A Hierarchical Model of Supply-Chain Integration

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 Interdependence
in the US Grocery Channel ∗
THEODORE H. CLARK tclark@usthk.ust.hk
ISMT Department, Hong Kong University of Science and Technology, Clearwater Bay, Kowloon,
Hong Kong
DAVID C. CROSON crosond@wharton.upenn.edu

The Wharton School of the University of Pennsylvania, 1316 Steinberg Hall-Dietrich Hall, Philadelphia,
PA 19104-6366, USA
WILLIAM T. SCHIANO wschiano@bentley.edu

Department of CIS, Bentley College, Waltham, MA O2154, USA
Abstract. This paper examines costs of and motivations for interconnectivity within the grocery supply
chain, employing evidence from multiple case studies and survey data to develop a seven-level model of
technology-enabled supply-chain connectivity and channel interdependence. This theoretical model, built
around 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 of
customers 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 “virtual
integration”. Indeed, limits on executive attention preclude this level from being achieved by more than a
small 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 suggest
that while a discernible hierarchy of levels of IT-enabled interorganizational connectivity
exists, not all relationships necessarily evolve to the highest level of “virtual integration”.
Indeed, limits on executive attention preclude this level from being achieved by more
than a small fraction of trading partners.
This paper examines existing patterns of interorganizational connectivity within
the U.S. retail grocery channel, suggesting a descriptive framework (modeled in part on
∗ A preliminary version of this research appeared in Proceedings of the Twenty-Ninth Annual Hawaii
International 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 information
sharing is illustrated using two examples of generic processes, product ordering and
payment, that span multiple levels of interconnectivity and interdependence between
different groups of customers and suppliers.
The paper is divided into five sections. This section 1 introduces the major themes
and describes the overall format of the paper. Section 2 provides a brief review of the
literature relevant to the issues addressed in this research and paper. Section 3 describes
the research design and methodology used to develop the research findings and model
presented 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 to
change 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 that
significant 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 authors
agree that reductions in frictional information transfer costs lead to overall process and
design improvements over time. Improvements in information technology and business-
to-business electronic commerce are creating opportunities for firms to dramatically
improve 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 fueled
by the opportunities created as a result of the dramatic reduction in communications
costs, particularly for computer-to-computer linkages and interorganizational connec-
tivity [44,63]. The digital connectivity applications now being implemented were all
technically feasible in 1980, but prohibitively expensive [64]. However, as IOS cost
barriers decline, organizational issues and trust become more important [41].
Organizational boundaries and relationships in the grocery industry evolved over a
period 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 always
technically feasible, the associated connectivity costs were too high relative to hierarchi-
cal modes of organization to make the networked organization practical [49]. Declining
connectivity costs have enabled networked-organization structures to become a preferred
design for many complex environments [56].
A HIERARCHICAL MODEL OF SUPPLY-CHAIN INTEGRATION 263
The economics literature on motivations for the formation of strategic alliances

