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Information Technology and Management 2, 261–288, 2001 2001 Kluwer Academic Publishers. Manufactured in The Netherlands.

A Hierarchical Model of Supply-Chain Integration:Information Sharing and Operational Interdependencein the US Grocery Channel∗

THEODORE H. CLARK [email protected] Department, Hong Kong University of Science and Technology, Clearwater Bay, Kowloon,Hong Kong

DAVID C. CROSON [email protected] Wharton School of the University of Pennsylvania, 1316 Steinberg Hall-Dietrich Hall, Philadelphia,PA 19104-6366, USA

WILLIAM T. SCHIANO [email protected] of CIS, Bentley College, Waltham, MA O2154, USA

Abstract. This paper examines costs of and motivations for interconnectivity within the grocery supplychain, employing evidence from multiple case studies and survey data to develop a seven-level model oftechnology-enabled supply-chain connectivity and channel interdependence. This theoretical model, builtaround a modified transactions-costs framework, is illustrated using examples of processes that span multi-ple levels of interconnectivity and interdependence within the grocery channel between different groups ofcustomers and suppliers. Our analysis suggests that while a discernible hierarchy of levels of IT-enabled in-terorganizational connectivity exists, not all relationships necessarily evolve to the highest level of “virtualintegration”. Indeed, limits on executive attention preclude this level from being achieved by more than asmall fraction of trading partners. The model generates eight testable hypotheses for further study.

Keywords: connectivity, integration, partnership, alliance, EDI, business process reengineering, inter-organizational systems, channel, retail, grocery, interdependence, supply chain management, interconnec-tivity

1. Introduction

Case studies of grocery product manufacturers, wholesalers, and retail chains suggestthat while a discernible hierarchy of levels of IT-enabled interorganizational connectivityexists, not all relationships necessarily evolve to the highest level of “virtual integration”.Indeed, limits on executive attention preclude this level from being achieved by morethan a small fraction of trading partners.

This paper examines existing patterns of interorganizational connectivity withinthe U.S. retail grocery channel, suggesting a descriptive framework (modeled in part on

∗ A preliminary version of this research appeared inProceedings of the Twenty-Ninth Annual HawaiiInternational Conference on System Sciences, 1996.

262 CLARK, CROSON AND SCHIANO

the ISO model of systems connectivity) for classifying progress in developing organiza-tional interdependence. This seven-level model of channel cooperation and informationsharing is illustrated using two examples of generic processes, product ordering andpayment, that span multiple levels of interconnectivity and interdependence betweendifferent groups of customers and suppliers.

The paper is divided into five sections. This section 1 introduces the major themesand describes the overall format of the paper. Section 2 provides a brief review of theliterature relevant to the issues addressed in this research and paper. Section 3 describesthe research design and methodology used to develop the research findings and modelpresented in section 4 of the paper. Finally, the implications of these findings for man-agers are discussed and several suggestions for extending this research are offered.

2. Literature review

The potential for interorganizational systems (IOS) to fundamentally redefine rela-tionships among suppliers, buyers and even competitors within an industry and tochange industry structure has been described extensively in the IS literature (e.g.,[1,3,6,12,24,27,37,39,50,51,53,57]). Transaction cost economics theory predicts thatsignificant reductions in transaction costs should enable new organizational and chan-nel structures [13,69,70]. Rigorous economic modeling and large sample empirical ev-idence suggests mixed findings with respect to pricing structures [5,36] but all authorsagree that reductions in frictional information transfer costs lead to overall process anddesign improvements over time. Improvements in information technology and business-to-business electronic commerce are creating opportunities for firms to dramaticallyimprove supply chain performance, with the literature describing the many innova-tive applications of IT to dramatically improve procurement and production processes[27,35,59].

Recent interest in interorganizational connectivity, including EDI, has been fueledby the opportunities created as a result of the dramatic reduction in communicationscosts, particularly for computer-to-computer linkages and interorganizational connec-tivity [44,63]. The digital connectivity applications now being implemented were alltechnically feasible in 1980, but prohibitively expensive [64]. However, as IOS costbarriers decline, organizational issues and trust become more important [41].

Organizational boundaries and relationships in the grocery industry evolved over aperiod of several decades to minimize the sum of transaction and production costs [19].Badaracco [3] suggests reductions in transaction costs enable firms to join in informa-tion alliances or partnerships, reducing the need for integrated ownership structures.Although these network types of organizational and industry structures were alwaystechnically feasible, the associated connectivity costs were too high relative to hierarchi-cal modes of organization to make the networked organization practical [49]. Decliningconnectivity costs have enabled networked-organization structures to become a preferreddesign for many complex environments [56].

A HIERARCHICAL MODEL OF SUPPLY-CHAIN INTEGRATION 263

The economics literature on motivations for the formation of strategic alliancesand the MIS literature on the motivations for interorganizational systems have divergedsomewhat in recent years. Mody [54] defines an alliance as “a flexible organizationthat allows firms with complementary strengths to experiment with new technological,organizational, and marketing strategies.” In examining the literature on the role of infor-mation (and, by extension, information technology) in the motivations to form or sustainsuch alliances, we note that economic models of partnership tended to be modeled usinganalytical tools of incomplete contracts, reputation, and transaction costs analyses (e.g.,[62,68]). A bridge between these theoretical constructs and established sociologicalperspectives on alliances [43] is needed. In contrast, studies of interorganizational inter-dependence in the MIS literature have been more qualitative. In those papers which dotake an integrative view, the emphasis lies mostly in explaining multinational expansionrather than innovative uses of technology for “business as usual” [38].

Studies have found EDI connectivity alone is not sufficient to generate substan-tial savings and organizational changes are necessary. Malone et al. [50] refer to theelectronic integration effect, in which adjacent channel members create “joint, interpen-etrating processes” at their interfaces. Skagen [65] in interviews with thirty companiesfound strategic and partnership benefits represented the chief gain for companies em-ploying EDI. Brousseau [11] found EDI could only be successful if business processeswere standardized along with EDI, and “the payoff of EDI is not due to EDI itself, butrather to the implementation of the new coordinating techniques” (p. 333).

We describe a preliminary, descriptive seven-stage path from independence to vir-tual integration, along with suggestions for empirical validation. In the spirit of Bensaouand Venkatraman’s [9] study of the automotive industry, we seek to describe a set ofempirical regularities occurring in technology-enabled interorganizational relationshipsin the U.S. retail grocery distribution industry. We propose a conceptual seven-level hi-erarchy channel of relationships not as a definitive taxonomy of interdependence, but asa framework built around repeated observation of common obstacles that captures someof the transition difficulties from one level of interdependence to another, with or with-out explicit investments in IOS. The multistage structure of our model generates specifichypotheses, testable across industries in cross-section and over time within the groceryvalue-chain.

3. Research design and methodology

The research design that generated our understanding of the qualitative commonalitiesintegrated case research, written surveys, and telephone surveys. Case studies, includingmultiple site visits to the manufacturers, distributors, and retailers’ operating locations,afforded the authors insight into the causal processes involved in a complex environment[10,71]. Such hands-on exploratory case research is recommended by several authors asessential for understanding the complex interactions between technology and organiza-tions, an essential element of research in MIS [8]. In conducting exploratory researchon phenomena that are not well understood, case research is often the most useful ap-


Table 1Summary data on case study sites.

