w5

 

read the articles and write a summary. These summaries should be no more than half a page.
The format of the summary is flexible, so feel free to use bullet points.
 

after writing each summary also answer these questions down below it “What did you find most interesting, unexpected, and disappointing.”

HBR
Spotlight

The 21st-Century Supply Chain

A supply chain stays tight only if every company on it
has reasons to pull in the same direction.

by V.G- Narayanan and Ananth Raman

Aligningnee
in Supply Chains

Wall Street still remembers the day it heard that Cisco’s much-
vaunted supply chain had snapped. On a mad Monday, April 16,
2001, the world’s largest network-equipment maker shocked inves-
tors when it warned them that it would soon scrap around $2.5 bil-

lion of surplus raw materials-one ofthe largest inventory write-offs in U.S. busi-
ness history. The company reported in May a net loss of $2.69 billion for the
quarter, and its share price tumbled by approximately 6% on the day it made that
announcement. Cisco was perhaps blindsided by the speed with which the United
States had advanced into recession, but how could this paragon of supply chain
management have misread demand by $2.5 billion, almost half as much as its sales
in the quarter? Experts blamed the company’s new forecasting software, and ana-
lysts accused senior executives of burying their heads in sockets, but those experts
and analysts were mostly wrong.

In truth, Cisco ended up with a mountain of subassembly boards and semicon-
ductors it didn’t need because ofthe way its supply chain partners had behaved in
the previous 18 months. Cisco doesn’t have production facilities, so it passes orders
to contract manufacturers. The contractors had stockpiled semifinished products
because demand for Cisco’s products usually exceeded supply. They had an incen-
tive to build buffer stocks: Cisco rewarded them when they delivered supplies
quickly. Many contractors also boosted their profit margins by buying large vol-
umes from component suppliers at lower prices than Cisco had negotiated. Since
the contractors and component makers had everything to gain and nothing to lose
by building excess inventory, tbey worked overtime to do so without worrying
about Cisco’s real needs.

94 HARVARD BUSINl SS REVIEW

The 21st-Century Supply Chain

When demand slowed in the first half of fiscal 2000,
Cisco found that it couldn’t cut off supplies quickly. More-
over, it wasn’t clear what Cisco had asked its suppliers to
produce and what the contractors had manufactured in
anticipation of Cisco’s orders. Many contractors believed
that Cisco had implicitly assured them it would buy every-
thing they could produce. Since Cisco hadn’t stipulated the
responsibilities and accountability of its contractors and
component suppliers, much ofthe excess inventory ended
up in its warehouses. However, the supply chain imploded
because Cisco’s partners acted in ways that weren’t in the
best interests ofthe company or the supply chain.

It’s tempting to ask, in retrospect, “What was everyone
thinking?” But Cisco’s supply chain is the rule rather than
an exception. Most companies don’t worry about the be-
havior oftheir partners while building supply chains to
deliver goods and services to consumers. Engineers-not
psychologists-build supply networks. Every firm behaves
in ways that maximize its own interests, but companies as-
sume, wrongly, that when they do so. they also maximize
the supply chain’s interests. In this mistaken view, the
quest for individual benefit leads to collective good, as
Adam Smith argued about markets more than two cen-
turies ago. Supply chains are expected to work efficiently
without interference, as if guided by Smith’s invisible
hand. But our research over the last ten years shows that
executives have assumed too much. We found, in more
than 50 supply chains we studied, that companies often
didn’t act in ways that maximized the network’s profits;
consequently, the supply chains performed poorly.

That finding isn’t shocking when you consider that sup-
ply chains extend across several function-> and many com-
panies, each of which has its own priorities and goals. Yet
all those functions and firms must pull in the same direc-
tion to ensure that supply chains deliver goods and ser-
vices quickly and cost-effectively. Executives tackle intra-
organizational problems but overlook cross-company
problems because the latter are difficult to detect. They
also find it tedious and time-consuming to define roles,
responsibilities, and accountability for a string of busi-
nesses they don’t manage directly. Besides, coordinating
actions across rirms is tough because organizations have
different cultures and companies can’t count on shared
beliefs or loyalty to motivate their partners. To induce
supply chain partners to behave in ways that are best for
everybody, companies have to create or modify monetary
incentives.

V.G. Narayanan (vnarayanan((i”hbs.t’dit) is a professor of
business tuiministration, and Ananth Raman (araman(a’hbs
.edit) is the UPS Foundation Professor of Business Loi;isties,
at Harvard Business School in Boston.

A supply chain works well if its companies’ incentives
arealigned-that is, if the risks, costs, and rewards of doing
business are distributed fairly across the network. For rea-
sons that we shall laterdiscuss, if incentives aren’t in line,
the companies’actions won’t optimize the chain’s perfor-
mance. Indeed, misaligned incentives are often the cause
of excess inventory, stock-outs, incorrect forecasts, inade-
quate sales efforts, and even poor customer service.

When incentives aren’t aligned in supply chains, it’s not
just operational efficiency that’s at stake. In recent years,
many companies have assumed that supply costs are
more or less fixed and have fought with suppliers for a big-
ger share ofthe pie. Eor instance, U.S. automobile manu-
facturers have antagonized their vendors by demanding
automatic price reductions every year. Our research, how-
ever, shows that a company can increase the size of the
pie itself by aligning partners’ incentives. Thus, the fates
of all supply chain members are interlinked: If the com-
panies work together to efficiently deliver goods and ser-
vices to consumers, they will all win. If they don’t, they
will all lose to another supply chain. The challenge is to
get all the firms in your supply network to play the game
so that everybody wins. The only way you can do that is
by aligning incentives.

Why Incentives Get out of Lino

C
ompanies often complain to us that their supply
chain partners don’t seem to want to do what is
in everyone’s best interests, even when it’s obvious

what’s best for the supply chain.This obstructive attitude,
we believe, is a telltale sign that incentives have gotten
out of line and companies are chasing different goals.