and the MIS literature on the motivations for interorganizational systems have diverged
somewhat in recent years. Mody [54] defines an alliance as “a flexible organization
that 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 sustain
such alliances, we note that economic models of partnership tended to be modeled using
analytical tools of incomplete contracts, reputation, and transaction costs analyses (e.g.,
[62,68]). A bridge between these theoretical constructs and established sociological
perspectives on alliances [43] is needed. In contrast, studies of interorganizational inter-
dependence in the MIS literature have been more qualitative. In those papers which do
take an integrative view, the emphasis lies mostly in explaining multinational expansion
rather 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 the
electronic integration effect, in which adjacent channel members create “joint, interpen-
etrating processes” at their interfaces. Skagen [65] in interviews with thirty companies
found strategic and partnership benefits represented the chief gain for companies em-
ploying EDI. Brousseau [11] found EDI could only be successful if business processes
were standardized along with EDI, and “the payoff of EDI is not due to EDI itself, but
rather 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 Bensaou
and Venkatraman’s [9] study of the automotive industry, we seek to describe a set of
empirical regularities occurring in technology-enabled interorganizational relationships
in 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 as
a framework built around repeated observation of common obstacles that captures some
of 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 specific
hypotheses, testable across industries in cross-section and over time within the grocery
value-chain.
3. Research design and methodology
The research design that generated our understanding of the qualitative commonalities
integrated case research, written surveys, and telephone surveys. Case studies, including
multiple 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 as
essential for understanding the complex interactions between technology and organiza-
tions, an essential element of research in MIS [8]. In conducting exploratory research
on phenomena that are not well understood, case research is often the most useful ap-
Table 1
Summary 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)
a Among 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 tested
and validated (or refuted) using more quantitative research methodologies.
Case-based research can be especially powerful when the research design involves
multiple 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 with
a 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 of
visits to company offices, with interviews conducted with at least eight managers from
each company. Those interviewed included executives from marketing, logistics, opera-
tions, information systems, and senior general managers (i.e., President or Vice President
level) from each company. Following these initial interviews, we conducted follow-up
telephone interviews with other managers recommended by these initial contacts, espe-
cially when additional data was required to complete a case study describing each of
these companies in detail. The interview findings from each company were summarized
in case drafts, and were extensively reviewed by the senior managers involved in the
original site visits. These case drafts were then revised and released by a senior officer
of 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 the Progressive Grocer Marketing Guidebook (1994), and was part of a
broader written and phone survey of grocery retailers [19]. Of the 109 retailers surveyed,
twenty-six returned completed surveys, and nineteen executives from these firms agreed
to participate in 1-h phone interviews to supplement the written data collection. The
survey was designed with the assistance of industry experts experienced in survey design
for 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 originally
expected to fit into an OSI-style model (originally created by the International Standards
Organization in 1974, and summarized in [48]) with some differences anticipated, but
the framework that emerged was neither anticipated nor understood during the research
design. 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 maintained
hypotheses 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 of
increasing levels of information sharing and consequent integration of operations, en-
abling the construction of a theoretical hierarchy of connectivity relationships. Research
findings 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 the
costs and benefits of moving from one level of IOS connectivity to another in terms of the
move’s impact on three major areas: production costs, transactions costs, and transac-
tion risks. Given our experiences within these supply-chain participants, we generated a
conjectural framework designed to generate specifically testable hypotheses about con-
nectivity, for future empirical validation or refutation. Our assumed stylized facts for
assembling this theoretical framework were as follows:
(A) Increased intensity of organizational connectivity decreases production costs, with
the 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 many
firms or how their coordination were organized. Such a result is consistent with
the principle of decreasing marginal returns through the relaxation of a constraint
in a cost-minimization problem. We also assumed that the lack of availability
of organizationally-controlled resources fundamentally limits the set of strategies
available to firms, and when the constraint that resources used by a firm must be
owned 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 of
strategies available for both firms to pursue will expand greatly.
(B) Transactions costs will tend to increase with higher levels of interconnectivity, with
this increase due in part to the effect of substituting coordination for production in
the total cost structure of the firm. Transactions costs in this context include the
explicit costs of organizing resources as well as the frictional transactions costs and
cost required by guarding against divergent incentives of alliance partners [69,70].
We assume that the sum of production and transactions costs will thus decrease in
alliances which manage to achieve higher and higher levels of connectivity, again
representing the gain in such a problem of minimizing total costs subject to a con-
straint on feasible actions limited by organizational connectivity, from relaxing the
constraint on maximum organizational communication and cooperation. (Clearly,
the additional coordination capabilities need not be used if they are economically
counterproductive.) In this setting, however, we expect the rate of decrease of total
costs to be decreasing in levels of coordination, in keeping with decreasing marginal
returns.
(C) Transaction risks – specifically, those encountered in and limiting the extent of
information-sharing partnerships designed to bolster interfirm coordination [25,26]
of shirking, poaching, and opportunistic renegotiation will be low until firms reach
middle levels of interconnectivity, will increase significantly at middle levels of
connectivity, and then decline at the highest levels. We thus hypothesize an inverse
U-shape for the economic impacts of these risks – whether these impacts are re-
alized as insurance premia, volatility of earnings or other financial outcomes, or
implicit future costs of uninsured risks borne by the weaker partner in a position
of strategic vulnerability, resulting in a tenuous alliance position wherein terms are
constantly 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 1
base case. For each level of interconnectivity, we have focused on the ordering and
payment processes in supply chain integration, as these two processes have been the
areas 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 transfer
of information between any two firms (retailer, wholesaler, and manufacturer) in the
channel. Although unusual today, some smaller grocery retailers still place orders to
wholesalers or manufacturers using physical delivery of a paper order via U.S. mail or by
sending tomorrow’s order back on today’s delivery truck, a practice especially common
for retailers in rural areas served by wholesalers, including MDI/Alex Lee [30]. Invoices
are mailed or delivered by hand to customers, and checks are mailed to suppliers, or
payment may be collected upon delivery.
This physical delivery of information is relatively slow compared with electronic
transmission of information. However, it provides firms with the most basic means of
connecting 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 maintain
relatively 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 infrastructure
of the “production” costs for delivery of goods. For mail delivery, firms can leverage
Table 2
Cost and risk implications of increased connectivity.
Level of connectivity Incremental impact of increased connectivity for
adopted Production costs Transaction costs Transaction risks
1 (Physical paper) – Very large decrease: Minimal increase: Minimal increase:
Connectivity is estab- Economies of scale Data transmission Risks can be almost
lished between firms and specialization. leverages existing eliminated with pru-
infrastructure. dent policies.
2 (Fax/Phone) – Large decrease: Minimal increase: Minimal increase:

