Collaborative planning free essay sample

From a review of the incomplete contracts literature and a case study of the CPFR arrangement between PG and Wal-Mart, this paper posits CPFR as a relational contract for managing economic incentive problems, which can arise in a vertical supply relationship due to transaction costs, agency costs, and relative bargaining positions. Theoretical propositions are developed regarding when this IT-supported intermediate form of vertical contracting is preferred to other governance modes and how CPFR can be an effective relational contract to support economic exchange and to create intellectual capital between trading partners. With efficient vertical coordination and enhanced specialisation incentives for mutual commitment, CPFR allows contracting parties to avoid the difficulties of formal contracting while realising the benefits that would be anticipated from vertical financial ownership. Keywords: CPFR; information sharing; mutual commitment, relational contract; vertical integration. Reference to this paper should be made as follows: Kim, S. M. and Mahoney, J. T. (xxxx) ‘Collaborative planning, forecasting and eplenishment (CPFR) as a relational contract: an incomplete contracting perspective’, Int. J. Learning and Intellectual Capital, Vol. X, No. Y, pp. 000–000. Copyright  © 200x Inderscience Enterprises Ltd. 2 S. M. Kim and J. T. Mahoney Biographical notes: Sung Min Kim received his PhD in Business Administration from the University of Illinois at Urbana-Champaign. He is an Assistant Professor of Strategy at the School of Business Administration, Loyola University Chicago. His research interests span the disciplines of strategic management, global management, and strategic entrepreneurship from the perspective of organisational economics. He has published articles in Strategic Management Journal, Journal of International Management, Journal of Retailing, Industrial Relations, Business Horizons, and Thunderbird International Business Review. He has also presented his research projects at several conferences organised by the Academy of Management and the Academy of International Business. Currently he advises Asian multinational enterprises and research institutes. Joseph T. Mahoney received his PhD in Business Economics from Wharton, University of Pennsylvania. He is Investors in Business Education Professor of Strategy, College of Business, University of Illinois at Urbana-Champaign. He has published over 50 articles in outlets such as Journal of Business Venturing, Journal of Management, Journal of Management Studies, Organization Science, Strategic Entrepreneurship Journal, Strategic Management Journal, and Strategic Organization. His publications have been cited from scholars in over 55 countries. His 2005 Sage book, Economic Foundations of Strategy has been adopted by over 30 doctoral programs. He is an Associate Editor of International Journal of Strategic Change Management, and Strategic Management Journal. 1 Introduction Collaborative planning, forecasting and replenishment (CPFR) is a new supply chain practice wherein trading partners use information technology (IT) and a standard set of business procedures to learn by combining their intelligence in the planning and fulfilment of customer demand (VICS, 2004). By linking sales and marketing information to supply chain planning and execution processes, CPFR can result in a simultaneous reduction in inventory levels and an increase in sales for both retailers and suppliers (Aviv, 2005; Schwarz, 2004). In the Operations Management literature, CPFR is considered superior to the earlier electronic data interchange (EDI)-based supply chain practices since it is based on much broader cooperative arrangements where retailers and suppliers jointly develop forecast by sharing point-of-sale (POS), inventory, promotions, strategy and production information (Terwiesch et al. , 2005). Potential economic benefits of CPFR are well-recognised and have been publicised in practice by successful retail businesses such as Wal-Mart. Despite anecdotal success stories, however, considerable controversy still surrounds CPFR and most collaboration initiatives in practice have not gone beyond the pilot stage (Kurtulus and Toktay, 2004). For example, according to the CPFR baseline study by KJR Consulting, 67% of Grocery Manufacturers of America (GMA) (2002) member companies are engaged in some forms of CPFR practice, with only 19% moving beyond pilot studies to implement CPFR with their trading partners (GMA, 2002). When implemented properly, collaborative supply chain relationships enable trading partners to create intellectual capital and economic value that no single firm could have created alone in the vertical chain (O’Keeffe, 2001). For many companies, however, the CPFR as a relational contract: an incomplete contracting perspective 3 attempts could be a costly failure because, along with increased economic benefits, collaborative arrangements also present a set of economic incentive problems due to increased dependencies (Blois, 2002). Specifically, asymmetric information sharing and imbalanced relation-specific investments could change ex post bargaining positions and thus affect ex ante risk assessment by contracting parties (Cachon and Netessine, 2004). In order to both create intellectual capital and to appropriate the economic value from a collaborative arrangement, trading partners must analyse the governance structure of vertical relationship and account for the economic incentive problems arising from information sharing and relation-specific investments. Theoretical development regarding CPFR has been underway mostly in the discipline of operations management. While many research papers investigate the economic value of sharing information in a supply chain, the extant literature on CPFR assumes either that the information available to the trading partner is exogenously given or that the information is always shared truthfully (Aviv, 2001). Under either of these assumptions, CPFR always results in both parties being better off, which falls short of explaining the lack of widespread adoption of CPFR in practice. A purely operational or technical approach on CPFR does not address the challenges of contracting economic intangibles and the difficulties of aligning economic incentives between contracting parties. In the absence of the analysis of economic incentive problems