There are three reasons why incentive-related issues
arise in supply chains. First, when companies cannot ob-
serve other firms’ actions, they find it hard to persuade
those firms to do their best for the supply network. A sim-
ple illustration: Whirlpool relies on retailers like Sears to
sell its washing machines because retailers’ salespeople
greatly infiuence consumer decisions. If Whirlpool doesn’t
offer lucrative margins on its products. Sears will plug
products that do or will encourage shoppers to buy its
private-label brand, Kenmore. However, Whirlpool can’t
observe or track the effort that Sears expends in pushing
its products. Since Sears’s actions are hidden from Whirl-
pool, the manufacturer finds it tough to create incentives
that induce the retailer to do what’s best for both compa-
nies. Such “hidden actions,”as we call them, exist all along
the supply chain.

Second, it’s difficult to align interests when one com-
pany has information or knowledge that others in the
supply chain don’t. For example, most U.S. automotive

96 HARVARD BUSINESS REVIEW

Aligning Incentives in Supply Chains

The Economics of Incentive Alignment

If a company aligns the incentives ofthe firms in its supply

chain, everyone will make higher profits. This isn’t an idie

claim; we can easily demonstrate it in the case of a two-

company supply chain.

Let’s say a publisher prints newspapers at a cost of 45

cents per copy and sells them to a news vendor for So cents

each, and the newspaper retails for $1,00. Let’s also assume

that demand for the newspaper is uniformly distributed

between lOO and 200 copies a day.

The vendor has to throw away unsold copies, so he has

to compare two kinds of costs before deciding how many

copies to stock. He loses 80 cents for every unsold copy, but

If demand exceeds supply, his opportunity cost is 20 cents

per copy. The vendor’s inventory level will be optimal when

the marginal understocking cost eguals the marginal over-

stocking cost – in this case, when he orders 120 copies. The

vendor will stock fewer copies than the average demand of

150 per day because the overstocking cost (80 cents) is four

times higher than the understocking cost (20 cents). That

could lead to frequent stock-outs.

If the publisher produced and sold the newspaper him-

self, he would incur an understocking cost of 55 cents (the

retail price less the printing cost) and an overstocking cost

of 45 cents (the unit costof printing). According to our cal-

culations, the publisher’s profits would be greatest if he

were to stock 155 copies, not no. (For details on how we ar-

rived at the numbers presented here, see V.C. Narayanan’s

technical note “The Economics of Incentive Alignment,”

Harvard Business School, 2004.) In fact, both the publisher

and the consumers would be happier if there were more

copies of the newspaper on the stands, but the vendor

would not be. The vendor stocks less than everyone else

would like him to because it is in his best interest to do so.

The publisher therefore needs to change the incentives of

the news vendor so that when the vendor chooses an in-

ventory level that is in his best interest, it increases the pub-

lisher’s profits.

One way the publisher could do that is by using a revenue-

sharing contract and lowering the price the vendor pays for

each copy from 80 cents to 45 cents. In return, the vendor

could retain, say, 65% ofthe sale price and pass on ss^siitothe

publisher. The retailer’s understocking costs would remain

20 cents, but his overstocking costs would fall because he’d

pay less for each copy. The retailer would now be inclined

to stock 131 copies instead of 120. The profits of both the re-

tailer and the publisher would rise (see the table below).

Alternately, the publisher could pay the retailer mark-

down money of, let’s suppose, 60 cents for every unsold

copy. That would lower the overstocking costof the retailer

and encourage him to stock more copies. The publisher

would more than make up for bearing someof that cost be-

cause of profits he’d gain in higher sales. In this case, the re-

tailer would stock 150 copies.

As the exhibit shows, both the publisher and the retailer

would earn more profits under the revenue-sharing and

markdown-money contracts considered here than under

the traditional system. The increase in profits would not

come at the expense of consumers, who’d pay the same re-

tail price- Inventory levels would also go up, which would

result in greater consumer satisfaction.

Costs
and Protits

Retail Price

Printing Cost

Wholesale Price

Vendor’s Share of Revenue

Vendor’s Compensation

for Unsold Copies

Vendor’s Understocking Cost

Vendor’s Overstocking Cost

nventory Level

Vendor’s Daily Profit

Publisher’s Daily Profit

Supply Chain’s Daily Profit

Traditiona

Contract

$1.00

S0.45

$0,80

100%

—

$0,20

$0.80

120 copies

$22,00

$42,00

$64 00

Revenue-Sharing
Contract

$1,00

$0.45

$0,45

65%

—

$0.20

$0,45

131 copies

$23.08

$44.17

$67,25

Markdown-Money

Contract

$1,00

$0.45

$0,80

100%

$0,60

$0.20

$0,20

150 copies

S25,00

$45,00

$70.00

2004 97

The 21st-century Supply Chain

vendors fear that if they share their cost data, the Big
Three auto manufacturers will use that information to
squeeze the vendors’ margins. For thdt reason, suppliers
are reluctant to participate in improvement initiatives
that would let manufacturers or other companies collect
such data. Since the suppliers insist on hiding informa-
tion, the Big Three’s supply chains don’t function as effi-
ciently as they could.

Third, incentive schemes are often badly designed. Our
favorite example of this problem is a Canadian bread
manufacturer that felt it needed to increase its stocks in
stores. The manufacturer allotted deiiverymen a certain
amount of its shelf space in stores and offered them com-
missions based on sales off those shelves. The delivery-
men gladly kept the store shelves filled – even on days
when rival bread makers were offering consumers deep
discounts on their products. The Canadian haker had to
throw away heaps of stale loaves, and its costs soared as
a result. The deiiverymen earned handsome commissions,
but the company’s profits fell because of an ill-conceived
incentive scheme.

Straightening Things Out

O
ur research suggests that companies must align in-
centives in three stages. At the outset, executives
need to acknowledge that there’s misalignment.

Then they must trace the problem to hidden actions, hid-
den information, or badly designed incentives. Finally, by
using one of three approaches that we describe in detail
later in the article, companies can align or redesign in-
centives to obtain the hehavior they desire from their
partners.