Electronic automation Reduced cycle-time Cost of electronic Limited risk created
creates large savings transmissions are can be effectively
over paper systems. rapidly declining. managed.
3 (EDI) – Computer Moderate decrease: Moderate increase: Minimal increase:

to computer data shar- Incremental reduction Costs were once Some 3rd party
ing in cycle-time and im- much higher, but risk, but mostly just
proved accuracy. are declining fast. process automation.
4 (New processes) – Large decrease: Moderate increase: Very large increase:

New applications Dramatic reductions Data transmission Poaching risks cre-
requiring additional in inventory and volumes increase ated by new data
data sharing manufacturing costs. dramatically. sharing between
firms.
5 (New policies) – Very large decrease: Minimal increase: Very large increase:
Operational integra- Redesign of channel Costs are similar to Addition of shirking
tion and channel processes provides level 4 connectivity, and opportunistic
BPR large cost reductions. but slightly higher. renegotiation risks.
6 (Channel optimiza- Very large decrease: Moderate decrease: Large decrease:

tion) – A cost reduc- Benefits extend from Reduced legal and Relationship
tion partnership individual processes monitoring costs becomes to valuable
to the entire firm. enable by more to risk losing so trust
trust. grows.
7 (Virtual integration) Very large decrease: Large decrease: Very large decrease:
– A joint-profit fo- Firms have single BUT scarce senior Risk is very low as
cused partnership profit optimization management time long as relationship
and shared goals. is key limiting stays at this level.
factor.
the existing shared infrastructure of the US postal service, paying only a low rental costs
for the use of this infrastructure for information transmission (e.g., a postage stamp). In
some cases, this physical-delivery-based ordering also requires simultaneous payment
for goods received upon delivery, which imposes a frictional transaction costs on both
buyer and seller [23], as the retail store needs to keep cash on hand for payment and the
deliverer must double as payment collector and cash handler. In addition, one reason
some firms may limit their connectivity to physical document interchange is that they
want to use special forms or documents that are easier to transmit physically (e.g., forms
in 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 choose
to adopt such connectivity with wholesalers and manufacturers rather than insisting on
self-sourcing. Without some minimal level of connectivity, buyers and sellers would be
unable to exchange goods and services, and all firms would have to provide complete
vertically integrated processes for providing goods to consumers. A list of items offered
with associated prices and a system of record-keeping to document what was ordered
and when, will frequently suffice to realize such fundamental gains from trade. This first
level of interconnectivity enables buyer and seller to “meet” and exchange information
on products offered and prices. Obviously, the principle of revealed preference indicates
that any firm not 100% vertically integrated has realized some value from entering into a
relationship involving change of goods and information – if there are no gains from co-
operation with other firms, the potential economic contribution of coordination is clearly
zero. The processes in level 1 represent the most simple and basic way that firms can
use for achieving interconnectivity, and this level of interconnection requires almost no
explicit 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 to
measure, and claiming full payment nonetheless), poaching (i.e., misuse of information
which 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 agreement ex post, due to a
shift 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-intensive
relative to more advanced technologies, and has largely been supplanted by some form of
technology-supported order transmission using a platform common to all channel mem-
bers. Transmitting orders using phone or fax eliminates the legal contract of the ordering
document, an omission that worried retailers and manufacturers during the early period
of adoption. The declining cost of telephone and fax ordering (both actual equipment
costs and increasing social acceptability of fax documents) and the increased speed of
information transmission (faxes travel faster than trucks) resulted in this becoming the
most popular ordering mode for the grocery industry in the early 1990s. Thus, this level
of interconnectivity might have emerged as the dominant design [52] for the industry
except that these technologies are themselves in the process of being replaced by more
direct 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 order

