Surviving Supply Chain Integration: Strategies for Small Manufacturers (2000)

Companies worldwide are creating alliances that are reshaping the basis of competition. Remaining competitive in these changing business environments requires the ability to create appropriate types of partnerships as needed. Partners may be defined as companies that agree to work together, often for a specific period of time or to achieve specific objectives, and share the risks and rewards of their relationship. In practice, partnerships are defined by both a relationship agreement between the partners and by their day-to-day interactions.

There are many types of partnerships including, for instance, joint ventures, licenses, and cooperative marketing and research agreements. Each party must carefully analyze its strategic needs and the risks and benefits of various types of partnerships before entering into an agreement. To reduce misunderstandings, participants should collectively agree on objectives, definitions of success, methods for sharing risks and rewards, and metrics for measuring performance. To succeed, partnerships must be based on trust and respect or, in rare cases, on an overriding need to achieve shared objectives.

Integrated supply chain partnerships involve more than legal agreements to work together. They involve complex interrelationships of shared activities, processes, interests, objectives, and competitive information. Information sharing and extensive cooperation are necessary for partners to react effectively to changes in the marketplace.

The participants themselves, who often have different views depending on their corporate objectives and roles in the supply chain, must determine the specific configurations of the partnerships. The creation of

successful partnerships requires visionary leadership, understanding of supply chain roles, and interpersonal and legal skills. Partners should consult with an attorney to avoid violating laws against restricting competition. Creativity and sensitivity to relationship issues are critical skills for overcoming problems that arise in intimately coupled, highly integrated supply chains. Only a constructive attitude, visionary leadership, and a strong commitment to mutual success can enable the highest levels of supply chain integration.

The underlying mechanism of supply chain integration is the development of strong customer and supplier relationships based on mutually agreed-upon performance standards. These relationships are usually defined by means of a contract, the proper structure of which is important for successful integration. Integrated supply chain relationships are often defined by additional agreements regarding product and financial flows, channel (product distribution) policies, price protection, contingencies, and capacity reservations (i.e., the guaranteed availability of specified levels of production capacity). Unlike purchase orders, which tend to be one-sided and generally ignore the issues of risk sharing and common goals, contracts are structured to meet the needs of the partners. Before an appropriate contract can be crafted, the partners should agree on a shared vision, objectives, and process framework. (It should also be noted that although contracts are recommended, they are not required and it is possible to achieve effective supply chain integration without them.)

Several aspects of contract development should be considered: (1) the difference between a myopic and a farsighted view of contracting; (2) the distinction between a contract structured as a set of legal rules and a contract that serves as a framework for the relationship among partners; (3) conflict avoidance and resolution, mutuality, creation and maintenance of order, and alignment of risks and rewards; and (4) different ways of structuring relationships among supply chain participants.

Some contracts are simple, such as those for the procurement of standard items, like office supplies, which are usually kept in stock and for which there are many suppliers. Unless large orders must be filled, these procurements do not require advanced planning or the creation of custom contracts. If specialty items, nonstandard tolerances, or special deliveries are involved, the nature of the contract and its capacity to serve the needs of the parties becomes more important. Each party will

want to look ahead, anticipate potential problems or hazards, and find ways to relieve these conditions by providing for them in the contract (or, more generally, in the overall supply chain relationship).

High levels of supply chain integration are more likely to be achieved with "win/win" contract approaches than with win-lose approaches. A long-term view is important for integrated supply chains in which the parties have a substantial bilateral stake in the relationship and contractual breakdowns can be costly. The typical intent of a partnership is to establish a relationship with increasing interdependency that will outlive the term of the contract. A farsighted view, although it may be difficult to implement, can increase benefits for all parties.

Contracts consisting of rules and contracts that serve as an operating framework for a relationship are very different. Lawyers and accountants often relate to the former, whereas business is more often conducted in the spirit of the latter. Contracts that serve as frameworks for relationships are based on four key ideas: (1) the objective of the contract is to serve the goals and desires of the parties, rather than those of the lawyers; (2) contracts that attempt to define complex relationships are unavoidably incomplete; (3) give and take by all parties is necessary to work through gaps, errors, and unanticipated situations; and (4) informal and formal features of the contract and of the organization are all part of the exercise. This is not to say that the letter of the contract is unimportant. If, despite their best efforts, the parties are unable to work through a contractual impasse, the contract can be useful for purposes of ultimate appeal.