Site Type Location 1994 sales Industry Case study reference($milion) rank

Procter & Gamble Manufacturer Ohio 30,296 1a Clark & McKenney (1994)

Campbell’s Soup Manufacturer New Jersey 6,691 10b Clark & McKenney (1994)

H.E. Butt Retailer San Antonio, TX 4,731c 12c Clark et al. (1994)

Hannaford Brothers Retailer New England 2,292c 25c Schiano et al. (1995)

MDI/Alex Lee Wholesaler North Carolina 750c 23c Croson & McKenney (1995)

Spartan Stores, Inc. Wholesaler Michigan 2,190c 8c Schiano & McKenney (1996)

aAmong U.S. soap and detergent firms, “Fortune 500 Largest U.S. Corporations”,Fortune, May 15, 1995.b Among U.S. food manufacturers, “Fortune 500 Largest U.S. Corporations”,Fortune, May 15, 1995.c Source:Progressive Grocer Marketing Guidebook, Trade Dimensions, Stamford, CT, 1995.

proach, enabling researchers to develop frameworks and models that can later be testedand validated (or refuted) using more quantitative research methodologies.

Case-based research can be especially powerful when the research design involvesmultiple case studies examining a single issue from different perspectives [31,71]. Mul-tiple sites at each level of the supply chain were selected to explore changes in rela-tionships between industry leaders. The case sites included two manufacturers, Procter& Gamble and Campbell; two retailers, H.E. Butt Grocery Company (HEB) and Han-naford Brothers (Hannaford); and two wholesale distributors, MDI/Alex Lee and Spar-tan Stores, Inc., as shown in table 1.

Although the companies examined lead the industry in both processes and chan-nel relationship innovation, each of these case sites has idiosyncratic relationships witha wide range of suppliers or customers within the grocery channel. This sample, un-abashedly nonrandom, provides the opportunity to examine technology-mediated chan-nel relationships from the perspective of these innovation leaders.

Each of the six case studies used in this research design involved several days ofvisits to company offices, with interviews conducted with at least eight managers fromeach company. Those interviewed included executives from marketing, logistics, opera-tions, information systems, and senior general managers (i.e., President or Vice Presidentlevel) from each company. Following these initial interviews, we conducted follow-uptelephone interviews with other managers recommended by these initial contacts, espe-cially when additional data was required to complete a case study describing each ofthese companies in detail. The interview findings from each company were summarizedin case drafts, and were extensively reviewed by the senior managers involved in theoriginal site visits. These case drafts were then revised and released by a senior officerof each company for use in research and teaching.

A telephone survey of grocery industry executives supplemented the case studies,providing additional insight regarding the generalizability of our case-study findings.The telephone survey was conducted with managers from the largest self-distributing


retailers listed in theProgressive Grocer Marketing Guidebook(1994), and was part of abroader written and phone survey of grocery retailers [19]. Of the 109 retailers surveyed,twenty-six returned completed surveys, and nineteen executives from these firms agreedto participate in 1-h phone interviews to supplement the written data collection. Thesurvey was designed with the assistance of industry experts experienced in survey designfor retailers in the grocery and apparel industries [37,40].

4. Research model and finding

This research on the evolving nature of relationships in the grocery channel was con-ducted without a strong hypothesis to validate, but assumed discernible levels of in-terorganizational connectivity would emerge. These connectivity levels were originallyexpected to fit into an OSI-style model (originally created by the International StandardsOrganization in 1974, and summarized in [48]) with some differences anticipated, butthe framework that emerged was neither anticipated nor understood during the researchdesign. We also expected to find a single dominant design [52] for supply-chain inter-connectivity, towards which all firms would evolve. Neither of these two maintainedhypotheses was borne out in the research findings; instead, we found a vertically differ-entiated hierarchy of supply-chain connectivity relationships.

Anecdotal evidence from the case studies provided strong support for a model ofincreasing levels of information sharing and consequent integration of operations, en-abling the construction of a theoretical hierarchy of connectivity relationships. Researchfindings from case studies and survey data provide support for this descriptive frame-work and are used to provide examples of each level of connectivity and interdepen-dence. Building upon the small-sample findings of these case studies, we analyzed thecosts and benefits of moving from one level of IOS connectivity to another in terms of themove’s impact on three major areas: production costs, transactions costs, and transac-tion risks. Given our experiences within these supply-chain participants, we generated aconjectural framework designed to generate specifically testable hypotheses about con-nectivity, for future empirical validation or refutation. Our assumed stylized facts forassembling this theoretical framework were as follows:

(A) Increased intensity of organizational connectivity decreases production costs, withthe rate of reduction first decreasing for incremental changes from low to mid-dle levels of connectivity, and then increasing at the highest levels of connectiv-ity. Production cost considerations in this context include all costs directly at-tributable to value generation which would be incurred regardless of how manyfirms or how their coordination were organized. Such a result is consistent withthe principle of decreasing marginal returns through the relaxation of a constraintin a cost-minimization problem. We also assumed that the lack of availabilityof organizationally-controlled resources fundamentally limits the set of strategiesavailable to firms, and when the constraint that resources used by a firm must beowned or controlled by a firm is relaxed (e.g., organizations can borrow one an-


Figure 1. Seven levels of organizational interconnectivity.

other’s resources) not only will efficiency improve on the margin, but the scope ofstrategies available for both firms to pursue will expand greatly.

(B) Transactions costs will tend to increase with higher levels of interconnectivity, withthis increase due in part to the effect of substituting coordination for production inthe total cost structure of the firm. Transactions costs in this context include theexplicit costs of organizing resources as well as the frictional transactions costs andcost required by guarding against divergent incentives of alliance partners [69,70].We assume that the sum of production and transactions costs will thus decrease inalliances which manage to achieve higher and higher levels of connectivity, againrepresenting the gain in such a problem of minimizing total costs subject to a con-straint on feasible actions limited by organizational connectivity, from relaxing theconstraint on maximum organizational communication and cooperation. (Clearly,the additional coordination capabilities need not be used if they are economicallycounterproductive.) In this setting, however, we expect the rate of decrease of totalcosts to bedecreasingin levels of coordination, in keeping with decreasing marginalreturns.

(C) Transaction risks – specifically, those encountered in and limiting the extent ofinformation-sharing partnerships designed to bolster interfirm coordination [25,26]of shirking, poaching, and opportunistic renegotiation will be low until firms reachmiddle levels of interconnectivity, will increase significantly at middle levels ofconnectivity, and then decline at the highest levels. We thus hypothesize an inverseU-shape for the economic impacts of these risks – whether these impacts are re-alized as insurance premia, volatility of earnings or other financial outcomes, orimplicit future costs of uninsured risks borne by the weaker partner in a positionof strategic vulnerability, resulting in a tenuous alliance position wherein terms areconstantly renegotiated to the weaker partner’s detriment.


Figure 2. Comparison of production and transaction costs resulting from increasing connectivity.

For our comparative analysis of relative levels of interconnectivity between firms,we used the most basic example of interconnectivity we could describe as our level 1base case. For each level of interconnectivity, we have focused on the ordering andpayment processes in supply chain integration, as these two processes have been theareas with the most obvious and significant changes the past 10–20 years.

4.1. Level 1: physical data transfer

This lowest and most traditional level of connectivity relies on direct physical transferof information between any two firms (retailer, wholesaler, and manufacturer) in thechannel. Although unusual today, some smaller grocery retailers still place orders towholesalers or manufacturers using physical delivery of a paper order via U.S. mail or bysending tomorrow’s order back on today’s delivery truck, a practice especially commonfor retailers in rural areas served by wholesalers, including MDI/Alex Lee [30]. Invoicesare mailed or delivered by hand to customers, and checks are mailed to suppliers, orpayment may be collected upon delivery.

