Incentives and Operational Excellence

Operational problems are a drag on business and often can be traced to poor controls in interorganizational settings, says HBS professor V.G. Narayanan. Here are his suggestions for tightening up those controls.
by Martha Lagace

Whether you're running a major medical supply company or a hole-in-the-wall video store, chances are you know how common operational problems are. If you are the medical supplier, for instance, you probably deal with a hospital group that would like more and more services—such as special delivery—for free. If you run the video store, you worry about the customer who comes in specifically to rent The Matrix but leaves annoyed and empty handed because the video isn't on the shelves today.

According to Harvard Business School professor V.G. Narayanan, a specialist in financial measures and incentives, many operational problems can be traced to poor controls in interorganizational settings: interorganizational because the medical supply company deals with a hospital group and the video store acquires its products from movie studios.

In a talk he gave to other HBS professors at the Faculty Research Symposium on May 20, Narayanan described some problems common both to major corporations and Mom-and-Pop shops, and offered practical solutions based on his new research.

Contract incompleteness is one reason why control problems exist in interorganizational settings, he said. It is an important reason, but by no means the only one, he added. Others include communication problems, a lack of hierarchy for resolving issues—think of Ford and Firestone, and the finger-pointing on both sides—and the potential for data manipulation.

Control problems in interorganizational settings are also hard to detect, he said. Usually, they cannot be ironed out by a common culture, shared belief system, or what he called "administrative fiats." As in the Ford/Firestone case, if not addressed adequately they can sometimes lead to major disaster—not just in monetary terms but also in human lives, said Narayanan.

Owens & Minor allowed customers to internalize the consequences of their demand for services.
— V.G. Narayanan

The case of Video Vault, a small outfit in Massachusetts, was a fine example of how an operational problem could be traced to misaligned incentives, and how technology was introduced to create a more valuable contract between parties.

Looking at the home-video market in general, Narayanan learned that between 20 and 25 percent of customers can't find the video they want when they go to their regular retailer. This "stockout" was not only a turn-off to customers but also a problem for both stores and studios.

Studios sell videocassettes to video rental stores at forty-five dollars, which are then rented out for around four dollars. Tapes are disposed of for five dollars after three months, so the retailer must rent out the tape ten times before selling it and breaking even. However, the incremental cost for studios to put an additional tape on the retailer's shelf is less than three dollars. Demand for an individual movie is highly uncertain and usually tapers off rapidly after the first few weeks, Narayanan said. So while the retailer needs to rent the tape ten times to break even, the channel breaks even on the first rental. (Video stores often make money on late fees, Narayanan noted.)

One contracting solution was for studios to sell tapes at three dollars to Video Vault and ask Video Vault for a share of the revenues, typically 50 percent. This allowed the retailers to break even with just one or two rentals. Monitoring and technology, however, were key to the implementation, and these had to be introduced by a third company, Rentrak.

Rentrak filled a niche because the studios had no way of verifying how many times a video was rented out and at what price. Rentrak monitored the scanner data and performed audits and spot checks to monitor compliance with the revenue-sharing contracts. Fifty years ago, Narayanan added, the movie industry did almost the same thing albeit in a low-tech manner: Movie distributors used to go to theaters and count the number of ticket stubs.

Smarter Pricing

A completely different interorganizational control problem was solved by the Fortune 500 medical supply distributor, Owens & Minor, Inc.

According to Narayanan, medical supply businesses typically bid for contracts from hospital association buying groups. For their part, the buying groups try to get as many products and services as they can for whatever fee they've agreed to pay in the contract.

Owens & Minor decided to offer its customers the option of activity-based pricing (ABP). This meant unbundling all its services and charging separately. Rather than recoiling, hospitals were more than happy to pay for services if it meant they would actually receive them without haggling.

According to Narayanan, the ABP solution worked because hospitals had to rationalize their part of the supply chain. "Owens & Minor allowed customers to internalize the consequences of their demand for services," he explained. "Owens & Minor developed cost drivers to understand the drivers of customer profitability."

ABP can be successful in some interorganizational settings because it helps reduce free-rider and private-information problems, he said. ABP is more valuable when a firm's customer base is very diverse. "When every customer is like everyone else, it's not going to add a whole lot of value," he said.

But ABP may not work magic at all organizations, he added. In one of the cases he studied, the Royal Bank of Canada, ABP "was exactly the wrong thing to do." The Royal Bank launched the experiment of charging its customers for separate services. As the bank quickly learned, the customers hated it.

"In fact, they were willing to pay a little bit more for the certainty of not being nickel-and-dimed," he said. The cost of measurement itself can sometimes override any benefits. For this reason, ABP may be a better bet for B2B interorganizational settings.

About the Author

Martha Lagace is senior editor of Working Knowledge.