The Carrot and the Stick: Leveraging Strategic Control for Growth

Vertical Incentive Alignment, “Asset Specificity,” and “Virtual Vertical Integration”

Today, one of the keys to business success rests with the concept of “vertical incentive alignment,” which is the design of vertical relationships in the value chain so that the incentives of all players are aligned with your best interests – so your buyers and suppliers have your best interests at heart by virtue of the structural relationship that you have set up.

One classic example goes back to the early 1990s, when Procter & Gamble (P&G) proposed jointly investing in an inventory control management system that would be jointly owned, managed, and run by P&G and Walmart.1 The system would track every P&G product sold by Walmart in the United States, recording sales as the product was run through the checkout scanner. Pre-specified stock levels would be set up so that if one of P&G’s products went below a certain level, P&G would replenish each store’s stock just in time. The result was that Walmart would never (or at least almost never) run out of P&G stock. Furthermore, P&G estimated that Walmart’s inventory holding costs on P&G products would be reduced by about 60 percent, since Walmart would receive P&G products to the store just in time, rather than have to warehouse and internally distribute them (today, Walmart doesn’t hold inventory, but back then it did).

So, what was in it for Walmart back in 1990? Clearly, it must have been appealing to have one of its major suppliers (P&G) reduce Walmart’s inventory holding costs by as much as 60 percent; indeed, to have a supplier contribute financially to this system (which Walmart was planning on investing in anyway) was clearly desirable. Furthermore, this arrangement had the potential to enable Walmart to make similar requests of other manufacturers. From Walmart’s perspective, there was little downside.

From P&G’s perspective, they were able to solidify a key relationship with their most important customer, Walmart. P&G also benefitted from having timely access to information: P&G could see sales in real time and get feedback on what sold well and where. Consequently, P&G could efficiently adjust their product mix for regions of the country – even down to the individual store level. While the list of benefits goes on, this still doesn’t get at the real, most important benefit and the reason why it was such a brilliant business move. Indeed, the strategy’s brilliance is inherent in the dynamics of any channel relationship.

A retailer is motivated by a number of things; margins and inventory turnover are clearly two important items. This system significantly reduced Walmart’s inventory holding costs on P&G products and P&G products alone; as a result, the effective margins that Walmart saw on ONLY P&G products went through the roof. Furthermore, since Walmart streamlined inventory, the turnover rate on P&G products increased substantially as well. What did Walmart want to do as a result? Sell more P&G product, sell more P&G product. P&G took a behemoth like Walmart, its number one customer, and perfectly aligned its incentives – all with a (relatively) small investment in the inventory control system. Better yet, P&G didn’t have to assess Walmart’s adherence to any contractual agreement; instead, it could just sit and watch. Why? Because P&G knew that Walmart would do what was in P&G’s best interest since it was in Walmart’s best interest to do what was in P&G’s best interest. Brilliant.

Interestingly, just a few months back, I had a conversation with someone who was the head of Walmart’s supply chain in the early 1990s. When I told him this story, his reaction was “That’s why they were telling me that!” Back in the early 1990s, he was being told, “P&G products get out the door first – they get priority.” However, until a few months ago, he hadn’t known why!

Today, Walmart runs on consignment, holds no inventory, and the entire supply chain is run to Walmart’s advantage; however, in 1990, this wasn’t the case. While P&G’s competitors eventually did break into the system at Walmart, P&G enjoyed almost a decade’s worth of competitive advantage in a hotly competitive business as they rolled the system out to other retailers, staying consistently one step ahead of the competition. P&G used the concept of asset specificity to its advantage.

DEFINITION: ASSET SPECIFICITY

Asset specificity refers to a joint investment – often well short of a full-blown merger or acquisition, and unique to the parties at hand – that aligns the incentives of the parties to the investment.

In order to see how the principles of vertical incentive alignment and asset specificity are even more important in today’s environment, recall the earlier example of the sensors on the windmills that can sense vibration and temperature changes so that they can anticipate an impending part or motor failure before it happens; data that are “out of tolerance” are sent up to the cloud, analyzed remotely, and trigger maintenance crews to be dispatched on-site. The advantage to the windmill owners and smaller manufacturers includes better “uptime,” lower maintenance costs, and the ability to compete with services provided by the big players, GE and Siemens. We can think of the windmill owner/operator as having a joint investment with the sensor provider/installer – they jointly share in windmill access. Let’s examine the incentives of the key players, as shown in table 6.1.