This physical delivery of information is relatively slow compared with electronictransmission of information. However, it provides firms with the most basic means ofconnecting with suppliers and creates benefits associated with production specialization(vertical integration is neither necessary nor financial attractive in this industry). How-ever, the data provided by this process is limited and slow, requiring firms to maintainrelatively high levels of inventory (compared with most firms today). In addition, pre-diction capabilities are weak with this slow and reactive demand model for production,leaving firms exposed to large whipsaw effects when consumer demand shifts quickly.

Incremental transaction costs are relatively low for this most basic form of inter-connectivity, especially compared to the production cost savings. With truck-based or-dering, the transaction can leverage the existing distribution and transport infrastructureof the “production” costs for delivery of goods. For mail delivery, firms can leverage


Table 2Cost and risk implications of increased connectivity.

Level of connectivityadopted

Incremental impact of increased connectivity for

Production costs Transaction costs Transaction risks

1 (Physical paper) –Connectivity is estab-lished between firms

Very large decrease:Economies of scaleand specialization.

Minimal increase:Data transmissionleverages existinginfrastructure.

Minimal increase:Risks can be almosteliminated with pru-dent policies.

2 (Fax/Phone) –Electronic automation

Large decrease:Reduced cycle-timecreates large savingsover paper systems.

Minimal increase:Cost of electronictransmissions arerapidly declining.

Minimal increase:Limited risk createdcan be effectivelymanaged.

3 (EDI) – Computerto computer data shar-ing

Moderate decrease:Incremental reductionin cycle-time and im-proved accuracy.

Moderate increase:Costs were oncemuch higher, butare declining fast.

Minimal increase:Some 3rd partyrisk, but mostly justprocess automation.

4 (New processes) –New applicationsrequiring additionaldata sharing

Large decrease:Dramatic reductionsin inventory andmanufacturing costs.

Moderate increase:Data transmissionvolumes increasedramatically.

Very large increase:Poaching risks cre-ated by new datasharing betweenfirms.

5 (New policies) –Operational integra-tion and channelBPR

Very large decrease:Redesign of channelprocesses provideslarge cost reductions.

Minimal increase:Costs are similar tolevel 4 connectivity,but slightly higher.

Very large increase:Addition of shirkingand opportunisticrenegotiation risks.

6 (Channel optimiza-tion) – A cost reduc-tion partnership

Very large decrease:Benefits extend fromindividual processesto the entire firm.

Moderate decrease:Reduced legal andmonitoring costsenable by moretrust.

Large decrease:Relationshipbecomes to valuableto risk losing so trustgrows.

7 (Virtual integration)– A joint-profit fo-cused partnership

Very large decrease:Firms have singleprofit optimizationand shared goals.

Large decrease:BUT scarceseniormanagementtimeis key limitingfactor.

Very large decrease:Risk is very low aslong as relationshipstays at this level.

the existing shared infrastructure of the US postal service, paying only a low rental costsfor the use of this infrastructure for information transmission (e.g., a postage stamp). Insome cases, this physical-delivery-based ordering also requires simultaneous paymentfor goods received upon delivery, which imposes a frictional transaction costs on bothbuyer and seller [23], as the retail store needs to keep cash on hand for payment and thedeliverer must double as payment collector and cash handler. In addition, one reasonsome firms maylimit their connectivity to physical document interchange is that they


want to use special forms or documents that are easier to transmit physically (e.g., formsin triplicate).

While transactions and coordination costs are modest for this form of intercon-nectivity, the net benefits for the firm can be quite large as a result of dramatic reduc-tions in production costs – which explains why, unsurprisingly, most retailers chooseto adopt such connectivity with wholesalers and manufacturers rather than insisting onself-sourcing. Without some minimal level of connectivity, buyers and sellers would beunable to exchange goods and services, and all firms would have to provide completevertically integrated processes for providing goods to consumers. A list of items offeredwith associated prices and a system of record-keeping to document what was orderedand when, will frequently suffice to realize such fundamental gains from trade. This firstlevel of interconnectivity enables buyer and seller to “meet” and exchange informationon products offered and prices. Obviously, the principle of revealed preference indicatesthat any firm not 100% vertically integrated has realizedsomevalue from entering into arelationship involving change of goods and information – if there are no gains from co-operation with other firms, the potential economic contribution of coordination is clearlyzero. The processes in level 1 represent the most simple and basic way that firms canuse for achieving interconnectivity, and this level of interconnection requires almost noexplicit technology at all.

Transaction risk is virtually nonexistent for this level of interconnectivity. All trans-actions are arms’ length by definition, and firms need not even rely on credit or loan rela-tionships being in place. The probability is low that firms could misuse this relationship,whether through shirking (i.e., deliberate underperformance on an attribute difficult tomeasure, and claiming full payment nonetheless), poaching (i.e., misuse of informationwhich was given for one purpose in another context, to the detriment of the other party)or opportunistic renegotiation (i.e., changing the terms of an agreementex post, due to ashift in bargaining power among the parties) with this level of interconnectivity.

4.2. Level 2: technology-supported order transmission

The physical transfer or ordering documents in level 1 is clearly slow and labor-intensiverelative to more advanced technologies, and has largely been supplanted by some form oftechnology-supported order transmission using a platform common to all channel mem-bers. Transmitting orders using phone or fax eliminates the legal contract of the orderingdocument, an omission that worried retailers and manufacturers during the early periodof adoption. The declining cost of telephone and fax ordering (both actual equipmentcosts and increasing social acceptability of fax documents) and the increased speed ofinformation transmission (faxes travel faster than trucks) resulted in this becoming themost popular ordering mode for the grocery industry in the early 1990s. Thus, this levelof interconnectivity might have emerged as the dominant design [52] for the industryexcept that these technologies are themselves in the process of being replaced by moredirect forms of data transmission. Ordering information to be transmitted between cus-tomers and suppliers is generally well structured and unambiguous, enabling less formal


means of transmission to substitute for physical transportation of a paper-based ordercontract. The reduction in required formality of the ordering document is a useful con-straint to relax, enabling new methods of communications which provide benefits toboth parties. Faxed invoices are uncommon, however, and faxed payments impossible.Physical delivery (via mail) of invoices and checks for payment were still dominant inthe early 1990s, with each case study firm still having more than 50 relationships of thistype in the late 1990s.

The primary benefit of phone or fax orders is reduced cycle time in the orderingprocess. By reducing the time for order transmission, firms can reduce inventory levelsby one day’s sales (or more). Firms can send orders to their vendors at the end of theday for delivery the following morning, rather than sending orders in at the time ofdelivery for the following day. Although this reduction in cycle time does result in largeinventory savings and lower stockouts for retailers, there is no change in the informationprovided to manufacturers for production and inventory management. Thus, most of thebenefits of this faster cycle time are realized by the customer, even though the costs ofimplementation are shared equally by customer and supplier firms (i.e., both need faxmachines).

Transactions costs increase at this level both due to the cost of capital equipmentand due to the incremental costs of telephone calls required to exchange information viaphone or fax. In effect, this use of fax represented one of the most basic examples ofthe substitution of “IT” (here, a fax machine on both ends) for inventory. Firms later ex-panded this basic theme using more sophisticated IT applications and infrastructure andfurther reduce inventories in higher levels of interconnectivity. Interestingly, some firmsin our study used telephone and fax as complementary technologies, using a telephonecall to verify the contents of faxed orders. The cost of errors for customers and vendorsdue to incorrect interpretation of faxed information (“Is that an eight or a three?”) andmalfunctions of fax equipment (“we never got your fax!”) was often higher than the costof investing in parallel transmission processes. The costs of fax equipment and of peoplewaiting to receive calls plus the costs of the calls themselves represented a transactioncost that was higher than the cost of the physical orders delivery (level 1) for most firms.However, the production costs savings enabled by fax and phone transmission morethan offset the increase in transactions costs for almost all firms by 1990. In addition,although physical transmission could be used with faster cycle time in theory, it wouldbe very expensive to send a truck to collect the order information alone, so transactionscosts for fax and phone orders is much lower than that of physical orders once the cycletime allowed for orders is reduced greatly.

