Oikos hd Summer Academy in St Gallen 11th-15th September 2000 Organisational Impacts on Supply Chain Costing Maria Goldbach Diplom-Ökonomin Diplômée de l INSEEC Bordeaux Department for roduction and the Environment Institute for Business Administration Faculty of Business, Economics and Law Carl von Ossietzky University of Oldenburg Birkenweg 5 26111 Oldenburg Germany Tel.: +49 441 798-8262 Fax: +49 441 798-8341 E-Mail: maria.goldbach@uni-oldenburg.de Abstract Ecological products are often too expensive to compete with conventional ones due to inappropriate market mechanisms. Eco-products require an active supply chain management and cost management techniques that integrate the whole supply chain. Even though increased transaction costs in green supply chains are identified as one of the major reasons for higher costs, the existing cost management approaches do not take into consideration the organisational design. This paper analyses the agency relationships in supply chains as well as their organisational implications on cost management (supply chain costing) at the example of target costing. The objective is to elaborate an analytical framework that provides evaluation criteria for alternative organisational designs and their implications on target costing to increase relationship efficiency.
Introduction There is an increasing necessity for firms to actively co-ordinate their supply chain for two major reasons: First, the globalisation of international markets and shortening market cycles, as for example in the textile sector, require a high level of competitiveness. Second, the introduction of ecological products such as textiles in the mass market cannot be realised with the existing market mechanisms. Integrated market mechanisms for green supply chains should consider the basic elements of an eco-strategy according to Hummel - cost, market and ecological aspects (Hummel 1997: 37) - as well as their organisational context: Costs Organisational Design Ecology Market Figure 1: Influences of the organisational design on the 3 dimensions of an eco-strategy. This work will focus on the cost element, as an important obstacle for competitive ecological products is their higher price which can be attributed to higher raw materials and production costs (see Myers/Stolton 1999: 86-100), higher transaction costs due to necessary co-ordination activities in green supply chains (see Seuring 2000), an inappropriate design and utilisation of cost management techniques in the supply chain (see Seuring 2000) an insufficient design of the co-operation and communication structures in the supply chain including their organisational implications. Maria Goldbach Organisational Impacts on Supply Chain Costing - 2 -
I assume that an agency cost management in the supply chain which takes into account chain adequate cost management techniques as well as the behaviour of the relevant actors in their organisational context, is susceptible to increase transaction efficiency in agency relations and therefore induce cost savings. The objective of this work is to elaborate an analytical framework that permits to design agency relationships in supply chain networks more efficiently, taking into account both organisational implications and cost management instruments such as target costing to increase transaction efficiency in agency relations. The paper will answer the following research questions: How can agency theory be applied to supply chains? How can this help to analyse the organisational design used in the supply chain? How can the agency relationship between the different actors and their utilisation of cost management instruments be designed more efficiently in order to realise cost saving potentials? This work combines current research in supply chain and cost management on the one hand with agency theory on the other hand and aims at providing an analytical framework for the organisational impacts of target costing in the supply chain. The theoretical reflections are to be verified empirically on the basis of qualitative interviews with open questions in a further research step to be defined in detail 1. This paper first introduces supply chain management in the textile sector extended to supply chain networks on the one hand and agency theory as an analytical framework for organisational relationships on the other hand. Second, these two basic elements are brought together applying the agency theory to supply chain networks to analyse the underlying actor s constellations. Important aspects such as the role of principal and agent as well as the problem of information sharing are discussed. Following, the utilisation of target costing in agency supply chain relationships is analysed taking into account agency problems and perspectives on incentive mechanisms. 1 For the methodology see for example Flick 1996 and Mayring 1993. Maria Goldbach Organisational Impacts on Supply Chain Costing - 3 -
Supply Chain Networks in the Textile Sector Supply chain management originates in the concept of the value chain (orter 1998) as well as recent developments in logistic and information technology. Traditional logistic though merely takes into account material and information as well as finance flows in the supply chain: Material flows up, information up and down and finance down the chain. This view is too restrictive, leaving aside reciprocal information flows as well as the co-ordination of activities between all supply chain partners, such as communication and co-operation (see Cooper; Lambert; agh: 1997). In supply chains which realise ecological products, mutual communication and cooperation among all chain partners is essential, especially in highly competitive environments such as the textile sector. Handfield and Nichols present a much more appropriate definition of Supply Chain Management: The supply chain encompasses all activities associated with the flow and transformation of goods from raw materials stage (extraction), through to the end user, as well as the associated information flows. Material and information both flow up and down the supply chain. Supply chain management (SCM) is the integration of these activities through improved supply chain relationships, to achieve a sustainable competitive advantage (Handfield and Nichols 1999:2). Material flows Finance flows Filament production Yarn production Fabric production including dyeing and finishing Clothing production Selling and distribution Information flows Figure 2: A typical supply chain for clothes (based on Seuring 2000: 2) Maria Goldbach Organisational Impacts on Supply Chain Costing - 4 -