The installation of the sensors provides perfect alignment across all players in this system and is both a method to align incentives and a point of strategic control: as seen above, (i) the windmill owner/operator gets lower maintenance costs; (ii) the smaller windmill manufacturers get to compete with the “big boys”; and (iii) the sensor manufacturer gets an effective lock on the maintenance business, since it can provide better, more cost-effective maintenance at margins that are the same as or better than those of its competition. This is indeed a brilliant approach and a “win-win-win” for the windmill owner/operator, the windmill manufacturer, and the sensor provider in this space.

1 Think about the things that have the potential to disrupt the existing way of doing business. What are the inevitable trends in your industry that, if you take advantage of them now, would give you a competitive advantage – even if it were in the short term only?

2 Use asset specificity to your advantage. Once you have identified the part of the value chain where you are competing and have identified gaps in competencies required to compete effectively – or to access a key strategic control point – use the concept of asset specificity whenever possible to align the incentives. Don’t immediately think merger and acquisition (M&A). You may be able to achieve the same result with a substantially smaller investment (and smaller managerial headache).

3 Managing customers and suppliers (i.e., vertical relationships) is all about incentive structure. It’s not simply about cooperating with suppliers; it’s also about how to align the incentive structure – using points of strategic control whenever possible. Often, a joint investment can help align parties to the same incentive, as it did for P&G.

The P&G and windmill sensor examples highlight the use of a (relatively) small investment that aligns the incentives of both parties. So, what is an investment (i.e., an asset specific to the relationship) that would align conflicts in the value chain in your industry?

DEFINITION: VIRTUAL VERTICAL INTEGRATION

Virtual vertical integration entails the integration across two (or more) firms whereby the form of the integration aligns the incentives of the firms involved. Virtual vertical integration can take the form of material movement (e.g., inbound and outbound logistics), financial instruments (e.g., automated payment systems), time, people, and any operational aspect of the organization that can be configured to the interests of both (or of multiple) parties but does not generally involve asset transfer or joint ownership.

Virtual vertical integration almost always involves some sort of asset specific (hence the term “asset specificity”) to the relationship between the parties involved, although this isn’t always necessary: for instance, financial integration (e.g., automated processing and payment of invoices) may involve little or no joint ownership of an asset unique to the venture. However, if it can be made unique to the relationship of the two parties, it can align the incentives of the two parties, with few or no specific assets involved. Today, examples of virtual vertical integration are numerous; the terms that firms use to integrate variations of the principle fit under “integrated materials management” and “performance-based logistics.” The key to all of these is not simply providing convenience to customers – rather, they need to be undertaken in such a way as to align incentives across both buyers and suppliers.

Key Takeaway: Use the concept of asset specificity to align incentives to your advantage across the value chain by first sketching out the existing value chain and then finding areas where incentives might be misaligned. From here, joint investments (e.g., sensors on windmills or P&G’s inventory control system) can facilitate alignment.

In the late 2000s, cellphone carriers were concerned that the proliferation of Android-based phones combined with iPhone and iOS-dominated devices would commoditize the carriers and that Google’s Android proliferation strategy would hasten this development. However, Google used the “carrot” (i.e., incentive alignment) to its advantage. Google allowed each carrier to add its own software and applications on top of the Android operating system in order to enable differentiation – and gave 30 percent of the Android app revenue back to the carriers.2

Google’s objective was to create as much competition between the carriers and manufacturers as possible, thereby pushing adoption and distribution. The carriers and manufacturers recognized that none of them could beat Apple individually; however, together, they could collectively gain by taking back strategic control from Apple. The lesson in all of this is that Google used the concept of incentive alignment flawlessly to get everyone on board with the then fledgling Android OS – the only way anyone had a chance to fight back against the Apple machine. Later, we will discuss how this notion of strategic control (the “Stick”) and vertical incentive alignment (the “Carrot”) can be effectively combined to generate better overall firm financial performance and success in the markets of today and the decades to come.