Transaction risks are still very limited for this increased level of interconnectivity.It is theoretically possible that firms could deliberately misinterpret faxed or telephonedinstructions, or claim to have not received a fax. It is hard to imagine serious motivationsto do so on a regular basis, although this could be one of the reasons that large invoicesare still frequently delivered by mail (or their electronic delivery is backed up by anofficial paper copy).


4.3. Level 3: electronic data interchange

The practice of Electronic Data Interchange (EDI) replaces physical paper ordering doc-uments, faxes, and confirming telephone calls with a highly structured, standardizedelectronic form transmitted over a communications network [32,67]. The adoption ofEDI ordering eliminates several manual steps in the ordering process, representing anew stage of connectivity in the channel. The number of supply chain partners at thislevel of connectivity increased from less than 10% of total relationships in 1990 to morethan 30% of total relationships by the late 1990s. Clearly, the availability of informa-tion technology is a necessary enabler of progress to this stage of connectivity. All ofthe case study sites and 80% of the executives in the telephone survey noted that EDIusageper sedid not significantly increase interdependence within the channel. EDI or-dering was described by several executives as similar to faxing orders, but more reliable(subject to fewer errors) and more expensive – EDI transmission fees on proprietarynetworks can be several dollars per order even today, compared to less than $1 to senda fax [42]. Firms justified the incremental expenses associated with EDI adoption pri-marily through its ability to eliminate manual data-entry costs and to increase orderreliability and accuracy. One advantage occasionally cited for EDI ordering is increasedspeed [32]. However, for grocery product ordering and in many other industries, placingorders via fax or phone is just as “fast” as using EDI, with data transmitted as rapidlyas the rest of the system can handle it. Faster cycle times and concomitantly furtherreduced inventory through EDI generate production-cost reductions which are modest atbest; empirical evidence from manufacturers [11,15,47] shows that EDI ordering is fasteror more efficient precisely when the data transmission process is more tightly integratedwith the order-processing information systems within the manufacturer, which enablesEDI orders to bypass some steps of the less-automated phone or fax ordering process.These more streamlined inventory-reduction practices are characteristic of higher levelsof interconnectivity.

Production cost continues the trend towards faster cycle time and reduced inven-tory, but rate of change between levels 2 and 3 is not as large as the improvement fromlevel 1 to level 2. Transactions costs for level 3 increase relative to the costs of transmit-ting similar orders via fax or phone. Fees paid to third-party EDI networks are higherthan phone charges; but improved accuracy does generate some costs savings (boththrough eliminating rekeying and required corrections as well as avoiding erroneous de-cisions based on incorrect information). At the most basic level, EDI transmissions obeyindustry-level standards, requiring little coordination before information handshakingcan occur; although custom EDI solutions are possible, the basic transaction set encom-passes most supply-chain needs in the grocery channel. Most firms interviewed in oursurvey found that the savings from EDI were generally sufficient to offset any additionalexpenses required. However, the savings for EDI were generally clerical cost savingsrather than large production cost benefits from lower inventory or reduced cycle time,as the inventory reduction resulting from EDI adoption without other changes in theirinternal and interorganizational processes were minimal.


While the adoption of EDI in level 3 did not significantly reduce production costs,it also did not significantly increase risks for firms adopting this increased level of phys-ical interconnectivity. All 23 supply-chain executives surveyed in our research claimedthat EDI adoption by itself had no impact on the level of mutual dependence and gen-erated no new transaction risks, as EDI was viewed solely as automation of existingtransactions [19]. In fact, in some ways, the move to EDI could actually reduce risksin the channel as the interposition of a third party, the EDI network service provider,between buyer and seller enabled firms to verify delivery of messages. In contrast, firmscould pretend that faxed messages had not been received or had been misunderstood.The highly structured EDI ordering form reduces both unintentional and deliberate mis-understanding – and by reducing the possibility of legitimate corrections, reduces therisk of unwanted alterations to orders. In as much as EDI ordering falls under the Uni-form Commercial Code, the same legal weight can be given to EDI orders as to paperorders. The improved ability to verify correct orders also reduces risks of deliberatemisinterpretation, as both parties receive identical confirmations that a particular orderwas received (with full and symmetric data integrity).

On the other hand, there were some potential risk factors added as a result of depen-dence on these third-party EDI networks. Slow or inconsistent delivery of informationby EDI service providers represents a form of shirking which did not exist at earlierlevels. Of course, information must be delivered to providers if it is to be transmitted,creating a potential poaching risk; encrypting this information reduces the risk that it willbe misused, but encryption is often not supported using industry-standardized networks.Grocery orders are of little interest to network providers; on the other hand, if finan-cial derivatives transactions were transmitted, the poaching risk from unencrypted EDIwould be much larger. The possibility that EDI network producers could engage in rene-gotiation of rates after parties become dependent on EDI, frequently cited in discussionsabout risks from using for-profit network service providers [7,20] deserves attention, butfierce rivalry among relatively undifferentiated network providers limits this risk fac-tor. On balance, industry executives tended to view the overall risks from migrating tolevel 3 interconnectivity as similar to the risks of level 2 interconnectivity, with increasedrisks due to third-party services but reduced risks between supply-chain partners for EDItransactions. This perspective seems to be justified based on the relatively small changein relative risk introduced by the adoption of these EDI systems.

4.4. Level 4: new information-intensive processes and data transmission

Extended features of EDI, such as electronic payment and invoicing systems, enablecompanies already using EDI for basic ordering functions to migrate to the 4th level ofconnectivity, using an extended EDI system such as UCS II to send invoices and us-ing electronic funds transfer (EFT) to send payments. At the 4th level, EDI is used toexchange pricing changes, bill-back charges, advanced shipping notices, and other in-formation related to invoicing and payment that, in the absence of an infrastructure thatmakes these transmissions almost automatic and free, might not otherwise be shared.


At this level, the ordering or payment processes still require human intervention and areessentially manual processes supplemented by new process and technological innova-tions that improve channel communications and efficiency. The 4th level of connectivityinvolves changing channel processes and the nature of information transmitted, but it isinteresting that few firms have developed this level of interconnectivity without movingon to level 5 interdependency. It is clearly possibly to move beyond simply using newtechnological capabilities for transmitting information faster, more cheaply, or more ac-curately without requiring changes in policies and processes. However, there were lessthan a dozen firms involved in these level 4 relationships that had not progressed ontohigher levels of connectivity. Retailers, for example, transmit warehouse inventory lev-els (or, in a further refinement) retail point-of-sale information to suppliers, in additionto transmitting product orders. The information on product movement, being relativelow bandwidth, costs the retailer or wholesaler little on the margin to provide, and addssignificant value for many suppliers in managing production and forecasting future ordervolumes. The richer data transmission capabilities of extended EDI enable this mutu-ally beneficial coordination, using information that has theoretically been available sincelevel 1 but prohibitively expensive to transmit.

Investment in such applications are frequently justified based on readily measur-able cash savings [22,34] even when their true economic value may be less measurable.Unfortunately, this frequently understates the benefits from these systems and discour-ages investments even when less quantifiable benefits may be large. However, as the costsavings resulting from these process innovations can be large, many firms have been ableto reengineer traditional processes within the firm to take advantage of additional infor-mation provided by EDI transmissions of ordering and other information.