inherent in vertical contracting, the prediction of preferred organisational form will be indeterminate (Mahoney, 1992). The current paper analyses CPFR from an incomplete contracting perspective. In this paper, CPFR is defined as a (type of) relational contract in which electronic information sharing and common organisational procedures for joint activities play a critical role in coordinating interdependent tasks between trading partners in the vertical chain. By drawing on the incomplete contracting literature, this paper examines the benefits and costs of CPFR practice as a distinct governance mode of a relational contract in vertical relations. Systematic and repeated interactions between trading partners under the CPFR arrangement could improve the mutual learning of business objectives and strategy and further induce reciprocal relation-specific investments in intellectual capital over time as an adaptive response to collaborative exchange environment. In addition, by analysing a case of the CPFR arrangement between Wal-Mart and Procter and Gamble (PG), it also identifies new challenges created by this new business practice and provides heoretical insights into better understanding of the incomplete contracting theories and managerial implications for this IT-supported supply chain practice. Although CPFR initiative is grounded in an operational efficiency concern for the supplier-buyer relationship, CPFR extends beyond traditional operational issues to emphasise vertical coordination and governance of the transactions in the vertical supply chain. Effective collaboration will only be possible if there is an effective governance structure that addresses potential economic incentive problems between the contracting parties. To the extent that information and actions are observable and that relation-specific investments are reciprocal under CPFR arrangement, CPFR provides an effective deterrence to ex post opportunism and further induces cooperation across firm-level boundaries. Greater efficiency gains from specific knowledge between CPFR partners are the reinforcing factors that make this intermediate form of relational contracting superior to standard vertical contracting or vertical financial ownership. Economic analysis of incentive problems in vertical relationship has primarily been based on organisational economics of incomplete contracting including transaction costs 4 S. M. Kim and J. T. Mahoney theory, agency theory, and property rights theory (Mahoney, 2005). These perspectives cover a wide range of possible contractual problems that arise from asymmetric information, bounded rationality and relation-specific investment. Information sharing between contracting parties plays a crucial role in these theories, with the general prediction that more or better information sharing will usually improve inter-firm governance and economic performance for both parties. Although there is considerable research on economic incentive issues in vertical relations, there is limited research on economic incentive problems that are related to the sharing of intangible assets in contractual settings in which there is an absence of enforceable property rights or viable vertical integration options. This paper provides an incomplete contracting analysis of when and how increased and systematic information sharing and joint activities mitigate a set of economic incentive problems in vertical relationships. Specifically, theoretical propositions developed in the paper examine ‘when this IT-supported intermediate form of vertical contracting is the preferred governance mode in hosting vertical relationship, and how CPFR can be an effective relational contract to support economic exchange and create intellectual capital between trading partners’. The application of incomplete contracting theories into new and increasingly important forms of IT-supported vertical contractual arrangements advances our understanding of firm-level boundary decisions and supply chain management. The remainder of the paper proceeds as follows. Section 2 reviews prior research studies concerning the incomplete contracts literature while focusing on the role of information sharing in relational contracting. Section 3 examines a case of CPFR arrangement between PG and Wal-Mart. Section 4 provides theoretical propositions on the CPFR arrangement as a relational contract. Finally, Section 5 presents discussion and conclusions. 2 Theories and literature Prior studies in the field of supply chain management practices suggest that, in order to develop a successful collaborative business relationship, the contracting parties must invest in obtaining relevant data, generating forecasts and then exchange their forecasts to form a single shared forecast for joint decision-making (Aviv, 2002; Cachon and Fisher, 2000; Cetinkaya and Lee, 2000; Lee and Whang, 2000). While information sharing and improvement efforts by one party could benefit both contracting parties, reliance on the other party is also to be increased over time as a result of repeated interactions with the chosen trading partners. Both contractual parties can either cooperate or decide to act non-cooperatively, foregoing the economic benefits of intellectual capital (Teece, 2000). These are the options that are open in the classical case of a prisoner’s dilemma game and potential failure in (vertical) coordination. Transaction costs theory maintains that markets rely on formal contracts that are largely enforceable y a court, but because formal contracts are typically incomplete, relational contracts may be needed in order to overcome some of the difficulties with formal contracts (Williamson, 1975, 1985). Especially when vertical financial ownership is not a viable option, both supplier and buyer could circumvent difficulties in formal contracting by adopting a relationa l contract approach to realise long-term mutual benefits from the exchange. 4 A relational contract allows trading partners to utilise detailed knowledge of their specific activities and to adapt to new information as it CPFR as a relational contract: an incomplete contracting perspective 5 becomes available (Macneil, 1980). For the same reasons, however, relational contracts cannot be enforced by the courts and so must be self-enforcing. For example, game-theoretic modelling studies on relational contracts in modern property rights tradition suggest that each party’s reputation must be sufficiently valuable that neither party wishes to renege on their agreements (Baker et al. , 2002; Gibbons, 2001; Halonen, 2002). In contrast, research studies from the transaction costs and classical equity perspective consider relational contracts as fixing the nature of contractual adjustment processes towards a balance between shares of ex ante sunk-cost investment and shares of ex post joint surplus (Crocker and Masten, 1991; Hackett, 1994; Williamson, 1985). 