Manufacturing and complex distribution

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is contractually committed to, but business still is not viable, there are only two options. To avoid closure of the distribution business, which will restrict the manufacturer’s sale, the manufacturer can integrate forward. Alternatively, the distributors can engage in additional value-adding activities outside the terms of the contract, which potentially can create conflicts when prioritizing efforts and attenuate new incentive conflicts. Managing these important value-adding activities across both manufacturing and distribution is a model of cooperation, we will discuss next.

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unknown to the manufacturer become mandatory to increase product attractiveness and competitiveness in the final product market. Value-adding intangible investments can take many different forms, like personal customer relations (Lightfoot, Baines and Smart, 2013) and an entrepreneurial mindset (Woodruff, 2002) that characterize these so-called multi-tasking environments (Holmström and Milgrom, 1991, 1994) where many activities are integrated at the distributors’ discretion. This is often the case with durable products that require additional services during its life-cycle or services that prompt recurring purchases (e.g., Baines et al., 2007; Brickley and Dark, 1987; Brown and Neu, 2005; Oliva and Kallenberg, 2003). These value-adding activities can extend the manufacturer’s product in parallel with other products including features downstream entrepreneurs finds valuable (Thompson, 1967).

The multiple locations of specific knowledge, capabilities and resources will change the interdependencies between manufacturing and downstream distribution. Even though coordination, distribution of power, and authority might not be evenly distributed as with simple selling and clear market break-even points, activities are now more reciprocal; this is because of the mutual dependence on specific investments, capabilities, and incentives (Thompson, 1967).

Hence, the manufacturer and the distributors are required to resolve the entrepreneurial challenge by coordinating independent value-adding activities through a form of relational governance (Gereffi et al. 2005). This also means that responsibility for the use of specific knowledge and resources located with distribution is critical to ensure the instrumental and economic efficiencies (Thompson, 1967). If the distributors do not ensure inclusion of up-to-date specific knowledge and resources, the value-adding of market-related activities will eventually decrease. This will then turn the relationship into a simple- or directional distribution setting. Therefore, incentive structures must be in place to ensure distributor investments and engagement of specific knowledge and resources (Holmström and Tirole, 1991)

Complex distribution creates contractual challenges to align the interests between manufacturing and distribution. Specifying tangible investments pose less of a challenge for the manufacturer. However, maintaining aggregated competitiveness of a long-linked, mediating and intensive technology (Thompson, 1967) is challenged by the potentially conflicting interdependencies between manufacturing and distribution. Developing contracts for use of intangible resources like entrepreneurial effort, specific, investments, and deployment of unique downstream resources to satisfy the demand of final buyers is increasingly difficult. This

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ultimately leaves contracts incomplete with certain elements non-contractible, thus posing several challenges to incentivize distribution (Grossman and Hart, 1986; Hart and Moore, 1990).

Therefore this creates an incentive problem between the distributors’ effort, investments, and use of tacit knowledge and the related output effects that are difficult to observe and evaluate objectively. The increasing plasticity of idiosyncratic resources (Alchian and Woodward, 1988) will also expose the manufacturer to potential moral hazard costs. Hence, the manufacturer needs to incentivize the distributors using contracts where distribution is the residual claimant of profits (Lafontaine and Raynaud, 2000). These incentives are rooted in assets ownership and entrepreneurial effort as the driver of investment for future returns (Brickley and Dark, 1987;

Grossman and Hart, 1986; Holmström and Tirole, 1991; Woodruff, 2002).

If the business model is no longer able to generate the necessary rents this can lead to a dilution of the manufacturer’s authority and ability to prioritize the distributors’ investments and efforts. The manufacturer is no longer able to exercise the same specific contractual control over all investments and activities pursued by downstream partners. With both the manufacturer and distributors’ being residual claimants from their own actions, there are potential conflicts of interests in the prioritization of multiple activities (Simon, 1951; Williamson, 1975). It is the pressure to serve respective equity interests that is the source of possible conflicts and incentive misalignments (e.g., Holmström and Milgrom, 1991, 1994; Shepard, 1993; Slade, 1996). With the reduced authority of the manufacturer, the downstream distributors might undertake actions that are in their own interest, but not the manufacturer’s. This might derive from the opportunism to break contractual terms, but also from changing conditions with opportunities and threats that request the use of specific downstream information, resources, and capabilities.

The determinants of the three distribution types of directional, complex, and simple selling are summarized in Table 2 below and outline different settings for the downstream governance of long-linked value-chain technologies.

80 Distribution types

Directional distribution (Captive supply)

Complex distribution

(Relational supply)

Simple selling - Spot market

transaction Determinants of distribution type

Complexity of distribution (final product market complexity -

value chain interdependencies) High High Low

Manufacturer's competences and capability to codify the complexity of transactions, engaging own resources and capabilities

High Low High

Distribution's idiosyncrasy of transactions, resources,

capabilities, and knowledge Low High High

Distribution's engagement in its own entrepreneurial

challenge Low Medium High

Manufacturer's responsibility towards distribution's

competitiveness in final product markets High Medium Low

Manufacturer's degree of coordination authority High Medium Low

Manufacturer's exposure to incentive misalignment from

sequential monopolies. (e.g., double marginalization) High Medium Low Manufacturer's ability to monitor distribution's costs related

to moral hazard Medium Low High

Manufacturer's exposure to distribution's moral hazard Medium High Low

Contract type and incentive methodology Self-enforcing Residual

claimant Markets

Table 2. Three characteristic typologies of the forward integrated value chain

The directional and complex distribution contexts of forward integrated supply chains display important value-creating differences along the value chain (Figure 1) as distributors interact with final users in the market for finished products (market 3). The liaison between manufacturing and forward distribution partners introduce interdependence complexities linked to mutually dependent transactions. This is where the codifiability of market information, specificity of competences, and incentives to promote effort are very different. If the

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manufacturer, in a directional distribution setting, requires high investment in tangible assets (the Y axis) and they contribute to the product value but only little to procedural activities (the X axis), the slope will be steep but the length of activities short. Hence, complex distribution will typically cross a steeper slope from the use of non-codified entrepreneurial activities and use of idiosyncratic resources, but possibly also a longer stretch of activities before the product is sold.

The flatter the slope, i.e., the lower the value creation, and the shorter the stretch, i.e., the fewer activities to integrate, the less problematic the governance challenges. The steeper the slope, particularly if the value creation derives from distributed idiosyncratic plastic resources, and the longer the stretch of activities, the higher is the difference in the resources and capabilities contributed by two sequential firms.