The following illustration gives an idea of the multiple relationships in a supply chain for ecological textiles with the trader as supply chain co-ordinator: Filament Yarn Fabric Clothing Buying department Environment department Material flows Finance flows Information Flows Trader Figure 3: Supply chain relationships in the textile sector The underlying structure resembles a network rather than a chain. The term supply chain network stresses the interactions between all network partners, not only those between neighbouring chain partners. 2 The supply chain network can be divided into direct value-added activities (material and finance flows between traditional chain partners) and indirect value-added activities (communication and co-operation in the network which imply information flows and co-ordination activities between chain partners that do not usually communicate directly such as the trader and the yarn.) The indirect valueadded activities do not add value but are necessary to support and improve the value-added process in the supply chain network. This work will focus on the communication and co-operation aspect, i.e. the indirect value-added activities in the supply chain network. 2 Supply chain network includes the terms of value chain and value network used by Schusser (Schusser 1999). Maria Goldbach Organisational Impacts on Supply Chain Costing - 5 -
The Agency Theory as an Analytical Framework for Supply Chain Relations How can the relationships between different actors in the supply chain be analysed in an institutional context? The New Institutional Economics provide an analytical framework explaining structure, behavioural implications, change and efficiency of economic institutions. The agency theory as one of the three pillars in institutional economics roperty Rights, Transaction Costs, Agency focuses on the contractual arrangements of institutions. (for an introduction see Ebers/Gotsch 1995, Richter/Furubotn 1999, Jensen/Meckling 1976). Jensen/Meckling define an agency relationship as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationship are utility maximizers, there is a good reason to believe that the agent will not always act in the best interests of the principal (Jensen/Meckling 1976: 308). Institutions or organisations as the object of research are defined as legal fictions which serve as a nexus for a set of contracting relationships among individuals. (Jensen/Meckling 1976: 310). As the supply chain network is based on multiple contracts, the agency theory provides an appropriate analytical framework. The actors in Agency Theory (principal and agent) are individuals characterised as utility maximisers with limited rationality and opportunistic behaviour. The principal asks the agent to provide a service for him because he considers the agent s knowhow to be superior to his own. The agent is paid for his service by the principal. The main agency problems occurring in this context are interest dissonance and information asymmetries in favour of the agent. In the textile sector for example, the trader (principal) asks the clothing (agent) to produce ecologically optimised clothes for him because he considers the clothing to be better qualified and specialised in this task. The intention of the agent is to sell the eco-product at the highest price possible without necessarily respecting the high ecological standards defined by the principal. The principal Maria Goldbach Organisational Impacts on Supply Chain Costing - 6 -
though demands a product, that is ecologically optimised to a certain standard, at a reasonable price. These intentions lead to interest dissonance between the two partners. The agent being a specialist in his domain, is better informed about his capabilities and intentions than the principal. This leads to two types of information asymmetries (see Ebers; Gotsch: 1995) 3 : - Hidden information means that before conclusion of the contract, the agent disposes of information to which the principal has no access, at least not at zero costs. - Hidden action refers to the agent s actions (determined by his capabilities and intentions) after conclusion of the contract up to fulfilment which diverge from the principal s aims. These agency problems cause costs. Jensen/Meckling identify several costs which occur in an agency relationship, called agency costs. (Jensen/Meckling 1976: 308) These are the sum of - Monitoring expenditures by the principal: Incentives and control mechanisms to limit harming activities carried out by the agent - Bonding expenditures by the agent: Guarantee of the agent that he will not take actions diverging from the prinicpal s interests - The residual loss: Quantified divergence between the agent s decision and the decision which would maximise the welfare of the principal. The challenge of agency theory consists in defining information, control and incentive mechanisms susceptible to maximise the principal s interests. The following reflections will focus on positive agency theory by Jensen/Meckling. This qualitative-empirical approach is more descriptive and less precise on a formal level, but closer to reality than a quantitative-empirical analysis. 3 Hart/Holmström distinguish hidden characteristics, hidden information and hidden action1987: 75f. Hidden characteristics describe an information advantage that occurs before, hidden information an advantage that occurs after conclusion of the contract. The definition of hidden action is equivalent. Maria Goldbach Organisational Impacts on Supply Chain Costing - 7 -