contract. The reduction in required formality of the ordering document is a useful con-
straint to relax, enabling new methods of communications which provide benefits to
both parties. Faxed invoices are uncommon, however, and faxed payments impossible.
Physical delivery (via mail) of invoices and checks for payment were still dominant in
the early 1990s, with each case study firm still having more than 50 relationships of this
type in the late 1990s.
The primary benefit of phone or fax orders is reduced cycle time in the ordering
process. By reducing the time for order transmission, firms can reduce inventory levels
by one day’s sales (or more). Firms can send orders to their vendors at the end of the
day for delivery the following morning, rather than sending orders in at the time of
delivery for the following day. Although this reduction in cycle time does result in large
inventory savings and lower stockouts for retailers, there is no change in the information
provided to manufacturers for production and inventory management. Thus, most of the
benefits of this faster cycle time are realized by the customer, even though the costs of
implementation are shared equally by customer and supplier firms (i.e., both need fax
machines).
Transactions costs increase at this level both due to the cost of capital equipment
and due to the incremental costs of telephone calls required to exchange information via
phone or fax. In effect, this use of fax represented one of the most basic examples of
the 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 and
further reduce inventories in higher levels of interconnectivity. Interestingly, some firms
in our study used telephone and fax as complementary technologies, using a telephone
call to verify the contents of faxed orders. The cost of errors for customers and vendors
due to incorrect interpretation of faxed information (“Is that an eight or a three?”) and
malfunctions of fax equipment (“we never got your fax!”) was often higher than the cost
of investing in parallel transmission processes. The costs of fax equipment and of people
waiting to receive calls plus the costs of the calls themselves represented a transaction
cost 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 more
than 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 would
be very expensive to send a truck to collect the order information alone, so transactions
costs for fax and phone orders is much lower than that of physical orders once the cycle
time 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 telephoned
instructions, or claim to have not received a fax. It is hard to imagine serious motivations
to do so on a regular basis, although this could be one of the reasons that large invoices
are still frequently delivered by mail (or their electronic delivery is backed up by an
official 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, standardized
electronic form transmitted over a communications network [32,67]. The adoption of
EDI ordering eliminates several manual steps in the ordering process, representing a
new stage of connectivity in the channel. The number of supply chain partners at this
level of connectivity increased from less than 10% of total relationships in 1990 to more
than 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 of
the case study sites and 80% of the executives in the telephone survey noted that EDI
usage per se did 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 proprietary
networks can be several dollars per order even today, compared to less than $1 to send
a 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 order
reliability and accuracy. One advantage occasionally cited for EDI ordering is increased
speed [32]. However, for grocery product ordering and in many other industries, placing
orders via fax or phone is just as “fast” as using EDI, with data transmitted as rapidly
as the rest of the system can handle it. Faster cycle times and concomitantly further
reduced inventory through EDI generate production-cost reductions which are modest at
best; empirical evidence from manufacturers [11,15,47] shows that EDI ordering is faster
or more efficient precisely when the data transmission process is more tightly integrated
with the order-processing information systems within the manufacturer, which enables
EDI orders to bypass some steps of the less-automated phone or fax ordering process.
These more streamlined inventory-reduction practices are characteristic of higher levels
of 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 from
level 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 higher
than phone charges; but improved accuracy does generate some costs savings (both
through eliminating rekeying and required corrections as well as avoiding erroneous de-
cisions based on incorrect information). At the most basic level, EDI transmissions obey
industry-level standards, requiring little coordination before information handshaking
can 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 our
survey found that the savings from EDI were generally sufficient to offset any additional
expenses required. However, the savings for EDI were generally clerical cost savings
rather than large production cost benefits from lower inventory or reduced cycle time,
as the inventory reduction resulting from EDI adoption without other changes in their
internal 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 claimed
that 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 existing
transactions [19]. In fact, in some ways, the move to EDI could actually reduce risks
in 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, firms
could 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 the
risk 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 paper
orders. The improved ability to verify correct orders also reduces risks of deliberate
misinterpretation, as both parties receive identical confirmations that a particular order
was 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 information
by EDI service providers represents a form of shirking which did not exist at earlier
