© CBSP, The University of Birmingham, 2005/2006.

Managing in Business to Business Markets:

Contracts, Negotiation and Conflict Resolution

Week 4 – Behavioural Foundations of Managing Supply 2: The Ethics of Purchasing and Supply

© CBSP, The University of Birmingham, 2005/2006.

• We have considered three models of self-interest orientation.

• Two of these have come under the title of trustworthy behaviour (altruism and simple self-interest seeking), the other has been termed opportunism.

• But what are the ethics of these different positions?

• Ethics are defined as a theory or system of moral values.

• In this session, we look at some key positions of business ethics and consider them in relation to the two parts of business actions: ends and means.

• In other words, what do the different schools think of self-interest seeking and what do they think about the manner in which that self-interest is sought?

Models of self-interest orientation and business ethics

© CBSP, The University of Birmingham, 2005/2006.

The ethics of purchasing and supply: what are your values?

1. Merchant banker encourages clients to buy dot-com shares on the basis that they are ‘stars’, when privately they considered them ‘dogs’ – Adverse Selection2. WPP claimed 3127 hours ($1.7m) of work ‘that wasn’t’ in its relationship with US Office of National Drug Control. Clifford Chance law firm similarly accused. CC staff were apparently pressured to act that way – Moral Hazard3. Pharma company gave out ‘free’ harmonic scalpels to clinicians in UK hospital (which meant that they escaped the hospital’s audit control system), knowing that the product needed consumables to be purchased in order for them to be used – Lock-in / By-passing customer rules4. Accenture encouraged Inland Revenue to sign a contract that (a) would lead it to be locked-in and (b) was inadequate to cope with future requirements – Lock-in5. Pharma companies hired out ghost-writers to produce biased drug trial articles and then paid clinicians to put their names to them. Then appeared in top-ranked medical journals – Aimed at leading to Adverse Selection6. Numerous UK financial institutions sold endowment mortgages and pension schemes on the basis that they were low risk, when actually they were high risk – but also yielded high commissions – Adverse Selection7. A UK public sector organisation ‘bluffed’ in a negotiation with a fabrics supplier that it had an alternative source of supply lined up that was cheaper, when in fact that was not the case – Strategic Misrepresentation8. PWC charged clients £57m of bogus expenses: charged full-rate air fares and then got kick-back from airlines – Moral Hazard9. Safeway used overwhelming market power to force meat supplier to lower prices to ‘bankruptcy levels’ 10. Lloyd’s of London ‘insiders’ created preferential ‘baby syndicates’ for themselves, whilst letting external investors insure the company for its more riskier customers – Moral Hazard11. Management consultancy undertook research and then wrote a report. It billed the healthcare provider client for the work. However, much of the claimed work was not done: it took most of the report from a previous project – Moral Hazard12. Automotive industry new entrant and partner of established automotive assembler collects intellectual property from partner during joint venture until it feels able to ‘go it alone’. Then ends JV and enters market as a rival

Exercise: Which of the following do you believe to be ethical?

© CBSP, The University of Birmingham, 2005/2006.

Deontology: Duties and Rights Consequentialism: Outcomes

The ethics of purchasing and supply: contested values / methods

Social Democratic View

• ‘Freedom as effective power …’

• Rewards should equal contribution, notwithstanding market power

• Individuals have obligations to society

• State intervention OK to achieve goals

• Business has multi-fiduciary duty

• Relatively equal societies validbecause not only just, but stable,civil and more productive

• Business cannot stand aside

• Most classes are divided on the cases on the previous slide. The (‘Western’) literature on business ethics is divided too. Essentially, what you believe to be ethical depends on your more general political perspective.

© CBSP, The University of Birmingham, 2005/2006.

Deontology: Duties and Rights Consequentialism: Outcomes

The ethics of purchasing and supply: contested values / methods

• Self-interest produces greatestprosperity – hidden hand

• Free markets create freesocieties

• ‘Freedom from interference’ (e.g. the state)

• ‘Freedom as choice’ (e.g. as a consumer)

• Right to market rewards as producer

• Business only has duty to shareholders

• Whilst conforming to ‘social norms’

Liberal Economic View

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Deontology: Duties and Rights Consequentialism: Outcomes

Legal Approach

• Liberal economic view except …

• ‘What is legal is ethical’ not ‘social norms’

• Usually associated with liberaleconomic view on hidden hand

‘Business as a Game’

• Liberal economic view except …

• Business does not need to play by thenormal rules of society as no-one expectsethical behaviour, therefore cheating is not unethical

• Usually associated with liberaleconomic view on hidden hand

The ethics of purchasing and supply: contested values / methods

© CBSP, The University of Birmingham, 2005/2006.

Self-interest Seeking (Ends)

With Guile (Means)

Social DemocraticView

Liberal EconomicView

LegalApproach

‘Business as aGame’ Approach

• These alternative ethical positions can then be applied to the concept of opportunism. In the boxes below, put ‘Yes’ or ‘No’, depending on whether the ethical position permits that type of behaviour.