Acceptthepremise. When we conduct straw polls with
executives, almost all of them admit they hadn’t thought
that incentive alignment was a problem in their supply
chains. We’re not surprised. Most companies find if diffi-
cult af first to come to grips with the relationship between
incentives and supply chain problems. Fxecutives don’t
understand the operational details of other firms well
enough to realize that incentives could be getting out of
whack. In addition, companies tend to avoid the subject
of monetary incentives because, if they raise il, their part-
ners may suspect them of merely trying to negotiate
lower prices fbr the products or services they buy.

Once companies get past these mental barriers, it’s rel-
atively easy fbr them to detect incentive misalignment.
They should expect problems to surface whenever they
launch change inifiatives, because these modify the incen-
tives of key stakeholders-and most stakeholders protest
loudly when incentives get out of line. For instance, in fhe
Iatei99os,businesses ranging from Campbell Soupto Li/

A Step-by-step Approach

Companies face incentive problems in their

supply chains because of

>hidden actions by partner firms.

>hidden information-data or knowledge that only

some ofthe firms in the supply chain possess.

>badly designed incentives.

They can tackle incentive problems by

>acknowledging that such problems exist.

>diagnosing the cause-hidden actions, hidden

information, or badly designed incentives,

^creating or redesigning incentives that will induce

partners to behave in ways that maximize the supply

chain’s profits.

They can redesign incentives by

>changing contracts to reward partners for acting

in the supply chain’s best interests.

>gathering or sharing information that was

previously hidden.

>using intermediaries or personal relationships to

develop trust with supply chain partners.

“niey can prevent incentive problems by

>conducting incentive audits when they adopt new

technologies, enter new markets, or launch supply

chain improvement programs.

>educating managers about processes and incentives

at other companies in the supply chain.

>making discussions less personal by getting executives

to examine problems at other companies or in other

industries.

Claibome fought the buMwhip effect -amplified fluctua-
tions in demand – by managing inventory themselves.
Rather than relying on distributors and retailers for or-
ders, fhe companies set up central logistics departments
to make purchasing decisions. Although these initiatives
could have helped the companies’ supply chains, they
failed because of open resistance from distributors and re-
tailers, who were convinced that the manufacturers had
marginalized their roles.

Pinpoint the cause. Executives must get to the root of
incentive problems, so they can choose the best approach

HARVARD BUSINrh.S RliVlhW

Aligning Incentives in Supply Chains

to bring incentives back into line. In our consulting work
with companies, we often use role play for this purpose.
We ask senior managers fo identify decisions that would
have been made differently if they or their suppliers had
focused on the supply chain’s interests instead of their
own interests. We then ask why decision makers acted as
they did. in some cases, the answers suggest improper
training or inadequate decision-support tools for manag-
ers; most of the time, however, they point to mismatched
goals. And we try to figure out whether the decisions were
motivated by hidden actions, hidden information, or badly
designed incentives.

Aligning incentives is quite unlike other supply chain
challenges, which are amenable to structured problem-
solving processes that involve equations and algorithms.
In our experience, only managers who understand the
motivationsof most companies in their supply chain can
tackle incentive-related issues. Since alignment also re-
quires an understanding of functions such as marketing,
manufacturing, logistics, and finance, it’s essential to in-
volve senior managers in the process.

Align or redesign. Once companies have identified the
root causes of incentive problems, they can use one of three
types of solutions-contract based, information based, or
trust based-to bring incentives back into line. Most orga-
nizations don’t have the influence to redesign an entire
chain’s incentives-they can change only the incentives of
their immediate partners. While it is often the higgest com-
pany in the supply chain that aligns incentives, size is nei-
ther necessary nor sufficienf for the purpose. In the late
1980s, the $136 million Swedish company Kanthal,a sup-
plier of heating wires, said that it would impose penalties
whenever the $35 billion GF. changed specifications with-
out warning. The mighty GB agreed to contract changes
requested by its small partner, and incentives became hef-
ter aligned as a result.

Reurriting Contracts

One way companies can align incentives in supply
chains is hy alfering contracts with partner firms.
When misalignment stems from hidden actions,

executives can bring those actions to the surface-unhide
them, as it were-by creating a contract that rewards or
penalizes partners based on outcomes. To retum to an
earlier example. Whirlpool may not be able to see what
Sears’s salespeople do to promote fhe manufacturer’s
washing machines, but it can frack fhe outcome oftheir
efforts-namely, increased or decreased sales-and draw
up agreements to reward them accordingly.

It’s necessary to alter contracts when badly designed
incentives are the problem. Let us think back to the

Canadian bread manufacturer whose deiiverymen over-
stocked stores when they were paid sales-based commis-
sions. The company changed the deliverymen’s behavior
by altering their contracts to include penalties for stale
loaves in stores, which could be tracked. While the penal-
ties reduced the incentive to overstock stores, the com-
missions ensured that the deiiverymen stili kept shelves
well stocked.

That may appear to be a minor change, but it’s a signif-
icant one. Companies often underestimate the power of
redesigning contracts. Small changes in incentives can
transform supply chains, and they can do so quickly, lake
the case of Tweeter, a consumer-electronics retail chain
that in May 1996 acquired the loss-making retailer Bryn
Mawr Stereo and Video. For years, Bryn Mawr’s stores
had reported lower sales than rivals had. Tweeter’s exec-
utives realized early that the incentives that Bryn Mawr
offered its store managers would not lead to higher sales.
For instance, while Tweeter penalized managers for a
small part of the cost of products pilfered from their
stores, Bryn Mawr deducted the full value of stolen goods
from their pay. Since store managers faced more pressure
fo prevent shoplifting than to push sales, they behaved
accordingly. They placed impulse-purchase products like
audiotapes and batteries behind locked cases, which re-
duced theft but killed sales. They spent more time track-
ing merchandise receipts than they did showing products
to consumers. They shut down stores while receiving mer-
chandise fo ensure there was no loss in inventory; never
mind the sales they lost in the process.