6 2. 1 Incomplete contracts perspective on vertical relationship Formal contracts are incomplete in the sense that there are inevitably some circums tances that are left out of the contract and that there will remain some residual rights of control that are not specified in the contract. Accordingly, all residual rights to the asset not expressly assigned in the contract accrue to the party who owns the asset. The allocation of the residual rights of control will thus have an important effect on the bargaining position of the parties to the contract since a party that owns the essential asset will be in a position to capture the economic benefit from the transactions which was not explicitly allocated in the contract by threatening to withhold the asset otherwise. According to the incomplete contracting perspective by Grossman and Hart (1986) and Hart and Moore (1990) – or the GHM models – the dilemma of providing economic incentives to the parties when the contract is incomplete can be mitigated if those parties are assured a substantial share of economic value they create by providing them with the ex post bargaining power inherent in asset ownership in terms of the residual rights of control. This incomplete contracts approach seeks to improve economic incentives through ownership of essential assets. In general, the GHM models suggest that an agent who is indispensable to an asset should own that asset, and that complementary assets should be owned by the same agent when complete contracts are infeasible. However, the GHM models limit the type of assets to tangible assets, such as machines and factories, because they are alienable and thus can change ownership. Brynjolfsson (1994) extends the GHM models and considers a setting where production requires the use of physical and information assets, focusing on optimal allocation and ownership of these assets. According to Brynjolfsson (1994), when the two complementary assets of production – i. e. , inalienable information and alienable physical assets – are separately owned by contracting parties, giving the informed party ownership of the physical asset will improve the informed party’s bargaining power to capture a higher value on the surplus in bargaining and economic incentives to invest ex ante. However, i t will reduce the investment incentives of the other party as it takes bargaining power away from the previous owner of the physical asset. Whether this loss is outweighed by the improved economic incentives to the informed party will be a function of how necessary the information is to the production and how important it is to maximise the incentives of the informed party relative to those of the other party. The more important it is to provide economic incentives to the informed party, the more likely it is that it will be optimal to give the informed party ownership of the physical asset. 8 This incomplete contracts approach enables us to examine how different level of the alienability and contractibility of the information asset affects the economic incentives of S. M. Kim and J. T. Mahoney contracting parties, thereby influencing inter-firm governance and economic performance of vertical relationships. 9 More specifically, when we compare the economic value created under the best possible ownership structure when information is alienable to the economic value created under the best possible ownership structure when information must be owned by a particular party, we can define the difference as the net economic value of alienability. In some circumstances, this net economic value can be quite large, which suggests that transforming information in a contractible form can create high economic value even without increasing the stock of knowledge itself. Economic incentives for IT investments in ways to make information alienable will be strongest if the economic value of alienability is high. In particular, the digital revolution has led to the creation of numerous alienable information assets. In addition, positive externalities of IT adoption suggest that more information will fall into this category. As a result, the reduction in information costs enabled by IT is leading to substantial new approaches to the organisational challenge of co-locating information and decision rights across firm boundaries. 10 Jensen and Meckling (1992) provide a useful framework for studying the issues of information assets, organisational structures and economic incentives in vertical relationships. Informational variables are fundamental to the structure of organisations because the quality of decisions is determined by the quality of information available to the decision-maker and therefore the co-location of pertinent information and decision rights enables the decision-maker to make optimal decisions. Co-location, however, has potential agency problems, since the economic interests of the informed party are seldom served in ways that correspond perfectly with the economic interest of the other party in its entirety. Hence, a trade-off arises between the use of better information and the control of behaviour that fails to create the aligned economic interests of the contracting parties. The inter-firm governance in vertical relationship can be understood as an attempt to locate decision rights so as to minimise the sum of the economic costs arising from poor information and agency problems. According to Jensen and Meckling (1992), there are two fundamental ways to bring information and ecision rights together: the information technology solution, which transfers the information required for the decision to the decision-maker, using the organisation’s IT systems, or the organisational redesign solution which redesigns the organisational structure so that the decision-making authority is where the pertinent information is located. The implementation of this co-location depends on the nature of the pertinent information. 