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Greening the supply chain: Shared savings contracts for chemical management services
by Charles J. Corbett, Anderson Graduate School of Management, UCLA; and Gregory A. DeCroix, Fuqua School
of Business, Duke University
The concept of "greening the supply chain" has received increasing attention in recent years. As
with many improvement initiatives, initial efforts have often focused on internal production processes,
with many companies reducing their use of raw materials through waste reduction and resource efficiency.
While such activities have yielded both environmental and financial benefits, their reliance on in-house
expertise and efforts have sometimes limited progress. Given the interdependencies among firms in a supply
chain, companies may be able to achieve greater gains by harnessing the expertise and efforts of their
supply chain partners--especially their suppliers.
A key incentive problem stands in the way of such cooperative efficiency gains, however--the simple fact that
suppliers earn more profits by selling more product. Although buyers may desire to reduce consumption of
such products, they will be hard pressed to encourage suppliers to offer assistance, even though suppliers
are often highly knowledgeable about ways to reduce consumption--sometimes even more so than their customers.
This conflict is particularly stark for any "indirect" materials--i.e., materials that facilitate the production
process but do not become an essential part of the finished product. Examples of these materials are wide-ranging,
from solvents in manufacturing processes to office supplies. Both buyer and supplier can exert effort to reduce
consumption of these indirect materials, hence making the overall supply chain more efficient. However, no
supplier will voluntarily participate in such a scheme unless contract terms are fundamentally revised, for
instance by shifting the supplier's revenue basis from quantity to service. This is currently occurring in a
number of industries, most notably among chemical suppliers who engage in "chemical management services" (CMS).
Rather than paying the supplier based on the quantity of chemical shipped, payment is based increasingly on the
service rendered by the supplier.
In a series of interviews with CMS providers, who generously shared their time and insights with us, we encountered
a wide range of situations. In some cases, the CMS provider was (or had been) a distributor, and was switching from
a relatively reactive role (supplying chemicals) to a more proactive role (supplying chemical management services).
In other cases, the CMS provider started out as a manufacturer, but gradually expanded its offerings to include
more service-related activities, even selling competitors' products. In both types of case, the CMS provider was
able to reduce the cost to the customer by achieving system-wide cost savings. The early cost savings achieved by
the distributors were typically primarily driven by product substitution (for instance, replacing branded products
by cheaper generics), while the early cost savings achieved by the manufacturers were typically more linked to
process improvement at the customer site. Over time, though, both types of CMS provider (distributor and manufacturer)
ended up achieving both types of cost savings (substitution and process improvement).
We also found that, although the contracts differ quite widely in their specific details, they can generally be thought
of as consisting of two components: a fixed part, which is essentially a service fee, independent of consumption of
chemicals, and a variable part, which does depend on the consumption of chemicals. In the traditional setting, the
fixed fee is zero, and the variable part is high enough to include a profit margin on the volume of chemicals sold.
Under a CMS contract, the fixed fee is much larger, while the variable part is often small or zero, or sometimes even
negative for CMS providers who arrange for disposal of chemicals after the customer has finished using them. If the
variable part is smaller than the supplier's unit cost to produce or procure the material, the supplier has an incentive
to exert effort to reduce consumption. The larger fixed fee guarantees profitability for the supplier even though it is
selling the material "at a loss".
What appeared to be one of the major questions facing CMS providers is: how should we modify the contract terms as we
go forward? For instance, once we have achieved the initial savings, should we reduce our fixed fees, or change the
variable fee, or both? In particular, it was felt to be important to offer some quick cost savings to the customer up
front to convince them of the value of this type of contract--this could be achieved by reaping the low-hanging fruit that
exists in most cases. Initially this factor was seen as more important than giving the customer incentives to exert
effort, and indeed, most early cost savings were largely or entirely driven by the CMS provider. However, once that
low-hanging fruit has been gobbled up, the customer needs to take more responsibility for achieving or at least helping
to achieve further cost reductions. Should the contracts then include a higher variable volume-dependent cost, to
encourage customers to participate more actively?
Interestingly, and in apparent contradiction to that question, it also seemed that the detailed nature of the contract was
not considered to be all that important. For instance, the folklore surrounding CMS frequently refers to "shared savings",
the idea being that buyer and supplier can help each other to achieve cost reductions, and then share the savings between
them in order to truly encourage each other to actually search for such cost reductions. In practice, however, it seems to
be very rare for this sharing of savings to occur by one party actually cutting a check for the other. Instead, it is more
common for such cost savings to be considered as one of several inputs into the annual contract renegotiation, i.e., efforts
to help each other are rewarded implicitly rather than explicitly.
We are continuing to study some of these issues from both a theoretical and practical viewpoint, asking questions such as:
What is the "optimal" contract structure? How should companies determine the contract parameters? How should companies modify
those contract parameters over time?
For more information on this article, or current research underway, please contact Professor Charles Corbett at
charles.corbett@anderson.ucla.edu or Professor Greg DeCroix at
decroix@mail.duke.edu.
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