The ethics of purchasing and supply: contested values - exercise

© CBSP, The University of Birmingham, 2005/2006.

The ethics of purchasing and supply

• One thing not mentioned in the consequentialist column of the first three ethical positions is the positive macro consequences of an absence of opportunism, particularly blatant opportunism.

• There is a great deal of evidence to suggest that a poorly functioning system of contract law and corruption present a drag on economic development.

• There can, therefore, in the case of the ‘business as a game’ position, be a distinction drawn between private interests and the public good, and again between the short-term and long-term.

• An individual may gain in the short-term from opportunism (free-riding’), but, if many behave the same, the ‘economy’ will most likely suffer and, potentially, that individual will in time end up losing too – depending on his or her dependence on the ‘economy’ in question.

• Even where all individuals do have a stake in an ‘economy’, there can still be collective action problems.

© CBSP, The University of Birmingham, 2005/2006.

Managing in Business to Business Markets:

Contracts, Negotiation and Conflict Resolution

Week 4 – Searching the Market: The Problemof Adverse Selection

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Classifying goods and services

• Goods and services are classified by marketers into three ‘information categories’.

• Search goods – goods and services whose quality can be satisfactorily evaluated prior to purchase. Basic physical goods come into this category.

• Experience goods – goods and services whose quality can only be evaluated after both purchase and a reasonable amount of use. For example, a haircut. Also, a car, a computer or computer software and a basic service, like a catering or cleaning service.

• Credence goods – goods and services whose quality cannot be fully evaluated even after they have been purchased and used. Examples are management consultancy services and legal services and the reason is the existence of multiple variables and an absence of a counterfactual.

© CBSP, The University of Birmingham, 2005/2006.

The adverse selection problem

• This classification is important to the problem of adverse selection – a key hazard for purchasing managers.

• This is because if a good or service is hard to evaluate, a situation exists where there is private as well as public information surrounding an exchange.

• If one party to a contract has private information at the time of contract negotiations that potentially reduces the value of the contract to the other party, we say that the situation is one of adverse selection.

• This notion was first put forward by Akerlof in his 1970 paper ‘The Market for Lemons’ – a paper eventually appreciated by the academic community.

© CBSP, The University of Birmingham, 2005/2006.

The adverse selection problem: example

• In the context of business to business relationships, adverse selection concerns the supplier selection part of the purchasing process.

• An example of adverse selection can be seen in the selection of ICL Fujitsu by the Lord Chancellor’s Department, a UK central government department, as its supplier for the ‘Libra’ IT project – a case from week 1.

• ICL Fujitsu claimed during the pre-contract negotiations that it could develop a system that would integrate all of the different agencies of the British legal system and do it for a certain price. It made these claims during its pre-contract pitch.

• It became clear after the contract had been signed that ICL Fujitsu had no such capability. Eventually, the LCD had to re-structure its supply arrangements.

© CBSP, The University of Birmingham, 2005/2006.

The adverse selection problem: example

• A further example concerns management consultancy. An NHS trust contracted with a niche consultancy for a project concerning supply chain efficiency – that is, the way in which the trust understood its demand for medical consumables and maintained appropriate stocks.

• The MD of the consultancy was highly able and put together a very good pitch as to how his organisation would undertake the project, provided projects done in the past, etc.

• However, the team that implemented the project did not include the MD. Over the previous year, he had stepped back from involvement in project delivery and had focused on sales activities.

• The team that was assigned to the trust’s project was poor and produced a poor report, offering little insight. Indeed, part of the brief was parceled off to another organisation.

© CBSP, The University of Birmingham, 2005/2006.

The adverse selection problem: potential solutions

• There are a number of classic ways of trying to manage adverse selection:

• Adverse selection can often be bad for suppliers (bad crowds out good).

- Signaling: suppliers often use signaling as a way of demonstrating quality. Certain desirable characteristics are shown to the other party.

• Adverse selection is always bad for buyers, as it affects VFM

- Screening: a re-numeration schedule based upon performance, for example.

- Warranties and Trial Periods

- Short initial contract terms- Identify service delivery team

© CBSP, The University of Birmingham, 2005/2006.

The adverse selection problem: potential solutions

- Contingent renewal: the idea that future business can affect current actions. Suppliers may not risk adverse selection in key accounts.

- Benchmarking: buyer compares supplier against other suppliers.

- Third party evaluation

- Reputation: On some occasions, the risk of losing reputation will in any case be sufficient to dissuade suppliers.

Potential Problems with Potential Buy-Side Solutions

- Benchmarking exercise may be affected by unwillingness of others to admit to mistakes.

- Contingent renewal may be affected by absence of future business. One-off transactions tend to be more beset by adverse selection.

- Principal-agent problem within supplier can affect impact of many of the mechanisms, especially contingent renewal and reputation.