This same set of incentives brings up a myriad of issues. Imagine the complex web of incentive minefields that this presents. For example, when you are looking at a collection of online sites or stores, what deal is going to pop up first? Is it the one mostly closely aligned with your interests or with the retailer’s interests? Can a store “buy your eyes” and influence what pops up on your screen – much as sponsored search advertising does on the internet version of Google? Who gets the revenue? Stay tuned; all of this is being played out even as you read this.

Groupon, Living Social, Square, BMW, Apple, Google, and Amazon – they all face similar issues with the most crucial part of their business: information. The use of information – and the way information can alter modern-day incentives – is perhaps the driving force behind successful companies today, whatever the industry. For example, BMW created a video version of a hypothetical future entitled “Breakdown.” A businessman is in a rental car on his way to the airport listening to a voiceover in the car – much like a navigation system or Apple’s Siri. The voiceover is reading his email back to him when an interruption overrides the reading with an urgent message: “WARNING, BREAKDOWN IMMINENT”; the voice then proceeds to direct him, turn-by-turn, to the nearest service station where a service attendant is waiting for him in clean white overalls – iPad in hand. The attendant informs the businessman that he was expecting his arrival and that his plane reservation and afternoon meetings were moved to accommodate his detour. The man responds by saying, “All I need is a taxi.” A yellow taxi then instantly arrives. The spot ends with the businessman saying, “All I need now is a million dollars ...” and, of course, nothing happens – much to his disappointment.

This isn’t just a Madison Avenue advertising fantasy; in many ways, the video mirrors what is already present in diverse industries. Performance-based logistics (PBL) in many manufacturing industries, “power by the hour” leasing agreements, and the embedded use of information in aviation markets are examples of how this fantasy is now a reality. To illustrate how information can play a pivotal role in the inter-firm incentive structure, let’s examine the use of advanced technology sensors aboard modern aircraft (e.g., Boeing’s 787, 747–8, or 737-NG, or Airbus’s A380). In the newer aircraft, onboard sensors determine when a part has failed and, in many cases, when it is about to fail. Embedded onboard communications notify ground crews before a plane touches down. Maintenance and repair facilities can be notified in advance so that the crews are waiting at the gate to replace the malfunctioning part. The result is more efficient maintenance operations and higher aircraft utilization rates (a key to operator profitability) as aircraft downtime is reduced – potentially significantly. Thus, there is a material and often significant competitive advantage in the market for maintenance, repair, and overhaul (MRO) organizations and airplane manufacturers that are better able to introduce, coordinate, and manage information flows in this regard.

The lesson here, however, is less about the particulars of the aviation industry than about what this does to the incentive structure across players in the industry. For instance, think about what this does to airline operators (e.g., American Airlines, Southwest, and Lufthansa) after such technology is embedded on board an aircraft or a family of aircraft (e.g., Airbus A320s or Boeing 737s). First, at low levels of “technology embeddedness,” one would expect a fair amount of resistance on the part of incumbent players in the industry. The operators would have few savings, since the technology is not incorporated into the maintenance and repair organizations on the ground; in fact, their costs might actually be higher because of the maintenance costs of the technology. Furthermore, for the MRO organizations, this is clearly a threat to their very livelihood; any cost savings to MRO operations would only come if the information on the plane was incorporated into the on-the-ground maintenance – and there is no incentive to do this if the level of embeddedness is still low.

As the information technology makes its way into a higher percentage of aircraft in the air, however, the incentive structure exactly reverses. For instance, with more sensor technology onboard the aircraft, the potential impact of sensor utilization increases dramatically (e.g., on operational utilization and efficiency). Once there is a broader diffusion of the information sensor (and related on-the-ground infrastructure support), it becomes economically viable to support the ground operations that will be waiting for inbound aircraft should an issue arise in flight. Furthermore, technology adoption turns from a threat into a potential source of growth and revenue generation for MRO facilities to the extent that they can extract higher margins by capturing some of the value of the increased efficiency of the operators. Of course, the tipping point between seeing the new technology as a threat and seeing it as an opportunity depends upon a complex set of cost, scale, and adoption considerations, the level of previous penetration, and when the transition is undertaken. An analysis of the value chain (as discussed earlier) may be essential for identifying this tipping point.