There is every reason, therefore, for contracts to be written and negotiated carefully, although this does not mean being legalistic. Because providing for every possible contingency is impossible, information disclosure and adaptive mechanisms must be included to assist the parties when difficulties arise and the formal terms of the contract take on added importance. Contracts are legal documents, after all, and relationships should be defined precisely in case the contract becomes the ultimate reference for resolving disputes. Mainly, however, contracts should be thought of as frameworks to aid the parties in realizing their collective purposes and mutual gains.

Neither party, especially not an SME, can unilaterally decide that a framework is the correct approach to define a supply chain relationship. Both parties must subscribe to the concept for it to be successful. If one party adopts a myopic, legalistic view and the other views the contract as a framework, both parties will be frustrated. It is important, therefore, that they agree on the nature of the relationship and recognize that each

party may have a different bottom line. Incomplete contracts can be fraught with hazards because the best short-term interests of one party rarely coincide with the short-term interests of the other. Therefore, a long-term view of the relationship is important, and a contract constructed as a framework helps to accomplish this.

An ideal supply chain contract is based on a history of mutual trust and provides a ''governance" structure that allows both parties to operate in a flexible, yet disciplined way, mitigates conflict, and aligns and shares both risks and rewards. Developing mutual experience and trust takes time, and a contract that outlines only the framework of a relationship may be impossible without it. Therefore, contracting should be considered an evolving process that proceeds in a slow and exploratory way, building on successes. Learning how to deal, adapt, and relate to each other is a normal part of a productive contractual exercise.

Supply chain relationships can be organized in many ways, and contracts must be customized to address the diversity of transactions and industries. Transactions, for instance, can be generic or specialized. The former are simple; the latter are often more complicated. Contracts typically address the size of the job in relation to the capabilities of the supplier, the length of the contract, the amount and kind of specialized investment required to support the transaction, the extent of supplier involvement in the design process, and the degree to which implementation entails real-time responsiveness. Contracts often contain security clauses addressing specialized investments and proprietary intellectual property. Specialized equipment that cannot be redeployed without the loss of productive value poses a greater risk than generic investments. Hence, added security features may be required in the contract to cover the redeployment of specialized equipment. In general, contract complexity increases with the magnitude of the job, the length of the contract, the amount of specialized investment, the degree of design investment, and the need for real-time responsiveness.

A basic procurement contract specifies a price, addresses contractual hazards, and provides for security features. If the hazards are great and the buyer refuses to safeguard the supplier against risk, the supplier should reflect this by charging a higher price (risk premium). However, considerations of mutuality suggest cost-effective security features be crafted so that the supplier is partially relieved of risk and the buyer pays a lower price.

Contracts regularly allocate risks and rewards. If the contract covers a single transaction of short duration, the parties typically negotiate hard to

secure all of the benefits and to transfer all of the risk to the other party. However, if the agreement is inequitable, the long-term relationship, which is essential for supply chain integration, is bound to deteriorate. Incentive systems embodied in the contract should ideally align the parties so that each has an appropriate stake in the success of the joint undertaking. Generally, the party with the greatest influence on the success or failure of the venture should be allocated greater portions of the risks and rewards.

A legalistic way to safeguard transactions is to include financial penalties for a premature breach of the terms of the contract. For example, both parties might make specialized investments for which redeploy-ability outside of the contract will be difficult. Thus, their exposure is symmetrical. Alternatively, the parties may provide for the reciprocal disclosure of information and auditing contingencies. The parties could also agree in advance to specialized mechanisms for settling disputes, such as arbitration. Contractual risk can also be reduced by ensuring that the staff members responsible for implementing the contract have backgrounds in and an appreciation of the continuity value of the relationship.

Finally, differences among industries with respect to maturity, technology, size distribution of firms, and product differentiation can pose different contracting and organizational challenges. In general, a mature industry with a dominant design and multiple firms producing homogeneous products poses fewer problems for contracting. For newer industries with rapidly changing technologies, in which a few firms are competing for the dominant design and in which real-time responsiveness and innovation are critical, contracting is more complicated.

As supply chain participants increasingly form alliances and partnerships, critics are starting to worry about the impact on competition. Regulators discourage schemes that reduce consumer options or price competition. In October 1999, the Federal Trade Commission, in consultation with the U.S. Department of Justice, issued antitrust guidelines for collaborations among competitors. The committee suggests that SMEs obtain competent legal advice to avoid legal problems associated with these complex issues.

Recommendation. Small and medium-sized manufacturing enterprises should develop a basic understanding of partnership agreements and, with legal assistance, use partnerships as a means of improving their responses to changing business conditions.