At this level of interconnectivity, firms are not yet willing to make major policychanges in restructuring channel operations, but they are willing to begin sharing moredata. In some cases, this data may provided at no costs or it may be sold to manufac-turers by retailers directly or via third-party intermediaries (e.g., market research firms).For manufacturers, access to retail sales or warehouse shipments information can dra-matically reduce inefficiencies and costs in production by reducing demand uncertainty.At the same time, information on current and expected pricing and inventory on handat manufacturers can reduce uncertainty for retailers and provides opportunities for re-tailer production costs savings via better planning and reductions in both inventory andstockout levels.

The transaction and coordination costs associated with this level of interconnectiv-ity increase with the amount of data shared, for two reasons. First, increased transmis-sion of data to support new processes between and within firms will increase the variablecosts of EDI network usage, as both more data and more types of data are transmittedvia third-party networks. Second, the decisions regarding what data should be sharedand with whom, as well as the high-level specifications of the desired capabilities ofnew systems developed to take advantage of the newly-available data will require signif-icant amounts of top management attention, as well as increased systems developmentcost for implementation. Such top management attention is not only scarce within the


organization, it is frequently difficult or impossible to procure on the open market – and,when available, very costly.

Extended uses of EDI also create significant opportunities for poaching by the sup-plier as the volume and types of data exchanged increase. Continuous and detailed shar-ing of quantity sold, replenishment timing, and other information through CRP agree-ments supported by sufficiently sophisticated POS technology can expose such forwardbuying, inventory excesses or shortages, or diverting behavior that have traditionallybeen major sources of profitability for retailers [26]. Having these activities exposedto the manufacturer undermines the negotiating position of the retailer, who also pro-vides the information necessary to make the inventory management system effective.Although channel efficiency may be improved by eliminating these behaviors, the re-tailer (who must supply the data) views the manufacturer’s use of this data as “poaching”when it is used for anything but logistics. In particular, the same detailed informationabout actual operational status which enables efficient management of inventories alsoremoves any possibility of using uncertainty about the actual levels of demand, inven-tory, or value of a particular product as a bargaining tactic. This complete transparencyof information is particularly threatening to grocery buyers and category managers, whosee their value-added as stemming from excellence in such distributive negotiation. Sucha threat to the role of the category manager, for example, may create a new “limit to in-terfirm coordination” [26] caused not by a technological impossibility but by an agencyproblem within the firm. Individuals’ or firms’ desires to keep this information secretmay prevent mutually beneficial investment in such data-gathering technologies; theadulterated data generated results in inefficient stocking and shipment decisions. Mostproposed supply-chain models from the operations management literature suggest thatfirms should share demand data with their suppliers in order to reduce total channelcosts. Although some firms have entered these data-sharing relationships, most execu-tives in the grocery industry have been reluctant to share data due to concerns about theassociated poaching risks.

The shift to this 4th level of connectivity represents a point of major increase intransactions risks, which poses a substantial barrier to further progress in supply-chainconnectivity. Buyer-supplier pairs who get over the level 4 hump generally manage toimplement level 5 easily, and find it unambiguously in their mutual interest to do so.

4.5. Level 5: new policies and integrated operations

The 4th and 5th levels describe a transition from atechnology-based theory of connec-tivity to a process-based one. Connectivity becomes limited not by the availability of ITbut by the degree to which processes can be coordinated across firms. The transition tothe 5th level of connectivity thus comes at a process-integration junction, such as whencustomers shift from placing orders with suppliers to allowing suppliers to ship prod-ucts as needed to replenish inventory as goods are sold. In the grocery industry, this newvendor-managed-inventory process is called Continuous Replenishment (CRP), with thislevel of connectivity virtually zero in 1990 and reaching up to 20% of transaction vol-


ume and 10% of total relationships by the late 1990s. Each of the case study firmshave been activity involved in developing these level four relationships during the early1990s, but increasing risks in reaching this connectivity level limit the rate of adoption ofthese innovations. Both case-study and survey data indicate that this new CRP mode of“ordering” not only offered much greater interdependence between firms in the industrybut also enabled dramatic improvements in channel efficiency [15,18,19]. The processchanges for each partner involved in implementing CRP are clearly different from thepurely technological tradeoffs and issues involved with migrating through earlier levelsof connectivity; at this level, mid- or senior-level managers from individual functionalareas must, for the first time, involve themselves in investment and policy decisionsdealing with supply-chain alliances.

Companies moving to the 5th level of connectivity in payment systems, for exam-ple, must implement new channel policies for invoicing and payment. Invoices might bepaid automatically when received, with a discount or float period negotiated as compen-sation for real-time payment. Any invoice disputes would then be resolved later, througha new charge-back or dispute resolution process, without disrupting the day-to-day flowof ordinary invoices. The replacement of existing processes for payment thus requiresnew financial management policies, the domain of the CFO rather than the CIO. Suchpayment systems no longer simply apply technological innovations aimed at improvingprocess efficiency or provide easier access to information within the channel, but insteadrepresent new ways of supporting essential business activities for both customers andsuppliers. Firms move to this level to increase predictability and control those channelprocesses which benefit from predictability more tightly.

Policy shifts towards integrated operations represent a change in perspective asfirms realize that they must move from private goals of cost minimization alone for theiroperations to a larger channel-level goal of profit maximization for the overall channel.Firms are not yet truly “channel focused” in that they count gains and losses for theirindividual firms without regard to their externalities visited on other channel members,but each channel member does realize that jointly implemented changes in processes,policies, and operations are needed to meet customer needs efficiently.

In general, moving to this fifth level of interconnectivity enables firms to dramat-ically reduce production costs by redesigning the essential value-creating processes ofdesigning, producing, distributing, and selling products to consumers. Direct productioncost savings through integration of logistics operations can be quite large. For example,firms linking ordering and delivery operations through CRP have experienced simulta-neous inventory and stockout reductions of 50% or more compared to prior processes’performance [15]. As available information substitutes for required inventory holdingsand as logistics costs decrease with information sharing, the channel becomes moreefficient (in terms of required inventory and shipping costs) as well as more effectivein meeting consumer requirements (delivering faster product introductions and lowerstockout frequency).

Although costs of enabling detailed coordination increase significantly, the charac-ter of these coordination costs is generally similar to those of the 4th level of intercon-


nectivity. The increase in coordination costs relative to level 4 connectivity is due to anincrease in the volume of data transmission and increased management time required forestablishing new processes and policies between firms. However, the production costssavings for this level are much higher than in the prior level of connectivity, and marginalgains in production-cost savings from integration and redesign of channel processes andpolicies greatly exceed the increased transactions costs.

Even though the net cost reductions from this higher level of connectivity can bequite large, the transaction risks are also much larger than for prior levels of intercon-nectivity. Serious poaching risks began at level 4, when only information was beingexchanged; in level 5, firms are conducting joint campaigns against inventory and ineffi-ciency and restructuring their buyer-supplier relationships, raising the issues of shirkingand opportunistic renegotiation. HEB points out, for example, that initiating CRP re-lationships with relatively small firms frequently does not pay; small firms claim to becommitted to overall cost and inventory reduction but instead practice trade loading, ei-ther deliberately or tacitly due to insufficient investment in management and systemscapabilities – an example of shirking. (Of course, some larger firms may be similarlypoor risks.) The complexity of CRP systems also places great demands on cooperativedevelopment between channel participants and outside technology vendors, who maynot have the same incentives for generating required system functionality or improvingexisting systems.