11 By definition, general knowledge, which is useful for decision-making , calls for the IT solution because it can be transferred at low cost. In contrast, when specific knowledge plays a key role in a decision the best solution calls for restructuring decision rights to provide decision authority to the one who possesses or has access to the pertinent information since the transfer of specific knowledge is too costly. If the structure of organisations is an efficient response to information costs, a change in information costs may induce a change in the organisational structure. In particular, new IT-supported business practices can change organisational structure and firm-level boundaries by facilitating certain information flows and by turning knowledge that used to be specific into general knowledge. While useful, Jensen and Meckling’s (1992) deterministic view on information costs and organisational structure has limitations in addressing potential incentive problems between organisations under information sharing agreements. For example, Demsetz (1992) maintains that the distribution of knowledge within a firm is endogenous to CPFR as a relational contract: an incomplete contracting perspective 7 management decisions as the firm decides what knowledge or information to acquire. This decision, once made, sets the knowledge content of the firm and changes the distribution of this knowledge within and between firms. The more basic determinants of organisational structure, then, are the governance and economic incentives that influence its decision as to what stocks of knowledge to acquire from and share with trading partners and to create intellectual capital in vertical relationships. Therefore, in order to examine the effects of information sharing on the economic incentives under CPFR arrangements, it is necessary to examine not only the ownership patterns of the complementary assets, but also the governance structure of information sharing relationships. 2. 2 Information sharing and relational contracts When information is shared between vertically adjacent firms, an important governance issue is the nature or level of information sharing. For example, some retailers share information related to the inventory or sales of the products while other retailers sell such information to suppliers. Initially, a retailer would share the information that creates the most economic value for the retailer and that reduces the retailer’s relative bargaining power the least. As the retailer shares more information, the relative effect that information sharing has on its bargaining position will tend to increase in the given vertical relationship. At some point, the economic costs of sharing additional information will outweigh the economic benefits and this is the point at which the retailer will stop sharing information. This approach explains why retailers share varying levels of information with different suppliers in competitive bargaining relationships. Seidmann and Sundararajan (1998) define four different levels of inter-firm information sharing based on the impact it has on the parties that contract to share the information to support the exchange in vertical relationship: ordering information, operational information, strategic information, and strategic competitive information. The base case of information sharing is the arrangement where the parties exchange just ordering information through electronic data interchanges (EDI), which are the most common forms of supply chain arrangements. At this basic level, both parties gain from reduced inventory levels and cycle times but the value gained is not necessarily symmetric since each party improves efficiency independently. Sharing operational information occurs when one party owns valuable information, while the other party possesses the skill to use this information more efficiently. An example of the situation is vendor management inventory (VMI) where the vendor manages inventory and replenishment for the retailer. The vendor has specialised knowledge of the production schedule of the products in question. This firm-specific and product-specific knowledge reduces the supply-side uncertainty, which will lower average inventory for the retailer. Another economic benefit that can be achieved in this cooperative arrangement is an increase in the retailer’s sales. However, the retailer’s costs of ordering and fulfilment are now born by the vendor, which increases supply-side costs. Sharing strategic information occurs when one party possesses information that is can derive little independent economic value from, but another organisation can use this information to generate strategic benefits for itself. 12 For example, a retailer possesses point-of-sale (POS) data on all the products it sells. In isolation, this information is not strategic for the retailer. However, a vendor can improve their demand forecasts and S. M. Kim and J. T. Mahoney production planning by analysing detailed transaction level POS information gathered from many retailers. In principle, both the vendor and the retailer could gain from improved vertical coordination. The retailer gets improved operational efficiency and reduced transaction costs while the vendor is able to generate accurate demand forecasts and production planning. However, it is not clear how much the retailer actually captures such benefits from information sharing. One benefit that may not be immediately tangible comes from relation-specific knowledge with the current trading partners. At the highest level of information sharing, it is possible for a retailer to allow some trading partners to access broader market information that provides additional competitive benefits to the vendor. Under exclusive category management or category captainship arrangement,13 for example, the chosen vendor can derive economic value from this strategic competitive information that other competitive vendors could not access. This form of information sharing does not give the vendor competitive advantage over the retailer, but provides substantial advantage over other vendors in the same category. Privileged access gives that vendor not only strategic benefits (from improved demand forecasts and production planning) but also competitive benefits (from sales and demand information about the whole product category), in addition to operational benefits (from superior inventory and replenishment management). It can also