After the acquisition. Tweeter stopped deducting re-
tail shrink from Bryn Mawr sfore managers’salaries and
started paying them a percentage of fhe profits from their
stores. While both sales and shrink affect profits, the re-
tailer effectively increased the importance of sales rela-
tive to shrink. The store managers therefore directed their
efforts toward increasing sales rather than decreasing
shrink. Although Tweeter left the store name unchanged,
kept the product mix intact, and retained the same store
managers, Bryn Mawr’s sales rose by an average of lo’if. in
1997. As managers moved merchandise to shelves where
consumers could touch products, shrink also increased,
from $122 a month to $600 a month per store. Net-not,
however, Bryn Mawr’sprofitsroseby2.s%of sales in those
12 months. Tweeter didn’t have to change people to cre-
ate a new culture at Bryn Mawr; it just changed their in-
centives. (For more details, see Nicole DeHoratius and
Ananth Raman’s”lmpactof Store Manager Incentives on
Retail Performance,” a Harvard Business School Working
Paper, September 2000.)

By changing how, rather than how much, they pay part-
ners, companies can improve supply chain performance.

NUVLMBFR 2004 99

The 21st-century Supply Chain

When that happens, all the firms in the chain make more
money than they used to. (See the sidebar “The Fconom-
ics of Incentive Alignment.”} In the 1990s, Hollywood
movie studios, such as Universal Studios and Sony Pic-
tures, found that frequent stock-outs at video retailers,
like Blockbuster and Movie Gallery, posed a major prob-
lem. A lack of inventory on store shelves meant that
everyone suffered: The studios lost potential sales, video
rental companies lost income, and consumers went home
disgusted. Inventory levels were low because the incen-
tives of the studios and the retailers weren’t in line. The
studios sold retailers copies of movies at $60 a videotape.
At an average rental of $3, the retailers had to ensure that
each tape went out at least 20 times to break even. The
studios wanted to sell more tapes, but the retailers wished
to buy fewer tapes and rent them out more often.

When the studios and the retailers explored the possi-
bility of sharing revenues, incentives began fo tee up.
Since it cost the studios only $3 to create a copy of a
movie, they could recoup their investment the first time
a consumer rented a tape. In theory, that meant the studios

went away disappointed. Industry experts estimated that
rental revenues from videotapes increased by 15% in the
United States, and the studios and the retailers enjoyed
a 5’\. growth in profits. Perhaps most important, stock-
outs at video rental stores fell from 25’̂ ‘. before revenue
sharing to less than 5% after revenue sharing.

Revealing Hidden Information

C
ompanies can also align incentives across the
supply chain by tracking and monitoring more
business variables, therehy making actions visi-

ble, or hy disseminating informafion throughout the sup-
ply chain.

The most effective way to reveal hidden actions is to
measure more variables. Infhe late 19H0S,Campbell Soup
offered distributors discounts several times every year,
hoping that the savings would be passed on to retailers.
However, distributors boLight more units than they sold
to retailers, so Campbell’s sales flucfuatcd wildly. For in-
stance, the company sold 40% of its chicken noodle soup

‘”1
By changing how, rather than how much, they pay
partners, companies can improve supply chain
performance. When that happens, everyone in the
chain makes more money.

could stock many more copies than the retailers could.
For fhe model fo work, though, the studios needed to de-
rive income not from tape sales but from rentals-as the
retailers did.

In the late 1990s, when video rental companies pro-
posed revenue-sharing contracts, the studios raised no
objections. They agreed to sell tapes to the retailers for
around $3 per tape and receive 50% of the revenues from
each rental. However, the studios needed to track the re-
taiiers’ revenues and inventories for the revenue-sharing
system to work. The studios and the video rental com-
panies relied on an intermediary, Rentrak, which ob-
tained data from the retailers’ computerized records and
conducted store audits to ensure that all tapes were ac-
counted for. ln fact, the contract-based solution wouldn’t
have worked if Rentrak hadn’t revealed previously hidden
information in the supply chain.

In less than a year, it became clear that revenue sharing
had led to a happy ending in the video rental industry.
The studios saw a hounce in their bottom lines, retailers
began to earn more money, and consumers no longer

each of those years during six-week promotional periods.
The uptick put a lot of pressure on the company’s supply
chain. When Campbell realized that it gathered data on
distributors’ purchases but nof on their sales, it invested
in information technology systems that could track both.
Then^ by giving the distributors discounts on sales but
not on purchases. Camphell eliminated the incentive to
forward-buy large quantities. That helped improve the
supply chain’s performance.

Technology isn’t always needed for managers to ob-
serve more variables. Some companies employ mystery
shoppers – agents who pose as custoiners – to ascertain
whether,say,distributors are pushing products or retailers
are offering services. Like many franchisers, Mobil uses
mystery shoppers to monitor restroom cleanliness and
employee friendliness at its gas stations.

Information systems derived from the principies of
activity-based cosf ing are crificai for measuring the costs
associated with hidden actions. No company knows that
befferthan Owens & Minor, a large distrihutor of medical
supplies. Hospitals used to pay O&M a fixed percentage of

100 IIARVARH KUSiNl SS KLVIEVV

Aligning Incentives in Supply Chains

the cost of items delivered. They
could, however, buy supplies di-
rectly from manufacturers if if was
cheaper to do so. For example, the
hospitals sometimes bought high-
margin products such as cardio-
vascular sutures from manufac-
turers to avoid fhe distributor’s
markup. The hospitals expected
O&M to supply products with
high storage, handling, and trans-
portation costs-adult diapers, for
instance-even though those items
gave the distributor low margins.
Cost-plus contracts led to a mis-
alignment in another area, too: In
general,disfributors were often re-
luctant to provide services such as
just-in-time deliveries, while the
hospitals demanded more such ser-
vices for the same fixed markup.

