Opportunism Knocks

The combined forces of globalization and enhancements in information technologies have long since changed the competitive landscape in many industries. To compete and prosper, companies in such industries must respond to the demands of customers who are highly price-sensitive. The result is a relentless drive for efficiency — and for lower costs.

In response, companies have embraced specialization and outsourced non-core activities. The heart of the decision to outsource economic tasks rather than perform them in-house frequently comes down to cost. This is true whether you are producing mobile phones or underwriting mortgages. The quest for efficiency thus leads, over time, to complex supply chains in which participants are increasingly disassociated from the final customer transaction.

Such efficiency can benefit consumers but also has a dark side. Complex supply chains with many agents are more prone to problems, and on occasion, to spectacular collapse. Examples from the last few years include the subprime mortgage crisis; the failure of the Peanut Corporation of America; the 2007 pet food scandal; lead paint on children’s toys in 2007; melamine-laced Chinese milk products; contaminants in the drug Heparin; and dioxin-contaminated Irish pork. The consequences can be dramatic. Peanut Corporation of America, a peanut-processing company based in Lynchburg, Virginia, whose sales were estimated at $25 million, triggered a $1 billion recall as its contaminated product found its way into some 2,000 products. The toy company Mattel Inc., based in El Segundo, California, suffered substantial damage to its reputation in 2007 when a supplier to a supplier to a supplier to a supplier of Mattel chose to use lead-based ingredients that were outside Mattel’s specifications.

Together, these crises and recalls should concern executives across a wide variety of industries. Although these problems appear to be very different and were certainly shaped by their unique circumstances, we propose that a primary cause was essentially the same: the failure of the market mechanism to root out opportunism within the different levels of the market or supply system. Such opportunism can take the form of insufficient care given to ensuring safety or quality standards — or even, in some cases, to criminal misconduct.

Our research is part of a series of interdisciplinary studies aimed at understanding why business systems fail and what leaders can learn from such failures. In this phase of the research, we conducted in-depth case analyses for eight high-profile failures since 2007. These failures spanned the spectrum from individual company issues to industry-wide crises. The research involved more than 50 interviews with key industry participants and regulators as well as in-depth reviews of media, court documentation and minutes from public hearings. Data gleaned from these sources were compared against known or generally accepted economic and leadership thinking in order to answer the question of whether old lessons need to be retaught or new theories need to be developed.

Our conclusion? The problem is not about greedy bankers or untrustworthy Chinese business practices; it is about human behavior and its impact on business decisions. Across a variety of industries and geographies, we find that today’s ultra-competitive environment has limited companies’ ability to ensure compliance throughout the supply system. In particular, complexity is an enabler of opportunistic behavior — especially in cases where the eventual discovery of the problems only occurs far from the original source.

What’s more, along with the complexity comes interconnectedness, where one company’s actions can have widespread effects. For example, a small Irish feed manufacturer started to use an unapproved type of oil in an industrial food dryer. Dioxins from the oil fumes found their way into the feed and eventually into the pigs that ate it. In December 2008, routine inspections found unacceptably high levels of dioxin in Irish pork, causing supermarkets in 25 countries to clear their shelves of the Irish meat. Total cost: some 200 million euros.

An ex post facto analysis of a system failure is easy, but predicting one or diagnosing problems on the fly is much more difficult. To us, the scary part about looking at commonalities across system failures is the recognition that the conditions present in the failed systems are clearly evident in numerous supply chains operating today. Does this mean that there are other failures waiting to happen? We believe it does. And, though failures may not all be as wide-reaching as those in our examples, they are nonetheless costly to the stakeholders involved. The Consumers Union has found that the 2006-2008 period produced record numbers of product recalls.

So what are managers to do? How can they check their own situations for integrity and stability? Though there are no silver bullets, we offer a checklist of five factors managers should consider.

Recognize the Opportunism Risk. Almost by definition, the longer the supply chain, the higher the risk of opportunism. Participants, far from the end consumer, work to optimize their local situation rather than the entire system — enabling a transactional mentality to dominate. Constant monitoring and updating of assumptions and procedures is required to allow managers to understand the dynamics of the risks they are facing.

Address Weaknesses in the Supply System. Managers need to look proactively for weaknesses within the supply system that have the potential to cause trouble. The most common weakness is what is often referred to as moral hazard: the lack of an incentive to guard against a risk when one is protected against it. For example, mortgage lenders and mortgage brokers acted as intermediaries who, once the mortgage was sold for the purposes of securitization, had little or no responsibility for ensuring payments. As a consequence, their decision making revolved around following the rules they were provided with rather than trying to spot unarticulated risks among borrowers or properties.

Re-evaluate Markets for Inputs. A third area of managerial focus should be markets nested deep within a supply chain. Markets within supply systems have a number of characteristics that open them to opportunism. By definition, markets are transaction-oriented and for defined commodities. The personal connectedness and contextual understanding that leads to the development of trust is purposely de-emphasized as the number of criteria used for evaluation is reduced and automated to allow for a larger volume of transactions with lower costs per transaction.

Markets are also repetitive. This allows for testing and probing on the part of opportunistic players. How likely is it that opportunistic behavior will be detected? What are the costs of opportunistic behavior relative to the benefits? When interactions are transactional, the calculus used by the supplier compares the value of the opportunistic strategy with the cost of getting caught and/or reprimanded. Contract manufacturers substituting ingredients and manufacturers sanitizing their plants to pass the food inspection are examples of this behavior.

Check for “Normalization of Deviation.” Trading off the value of markets for inputs with their inherent risks is difficult. An ongoing testing of the integrity of the evaluation rules is a minimum, but it is the normalization of deviation that is probably of more concern. Diane Vaughan coined this term when reanalyzing the Challenger space shuttle disaster. In her book The Challenger Launch Decision, Vaughan focused her research on the O-ring failure that caused the disaster and found that every time O-ring irregularities occurred, engineers could account for such irregularities, so that O-ring damage became the norm rather than a signal of danger. In the subprime crisis, independent mortgage brokers tested diverse (and extreme) borrower/property combinations with mortgage lenders. Lenders approving “special cases” would later find an increasing proportion of their underwritten mortgages having similar characteristics — effectively creating a new normal. In markets for inputs, accepting deviations from the evaluation criteria, however slight and under whatever circumstances, can, over time, lead to this same type of normalization process where the enforced evaluation criteria vary from design and problems may multiply further up the chain. Consequently, where costs of failure are high, periodic audits are needed.

Understand the Role of Regulation. Any discussion about hidden risks and system failures leads inevitably to the role of regulation. This is where most managers get queasy, because regulation costs money and runs counter to the goal of ever-increasing efficiency. However, such an analysis uses an incorrect calculus. Yes, unit costs go up with increased regulation, but if these costs mitigate or dramatically reduce the risks of a major failure, the net present value of regulation can be highly positive. The key is to match the regulator and the regulations to the risks in the system. This matching process can result in regulators of many forms, from government regulators to organizations created to provide effective industry self-regulation, such as the Institute of Nuclear Power Operations, based in Atlanta, Georgia.

As recent examples indicate, the cost of opportunistic behavior in today’s complex supply chains can be high. It therefore behooves companies to dig into the details of their supply systems to understand the risks and work proactively to prevent problems. After all, on the road to efficiency, what you don’t know can hurt you.