CRP agreements, in which the vendor agrees to replenish those items actually soldbased on the retailer’s providing accurate demand data based on actual sales, clearlyprohibit buying additional quantities “on the side” for investment purposes. Retailers,however, are frequently more or less on their honor to report quantities sold accurately;in addition to the risk of the retailer shirking on its obligation to provide accurate in-formation to guide efficient restocking procedures, there is the potential for out-and-outfraud by retailers who may take advantage of manufacturers’ willingness to accept theirself-reported quantities sold at face value. By misrepresenting these quantities, they maybe able to profit through conducting arbitrage (e.g., diverting) between favorable (butconstant) CRP prices and market prices (promotions) available to other non-CRP firms,not only appropriating extra profits but also destroying the effectiveness of regional- orquantity-based price discrimination tactics by the manufacturer.

Extensive time-series data about retailers’ true demand for manufacturer’s productsmay also allow manufacturers to renegotiate pricing agreements to extract 100% (ormore) of the gains from channel efficiency. Once investment and buffer inventory iseliminated from the channel, retailers rely on manufacturers on a day-to-day basis toprovide a continuous flow of product, and are thus potentially vulnerable to a strategicembargo (or the credible threat of one backing up a price increase). EDLP prices maythus be renegotiated upwards after retailers’ inventory positions are drained. Althoughsuch tactics seem quite heavy-handed, retailers are loath to sink capital into relationship-specific investments [45] under the threat of such expropriation.

Simply proving that potential benefits from virtual integration are sizable doesnot automatically make such arrangements desirable, or even workable: risks created


by transforming a previously arms-length transaction must also be taken into account.Clemons and Row [26] point out that sharing information and eliminating inventory inthese situations benefits the partner with better outside alternatives, consistent with theanalysis provided by Williamson [70] and Klein et al. [45]. One partner in an alliancemight appropriate more than 100% of the value gained from virtual integration; the ratio-nal anticipation of this expropriation indicates that such alliances would not be formed,even though their social value from potential cost savings might be billions of dollars[46]. The true costs of such transaction risks are not so much in explicit costs of mon-itoring, legal contracting, and inefficient investment, but because such risks discourageadoption of new technologies and channel processes and thus forego mutually beneficialopportunities. Transaction risks may limit the penetration of such adoption even whensome relationships can be formed. Although channel process redesign (e.g., CRP) pro-vides significant and tangible operational benefits for both manufacturers and retailers[15], the level of CRP usage with channel partners for both HEB and P&G (both leadersin CRP adoption) was still below 50% of total sales in 1998. Many firms, includingdedicated adopters of these new processes, recognize that transaction risks increaseddramatically with these new 5th level interconnectivity changes in channel policies, andhold back from potentially mutually beneficial process coordination because of lack ofalignment of organizational incentives.

4.6. Level 6: joint channel optimization relationships

The movement from level 5 to level 6 is limited by incentive alignment among channelmembers, not the availability of technology. The sixth level of connectivity expands thecooperative relationship beyond the ordering process to operations in general, and in-volves meetings and discussions between firms’ representatives focused specifically onimproving the existing relationship and seeking new opportunities for further eliminatingcosts and otherwise improving joint operations. To accomplish these highly integratedtasks, the organizations must first invest in aligning their mutual incentives – a changein mindset that will expand further in the next level. The number of these level 6 rela-tionships were limited to 15–20 firms at most, as a high degree of management trust wasrequired to transition to this joint optimization relationship level.

This relationship-building stage, a shift from channel members’ perceiving of theoccupants of adjacent channel levels asrivals to perceiving them aspartners[28], oftenbegins with the policy changes that enabled connectivity to move to the previous levelof the framework. All of the case-study sites enthusiastically supported developing thistype of exploratory relationship of mutually beneficial investment opportunities withchannel partners, but only with selected channel partners. Most retailers participatingthe survey interviews were willing to change policies and invest in collecting, analyzing,and transmitting information to strengthen coordination in support of CRP implementa-tion, where payback could be demonstrated. However, many retailers were unwilling toextend this flexibility new and unproven innovations, even when the manufacturer urgedthem to invest and was willing to accept the risks of potential problems. These retail-


ers stuck in level 5 viewed investing in CRP as a strategic necessity [21,22] to achievecompetitive costs and operating efficiencies, but remained unwilling to trust their sup-pliers in a collaborative relationship to seek additional sources of savings or incrementalprofits. Such retailers viewed channel management purely as a distributive negotiatingprocess [33] in which a one-dimensional bargaining zone (e.g., wholesale price) nec-essarily linked the gains of one party to the other’s losses. In contrast, firms movingto level 6 and especially to level 7 expanded the negotiation process to include creativesolutions, side payments for unusual expenditures on their partners’ behalf, and annualbalancing of major investments made in the success of the relationship. Reimbursementfor unusual expenditures are frequently supported by detailed information about costsand benefits, but the decision to make the investment (and receiving reimbursement forcosts incurred) would not necessarily require unanimous agreement in advance [29].

A peculiar alteration of the direction of costs occurs at level 6: at previous levels,improvements in production cost carried with them an inevitable increase in transactionscosts (even as total costs declined). The direct marginal transactions cost of moving fromlevel 5 to level 6, however, is generally negative. All of the necessary technology willlikely have been put in place, and control procedures developed, at an earlier level. In-deed, many of the legalistic purposes of documenting every part of every transactionmay be made obsolete because of a clear understanding that partnership between thefirms is permanent and highly valuable (at least compared to the cost of the items in dis-pute). Once it becomes assumed that any arguments between the firms will be resolvedthrough internal arbitration rather than legal action, the reduction in paperwork costs canbe significant.

Oddly enough, transactionrisksalso decline as organizations become close enoughto make basic decisions on one another’s behalf. The substantial efficiency gains fromclose cooperation will be lost if the relationship sours, and thus, are held hostage togood behavior (i.e., refraining from shirking, poaching, or opportunistic renegotiation) –forming a wholly rational basis for interorganizational trust. Trust in these supply-chainalliances must be constructed not through nebulous psychological trust-building exer-cises, or through “cheap talk” claiming total commitment while secretly maintainingoptions for reversion or escape, but through the deliberate undertaking of irreversible ac-tions that commit both parties equally and irrevocably to the success of the partnership.In a perverse way, the dramatic overall reduction of IT costs and the emergence of openstandards can thus harm supply-chain alliance stability. Fixed investments in flexibleIT systems are no longer necessarily included in the assets whose value is held hostageto good alliance behavior, as they can be easily redeployed to other purposes and theirvalue salvaged.

A significant incremental cost is the substantial increase in commitment of top-tier management time required to structure a partnership between two separately ownedfirms. Although this resource is generally not explicitly priced, as a constrained resourceits opportunity cost must be considered. It is certainly possible that, when this valuableasset is accounted for correctly, overall costs of coordinating this relationship will in-crease beyond level 5.


4.7. Level 7: virtual channel integration

At the seventh and highest level, senior managers in both companies establish closerelationships based on mutual trust, and become willing to disclose sensitive and pro-prietary information which, when used correctly, benefits the channel overall. At thislevel of connectivity, firms behave as if there were joint equity ownership of the channel,seeking to maximize joint channel profit even as allying firms retain separate ownershipstructures [28]. Side payments, when required, can be made on a noncontractual basisbased on imperfectly observable or subjective estimation of benefits created [4]. None ofour case study firms had been able to implement virtual integration with more than sevensupply chain partners, and most senior executives felt that it would be nearly impossibleto develop this degree of integration and trust with more than a dozen channel partners.