O&M found an opportunity to
realign incentives when if switched
to an activity-based costing system
and got a handle on the profit-
ability of its services to hospitals.
Until then, O&M knew when its
customers requested services such
as emergency deliveries; what it
didn’t know was the effect of those
requests on ifs costs and profits. In other words, custom-
ers’actions weren’t hidden from O&M, but the impact of
those actions was. After O&M had figured out the cost
of its services, the distributor asked customers for fees
according to the services they desired. But first, to test the
change, O&M approached a hospital that had rejected its
overtures two years earlier. O&M explained that instead
ofoffering a cost-plus contract, it would charge per service
requested. It shared its cost data with the hospital to show
that the fees weren’t unreasonable.

The hospital’s reaction was so encouraging that, in
1996, O&M offered all its customers a choice between an
activity-hased-pricing system and a traditional contract.
O&M’s activity-based contracts offered hospitals a menu
of services and quoted a price for each one. A hospital
could choose just-in-time deliveries, for e.Kample, but it
would have to pay for them. O&M believed that by de-
signing mutually beneficial incentives, it could induce
hospitals to act in ways that would be good for both them-
selves and O&M. The company wasn’t wrong; most hos-
pifals were happy to have a distributor provide all the ser-
vices they wanted, even if that meant paying extra. In

2003, O&M’s sales from activity-based-pricing contracts
reached $1.35 billion, which was nearly one-third of its
turnover of $4.2 hillion.

De ve lop ing Trust

C
lompanies can sometimes use trust-hased mecha-
[nisms to prevent incentive problems from crop-
ping up in supply chains. That may sound like a

contradiction, since firms are more likely to trust each
other when their incentives are in line. When companies
realize from fhe outset that working with partners will
not he easy, though, they can use intermediaries fo pre-
vent supply chains from breaking down. The use of a
middleman has become more popular as American and
European companies have outsourced manufacturing to
developing countries, where legal contracts are often
harder to enforce.

When Western companies link up with Asian manu-
facturers or component suppliers, each party has mis-
givings about the other’s interests. The importers are
convinced that the vendors won’t deliver on time, can’t

NOVl M B t R 2 0 0 4 101

The 21st-century Supply Chain

produce consistent quality, and will give greater priority
to companies that will pay higher prices. They also fear
that the contractors will reduce their cosf s hy bribing gov-
ernment officials or using child labor. As Nike found,
those dubious practices give importers, rather than their
suppliers, bad reputations. For their part, suppliers fear
that importers might reiect products. Since importers
enter into contracts six to nine months in advance of de-
livery, vendors doubt companies’ ability to predict con-
sumer demand accurately. They worry that demand for
products will he lower than anticipated and that import-
ers will reject consignments, pretending that the quality
wasn’t up to snuff

Under those circumstances, the presence of an inter-
mediary can help align the incentives ofthe two parties.
For instance, the Hong Kong-based supply chain inter-
mediary Li & Fung has become adept at marrying the in-
terests of manufacturers and suppliers. The company,
which has created a network of factories in Asia, enforces
a code of ethics that precludes its network from providing
unhygienic work conditions,for example, or paying below
the minimum wage. Li & Fung monitors ifs suppliers to
ensure that they adhere to the quality and ethical stan-
dards that Western importers demand. It employs a chief
compliance officer, who reporfs directly to the company’s
chairperson. Li & Fung accounts for roughly half the vol-
umes of all its suppliers every year. If a vendor reneges on
its promises, it stands to lose a great deal of business from
Li & Fung. At the same time, Li & Fung keeps multina-
tional companies honest. If they make frivolous demands
of suppliers or refuse to take delivery of products at con-
tracted prices, Li & Fung will deny them access to its not-
work in the future. Thus, Li & Fung is able to align incen-
tives because of the repeat business it offers importers
and suppliers.

Just as Li & Fung’s reputation reduces the need for for-
mal confracts, so can the relationships between individu-
als in companies. Klaus Obermeyer, the founder ofthe
fashion skiwear manufacturer Sport Obermeyer, formed
a joint venture with the Hong Kong-based supplier Ray-
mond Tse in i9f̂ 5 fo source raw materials, cut and sew gar-
ments, and coordinate shipping. Over the last 19 years,
Klaus OLiermeyer has left most production and invest-
ment decisions to Tse. He values his relationship with Tse
and, given their history working together, believes that
Tse will not make decisions that aren’t in both companies’
interests. The desire to preserve their relationship has
been a sufficient incentive for Obermeyer and Tse to act
only in ways that are mutually beneficial.

Companies should explore contract-based sokitions be-
fore they turn to other approaches, because contracts are

quick and easy to implement. They should bear in mind,
though, that advances in technology have reduced the
cost of infbrmafion-based solutions. For instance, some
organizations have made real-time sales data available
throughout supply chains – and that was unimaginable
five years ago. In fact, we recommend information-based
solutions ahead of trust-hased ones. Companies can adopt
the latter only if they are able to identify trustworthy in-
termediaries, and that is often difficult.

Before we conclude, we must mention two caveats.
First, a solution that resolves incentive misalignment for
one company might exacerbate the problem fbr another,
txecutives should therefore coordinate the interests of
all the companies in a supply chain at the same time.
Second, companies must align the incentives of all the key
decision makers in their supply chains. Although it is dif-
ficult for one company to change the incentives of exec-
utives in other organizations, it can point out possible
misalignments to partners. Consider the following ex-
ample: A Boston-based start-up placed kiosks for dis-
pensing its products in retail stores. It offered incentives
to retailers but failed to ensure that the retailers passed
on those incentives to store managers. Since fhe store
managers could decide where to place the kiosks but
weren’t motivated fo display them prominently, the start-
up found kiosks in corners where few consumers would
notice them. By flagging the issue fbr the retailers, the
starf-up was able to tackle the problem before it got to
he too late.