Table 6.2 outlines the incentives for key players in the market across the value chain. For example, it reveals that the technology (which aircraft manufacturers spent billions of dollars developing) only adds manufacturer costs and little in the way of benefit to the other players in the value chain – unless sufficient scale can be achieved so that the potential cost savings and efficiencies can be fully realized in the market.

Scale (size) lowers the cost of the network of maintenance and repair benefits associated with the information transmitted from the plane; without that scale (i.e., if only a small fraction of planes in service have these capabilities), such an offering will not likely take off in the market. Hence, the focus of early strategy should be on gaining scale at all costs. The first to market with a service that gains scale – and, accordingly, takes advantage of that scale – will most likely win in the market. Once the market has been won, the ongoing advantage would be significant, since the original need for scale makes additional entry at this point unattractive (given that one firm is in the market with significant scale). For start-up after start-up, similar issues are emerging today. For example, Pandora’s ability to compete against other competitors (e.g., iHeartRadio, iPods, iPhones, smartphones, and internet radio) depends upon their ability to rapidly grow installed base in an attempt to build entry barriers.

The importance of scale is certainly recognized by private equity firms; after “investing in the person” (i.e., betting on the main visionary behind the proposed business), the ability to scale an idea is often cited as the main reason to invest – or not invest – in a proposal. Yet, the discussion around table 6.2 (on the aviation industry) suggests that major players in this market may not understand this important point (an observation not unique to this market). To illustrate, think about the following:

1 Services are being launched by major players (e.g., Boeing, Airbus, and Lufthansa Technik) with the goal of having them earn money out of the gate. However, short-term profitability should not be the priority: a focus on gaining early penetration should preempt every urge to focus on profitability. If there is a long-run play in this market, then whatever determines long-run success should drive short-run strategic decisions. The winner will be the one that can gain scale as quickly as possible, not the one that is profitable out of the gate. Spend to build scale initially, and reap the benefits later.

2 On the “platform” side, scale is huge; however, one of the main benefits to scale, on selling an airplane, is the potential for the annuity of services (e.g., flight and maintenance training, service, and support) that come from selling an airplane. As the market for services grows, new entrants (e.g., Honda Jet, Embraer, Bombardier, and Russian and Chinese firms such as COMAC) compete for the smaller, passenger (i.e., “commuter”) end of the market; as more and more routes use smaller jets (e.g., a doubling of regional jets in service through 2035 is expected),3 the ability to grow scale on the maintenance side for the two major players in the industry (i.e., Boeing and Airbus) diminishes over time. Thus, the move to services now becomes increasingly urgent.

More generally, speed to critical mass can hinder future entrants. Think of YouTube, Google, Skype, Facebook, and others; not only would a potential competitor have to produce a platform as good as (or better than) each of these in order to compete effectively, they would have to battle the installed base issue. Indeed, if “everyone” is on Facebook, where else would you go to connect to friends? Thus, growth to scale can be a barrier to entry by competitors – if you get in first and grow scale, this reduces the incentive for secondary entrants to come into the market. Combine this with a point of strategic control in the market and you have significantly increased your chances of success.4

This concept extends in a number of other directions, including corporate governance. Recently, I gave a talk on the topic of corporate governance at the Yale Law School to a group of corporate board members from a variety of large multinational corporations. At the beginning of the talk, I played a video featuring various wearable projects (ranging from contact-lens versions of Google’s Glass to virtual reality [VR] glasses by Oculus to holographic projected iPhones to cameras embedded in contact lenses). The result of many of these technologies is that, in the future, a meeting could be broadcast live without the participants even knowing. The point for corporate governance is that companies can’t govern by rules anymore; governance needs to happen by incentives – firms will need to ensure that participants do not want to broadcast meetings surreptitiously.

Today, many markets are characterized by what economists have called “asymmetric information,” which is just a fancy term for instances when a buyer and seller have different information. For example, sellers of an automobile may know about a defect in the car that they are selling, but unless they reveal this, the buyer doesn’t.

There are numerous, classic examples of this, including the “lemons” market (suggested by George Akerlof many years ago).5 The principle is simple, yet chilling. When there is asymmetric information between buyers and sellers in a market, the bad quality products will drive out the good ones so that we are only able to buy “lemons” (i.e., poorer quality products) or, worse yet, nothing at all.

