Ailment #3 – The Activity Trap

Many companies that suffer from the “Outsourcing Paradox” often suffer from the Activity Trap. Traditionally, companies that purchase outsourced services use a transaction-based model. Under a transaction-based model, the service provider is paid for every transaction—regardless of whether or not it is needed. Businesses are in the business to make money – and outsource providers are no different. The more transactions performed, the more money for the outsource provider. The outsource provider has no incentive to reduce the number of non-value-added transactions, because a reduction of transactions would result in a reduction of revenue.

The Activity Trap can manifest itself in a variety of transaction-based outsource arrangements. When the contract structure is cost reimbursement, the outsource provider has no incentive to reduce costs because profit is typically a percentage of direct costs. Even if the outsource provider’s profit is a fixed amount, the typical outsource provider will be penalized for investing in process efficiencies to drive costs down. In a nutshell, the more inefficient the entire support process, the more money the service provider can make.

Perverse incentives play a major factor in the Activity Trap as well. Nineteenth-century paleontologists traveling to China used to pay peasants for each fragment of dinosaur bone (dinosaur fossils) that they produced. Bill Bryson, author of A Short History of Nearly Everything (Broadway Books: New York, NY, 2003) said the paleontologists later discovered that peasants dug up the bones and then smashed them into multiple pieces to maximize their payments. Or think of the farmed Hanoi rats: how many rats can you find in your outsourced processes?

The table below on the next page outlines characteristics of companies suffering from the Activity Trap in their efforts to outsource 3rd party logistics services.

Company outsourcing for services Service providers’ typical reaction under a transaction-based model
I forecast over. We charge you to store and count your product monthly; the more you have the more we make.
I forecast under. We charge rush fees to expedite your products to market
I manage my suppliers poorly. Your suppliers caused us to rework your product into new packaging. We have to charge you more money to rework.
Inventory working capital is killing me. We don’t own your inventory – we just provide services to you. Actually, we like when you have too much because we charge to hold it.
I specified the wrong shipping requirements. We ship as we are told. You didn’t tell us about the special label.

Source: Supply Chain Visions

 

Inherent in the Activity Trap is a disincentive to try to drive down transactions – another symptom seen in the Zero-Sum game. But does this really happen? Unfortunately, it does.

On one recent site visit, we asked the general manager of a third-party logistics (3PL) provider what the large area full of “orange tagged” pallets was for. She replied, “That’s some of our customer’s old inventory I need to move to an outside storage facility.” When we dug further we found out it was product that was well over five years old – and at the rate it was moving would last 123 years (that is not a typo). When we pressed further, asking why the company didn’t work with the customer to scrap the material, the answer was “Why? I charge $18 a pallet per month to store it. I’d lose revenue if I did that!”

Another victim of the Activity Trap, a large technology company, was transferring sales support activities from one outsourced provider to another. Company officials found that the data required to run certain reports was no longer current, and the new data was being stored in a new format in a different location. Because the company had not informed the current provider, the reports the provider had produced for the past five months were incorrect. In a damage-control drill, the team learned good news and as well as bad news – the sales manager who had requested this reporting had been transferred, and the new sales manager did not use this (now inaccurate) report. But preparation of the report was still a required activity, and the technology company was being charged each month to generate the report.

A third example of the Activity Trap comes from outsourced manufacturing. A contract manufacturer performed final kitting and assembly “pack-out” as a value-added service for its customer. The customer had given the contract manufacturer the bill of materials with detailed instructions to use a specified finished-goods “pretty box” for the product. Each “kit” consisted of multiple parts organized in a box. The contractor needed to assemble the box and then insert the parts in an organized manner – a process that involved 12 “touches.” The contractor charged a flat fee per “touch” to assemble the box carton, plus a fee of one “touch” for each item placed in the kit. Officials at the contract manufacturer knew that the particular box design was not efficient, but simply did what they were told rather than proactively offering solutions for an improved box design and assembly process that would have eliminated touches.

If you are outsourcing, is the agreement based on pushing the cash register button every time a specified activity is performed? If so, you’ve become caught in the activity trap.

Read More! Move on to Ailment #4 The Junkyard Dog Factor

Comments

  1. Gopal Anandan says:

    Good examples sighted here and I’d like to add one too.
    In a loosely structured contract (with an outsourced procurement partner) – we did find a variant of the first example. Besides purchasing more of what was actually needed, the unit purchase price was high as well – thus increasing the profits (which was a % of the total purchases made) of the outsourced partner. The most common reason cited for the relatively higher prices were insufficient and very less time provided for purchases which was forcing spot procurement.

    The need for tightening and regular monitoring of the contract cost clauses, service level expectations, price variation clauses was immediately felt.

    Regards,
    Gopal
    Supply Chain Consultant

  2. Activity-based pricing can cause freakish unintended consequences as they can create incentives that actually prevent achievement of what the outsourcing company really wants. How can this happen? http://scvisions.blogspot.com/2011/04/freaks-in-supply-chain.html

Speak Your Mind

*