Companies should periodically study their supply
chains, because even top-performing networks find that
changes in technology or business conditions may alter
fhe alignment of incentives. Firms can fake three steps
to facilitate discussions about misalignments. First, exec-
utives should conduct incentive audits whenever they
adopt new technologies or enter new markets. Such au-
dits verify that fhe incentives offered to key individuals
and stakeholders are consistent with the behavior that
companies expect of their partners. Second, companies
should educate managers about their supply chain part-
ners. Only then will manufacturers better understand dis-
tributors, for insfancc, or will retailers realize the con-
straints manufacturers face. Third, since executives are
often uncomfortable discussing how incentives infiuence
their decisions, it’s useful to depersonalize the situation
hy getting managers to examine case studies from other
industries. It’s critical to get the conversation started – in
most supply chains, having companies admit that incen-
tive problems even exist is more than half the battle. U

Reprint R04nF; HBR OnPoint S363
To order, see page 151.

102 H A K V A R L ) B l l S I N l – S S l i l V I I W

New Belgium Brewing: Ethical and
Environmental Responsibility1

Although most of the companies frequently cited as examples of ethical and
socially responsible firms are large corporations, it is the social responsibility initiatives
of small businesses that often have the greatest impact on local communities and
neighborhoods. These businesses create jobs and provide goods and services for
customers in smaller markets that larger corporations often are not interested in serving.
Moreover, they also contribute money, resources, and volunteer time to local causes.
Their owners often serve as community and neighborhood leaders, and many choose to
apply their skills and some of the fruits of their success to tackling local problems and
issues that benefit everyone in the community. Managers and employees become role
models for ethical and socially responsible actions. One such small business is the New
Belgium Brewing Company, Inc., based in Fort Collins, Colorado.

History of the New Belgium Brewing Company

The idea for the New Belgium Brewing Company began with a bicycling trip
through Belgium. Belgium is arguably the home of some of the world’s finest ales, some
of which have been brewed for centuries in that country’s monasteries. As Jeff Lebesch,
an American electrical engineer, cruised around that country on his fat-tired mountain
bike, he wondered if he could produce such high-quality beers back home in Colorado.
After acquiring the special strain of yeast used to brew Belgian-style ales, Lebesch
returned home and began to experiment in his Colorado basement. When his beers earned
thumbs up from friends, Lebesch decided to market them.

The New Belgium Brewing Company (NBB) opened for business in 1991 as a
tiny basement operation in Lebesch’s home in Fort Collins. Lebesch’s wife, Kim Jordan,
became the firm’s marketing director. They named their first brew Fat Tire Amber Ale in
honor of Lebesch’s bike ride through Belgium. New Belgium beers quickly developed a
small but devoted customer base, first in Fort Collins and then throughout Colorado. The
brewery soon outgrew the couple’s basement and moved into an old railroad depot before
settling into its present custom-built facility in 1995. The brewery includes an automated
brewhouse, two quality assurance labs, and numerous technological innovations for
which New Belgium has become nationally recognized as a “paradigm of environmental
efficiencies.”

Today, New Belgium Brewing Company offers a variety of permanent and
seasonal ales and pilsners. The company’s standard line includes Sunshine Wheat, Blue

1 © O.C. Ferrell 2006. We appreciate the work of Nikole Haiar in helping draft the previous edition of this case, and Melanie Drever
who assisted in this edition. This case was prepared for classroom discussion, rather than to illustrate either effective of ineffective
handling of an administrative, ethical or legal decision by management. All sources used for this case were obtained through publicly
available material and the New Belgium website.

Paddle Pilsner, Abbey Ale, Trippel Ale, 1554 Black Ale, and the original Fat Tire Amber
Ale, still the firm’s best-seller. Some customers even refer to the company as the Fat Tire
Brewery. The brewery also markets two types of specialty beers on a seasonal basis.
Seasonal ales include Frambozen and Abbey Grand Cru, which are released at
Thanksgiving, and Christmas and Farmhouse Ale, which are sold during the early fall
months. The firm occasionally offers one-time-only brews, such as LaFolie, a wood-aged
beer, which are sold only until the batch runs out.

Until 2005, NBB’s most effective form of advertising has been its customers’
word of mouth. Indeed, before New Belgium beers were widely distributed throughout
Colorado, one liquor store owner in Telluride is purported to have offered people gas
money if they would stop by and pick up New Belgium beer on their way through Ft.
Collins. Although New Belgium beers are distributed in just one-third of the United
States, the brewery receives numerous e-mails and phone calls every day inquiring when
its beers will be available elsewhere.

With expanding distribution, however, the brewery recognized a need to increase
its opportunities for reaching its far-flung customers. It consulted with Dr. David Holt, an
Oxford professor and branding expert. After studying the young company, Holt, together
with Marketing Director Greg Owsley, drafted a 70-page “manifesto” describing the
brand’s attributes, character, cultural relevancy, and promise. In particular, Holt
identified in New Belgium an ethos of pursuing creative activities simply for the joy of
doing them well and in harmony with the natural environment. With the brand thus
defined, New Belgium went in search of an advertising agency to help communicate that
brand identity; it soon found Amalgamated, an equally young, independent New York
advertising agency. Amalgamated created a $10 million advertising campaign for New
Belgium that targets high-end beer drinkers, men ages 25 to 44 and highlights the
brewery’s image as being down to earth. The grainy ads focus on a man rebuilding a
cruiser bike out of used parts and then riding it along pastoral country roads. The product
appears in just five seconds of each ad between the tag lines, “Follow Your Folly … Ours
Is Beer.” The ads helped position the growing brand as whimsical, thoughtful, and
reflective. In addition to the ad campaign, the company maintained its strategy of
promotion through event sponsorships.

New Belgium Ethical culture

According to Greg Owsley Director of Marketing for New Belgium Brewing beyond a
desire for advertising and promotion ethics there is a fundamental focus on the ethical
culture of the brand. Although consumer suspicion of business is on fully raised eyebrow,
those in good standing- as opposed to those trading on hype- are eyed with iconic-like
adoration. From this off polarization comes a new paradigm in which businesses that
fully embrace citizenship in the community they serve can forge enduring bonds with
customers. Meanwhile, these are precarious times for businesses that choose to ignore
consumer’s looking at brands from an ethical perspective. More than ever before, what
the brand says and what the company does must be synchronized. NBB believes the
mandate for corporate social responsibility gains momentum beyond the courtroom to the
far more powerful marketplace, any current and future manager of business must realize

that business ethics are not so much about the installation of compliance codes and
standards as they are about the spirit in which they are integrated. Thus, the modern-day
brand steward- usually the most externally focused member of the business management
team- must prepare to be the internal champion of the bottom line necessity for ethical,
values-driven company behavior.