In order to illustrate this principle, imagine that two companies – Company A and Company B – both have products in the widget market; however, Company A’s product is of superior quality to that of Company B, and it costs more to produce higher-quality products. Assume further that each company knows more about the quality of the product than any potential buyer. We call this “asymmetric information,” since the information is “asymmetric” between the buyer and seller. In this example, a buyer can only ascertain quality after purchasing and using the product; and when the product has been used, it cannot be returned. Since buyers cannot ascertain the actual quality level before buying, they would only be willing to pay for average quality in the market. Indeed, why would you pay for higher quality when you could not tell that a product is indeed of higher quality?

Under these circumstances, it makes little sense for the high-quality producer, Company A, to continue to produce – at a higher cost – a higher-quality product, since the market is not rewarding the higher quality with a higher price. Thus, all above-average quality products will be driven out of the market. Once this happens, we can tell the story again with the remaining products in the market, and once again the above-average quality products will be driven from the market. This will continue, of course, until either only poor quality or, in the extreme case, no products remain. Thus, a market can fail due to uncertainty and asymmetric information; if “bad” (low-quality) products drive out “good” (higher-quality) products from a market, only a market for “lemons” (i.e., poorer quality products) can exist!

In practice, of course, there are various reasons why this may not play out as Akerlof had described; these include repeat buying behavior; the existence of intermediaries, which are sometimes referred to as “Akerlof intermediaries” (e.g., internet ratings services like Yelp, Epinions, and CNET); and good old-fashioned word of mouth.

Philip Nelson once claimed that advertising contained relevant information6 (i.e., when products were associated with more frequent advertising, they were actually of higher quality). The logic, which is provocative, is also intriguing. Take our example above wherein Company A’s product is of superior quality. In this instance, if this quality could be discerned at point of sale (POS) – such as a pair of trousers whose fabric and stitching can be evaluated – companies that advertise more will attract more customers to their stores (assuming the advertising works). Since quality can be evaluated at POS, this will generate a higher level of sales, thereby providing a return on the advertising investment. We thus may not expect to see advertisements for products of inferior quality (e.g., those made by Company B). Company B may not have an incentive to advertise, since they could only really hope to get customers into the store; once the customers got there, they would likely observe that the product was of inferior quality and most likely wouldn’t purchase it, and thus the advertising cost would be wasted.

For products associated with “search” qualities (i.e., the quality could be ascertained prior to purchase), the advertising actually contains information about quality. Note that this would also be true for products with qualities that may not be investigated prior to sale and that are largely successful as a result of repeat purchases. Thus, advertising contains credible information (and can actually serve to reduce the asymmetric information between buyers and sellers) for products with qualities that can be investigated (i.e., searched) prior to purchase or qualities that can only be ascertained after purchase but generate a substantial number of repeat purchases.

Research in this area generally defines “search” qualities (aspects of an offering that can be evaluated prior to purchase), “experience” qualities (qualities that can only be evaluated after purchase, such as in a can of soup or a can of paint), and “credence” qualities. Credence qualities are qualities that we can’t evaluate even after the purchase and consumption process; for example, when your car is repaired, do you really know if the mechanic replaced the part with an original, manufacturer-certified part or a cheaper refurbished part? When competing in a market – and competing in the information game with rivals – knowing and understanding the nature of information is crucial. Think of Amazon and eBay. It is in their best interest to turn the information “game” into one of search qualities (i.e., provide credible, user-based ratings, return guarantees, and support). Informational asymmetries are reduced between buyers and sellers (e.g., the buyer knows more about the probability of seller service or quality gaps as a result of the ratings), and Amazon and eBay turn the products in their offering lineups (think Amazon Marketplace) into more of a search offering, thereby providing an informational strategic advantage over less “omnipresent” competitors.

For many companies today, the strategic use of information and informational asymmetries presents radically different problems; however, some companies (e.g., Amazon, eBay, Facebook, and Alphabet) face almost the reverse issue – that of too much information. Such companies process extraordinary amounts of data every minute; firms that use the data most efficiently reduce buyer-related informational asymmetries and thus gain strategic advantages in the market. The game – like the games discussed earlier – is real, alive, and well. Only this time, the game is one of information and signaling. Thus, knowing the nature of the informational game is the first step toward using it for your strategic advantage.