reduce the retailer’s operating costs substantially – not only are all order management costs eliminated, but also the retailer deals with only one vendor per category and hence has a substantial reduction in its transaction and merchandising costs. From the incomplete contracting perspective, high level of information sharing between contracting parties may induce superior governance of relational contracting in vertical relationship, which substitutes for standard vertical contracting or vertical financial ownership. Research studies have suggested that vertical coordination and control are often achieved not by financial ownership but by dense flows of information, technology, capital and human resources across firm-level boundaries and these flows are backed in part by promise and reputation rather than entirely by court-enforced contracts (Williamson, 1985). More recently, Baker et al. (2002) develop an economic model of relational contracts and analyse the collaboration incentives of contracting parties for their interdependent tasks. In this economic model of repeated games, the collaborative relationship between contracting parties takes centre stage, and the ownership of the assets or integration decisions are regarded as instruments to provide economic incentives for relation-specific investments in the service of that relationship. For example, in a supply relationship between an upstream vendor and a downstream retailer, the downstream party would like the upstream party to take actions that improve operational efficiency in the downstream distribution process (i. e. economic incentives to make relation-specific investments for quasi-rents). But, when each party’s actions are unobservable (moral hazard) and outcomes are observable but not verifiable (non-contractibility), the vendor may give attention to the alternative buyers so as to improve its bargaining position with the current partner while the retailer would like to capture all quasi-rents generated in the relationship. Such opportunistic acti ons by the vendor and the retailer would dissipate economic value that they could create from relation-specific investments and cooperation. However, in a given environment, a desirable relational contract might be feasible either under integration (i. e. , relational employment contract) or under non-integration (i. e. , relational outsourcing contract) (Baker et al. , 2002). 15 For example, under either ownership structure, the downstream party can promise to pay the upstream CPFR as a relational contract: an incomplete contracting perspective 9 party a bonus contingent on superior outcomes that are observable but non-contractible. According to Baker et al. (2002), the outcome of this repeated games model depends on the size of the economic incentive to renege on a relational contract – i. e. , the extent to which the short-run economic payoff from defection exceeds the long-run economic payoff from cooperation. The key question is whether integration or non-integration can make a given promise self-enforcing. If the downstream party reneges on the bonus under integration, he still owns the good. But, if the downstream party reneges on the bonus under non-integration, he cannot use the good without buying it for at least its value in its alternative use. In this sense, non-integration gives the upstream party more recourse if the downstream party should renege on the promised bonus. But non-integration creates an economic incentive for the upstream party to increase the value of the good in its alternative use, in order to improve her bargaining position with the downstream party [Baker et al. , (2002), pp. 1–42]. Thus, the guiding principle is to induce efficient collaborative actions and to discourage inefficient opportunistic actions by implementing the best possible relational contract which uses informal or flexible instruments, including information sharing and mutual learning, in tandem with formal instruments of asset ownership to ameliorate potential hold-up problems. 16 However, the drawback of any relational contract is that is cannot be fully enforced by th e courts and so must be self-enforcing. In particular, having a relational contract between firms that utilises the contracting parties’ specific expertise typically makes it prohibitively expensive for the courts to adjudicate contractual disputes. Therefore, to be effective, each party’s concern for its reputation and gains from the long-term relationship must outweigh that party’s economic incentive to renege on the relational contract (Baker et al. , 2002). When it is infeasible or too costly to vertically integrate interdependent tasks, contracting parties might try to uild effective economic deterrence to contractual hold-up (Williamson, 1983). The key to effective economic deterrence is to give each contractual party sufficient means to respond to any opportunistic behaviour by the other contractual party. However, there will be insufficient economic deterrence if the economic gain that one party can get from opportunistic behaviour more than offsets the economic penalty the other can possibly impose. Such an economic situation can be remedied if the favourably positioned party provides the vulnerable party with an economic bond to support exchange. 7 Reciprocity transforms a unilateral relation into a bilateral relationship, where both contracting parties understand that the exchange will be continued only if economic reciprocity is observed (Chi, 1994). One way to avoid contractual hold-up and thus to support economic exchange is for the buyer and supplier to devise a mutual reliance relationship. Mutual commitment can serve to equalise the risk exposure of the contractual parties, and thereby reduce the economic incenti ve of any contractual party to behave opportunistically in the exchange process ex post (Kim and Mahoney, 2006). In sum, one way to avoid inefficient actions in vertical relationship is to devise a mutual reliance relationship, in which the potentially opportunistic contractual parties reciprocally invest in relation-specific assets and processes, such as inter-organisational IT system, just-in-time practice or co-location of production facilities, which create intellectual capital and greater economic value only in the current exchange relationship. If the non-salvageable economic value of mutual commitment is substantial for both the buyer and the supplier, an efficient exchange outcome is to be expected. Reciprocal exposure to commit credibly to the contractual agreement is accomplished through 10 S. M. Kim and J. T. Mahoney sunk-cost investments in relation-specific assets and processes in which high switching costs are strategically incurred if any attempt is made to change contracting parties or to renegotiate contracts opportunistically. 