27 April 2007

from the Stanford GSB Knowledgebase

Strong relationships are frequently more important than legally binding contracts when companies outsource key operational activities.

Researchers say that as more firms form international relationships—particularly in innovation-intensive industries such as biopharmaceuticals or high tech—ironclad legal agreements can be impractical, if not impossible. Overburdened court systems around the world and the growing complexity of the types of collaborative deals being forged mean that increasingly firms rely on the threat of loss of future business rather than the court system to enforce those deals.

“When an innovative product is under development and a supplier must invest in capacity up front, it can be difficult—if not impossible—to write a court-enforceable contract that specifies exactly what will be delivered,” says Erica Plambeck, associate professor of operations, information, and technology at the Stanford Graduate School of Business.

For example, she says, electronics giant Toshiba is continually making design changes, frequently substantial ones, throughout the development process. If Toshiba’s suppliers delayed making capacity investment for manufacturing a new product until the design was finalized and a court-enforceable procurement contract could be negotiated, Toshiba would miss the small windows of opportunity that the consumer electronics market allows for releasing state-of-the-art products. Therefore, Toshiba needs suppliers to build capacity early, without a contract. In a one-off transaction, a supplier would be likely to build far too little capacity, anticipating that Toshiba would attempt to negotiate a low price for production once the capacity investment was made. But within the context of an ongoing, cooperative relationship, Toshiba could offer more generous compensation, and convince the supplier to expand its capacity—and both firms’ profits—even without a contract.

Alternatively, she says, there are cases where assurances about the quality or quantity of output cannot be legally enforceable. “Frequently, producing a viable product depends on the collaborative efforts of both parties, and it’s difficult to determine fault if something goes wrong,” she says. A case in point: A biopharmaceutical firm could hand over genetically modified cells and the liquid medium in which to multiply them to a supplier, who then would be responsible for managing that fermentation process to produce a therapeutic protein. If the protein yield is unexpectedly low, a court would have difficulty determining whether the cells and medium were of poor quality or the supplier made mistakes in managing the fermentation process.

“This kind of complicated business arrangement can be difficult to specify in a contract in a manner that a court could enforce,” says Plambeck. “Under such conditions, an ongoing relationship between partners is critical to cooperation.”

Plambeck has written a series of papers on so-called relational contracts—agreements enforced by the value of the ongoing cooperative relationship—research she has conducted with Terry Taylor, an associate professor in the business school at Columbia University. Plambeck became interested in relational contracts after realizing that there was an almost universal assumption in the operations and supply chain management literature that all contracts were court-enforced.

“By recognizing that the strength of incentives for investment in design, capacity, and inventory are limited by the value of the future business, one obtains qualitatively different managerial insights and policies for operations and supply chain management,” she says. There is a rich body of economics research in this area—indeed, it was a Stanford economics professor, Robert Gibbons (now at MIT) who coined the phrase “relational contracts.” Plambeck and Taylor build on this existing work by taking the abstract idea of relational contracts and applying it to dynamic problems of collaborative product development, capacity, production, and inventory management.

Plambeck has some high-level recommendations for managers.

First, “figure out the potential to generate profits through a collaborative relationship and the dynamic value of that relationship to each partner,” she says. For example, a major oil company built an innovative production facility for renewable energy in China, even though that required sharing valuable intellectual property (IP) assets with a local partner. Conventional wisdom would rule against the plan because the weak court system for protecting IP in China could result in the local partner taking the IP and setting up a competitive business endeavor. However, the oil company realized it could depend on a relational contract to protect the intellectual property because it was continuing to innovate and that the value of its IP was increasing over time.

When asked if he was worried that these intellectual property assets would be stolen, a senior executive at the firm said no. “He believes that the Chinese partner would understand that because the firm is continuing to improve the relevant technology, it would be shooting the goose that lays the golden eggs,” says Plambeck. After all, stealing the IP would only provide it with a soon-to-be-outdated snapshot of the technology—and ruin a valuable relationship, she says. Of course, if the technology ever became static and stopped evolving, there could be a problem in this area, Plambeck said.

Secondly, to motivate suppliers to invest in innovation or capacity, it’s best to have a relatively small number of suppliers, assure them that you will be providing them with a certain level of business, and show them a path for growth through innovation. For example, in its push for environmental sustainability Wal-Mart is consolidating its business and developing more collaborative long-term relationships with the most innovative suppliers in certain high-impact product categories. Wal-Mart executives say that this stimulates environmental innovation and “a race to the top.” For example, Wal-Mart is also making some unaccustomed multi-month quantity commitments for the first of the laptop computers to be compliant with the European Union's Restriction of Hazardous Substances Directive as well as multi-year quantity commitments for organic cotton.

Third, in joint production it is critically important to have a common IT system for measuring and monitoring the contributions of all parties to the production process. If the joint production process is an impenetrable “black box,” each firm knows it can claim that a bad outcome—such as a low yield of a therapeutic protein—is not its fault. A blame game can ensue in which the parties can point fingers at each other or—alternatively—attribute the failure to simple bad luck. In such cases, putting specialized software in place that shows all the parties exactly what happens throughout the process means that responsibility for failures can be pinpointed more exactly. A detail-oriented and impartial monitoring system protects the relationship from deteriorating if something goes wrong and gives much stronger incentives for all parties to put their highest efforts into optimizing the joint production process.

“It’s essential that there is an indisputable—and jointly accessible—record that ensures a common understanding of what happens each step of the way,” says Plambeck.

Finally it’s important to understand that the mutual trust that is so necessary for relational contracts to succeed is not based solely on personal rapport, business ethics, or other altruistic motivations. Rather, says Plambeck, “it is primarily about profit maximization. It’s about making promises that are in your best interest to keep.”