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Inter-firm Performance Measures, Supply Chain Performance and Incentive Contracts

Inter-firm Performance Measures, Supply Chain Performance
and Incentive Contracts
*




Jason D. Schloetzer
Ph.D. Candidate
University of Pittsburgh
jschloetzer@katz.pitt.edu

December 7, 2007


Abstract:
Using performance measurement data from a leading international manufacturer
regarding its relationships with 165 independent distributors, this study provides empirical
evidence on the relation between supply chain value drivers and future supply chain performance.
Further, the analysis shows that these value drivers play a significant role in supply chain
incentive contracts. Specifically, the effective adoption by one supply chain participant of another
participants preferred processes (process alignment) and the effective exchange of relevant
information throughout the supply chain (information exchange) have a significant positive
association with aspects of future supply chain financial performance. In addition, these
nonfinancial performance measures contain additional information not reflected in past financial
measures. The relative weights placed on these measures in supply chain incentive contracts and
performance evaluations are broadly consistent with the informativeness criterion. Taken
together, it appears that supply chain contract designers identify value drivers and incorporate
them as performance measures in supply chain incentive contracts.


*
This paper is based on my dissertation to be completed at the University of Pittsburgh. I thank my committee
members, Mei Feng, Ranjani Krishnan, Nandu Nagarajan, Shawn Thomas, and especially Harry Evans (Chair),
for their guidance and help. I also thank Jason Brown, Jon Glover, Yuhchang Hwang, Pierre Liang, Don Moser,
Prem Prakash, Dhinu Srinivasan and seminar participants at Carnegie Mellon University and the University of
Pittsburgh for their comments. I am indebted to several research site and consulting firm employees for
generously sharing their data and time. The data presented in the paper has been modified by a common factor
in order to protect research site confidentiality. Any errors are my own.



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I. INTRODUCTION
The economic flow of goods, from raw materials acquisition through the delivery of
finished products to the consumer, generally involves multiple, independent firms which together
form a supply chain. Within a supply chain, the manufacturer operates at the nexus of many
important relationships. The manufacturer interacts with suppliers to obtain necessary
components, such as an automotive company obtaining process tooling for a new car program
(e.g., Anderson et al. 2000). Once manufacturing is complete, the manufacturer engages its
distribution and retail network to fill orders and sell its products. Because distributors and
retailers are often the manufacturers interface with the consumer, the manufacturer must control
downstream firms in the supply chain to satisfy consumers and maximize profitability.
Manufacturers distribute their products to consumers in a variety of ways, from owning
the distribution network, to franchising distributors (e.g., soft drink bottlers) or employing
independent distributors (e.g., petroleum-based lubricants). In this paper, I focus on the
manufacturer-independent distributor supply chain arrangement.
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According to the National
Association of Wholesale-Distributors, revenues of the approximately 260,000 independent
distributors operating in the U.S. totaled $3.9 trillion in 2006, with grocery and petroleum
products distributors representing the two largest industry sectors. The magnitude of these figures
suggests that independent distributors are an important link in the manufacturers supply chain.
Supply chain relationships, such as those between manufacturers and distributors, have the
potential for agency conflicts similar to those faced by a vertically integrated manufacturer. The
distributors selling and operating actions affect both its utility and that of the manufacturer.
While the distributor and manufacturer seek to maximize profits, the distributor, who typically
stocks products from competing manufacturers, may not share the objective of selling the

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Brickley and Dark (1987) and Lal (1990) provide excellent descriptions of agency issues in franchises.
Lafontaine and Slade (2007) review this literature. With a franchise contract, the manufacturer faces legal
constraints in dealing with franchisees. For example, franchise contracts are often on-going, unless the
franchisor formally terminates the franchisees contract due to good cause, as defined by state law.



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manufacturers products. Because the manufacturer does not directly observe distributor choices,
such as the allocation of sales effort across competing brands, the manufacturer only observes an
imperfect signal of the distributors actions. For example, poor sales growth could be due to the
distributor selling competing products, stocking insufficient inventory, setting prices outside of
the manufacturers preferred range or providing inadequate sales training (Lassar and Kerr 1996).
In order to mitigate such conflicts, the party with more bargaining power (principal) would design
contracts to align the interests of other parties (agents) with value creation. To do this effectively,
the principal (manufacturer) must identify supply chain value drivers and incorporate them as
performance measures in the agents (distributor) contract in a cost-effective manner. In my
study, I first establish which performance measures appear to be value drivers and then show that
these measures play a significant role in manufacturer-distributor incentive arrangements.
Recent literature emphasizes that monitoring supply chain activities, and tying these
performance measures to incentive contracts, can enhance incentive alignment (e.g., Lafontaine
and Slade 1996; Narayanan and Raman 2005; Kaplan and Norton 2006). Supply chains are
frequently characterized as engaging in processes that span firm boundaries, such as joint decision
making (Ittner et al. 1999) and the synchronization of activities across firm boundaries (Kulp et al.
2004). The synchronization of activities across the supply chain can help align participants
incentives, which can mitigate incentive conflicts. Hence, the manufacturer can promote
incentive alignment through process alignment, which I define as the effective adoption by one
supply chain participant of another participants preferred processes. For example, a
manufacturer may have a preferred process for selling its products (e.g., stocking full product line,
participating in marketing programs), and, therefore, encourage its supply chain participants to
adopt these processes. Effective process alignment can standardize service quality (Dyer 1996;
Anderson et al. 1994) and facilitate the control and coordination of supply chain tasks.



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In addition to monitoring process alignment, the manufacturer can promote incentive
alignment and more broadly enhance sales efficiency by exchanging relevant information with its
distributors (e.g., Chen 2003). Unlike process alignment, which focuses on the coordination of
activities between firms, information exchange captures the communication between firms
regarding the external customer relationship. Specifically, I define information exchange as the
effective exchange of relevant information among supply chain participants on issues important to
supply chain performance, such as developing product pricing proposals, providing competitive
intelligence, and discussing inventory levels. Manufacturers and distributors are highly
interdependent (Anderson and Narus 1990), and exchanging information is a common feature of
these relationships (Kulp et al. 2004; Baiman and Rajan 2002a, 2002b). Effective information
exchange may enhance supply chain performance both by reducing distributor information rents
and by revealing hidden information for decision making purposes (Narayanan and Raman 2005).
However, information exchange also exposes the supply chain to opportunistic information
reporting by its participants.
Despite recent calls for extending intra-firm performance measurement to inter-firm
settings (e.g., Lapide 2000; Rizza 2006; Charron 2006), limited empirical research has
investigated the role of performance measures in supply chain incentive schemes.
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It is important
to examine supply chain performance measurement because supply chains are a valuable
economic (Hendricks and Singhal 2005; Randall and Ulrich 2001) and strategic (Lassar and Kerr
1996) asset. In addition, recent analytical research suggests that the threat of contract termination,
which may be contingent on specified performance measures, can play an important role in
sustaining inter-firm relationships (Baiman and Rajan 2002a; Baker et al. 2002; Levin 2003;
Plambeck and Taylor 2006). These results suggest that monitoring may be used not only to

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For example, Narayanan and Raman (2005) discuss an example of a home appliance manufacturer that seeks to
improve its retail partners performance. Because retailer sales efforts are not directly observable, the
manufacturer must rely on sales outcomes, a noisy signal of retailer effort. The authors recommend alleviating
retailer moral hazard via