3 An illustrative case: PG and Wal-Mart This section describes the development and evolution of IT-based vertical relationship between Procter and Gamble (PG) and Wal-Mart. There are at least two purposes for adopting this exploratory approach. First, it illustrates how relational contracts, which have been examined mostly in the formal contracting literature, emerge and evolve over time in practice as a collaborative supply chain arrangement in the vertical chain. Second, careful observation of the case provides further insights to examine what the analytical models of relational contracts predict under a set of assumptions. New findings and insights from this case study enable development of theoretical propositions and future research agenda that have not fully addressed in the extant research literature. . 1 Initial conditions and early efforts Wal-Mart has pioneered many aspects of retailing including information management by heavily investing in IT system. By 1987, Wal-Mart completed its communications network installation that sends data from all stores to headquarters, providing real-time inventory data. As a result, Wal-Mart merchandise was tailored to individual markets and stores through its ‘traiting†™ practice which is a process that indexed product movements in the store to over a thousand store and market traits. This efficient distribution and merchandising system enabled Wal-Mart to offer lower prices to customers than traditional grocery retailers. Wal-Mart gave its store managers more latitude in setting prices than did centrally priced chains. Store managers priced products to meet local market conditions in order to maximise sales volume and inventory turnover (Foley and Mahmood, 1996). In its vendor relationship, Wal-Mart eliminated manufacturers’ representatives from negotiations at the beginning of 1992 and centralised its buying at the head office, with no single supplier accounting for more than 2. % of its purchases. PG is one of the largest manufacturers supplying grocery retailers and wholesalers and a leader in designing branded consumer goods. PG had developed a reputation for aggressive and successful world-class development and marketing of high-quality consumer goods. The strong consumer pull provided the company with an advantage in dealing with retailers and wholes alers (Clark and McKenny, 1995). Relationships between PG and the buyers through 1980 had primarily been based on negotiations over short-term initiatives and promotions. The reliance on a multitude of promotional programmes increased buyer inventories and required manufacturers to also maintain large inventories in order to be able to meet the high demand artificially created by forward buying during these promotional periods. Information sharing between PG and the buyers was limited often as a result of conventional business practices. Brand managers with meet-sales-quota-or-else directives to retail buyers were rewarded mainly based on low-cost purchase volumes (InformationWeek, 2001). Because there was no collaborative sharing of sales data, the supplier could not see the discrepancy between what the retailer bought and what it actually sold to consumers until weeks later, if at all, from third party research firms that aggregate and sell POS data. CPFR as a relational contract: an incomplete contracting perspective 11 In the mid 1980s, PG launched several projects to improve supply logistics and reduce channel inventory by implementing a process that eventually was called continuous replenishment process (CRP). In 1985, PG tested this new approach to channel logistics for replenishment ordering with a moderate-size grocery chain. This test involved using EDI to transmit data daily from the retailer to PG on warehouse product shipments to each store. PG then determined the quantity of products to be shipped to the retailer’s warehouse by using shipment information rather than retailer-generated orders. The results of this initial experiment were impressive in inventory reductions, service improvements, and labour savings for the retailer (Grean and Shaw, 2002). A key element of the new practice was the development of common databases for product pricing and product specifications. The common databases in CRP implementation were designed to provide data directly to the buyer’s own system electronically. This electronic link resulted in dramatic reductions in invoice deductions for the retailers using the new pricing database to verify or confirm purchase order information. In April 1988, PG began shipping products based on retail sales data and placing orders automatically for the retailer. More importantly, in order to strengthen their CRP operations, PG overhauled its time-honoured system of compensating brand managers. The company eliminated sales quotas and created business-development teams with trading partners, starting with its most important one, Wal-Mart. By 1993, Wal-Mart had become PG’s largest customer, doing about $3 billion in business annually, or about 10% of PG’s total revenue and PG was one of the first manufacturers to link up with Wal-Mart by EDI. In response, Wal-Mart suggested that PG simply ships products on a just-in-time basis by sharing its retail sales data in real-time. By understanding potential benefits from their complementary information and supply chain practices, the relationship between PG and Wal-Mart began to change from adversarial to cooperative one. To emphasise their strong commitment to the new collaborative practice, the PG and Wal-Mart team developed a common mission statement: â€Å"The mission of the Wal-Mart/PG business team is to achieve the long-term business objectives of both companies by building a total system partnership that leads our respective companies and industries to better serve our mutual customer – the consumer. [Grean and Shaw, (2002), p. 160] With top executives from both companies committed to rapid adoption as an organisational enabler of process improvement efforts, implementation of CRP with Wal-Mart took less than two months in total (Lok et al. , 2005). 