders of data analysis:  Set up your processes so you can capture the data that you can mine for insights that lead to process improvement.

We urge our clients to go beyond data analysis to explore the incentives that … drive the behaviors that generate the data that you can mine for insights that lead to process change.  We believe that becoming a “freak” about incentives will actually lead to process transformation, not just process improvement.

Consider a typical 3PL’s pick, pack and ship operation.  Most such contracts are priced by the activity.  Each pick, pack, or ship gets charged at a set price.  Enter a business owner who wants transformational change.  She asks for it at a QBR.  She sends out an email.  She brings it up in a one-on-one with her counterpart at her service provider.

She’ll promptly get transformational change, right?

What the Freaks teach us is that people and organizations respond to three types of incentives:  Economic, social and moral.  “Economic incentives” mean money.  Do this, make money.  Do that, make more money.  “Social incentives” mean peer pressure, appearances, keeping up with the Joneses.  Do this, look good to your friends.  Do that, look good to your community.  “Moral incentives” are defined by what the individual believes is right, or by the values an organization espouses.

What incentives does our 3PL have to generate transformational change?   Moral incentives?  Yep, right there in the corporate values statement:  Be an agent for transformational change for our clients.  So in that QBR, the 3PL’s managers are enthusiastic and promptly start tossing around ideas.

Social incentives?  Producing transformational change has some cachet in the 3PL world.  You can win awards for it!  So the 3PL’s executives say “You betcha” and start tossing around ideas.

And the economic incentives?  Well, let’s see.  It turns out that with an activity-based pricing model, our 3PL would actually be penalized for innovation

How can that be?

Because pretty much any transformational change involves taking picks, packs and ships out of the process.  If our 3PL gets paid for every pick, pack and ship, taking any of them out means giving up revenue.

Why would they want to do that?

Of course they wouldn’t.  In the world of Vested Outsourcing, if you want transformational change, an activity-based pricing structure becomes a perverse incentive because it penalizes the behavior you really, really want.  We call it the Activity Trap.

Our frustrated business owner might say, “You should do it because it’s the right thing to do.”  To our 3PL’s executives, a more important “right thing to do” is grow profits.  She might say, “You could win an award.”  To the 3PL, it might be more important to look good to their investors.

In either case, giving away revenue might not be such a good place to start.

How might our business owner and her 3PL change their pricing model to help them generate transformational change AND grow profits for both?  I look forward to your suggestions.

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