Lack of Trustworthy Sales Forecasts Costs Billions

This guest post was created by MIT Sloan School of Management.

 

 

 

Trust plays a big part in everyday relationships. Could it also be an important resource in business relationships?

MIT Sloan School assistant professor Karen Zheng and two colleagues set out to answer that question in a study of trust within supply chains. By conducting experiments using computer simulations, the researchers found that trust can, indeed, be an effective tool for resolving potential business conflicts.

"The message we have for companies is that contracts are not the only way to resolve issues," Zheng said. "There are many market conditions in which trust between the parties by itself is a sufficiently powerful way to resolve incentive conflicts."

The subject chosen for the study is one of the most vexing problems in supply-chain management: manufacturers' tendency to issue overly optimistic forecasts.

Manufacturers want to be sure they have abundant supply to satisfy customers. But inflated forecasts can prompt suppliers to overproduce, which can lead to costly losses. In 2001, the networking-equipment supplier Cisco had to write off $2.1 billion in excess inventory because of inflated customer forecasts.

To understand the role of trust in a forecast-sharing setting, Zheng and her colleagues Ozalp Ozer of the University of Texas at Dallas and Kay-Yut Chen of Hewlett-Packard Laboratories recruited for a computer experiment graduate students in business-related fields. The participants all had some familiarity with how manufacturers and suppliers interact. Some of the participants were assigned the role of suppliers and others, manufacturers.

"With the software, we varied two conditions: the cost of the product the supplier was producing and uncertainty in market demand," Zheng said. "Then we saw how changes in these two conditions affected trust between the parties and whether the changes affected decisions they made in the market."

The researchers found that when the cost of the product was low and the manufacturer's market was stable, trust was high and the businesses cooperated. According to the researchers, ink cartridges represent such a market. They are relatively cheap to produce, and the market for them is stable.

When cost was high and the market uncertain, trust was low and cooperation broke down. A real-life example, according to the researchers, can be found in laptop computers, which are costly to produce and face a volatile market. In these cases, parties probably need to rely on contracts to manage their relationships, according to Zheng.

When the cost of a product was low and markets were uncertain, trust remained sufficient for cooperation, the researchers found. An example is DVD movies, which are cheap to produce but are sold in volatile markets.

"Our key insight is that the risk entailed by trusting, which is influenced by the product's cost, has a greater impact than market uncertainty in affecting people's trust," Zheng said. "When that risk is low, companies will naturally cooperate with each other."

To illuminate the experiment's findings, the researchers developed a mathematical model that quantifies trust and its close relative, trustworthiness, to show how they jointly affect forecast sharing.

A company that is in a supply-chain relationship could use the model for guidance in dealing with the other firm, according to Zheng. "If a company has a rough assessment of how much its partner trusts the company, it can use this model to figure out how the partner will act and what will be the optimal decision for itself," she said.

The researchers' findings were published in the June 2011 issue of the journal Management Science in the article "Trust in Forecast Information Sharing."

Academic researchers have typically overlooked trust as a factor in supply-chain relations. Previous studies have primarily assumed the parties have either complete trust in each other or absolute mistrust, according to the researchers. "What we have found in this study is that decisions people make fall between these two extremes. Their behavior shows a continuum of trust and trustworthiness," Zheng said.

Action tips:

1. Tap into the MIT Sloan School of Management research and commentary.

2. Integrate your supply chain into your CRM solution and use predictive analytics to bring forecasting accuracy above 90 percent.

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Comments

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