3. 2 Evolution to CPFR arrangements In an attempt to fully capture the advantages associated with informed decision-making in the vertical chain, C RP relationship between PG and Wal-Mart had evolved into vendor management inventory (VMI). VMI is a vertical arrangement where PG takes on the responsibility of managing the inventory at Wal-Mart’s warehouse for the products it supplies, thereby achieving co-location of pertinent information and decision rights in the supply chain. Initially, VMI was guided by a long-term contract that specifies the financial terms, inventory constraints and performance targets such as service measures. This vertical 12 S. M. Kim and J. T. Mahoney arrangement can be mutually beneficial for the retailers and the supplier. The retailer is relieved of the burden to specify, place, and monitor purchase orders, while maintaining guaranteed service levels. The supplier benefits from substantially reduced demand uncertainties and safety stocks, reduced logistics costs and lead-times and improved service levels (Aviv, 2002). Mutual reliance and understanding of their businesses developed in the process of implementing a series of supply chain initiatives further induced their commitments to their long-term collaborative relationship. As PG and Wal-Mart began to increase the level of information sharing and joint activities from inventory to sales forecasting and strategic planning, their VMI partnership had evolved into collaborative, planning, forecasting, and replenishment (CPFR) relationship. CPFR was started by Wal-Mart in 1993 as its internal experiment, and CPFR was coined through piloting the practice with Warner Lambert. The subsequent goal was to develop industry standards for vertical collaboration using the internet, much like what was done with EDI for CRP practice in the 1980s. The successful CPFR pilot led to the creation of the voluntary inter-industry commerce standards (VICS) sponsored by CPFR Working Group in 1996 and is in active existence today. Using private and public exchanges, CPFR became accessible to both large and smaller companies as the best practice in the supply chains. Because CPFR uses a set of formal procedures and technological models that are open yet allow secure communications between trading partners, it is considered the most structured collaborative business framework. Setting up a CPFR relationship with a trading partner is a structured nine-step process that has been hashed out over several years by the VICS group. Successful implementation of CPFR boils down to trading partners setting expectations up front about information sharing and joint activities and then implementing a sequence of common procedures adaptively. Combined with electronic sharing of information over the Internet link, CPFR partners are able to engage in total supply chain visibility and forecasting (Schwarz, 2004). In its CPFR partnership with PG, Wal-Mart’s marketing information is integrated with PG’s manufacturing systems to make better consumer-based decisions across their firm-level boundaries. For example, Wal-Mart’s POS data show the transaction-level information about consumer’s choices, thus providing the actual demand information on what is selling and the selling price. PG’s products are then developed, manufactured and delivered to meet those customer needs in a timely manner. CPFR pilot with PG provided a structured contractual platform for joint forecasting and planning activities between Wal-Mart and its vendors that ultimately drive the replenishment process through the entire supply chain. By 2003, Wal-Mart has established over 600 trading partners through CPFR to reduce its operating expenses to the lowest in the industry. Successful collaboration with CPFR partners allowed Wal-Mart to price its products 10% below most of the competitors (Andraski and Haedicke, 2003). The case study of the CPFR arrangement between Wal-Mart and PG reveals that successful implementation of CPFR depends not only on extensive information sharing but also on mutual learning about as well as commitment to the dedicated partners from the repeated interactions. It grows out of first gaining an awareness of its contractual partners’ business needs by asking: â€Å"What is competitive advantage of your partners? What is the competitive advantage to you if you combine them with yours? What kind of business relationship does that create? . Thus, successful implementation of CPFR requires higher levels of communication including the exchange of strategies and objectives between partners at the beginning of a planning period. CPFR as a relational contract: an incomplete contracting perspective 13 To sum up, the previous case provides the following insights on the CPFR arrangement. First, the CPFR arrangement improves overall visibility in the vertical chain from electro nic information sharing and thereby enhances operational efficiency in vertical contractual relations. This arrangement allows trading partners to reduce inventory costs and to increase retail sales by synchronising demand forecasting and production planning. These factors provide trading partners economic incentives to jointly develop this IT-supported governance mode of vertical contracting. Second, the impact of information sharing is not merely operational. Information sharing also alters the relative bargaining power of the contracting parties in the vertical relationship. Additionally, developing cooperative relationship requires substantial time and efforts for both parties to better understand their interdependent activities and business objectives. Therefore, without anticipation of substantial long-term economic benefits for both parties, there are potential economic incentive problems between the contracting parties, which will make it difficult to develop CPFR relationships in the vertical chain. Third, in a successful CPFR relationship, the retailer has stronger economic incentives to further specialise in collecting and sharing as much information as possible that is of economic value to the vendors and the retailer. Similarly, the vendor, who has privileged access to the retailer’s information and decision-making authority, has economic incentives to specialise in making effective replenishment and production decisions which will make its activities more valuable in the given relationship. Such reciprocal specialisation