In level 6, firms shifted from implementing individual process and policy changesto seeking new opportunities for creating mutual improvements in their operations. Inlevel 7, firms extend this to change the focus from one of seeking cost reduction opportu-nities to seeking new ways of maximizing joint profitability from the overall relationship.Managers are willing to accept both costs and risks from investments and innovationswhich may have limited benefits for the investing firm if the overall impact on the jointprofits for both firms is expected to be positive. Losses or shortfalls by one partner insuch a relationship would be discussed and covered by some form of transfer of valueperiodically, but detailed negotiations of value and cost sharing need not occur prior toinnovation adoption.

At this level, firms involved are willing to invest in improving the overall economicvalue of the relationship, even absent short-term return on investment for themselves,because they anticipate that unexpected or serendipitous opportunities to improve chan-nel efficiency and effectiveness will arise. In addition, the recognize that accuratelyprojecting the costs and benefits from new channel processes is often quite difficult,making it more reasonable to discuss cooperative sharing of costs and benefits after im-plementation and success more reasonable than fixing transfer pricing and terms priorto implementation. Effectively capturing the benefits from these fortuitous investmentopportunities requires an umbrella agreement between the partners that require firms tomake small investments to benefit the other, with settlements of a fair sharing of valuecreated to be determined later. This cooperative alliance approach is a far cry from the“cash on the barrelhead” mentality of level 1 interorganizational connectivity.

4.8. Limits to supply-chain coordination

The seventh level of connectivity requires close cross-firm relationships between seniormanagers for the first time, and involves sharing of information traditionally consideredproprietary and very sensitive (e.g., information on costs, margins, or plans for productintroduction). The limited availability of top management attention and the time requiredto develop the trust necessary to support this level of interdependence and connectivitycombine to constrain the number of these highest-level relationships a firm can main-tain. Not only is the cost of this resource high, but its sheer lack of availability in the


Table 3Management implications and tradeoffs from increasing connectivity levels.

Level of connectivity Relative advantages of adoption Relative disadvantages ofof this level adoption of this level

1 (Physical paper) – Connectiv-ity is established between firms

Vertical integration is the onlyalternative to some form ofconnectivity, and there are largebenefits of some outsourcing.

Limited disadvantages, espe-cially since coordination costsare declining and the risks oflinking with other firms can bemanaged.

2 (Fax/Phone) – Electronic au-tomation

Time savings can reduce stock-outs, increase sales, and reducechannel inventory and productmanufacturing costs.

Limited disadvantages, espe-cially as the costs of communi-cations have declined over timeand as reliability has improved.

3 (EDI) – Computer to com-puter data sharing

Additional savings in cycle-time and reduction in orderingerrors will generally more thanoffset any incremental costs.

Reliance on third-party vendorsmay increase, which could bea problem if some very sensi-tivity information needed to beshared.

4 (New processes) – New ap-plications requiring additionaldata sharing

Dramatic inventory and fac-tory cost reductions often resultfrom increased sharing of infor-mation between firms.

The information shared can beused to shift balance of powerwithin an industry, so value cre-ated may not be shared by all.

5 (New policies) – Operationalintegration and channel BPR

New channel policies andprocesses enabled by sharingof additional informationcreate large incremental costsavings.

In addition to power shifts,firms may not implement newchannel processes well, so part-ners must be carefully selectedfor success.

6 (Channel optimization) –A cost reduction partnership

Improvements in efficiencyacross the entire channel re-lationship can provide largesavings for cooperating firms.

As the benefits and successesfrom integration expand, riskcan decrease, but the manage-ment time involved can becomesignificant.

7 (Virtual integration) – A joint-profit focused partnership

Profit optimization instead ofcost minimization opens upnew opportunities for value cre-ation and improved effective-ness.

Senior management time andcommitment is required; theserelationships will require largeinvestments of executives’ time.

marketplace provides a natural limit to the number of level 7 relationships that any onefirm can handle. HEB, one of the grocery retailer case sites, implemented the 3rd levelof connectivity (EDI ordering) with vendors supplying 96% of its grocery products [14],and achieved 50% of its grocery volume using CRP (5th level). HEB skipped the 4thlevel of connectivity entirely because they were unwilling to supply manufacturers withdata on HEB sales and inventory levels without a commitment from the manufacturerto use that data solely to support a more efficient channel replenishment process using


CRP. Although HEB shared the 5th level of connectivity with more than 50 firms, only15–20 of these firms could be accurately described as level 6 relationships which soughtmutual benefit, and only seven firms had evolved to the seventh level of forming vir-tual channel alliances with HEB. Senior management at HEB and the other case studiesindicated they would be unable to support more than ten to twelve virtual alliance rela-tionships at this highest level of connectivity due to the heavy load on management timeand attention imposed by alliance formation and maintenance.

HEB management saw no such limitation on development of more 6th-level rela-tionships, however, as these involved investments of the time of mid-level or front-linemanagers in the companies (rather than top-level executives) and the investment of thesemanagers’ time could thus be justified by productivity improvements in the channel re-lationship. Although HEB led retailers in CRP penetration, senior management viewedCRP as simply the vehicle through which they could enter into mutually beneficial part-nerships with their suppliers through forming these level 6 channel optimization rela-tionships. HEB viewed the development of and investment in interdependent channelpartnerships as essential to maintaining a market leadership position and to continuedreductions in costs and improved efficiency. HEB management furthermore viewed im-provement of channel efficiency as a continual process that required ongoing investmentsin coordination and interdependence to discover new opportunities for improvement,rather than as an enabler for a single process improvement such as CRP.

Hannaford also viewed channel relationships as important sources of potentialcompetitive advantage and actively invested in developing stronger coordination link-ages with many of its suppliers. Hannaford management also viewed CRP as a meansto develop these “Joint Optimization Relationships” (JOR) with vendors. Twelve manu-facturers had committed to investing in JOR linkages with Hannaford by late 1994, butonly three of these JOR partners were considered strategic alliances that would fit withinthe seventh level of the connectivity framework [60]. P&G and Campbell also describeddiffering levels of partnerships and interdependence with their customers, with no morethan ten customers meeting the characteristics of level seven alliances with either man-ufacturer. While both manufacturers had many customers at level 3 and many retailersat level 4, each had fewer than 40 customers at the 5th level and fewer than 25 at the6th level of connectivity. Campbell management offered several examples of firms thathad moved to the 4th level of connectivity, sharing data on warehouse inventory levelsto prepare for or to test CRP capabilities, but who proved unwilling to make the policychanges required to implement CRP. For these retailers, allowing the manufacturer con-trol over determining ordering quantities and placing orders was the real barrier; sharingthe data was almost an afterthought.

Few retailers had problems implementing EDI or other technological innovations,but many were reluctant to make the policy changes required to shift to a new level ofefficiency in ordering due to the requisite increased dependence on the manufacturer.These retailers remain stuck at level four, with little hope of advancement. Wholesalerswere particularly reluctant to make the shift to CRP processes, as the required policychanges involved extensively renegotiating contract terms with their retailer customers


to maintain existing wholesale margins, but removed traditional profit opportunities thathad sustained wholesalers under the traditional ordering process. Although the whole-salers participating in the case studies were leaders in the industry, and publicly com-mitted to adopting CRP, the difficulty with renegotiating policies with their customersrequired these firms to move more slowly on CRP adoption to survive the transition.These wholesalers and some retailers, for example, were working with manufacturers todevelop alternative pricing and shipment policies that would enable them to realize ben-efits from CRP benefits without eliminating the “inside margins” that had resulted fromtraditional pricing and procurement policies in the channel. Without a pre-negotiatedindustry plan for distributing the gains from improved channel efficiency, wholesalersfeared that CRP process would first arbitrage the very economic inefficiencies in thetraditional ordering process that had provided the wholesaler with profits.

