Value Chain Glossary: Governance
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Governance
Refers to the dynamic relationships among firms in a value chain and their ability to determine, control and/or coordinate the terms and conditions of transactions.
The connections between industry activities within a chain can be described along a continuum extending from market-governed value chains, characterized by arm's length relationships, to hierarchical value chains characterized by direct ownership of the production process. In market-governed value chains, each level of players along the chain acts independently from the next. Farmers sell to the highest paying wholesaler. Wholesalers set competitive prices to sell to retailers. These market relationships are governed by price alone. At the other end of the continuum, hierarchical governance structures take the form of fully integrated systems such as a company that produces and retails a product under one structure. All market activities from production to sale are governed and owned by a single entity.
Between these two extremes are three network forms of inter-firm governance: modular, relational and captive. Network-style governance represents a situation in which the lead firms exercises power through coordination of production vis-à-vis suppliers (to varying degrees), without any direct ownership of the firm. All five value chain governance structures are illustrated and described below.
Governance Structure Continuum
Market: Information on product specifications is easily transmitted, and suppliers can make products with minimal input from buyers. These arms-length exchanges require little or no formal cooperation between actors and the cost of switching to new partners is low for both producers and buyers. Price alone determines transactions.
An example of a purely market governance structure is when intermediaries price tomatoes at various national wet markets and purchase from the lowest price wholesaler.
Modular: Occurs when complex transactions are relatively easy to codify. Suppliers in modular chains make products to customer’s specifications and take full responsibility for process technology associated with production. Though costs associated with switching to other suppliers are low, linkages are more substantial than in simple markets because of the high volume of information flowing between producers and buyers.
The retail-apparel industry is highly modular by nature. Raw materials, base production and labor typically account for 75% of total costs. To manage cost concentrations at the base of the value chain, apparel retailers span the globe to source manufacturing from "lowest cost-highest value" producers. Communication and information flows between the buyers and suppliers is well-codified through patterns and clear specifications. While the raw material (e.g. dye, material) is typically provided by the buyer, cut and sew production houses bare the responsibility for on-time delivery that meets exact buyer requirements. [1]
Relational: Occurs when buyers and sellers rely on exchange of complex information that is not easily transmitted or learned. This results in frequent interaction and knowledge sharing between parties. Such linkages require trust and generate mutual reliance, which are regulated through reputation, social and spatial proximity, family and ethnic ties, and the like. Despite mutual dependence, lead firms still specify what is needed, and thus have the ability to exert some level of control over suppliers. Producers in relational chains are more likely to supply differentiated products based on quality, geographic origin or other unique characteristics. Relational linkages take time to build, so the costs and difficulties required to switch to a new partner tend to be high.
Despite cultural differences between Asian cultures, managerial norms that foster group and family loyalty, personal relationships and deference to hierarchical structures, are common throughout the region. These similar values can be said to contribute to an unspoken understanding between firms in the region. Honda and Toyota, two Japanese manufacturers, invest a great deal of time and money to establish deep and lasting, reliable relationships with their suppliers.
Captive: Small suppliers are dependent on one or a few buyers that often wield a great deal of power through thorough monitoring and control by the lead firm. The power asymmetry in captive networks forces suppliers to link to their buyer under conditions set by, and often specific to, that particular buyer, leading to thick ties and high switching costs for both parties. Since the core competence of the lead firms tends to be in areas outside of production, helping their suppliers upgrade their production capabilities benefits the lead firm by increasing the efficiency of its supply chain. Ethical leadership ensures suppliers receive fair treatment and an equitable share of the market price.
Hortifruti, a produce wholesaler dedicated to supplying produce to supermarket chains throughout Central America, sources from a set of captive preferred suppliers through contractual relationships. Hortifruti chooses to source from preferred suppliers because the firm can manage calanderization schemes with suppliers to get a more even seasonal flow of production, thus avoiding the dearth-glut cycle faced be traditional local spot markets. Hortifruti also provides price incentives and technical assistance as embedded services to maintain quality control and ensure on-time delivery. [2]
Hierarchical: Describes chains characterized by vertical integration and managerial control within lead firms that develop and manufacture products in-house. This usually occurs when product specifications cannot be codified, products are complex, or highly competent suppliers cannot be found. While less common than in the past, this sort of vertical integration is still an important feature of the global economy.
Zara, the Spanish clothing company, has adopted a fully integrated hierarchical governance structure. Zara's leadership attributes the firm's structure to its competitive advantage in the industry. Because its formula for success is based on providing customers with up-to-the-minute fashion at low cost, its supply chain architecture enables retail stores to provide feedback to company headquarters through its IT system, so that its designers quickly identify the most popular styles and designs. Moreover, unlike other clothing companies that outsource manufacturing, Zara owns the entire supply chain, from manufacturing through distribution to retail.
Using this strategy, Zara is able to simplify its supply chain and differentiate its products through stylish design and low price. In this way, Zara has been able to reduce time to market for new styles to three to four weeks, significantly faster than the competition. By simplifying business processes and completing on price and fashion, Zara is enjoying higher profits than the competition during the last decade, indeed a sustainable competitive advantage.[3]
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Footnotes
- ↑ [1] The Global Apparel Value Chain: What Prospects for Upgrading. United Nations Industrial Development Organization. Gereffi, Gary; Memedovic, Olga. 2003.
- ↑ [2] Upgrading, Changing Competitive Pressures and Diverse Practices in the East European Apparel Industry. Pickles, John; Smith, Adrian; Bucek, Milan; Roukova, Poli; Begg, Robert. April 2006.
- ↑ [3] microREPORT: Hortifruti in Central America: A Case Study About the Influence of Supermarkets on the Development and Evolution of Creditworthiness Among Small and Medium Agricultural Producers. Gonzalez-Vega, Claudio; Chalmers, Geoffrey; Quiros, Rodolfo; Rodriguez-Mega, Jorge. April 2006.