Agency Relationships in Supply Chain Networks The multiple relationships between supply chain partners visualised in figure 3 rely on explicit and implicit contracts 4 which form the essence for any organisation, both on the internal and external level: Since the specification of rights is generally effected through contracting (implicit as well as explicit), individual behavior in organizations [...] will depend upon the nature of these contracts (Jensen/Meckling 1976: 308). In traditional agency theory, the actors are individuals and not firms (see Jensen/Meckling 1976: 311). Extending the agency theory to the supply chain context, the firm as an institution is replaced by the supply chain, principal and agent are no more individuals but firms: rincipal = Individual Firm = Institution Agent = Individual rincipal = Firm Supply Chain = Institution Agent = Firm Figure 4: Firm and Supply Chain Agency-Relationships Jensen/Meckling state that the personalization of the firm [...] is seriously misleading. The firm is not an individual. It is a legal fiction which serves as a focus for a complex process in which the conflicting interests of individuals [...] are brought into equilibrium within a framework of contractual relations. In this sense the behavior of the firm is [...] the outcome of a complex equilibrium process. We seldom fall into the trap of characterizing the wheat or the stock market as an individual, but we often make this error by thinking about organizations as if they were persons with motivations and intentions. (Jensen/Meckling 1976: 311). This would mean, that individuals cannot simply be replaced by firms, transferring the agency theory to the supply chain context. Schulz von Thun though points out, that individuals integrate competing interests, motivations and intentions (Schulz von Thun 1998a: 39, for more details see Schulz von Thun 1998b). In consequence, 4 See Ripperger 1998: 28ff. Maria Goldbach Organisational Impacts on Supply Chain Costing - 8 -
intentions and actions of individuals are equally the result of an inner complex equilibrium process similar to the one in an organisation. Referring to Schulz von Thun, the transition of agency theory on the supply chain context would not offend its postulates. I will consider that the behaviour of a firm as the result of this equilibrium process is determined: a) by the motivations and intentions of multiple individuals b) by the underlying principal-agent relationships within the firm on department level, e.g. between environment and buying department. The behaviour of the whole supply chain is the outcome of an equilibrium process of interests between the participating firms. This leads to 3 levels of interests in the supply chain: Supply Chain Firm / Department Individual Figure 4: yramid of interests in the supply chain This work focuses on the firm/department interests treating them as individual s interests according to Jensen/Meckling. Who is the principal and who the agent in a supply chain relationship? This question can only be answered within a given specific context as portrayed by three short examples: If a trader wants to introduce ecologically optimised clothes into its collection and engages its supplier to provide such clothes, the trader is the principal and the supplier (e.g. the of the clothes) the agent. If, on the internal level, the environment department of the trader takes the initiative and tries to persuade the buying department to purchase eco-clothes i.e. to realise its aims, the former is the principal, the latter the agent. Maria Goldbach Organisational Impacts on Supply Chain Costing - 9 -
If, though, the buying department wants to buy ecologically optimised clothes by its own initiative and asks the environment department for support, the buying department is the principal, the environment department the agent. 5 Considering that a trader s environment department wants to support ecological clothes in its collection, i.e. takes the role of the principal, the agency relations in the supply chain can be modelled as follows: Filament A Yarn A Fabric A Clothing A Buying department A A A A A Environment department Material flows Finance flows Information Flows rincipal A Agent Trader Figure 5: Agency relationships in the supply chain. All actors, except for the environment department (which I consider as the main principal, i.e. the one who originally defined the aim to introduce ecological textiles into the supply chain), are at the same time principal towards one actor and agent towards another one. This double role of principality and agency may enforce interest dissonance along the supply chain and induce further information asymmetries. The trader who decides to realise ecologically optimised clothes acting as a chain coordinator is faced with raising information asymmetries going back the supply chain. Usually, the firm is only in contact with its direct supplier, the of the clothes. This relationship is familiar to the involved actors (clothing and buying department of the trader). If the environment department co-ordinates the whole chain, it takes up a role it usually does not hold and in consequence is not familiar 5 The environment department has agency relations with all the partners in the supply chain. The resulting implications of possible multi-agent problems will be discussed in detail in further work and Maria Goldbach Organisational Impacts on Supply Chain Costing - 10 -
with. Therefore I assume that information asymmetries increase going back the supply chain: Filament A Yarn A Fabric A Clothing A Buying department A A A A A Environment department Information Sharing rincipal A Agent Trader Figure 6: Raising Information asymmetries along the supply chain How can information, control and incentive mechanisms be efficiently implemented in agency supply chain relationships? Which role do cost management techniques play to reach cost objectives in green supply chains? be left aside in this paper. Maria Goldbach Organisational Impacts on Supply Chain Costing - 11 -