• Align incentives, align incentives, align incentives. A key part of strategic planning is the alignment of incentives throughout the value chain.

• Today’s successful companies align incentives upstream and downstream in the channel – with suppliers and customers alike.

• The best type of business to business (B2B) relationship benefits both the seller and the customer.

• Identify the inevitable trends in your industry that could give you a competitive advantage – even in the short run only. How might you turn them into a sustainable competitive advantage?

○ Once you have identified your key part of the value chain (i.e., where you are competing) and gaps in the competencies required to compete effectively in that part of the value chain (or to access a key strategic control point), use the concept of asset specificity, whenever possible, to align incentives across the board.

○ Don’t immediately think mergers and acquisitions (M&A). You may be able to achieve the same result with a substantially smaller investment (and smaller managerial headache).

○ Managing customers and suppliers (i.e., vertical relationships) is all about incentive structure. First and foremost, spend time understanding (i) where the power is in the channel and (ii) what incentivizes each player in the value chain.

○ Connect these incentives to your ultimate objective of maximizing profits in the high-priority segments of your market.

○ Use both the “carrot” (via incentive alignment, the subject of this chapter) and the “stick” (via the utilization of strategic control points). Research, which is discussed in the next chapter, has shown that using this type of carrot and stick, in concert, can be particularly effective for generating long-term success in today’s market.

1 Much of the detail of this section comes from personal conversations with John Pepper at P&G during this period, all occurring at the Yale School of Management.

2 Source: Fred Vogelstein, Dogfight: How Apple and Google Went to War and Started a Revolution (New York: Farrar, Straus and Giroux, 2013), 120.

4 More generally, the academic literature has studied this phenomenon from a variety of perspectives. Perhaps most relevant to the discussion here is the “diffusion” literature, which studies the rate and size of the adopting pool for any new innovation. See Antonio Ladrón-de-Guevara and William Putsis, “Multi-Market, Multi-Product New Product Diffusion: Decomposing Local, Foreign, and Indirect (Cross-Product) Effects,” Customer Needs and Solutions, Springer, Institute for Sustainable Innovation and Growth (iSIG), 2 (1) (March 2015): 57–70, for a recent example.

5 George Akerlof was awarded a Nobel Prize in Economic Science in 2001 for his work in this area. See George A. Akerlof, “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism,” Quarterly Journal of Economics, 84 (3) (1970): 488–500.

6 Philip Nelson, “Advertising as Information,” Journal of Political Economy, 82 (2) (1978): 729–54. (Professor Philip Nelson was an advisor of mine as an undergraduate and a gifted, albeit animated and eccentric, teacher.)

Entity	Incentive	Direct Costs
Windmill Owner/Operator	Reduced maintenance costs	Zero
Windmill Manufacturer	Ability to compete directly with larger players (e.g., GE and Siemens) in ways they could not on their own	Zero
Sensor/maintenance provider	Lock in on high-margin maintenance contracts, install stickiness	Sensor, Analytics, Maintenance

Part of Value Chain	Incentive
Manufacturer (e.g., Boeing, Airbus, Embraer, COMAC)	Increased sales and value capture possible only if there exists enough of an installed base to make unique MRO capabilities of aircraft scalable – thus, penetrate as quickly as possible to gain scale; if not, technology has no clear advantage and only adds cost. Furthermore, the solution needs to be proprietary (i.e., to manufacturer planes) or there is no differential competitive advantage.
Operator (e.g., American, United, Lufthansa)	Since the technology has the potential to produce huge gains in efficiency and aircraft utilization rates – but entails a significant upfront investment – adoption will only occur once enough aircraft possess the technology. Furthermore, gains only occur if there is an advantage over rivals. For “single-fleet” operators, incentive is closely aligned with manufacturers; for “mixed- fleet” operators, incentives depart significantly from manufacturers.
Maintenance, repair, and overhaul (MRO) (e.g., Lufthansa Technik)	This is where it gets complicated. When standalone MROs work on mixed fleets, there is little incentive to scale – unless technology solutions, across manufacturers, are compatible. For standalone MROs focusing on single fleets (e.g., Boeing), scale gives them a competitive advantage, provided that the technology is proprietary. For operator-owned MROs (such as Technik) or operators that do their MRO work in-house, there is a significant threat of being incentivized out of the business.