At New Belgium, a synergy of brand and values occurred naturally as the firms ethical

culture- in the form of core values and beliefs- and was in place long before NBB had a
marketing department. Back in early 1991, New Belgium was just a home-brewed
business plan of Jeff Lesbesch, an electrical engineer, and his social worker wife, Kim
Jordan. Before they signed any business paperwork, the two took a hike into Rocky
Mountain National Park. Armed with a pen, and a notebook they took their first stab at
what the fledgling company’s core purpose would be. If they were going forward with
this venture, what were their aspirations beyond profitability? What was the real root
cause of their dream? What they wrote down that spring day, give or take a little
wordsmithing, was the core values and beliefs you can read on the NBB website today.
More important, ask just about any New Belgium worker, and she or he can list for you
many, if not all, these shared values and can inform you which are the most personally
poignant. For NBB branding strategies are as rooted in our company values as in other
business practices.

New Belgium’s Purpose and Core Beliefs

New Belgium’s dedication to quality, the environment, and its employees and cus-
tomers is expressed in its mission statement: “To operate a profitable brewery which
makes our love and talent manifest.” The company’s stated core values and beliefs about
its role as an environmentally concerned and socially responsible brewer include:
. ■ Producing world-class beers
. ■ Promoting beer culture and the responsible enjoyment of beer
. ■ Continuous, innovative quality and efficiency improvements
. ■ Transcending customers’ expectations
. ■ Environmental stewardship: minimizing resource consumption, maximizing energy
efficiency, and recycling
. ■ Kindling social, environmental, and cultural change as a business role model
. ■ Cultivating potential: through learning, participative management, and the pursuit of
opportunities
. ■ Balancing the myriad needs of the company, staff, and their families
. ■ Committing ourselves to authentic relationships, communications, and promises
. ■ Having Fun.

Employees, believe that these statements help communicate to customers and other
stakeholders what New Belgium, as a company, is about. These simple values developed
15 years ago are just as meaningful to the company and its customers today even though
there has been much growth.

Employee Concerns

Recognizing employees’ role in the company’s success, New Belgium provides many
generous benefits. In addition to the usual paid health and dental insurance and retirement

plans, employees get a free lunch every other week as well as a free massage once a year,
and they can bring their children and dogs to work. Employees who stay with the
company for five years earn an all-expenses paid trip to Belgium to “study beer culture.”
Perhaps most importantly, employees can also earn stock in the privately held
corporation, which grants them a vote in company decisions. New Bel-gium’s employees
now own one-third of the growing brewery. Open book management lets employees see
the financial costs and performance.

Environmental Concerns

New Belgium’s marketing strategy involves linking the quality of its products, as well
as their brand, with the company’s philosophy toward affecting the planet. From leading-
edge environmental gadgets and high-tech industry advancements to employee-
ownership programs and a strong belief in giving back to the community, New Belgium
demonstrates its desire to create a living, learning community.

NBB strives for cost-efficient energy-saving alternatives to conducting its

business and reducing its impact on the environment. In staying true to the company’s
core values and beliefs, the brewery’s employee-owners unanimously agreed to invest in
a wind turbine, making New Belgium the first fully wind-powered brewery in the United
States. Since the switch from coal power, New Belgium has been able to reduce its CO2
emissions by 1,800 metric tons per year. The company further reduces its energy use by
employing a steam condenser that captures and reuses the hot water that boils the barley
and hops in the production process to start the next brew. The steam is redirected to heat
the floor tiles and de-ice the loading docks in cold weather. Another way that NBB
conserves energy is by using “sun tubes,” which provide natural daytime lighting
throughout the brew house all year long.

New Belgium also takes pride in reducing waste through recycling and creative

reuse strategies. The company strives to recycle as many supplies as possible, including
cardboard boxes, keg caps, office materials, and the amber glass used in bottling. The
brewery also stores spent barley and hop grains in an on-premise silo and invites local
farmers to pick up the grains, free of charge, to feed their pigs. NBB even encourages its
employees to reduce air pollution by using alternative transportation. As an incentive,
NBB gives its employees “cruiser bikes”— like the one pictured on its Fat Tire Amber
Ale label—after one year of employment and encourages them to ride to work.

New Belgium has been a long-time participant in green building techniques. With
each expansion of the facility they have incorporated new technologies and learned a few
lessons along the way. In 2002, NB agreed to participate in the United States Green
Building Council’s Leadership in Energy and Environment Design for Existing Buildings
(LEED-EB) pilot program. From sun tubes and daylighting throughout the facility to
reusing heat in the brewhouse, they continue to search for new ways to close loops and
conserve resources.

Reduce, Reuse, Recycle- the three ‘R’s of being an environmental steward. The
reuse program includes heat for the brewing process, cleaning chemicals, water and much

more. Recycling at New Belgium takes on many forms, from turning “waste” products
into something new and useful (like spent grain to cattle feed), to supporting the
recycling market in creative ways (like turning their keg caps into table surfaces). They
also buy recycled whenever they can, from paper to office furniture. Reduction surrounds
them – from motion sensors on the lights throughout the building to induction fans that
pull in cool winter air to chill their beer – offsetting their energy needs is the cornerstone
to being environmentally efficient.

Social Concerns

Beyond its use of environment-friendly technologies and innovations, New
Belgium Brewing Company strives to improve communities and enhance people’s lives
through corporate giving, event sponsorship, and philanthropic involvement.
Since its inception, NBB has donated more than 1.6 million dollars to organizations in the
communities in which they do business. For every barrel of beer sold the prior year, NB
donates $1 to philanthropic causes within their distribution territory. The donations are
divided between states in proportion to their percentage of overall sales. This is their way
of staying local and giving back to the communities who support and purchase NB
products. In 2006, Arkansas, Arizona, California, Colorado, Idaho, Kansas, Missouri,
Montana, Nebraska, Nevada, New Mexico, Oregon, Texas, Washington and Wyoming
received funding.