incentives are the reinforcing factors to realise greater economic benefits from the CPFR partnership. Finally, CPFR provides trading partners a set of structured organisational procedures and technological standards where contracting parties systematically increase mutual reliance on each other’s business from increased information sharing and delegation of decision-making on interdependent value-chain activities. The structure of bilateral reliance for joint forecasting and planning under the CPFR arrangement could induce cooperative actions by CPFR partners over time toward a mutual commitment to their long-term relationship. The case study of the evolution of vertical relationship between PG and Wal-Mart provides supporting evidence for the predictions of the incomplete contracts literature but also reveals some limitations of the formal contracting approach in explaining the role of informal mechanisms in their adaptive efforts toward mutual commitment. Consistent with the incomplete contracts literature that has been reviewed in the previous section the case study illustrates how increased communication and joint activities from the repeated exchange could lead to superior vertical coordination without resorting to costly vertical integration while overcoming the difficulties of formal contracting in vertical relations. More specifically, successful implementation of CPFR requires high levels of information sharing between contracting parties, as suggested by Seidmann and Sundararajan (1998) and the delegation of decision rights and the use of IT solutions for the co-location of pertinent information and decision rights as suggested by Jensen and Meckling (1992). Effective CPFR partnership in vertical relations is also supported by combining the complementary assets of information and production and jointly realising economic benefits from the repeated exchange with the current trading partners as implied by Baker et al. 2002) and Williamson (1983). The CPFR arrangement between PG and Wal-Mart provides them with a cooperative platform to further improve 14 S. M. Kim and J. T. Mahoney operational efficiency and vertical coordination across firm-level boundaries. The sources of economic value creation and incentive problems under the CPFR arrangement are detailed, focusing on the role of IT-based info rmation sharing and mutual adaptation efforts between buyer and supplier in the retail industry. However, the case study also reveals that successful CPFR arrangement between PG and Wal-Mart is rather an exception and it has not been effectively extended to other vendor-retailer relationships in practice. While previous research studies in the formal contracts literature highlight the nature of the incentive problems by providing analytical models of vertical contracting under a set of assumptions, they are limited in addressing the conditions and difficulties of implementing a relational contract in practice. More specifically, formal contracting studies often ignore the importance of simultaneously managing bargaining power and information asymmetries, transaction contingencies and informal coordination mechanisms in the development of collaborative vertical relationship which requires mutual learning of interdependent activities in the vertical chain. In our efforts to contribute to theory building, next section will focus on these new insights from the case study and develop theoretical propositions regarding the conditions for successful implementation of CPFR as a relational contract in comparison to other governance modes in vertical relations. 4 CPFR as a relational contract From the review of the incomplete contracts literature and the case study of CPFR arrangement between PG and Wal-Mart, this paper posits CPFR as a relational contract which becomes an alternative governance mode to standard vertical contracting or vertical financial ownership. In the strategic management literature, Mahoney (1992) identifies advantages (e. g. , coordination and control, audit and resource allocation, motivation and communication) and disadvantages (e. g. , bureaucratic, strategic and production costs) of vertical financial ownership and suggests that every motive for vertical financial ownership may be achieved alternatively by an appropriate vertical contract when agency and transactions costs are assumed to be absent. Similarly, the current paper suggests that, if agency and transactions costs can be substantially reduced under the CPFR arrangement in the vertical chain, this governance mode of relational contracting allows the trading partners to achieve efficient vertical coordination and jointly create greater economic value than those from standard vertical contracting or from vertical financial ownership. One of the new findings from the previous case study of PG and Wal-Mart is that, as new technology and supply chain practices become available and as their business environments change over time, the governance between PG and Wal-Mart has eventually evolved in order to better manage their vertical relationship and maximise mutual benefits from the repeated exchanges. According to Baker et al. (2002): â€Å"Relational contracts within and between firms help circumvent difficulties in formal contracting† (p. 40). In a given environment, the efficient organizational form maximizes the total surplus. For some parameter values, relational employment will be the efficient organizational form; for others, relational outsourcing will dominate† (p. 58). Similarly, in the comparative institutional analysis of governance structures, Williamson (1985, p. 408) concludes that: â€Å"Flawed modes of economic organisation for which no superior feasible mode can be described are, until something better comes along, winners nonetheless†. As CPFR as a relational contract: an incomplete contracting perspective 5 discussed in the literature, relational contracts offer important advantages over standard formal contracting and vertical financial ownership, but relational contracts are vulnerable to reneging. Therefore, implementing the best feasible relational contract, such as CPFR in the current paper, requires further evaluating necessary and sufficient conditions with respect to transaction contingencies, relative bargaining power and information asymmetries between trading partners, and specialisation and cooperation incentives in the service of their collaborative relationship.