The barrier to increased supply-chain connectivity for wholesalers was not lack oftechnology or even lack of awareness of process innovations, but the difficulty in makingthe fundamental policy changes required to take advantage of these new technologicaland process innovations. Even so, one wholesaler had invested extensively in developingrelationships at the sixth and seventh level of the framework with several manufacturers,and had similar relationships in place with several of its retailer customers. This case sitehad pursued a strategy significantly different from that of most wholesalers in that thecompany had aggressively marketed its services to large chains and large manufactur-ers as a potential outsourcer, who could provide a more efficient way of accomplishingdistribution functions within the channel. Most customers could provide, and had pro-vided, their own distribution services, but were less cost-efficient at doing so than thewholesaler. By acting as, in effect, the in-house distribution arm of several of thesefirms, this innovative wholesaler developed strategic relationships at either the sixth orseventh level of the connectivity framework. These relationships required extensive in-vestments of senior management time and attention, the limits on which comprised themost serious limitations on revenue growth. Even so, investing in developing high levelsof connectivity and interdependency had helped the firm to grow substantially.

4.9. Testing the model: summary of distinctions among levels

The key separators between adjoining levels of connectivity were technology improve-ments for the transitions from the first two levels, transmission of new or more complexinformation for the shift from level 3 to level 4, and adoption of new policies and newprocesses for the step to the 5th level of connectivity. The transition to the sixth levelof connectivity comes when the scope of the interdependence relationship shifts from afocus on one or two processes to a focus on each company individually recognizing theimportance of their role in the relationship as a means to improve operations for bothfirms in multiple areas. Buoyed by their success in a narrow arena, both firms strengthentheir relationships through investments in time, effort, and capital across all areas ofinteraction.


Our theoretical framework, inspired by case studies and survey research, gives riseto several empirically testable assumptions. Only collection of further firm-level datacan determine whether this model possesses the internal structural coherence requiredto generate accurate predictions of future behavior. These hypotheses, deliberately setforth in terms of provocative alternative hypotheses which might be invoked to reject amaintained null, are as follows:

(1) Coordination costs substitute for production costs as levels of connectivity increase;

(2) When connectivity reaches level 6, omitting the opportunity cost of top managementtime will causes apparent coordination costs to actually decrease;

(3) Transactions risks reach a maximum before connectivity does (i.e., before level 7);

(4) Management attention limits the number of sustainable level 7 partnerships;

(5) Firms which progress to level 4 are unlikely to stay, moving quickly on to level 5;

(6) Many firms will be left in levels 2 and 3, never progressing further;

(7) Although moving from level 1 to level 2 yields substantial production cost savings,moving from level 2 to level 3 does not [15,55,66].

(8) As a result of (5), (6) and (4), firms should be observed to cluster in levels 2–3, 5and 6; no single dominant design will emerge, even when technology is availableand cheap.

(9) Information sharing in the absence of cooperative ventures is of sharply limitedvalue; cooperative ventures require management coordinative resources in additionto IT; therefore, sharing information alone is of sharply limited value – a generaliza-tion of Clark [19] and Brousseau [11].

We hope that the formulation of these specific hypotheses, some of which maybe refuted upon further study, stimulates interest in empirical studies about the intra-industry distribution of connectivity relationships.

5. Conclusions and managerial implications

While the rewards for successfully achieving higher levels of organizational connectivitycan be significant, these rewards cannot be achieved without increased risk and interde-pendence. Policy decisions can be avoided or delayed at the early stages of connectivity,but higher levels of interorganizational coordination required significant levels of trustand mutually agreed upon standards or terms of agreement to be established before thetop two or three levels of the connectivity hierarchy can be realized. Establishing thistrust can be difficult to achieve when there is a dramatic imbalance of power in the rela-tionship, but it is possible to achieve when binding commitments to the relationship arevoluntarily made by the firm in a stronger bargaining position. This outcome also re-quires a clear recognition of the potential benefits of cooperation by senior managementof both firms.


In spite of power differences and intense price/margin negotiations between firmswithin the grocery channel that make the evolution of cooperation possible, cooperationcan evolve in the repeated multi-player environment where the benefits of cooperationare substantial but the risks of “defection” in negotiations are significant [2]. However,the demands on managerial time and attention for investing in and forming such relation-ships is significant, and create a natural limit to the number of such alliances that can besimultaneously sustained by any specific company in the industry. This provides lead-ing companies that are actively working with channel partners to create these high levelconnectivity relationships with an effective barrier to entry for firms seeking to developthese high-level channel relationships later. Thus, the benefits from investing in channelrelationships and coordination may prove to be more sustainable than many investmentsthat firm make in technology or process innovations.

Even so, there does appear to be an interesting plateau effect in total costs declin-ing rapidly for the early increases in connectivity, but then declining only slightly asfirms adoption the 3rd and 4th levels of channel integration. As firms shift into the5th level of connectivity, costs again begin declining more rapidly, as technology andprocess changes are linked tightly to change policies and process between firms requir-ing a increasing level of trust and focus on total channel benefits. As firms shift intothe two highest levels of connectivity and integration, trust and management integrationbecomes the driver of change and the potential benefits from the integrated relationshipsbecome at least as large as the savings realized from the early advances in interconnec-tivity.

6. Opportunities for extending research

This research model is based on a limited number of case studies and survey interviewswithin a single industry, so is unlikely to be generalizable across all industries or con-texts. Nowhere in the formulation of the model, however, did we invoke the idea that thegood being transferred in the channel was edible (or had any other particular characteris-tic of consumer packaged goods). These results (and the hierarchical connectivity modelof IT mediated by coordinated relationships) thus ought to generalize to other sorts ofgeneral merchandise shipped in case quantities, sold through many distributed retailers,branded by relatively few manufacturers holding substantial bargaining power. Manyindustries, including low-end apparel, hardware, hospital supply, computers and elec-tronic components, auto parts, office supplies, books and music distribution, and massmerchandising of miscellaneous items face similar issues of maintaining inventories ofmyriad SKUs from scores of suppliers.

Only leading wholesalers and manufacturers were included in this study, and abroad industry survey of these groups would afford a broader perspective on the rela-tionships in the industry. However, this model applies to several contexts within the gro-cery channel, including retailer to manufacturer, retailer to wholesaler, and wholesalerto manufacturer. The model might also be extended to include relationships betweenretailers and “store door delivery” vendors. This research focused on U.S. firms, and


may have limited applicability to non-US contexts where antitrust regulations restrictingprocurement practices in vertical supply chains are less restrictive.

This model could be validated through a larger empirical study focusing on classi-fying relationships across the channel and exploring the distribution of levels. Our ninehypotheses ought to be particularly useful in framing such a study’s structure. A cross-industry study would also be useful to explore what drives the distribution within anindustry, e.g., industry characteristics of concentration, competitiveness, profitability,etc. A later study could also combine data on organizational performance measures withsurvey data on level of coordination to examine statistically the relationship betweenincreased coordination and improved channel or firm performance. We hope that ourmodel of increasing levels of supply-chain connectivity, and its associated set of testablehypotheses, contributes to understanding of the relationship between information tech-nology and management practice.

Acknowledgements

The comment of one anonymous referee is appreciated. We would also like to thank theUniform Code Council and the Harvard Business School Division of Research for theirgenerous support of this research.

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