Funding decisions are made by the NB Philanthropy committee, which is
comprised of employees throughout the brewery including owners, employee owners,
area leaders and production workers. New Belgium looks for non-profit organizations
that demonstrate creativity, diversity and an innovative approach to their mission and
objectives. The Philanthropy committee also looks for groups that involve the community
to reach their goals.

NBB also maintains a community bulletin board in its facility where it posts an
array of community involvement activities and proposals. This community board allows
tourists and employees to see the different ways they can help out the community, and it
gives nonprofit organizations a chance to make their needs known. Organizations can
even apply for grants through the New Belgium Brewing Company Web site, which has a
link designated for this purpose.

NBB also sponsors a number of events, with a special focus on those that involve

“human-powered” sports that cause minimal damage to the natural environment. Through
event sponsorships, such as the Tour de Fat, NBB supports various environmental, social,
and cycling nonprofit organizations. New Belgium also sponsored the MS 150 “Best
Damn Bike Tour,” a two-day, fully catered bike tour, from which all proceeds went to
benefit more than five thousand local people with multiple sclerosis. NBB also sponsored
the Ride the Rockies bike tour, which donated the proceeds from beer sales to local non-
profit groups. The money raised from this annual event funds local projects, such as
improving parks and bike trails. In the course of one year, New Belgium can be found at
anywhere from 150 to 200 festivals and events, across all fifteen western states.

Organizational Success

New Belgium Brewing Company’s efforts to live up to its own high standards have
paid off with numerous awards and a very loyal following. It was one of three winners of
Business Ethics magazine’s Business Ethics Awards for its “dedication to environmental
excellence in every part of its innovative brewing process.” It also won an honorable
mention in the Better Business Bureau’s 2002 Torch Award for Outstanding Marketplace
Ethics competition. Kim Jordan and Jeff Lebesch were named the recipients of the Rocky
Mountain Region Entrepreneur of the Year Award for manufacturing. The company also
captured the award for best mid-sized brewing company of the year and best mid-sized
brewmaster at the Great American Beer Festival. In addition, New Belgium took home
medals for three different brews, Abbey Belgian Style Ale, Blue Paddle Pilsner, and
LaFolie specialty ale.

According to David Edgar, director of the Institute for Brewing Studies, “They’ve
created a very positive image for their company in the beer-consuming public with smart
decision-making.” Although some members of society do not believe that a company
whose major product is alcohol can be socially responsible, New Belgium has set out to
prove that for those who make a choice to drink responsibly, the company can do
everything possible to contribute to society. Its efforts to promote beer culture and the
connoisseurship of beer has even led it to design a special “Worthy Glass,” the shape of
which is intended to retain foam, show off color, enhance the visual presentation, and
release aroma. New Belgium Brewing Company also promotes the responsible
appreciation of beer through its participation in and support of the culinary arts. For
instance, it frequently hosts New Belgium Beer Dinners, in which every course of the
meal is served with a complementary culinary treat.

According to Greg Owsley Director of Marketing although the Fat Tire brand has a
bloodline straight from the enterprise’s ethical beliefs and practices, the firm’s work is not
done. They must continually re-examine ethical, social and environmental
responsibilities. In 2004, New Belgium received the Environmental Protection Agency’s
regional Environmental Achievement Award. It was both an honor and a motivator not to
rest on our naturally raised laurels. There are still many ways for NB to improve as a
corporate citizen. They still don’t produce an organic beer. The manufacturing process is
a fair distance from being zero waste or emission free. There will always be a need for
more public dialogue on avoiding alcohol abuse. Practically speaking, they have a never-
ending to-do list. NBB also must acknowledge that as their annual sales increase, the
challenges for the brand to remain on a human scale and culturally authentic will increase
too. How to boldly grow the brand while maintaining its humble feel has always been a
challenge.

Every six-pack of New Belgium Beer displays the phrase, “In this box is our labor
of love, we feel incredibly lucky to be creating something fine that enhances people’s
lives.” Although Jeff Lebesch has “semi-retired” from the company to focus on other
interests, the founders of New Belgium hope this statement captures the spirit of the
company. According to employee Dave Kemp, NBB’s environmental concern and social
responsibility give it a competitive advantage because consumers want to believe in and

feel good about the products they purchase. NBB’s most important asset is its image—a
corporate brand that stands for quality, responsibility, and concern for society. Defining
itself as more than just a beer company, the brewer also sees itself as a caring
organization that is concerned with all stakeholders, including the community, the
environment, and employees.

Questions
1. What environmental issues does the New Belgium Brewing Company work to
address? How has NBB taken a strategic approach to addressing these issues? Why
do you think the company has chosen to focus on environmental issues?
2. Are New Belgium’s social initiatives indicative of strategic philanthropy? Why
or why not?
3. Some segments of society vigorously contend that companies that sell alcoholic
beverages and tobacco products cannot be socially responsible organizations be-
cause of the nature of their primary products. Do you believe that New Belgium
Brewing Company’s actions and initiatives are indicative of an ethical and socially
responsible corporation? Why or why not?
4. What else could New Belgium do to foster ethical and responsible conduct?

Sources: These facts are from Greg Owsley, “The Necessity For Aligning Brand With Corporate Ethics,” in Sheb L. True, Linda
Ferrell, O.C. Ferrell, “Fulfiling Our Obligation, Perspectives on Teaching Business Ethics,” Kennesaw State University Press 2005. p.
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pp. E1, E3; Rachel Brand, “Colorado Breweries Bring Home 12 Medals in Festival,” Rocky Mountain News,
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Behavior: Building Marketing Strategy, 8th ed. (Irwin McGraw-Hill, 2001); David Kemp, Tour Connoisseur, New Belgium Brewing
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