Target Costing in Agency Supply Chain Relationships Supply Chain Costing (see Seuring 2000, Cooper/Slagmulder 1999) aims at providing cost management instruments for the whole supply chain which serve as a basis for decision makers to actively influence and manage costs. In this view an important aspect is left aside: Costs are not only information instruments but perception patterns susceptible to induce specific actions of the involved actors. The following paragraphs focus on target costing in the supply chain as a control instrument that increases transaction efficiency by influencing actors behaviour. (see Cooper/Slagmulder 1999) Target costing is carried out in several steps: 1. Definition of the target selling price based on the market conditions. 2. Deducting the target profit margin from the target selling price to obtain the allowable target costs. 3. Splitting of the allowable target costs if these are not equal to the current ones. 4. Different mechanisms are applied to approach target and current costs. (see Seidenschwarz 1997, Kucher/Simon 1997) To assure the competitiveness of ecological textiles in the mass-market, a trader may realise a price equal or similar to the conventional one using target costing. The suppliers, i.e. the agents from the trader s point of view, are the partners competent in reducing production costs, the technical know-how being on their side. The mechanism of fixing target costs to the suppliers can be illustrated as follows 6 : Market target price (market conditions) - target profit margin - internal surcharges = Supplier s target price This approach is illustrated in the following example: The environment department of a trader as the main principal in the supply chain makes use of the target costing mechanism to solve the problem of increased prices for eco-textiles. The higher costs of the end product, caused by more expensive 6 For details on chained target costing see Cooper/Slagmulder 1999. Maria Goldbach Organisational Impacts on Supply Chain Costing - 12 -
production costs for example for organic cotton and yarn (see Myers 1999: 86ff) a surcharge calculation leading to important multiplication effects as well as increased co-ordination/transaction costs in the supply chain, are resolved by transmitting the responsibility for costs to the suppliers at each stage of the supply chain. The relation between principal and agent concerning the utilisation of cost information is characterised by information asymmetries and interest dissonance. The agent knows beforehand apart from exogenous uncertainties if he is deliberate and able to realise the target price fixed by the principal (hidden information). If he actually will realise it is a matter of capability as well as of intention (hidden action). The fact that the supplier s price is fixed by the trader corresponds to the market target costs being fixed by the market. This implies, that the trader transfers the entire responsibility for realising target costs to its suppliers. Target Costing in the agency supply chain relations could be designed more efficiently by implementing incentive mechanisms such as profit sharing between principal and agent or promises to buy minimum or fixed quantities of ecologically optimised (possibly of additional conventional clothes) if the target price is respected. Without any incentives, the supplier might either refuse to produce ecological textiles or look for a different partner ready to pay a higher price. The preceding comments give a first idea of the organisational impacts on cost management instruments in agency supply chain relationships. These are to be intensified in further research focusing on the utilisation of target costing as a disciplining mechanism and its potentials to improve the relationship design in order to increase transaction efficiency (see Cooper/Slagmulder 1999: 10). Maria Goldbach Organisational Impacts on Supply Chain Costing - 13 -
erspectives on further work The preceding reflections presented supply chain networks and agency theory as basic elements for an institutional analysis of supply chain networks as well as the use of target costing in this context. The analysis of agency supply chain relationships requires further reflections and research. Two essential questions have yet remained unanswered: Are there any differences other than the transition of roles from individual to firm and from firm to supply chain in the analysis of agency supply chain relationships? Is it sufficient to focus on the firm (and department) supply chain interests or is there a necessity for an integrated analysis taking into account the different levels of interest, as well as their complex interactions? The further analysis of Target Costing in agency supply chain relationships should focus on three questions: How can a target costing relationship between a firm and its supplier be characterised? What are appropriate control and incentive mechanisms for the principal to assert target costs? How do the actors use target costing and how can its utilisation be optimised and designed applying agency theory? Different criteria as well as influencing parameters on alternative possibilities are to be identified to provide an analytical framework allowing to evaluate alternative institutional designs and their implications to support the principal s decision process. The empirical work which has merely focused on the principal s behaviour so far, is to be extended on an analysis of the agent s intentions and capabilities to achieve valid empirical results about the agency relationship. The combined theoretical qualitative-empirical approach aims at opening design options for an active supply chain costing at the example of target costing that takes into account the institutional impacts influencing supply chain relationships. Maria Goldbach Organisational Impacts on Supply Chain Costing - 14 -
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