levels. 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 will
be 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 EDI
would 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 discussions
about risks from using for-profit network service providers [7,20] deserves attention, but
fierce rivalry among relatively undifferentiated network providers limits this risk fac-
tor. On balance, industry executives tended to view the overall risks from migrating to
level 3 interconnectivity as similar to the risks of level 2 interconnectivity, with increased
risks due to third-party services but reduced risks between supply-chain partners for EDI
transactions. This perspective seems to be justified based on the relatively small change
in 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, enable
companies already using EDI for basic ordering functions to migrate to the 4th level of
connectivity, 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 to
exchange pricing changes, bill-back charges, advanced shipping notices, and other in-
formation related to invoicing and payment that, in the absence of an infrastructure that
makes these transmissions almost automatic and free, might not otherwise be shared.
At this level, the ordering or payment processes still require human intervention and are
essentially manual processes supplemented by new process and technological innova-
tions that improve channel communications and efficiency. The 4th level of connectivity
involves changing channel processes and the nature of information transmitted, but it is
interesting that few firms have developed this level of interconnectivity without moving
on to level 5 interdependency. It is clearly possibly to move beyond simply using new
technological capabilities for transmitting information faster, more cheaply, or more ac-
curately without requiring changes in policies and processes. However, there were less
than a dozen firms involved in these level 4 relationships that had not progressed onto
higher levels of connectivity. Retailers, for example, transmit warehouse inventory lev-
els (or, in a further refinement) retail point-of-sale information to suppliers, in addition
to transmitting product orders. The information on product movement, being relative
low bandwidth, costs the retailer or wholesaler little on the margin to provide, and adds
significant value for many suppliers in managing production and forecasting future order
volumes. The richer data transmission capabilities of extended EDI enable this mutu-
ally beneficial coordination, using information that has theoretically been available since
level 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 cost
savings resulting from these process innovations can be large, many firms have been able
to 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 policy
changes in restructuring channel operations, but they are willing to begin sharing more
data. 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 hand
at manufacturers can reduce uncertainty for retailers and provides opportunities for re-
tailer production costs savings via better planning and reductions in both inventory and
stockout 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 variable
costs of EDI network usage, as both more data and more types of data are transmitted
via third-party networks. Second, the decisions regarding what data should be shared
and with whom, as well as the high-level specifications of the desired capabilities of
new systems developed to take advantage of the newly-available data will require signif-
icant amounts of top management attention, as well as increased systems development
cost 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 forward
buying, inventory excesses or shortages, or diverting behavior that have traditionally
been major sources of profitability for retailers [26]. Having these activities exposed
to 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 information
about actual operational status which enables efficient management of inventories also
removes 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 transparency
of information is particularly threatening to grocery buyers and category managers, who
see their value-added as stemming from excellence in such distributive negotiation. Such
a 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 agency
problem within the firm. Individuals’ or firms’ desires to keep this information secret
may prevent mutually beneficial investment in such data-gathering technologies; the
adulterated data generated results in inefficient stocking and shipment decisions. Most
proposed supply-chain models from the operations management literature suggest that
firms should share demand data with their suppliers in order to reduce total channel
costs. 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 the
associated poaching risks.
The shift to this 4th level of connectivity represents a point of major increase in
transactions risks, which poses a substantial barrier to further progress in supply-chain
connectivity. Buyer-supplier pairs who get over the level 4 hump generally manage to
implement 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 a technology-based theory of connec-
tivity to a process-based one. Connectivity becomes limited not by the availability of IT
but by the degree to which processes can be coordinated across firms. The transition to
the 5th level of connectivity thus comes at a process-integration junction, such as when
customers 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 new
vendor-managed-inventory process is called Continuous Replenishment (CRP), with this
level 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 firms
have been activity involved in developing these level four relationships during the early
1990s, but increasing risks in reaching this connectivity level limit the rate of adoption of
these 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 industry
but also enabled dramatic improvements in channel efficiency [15,18,19]. The process
changes for each partner involved in implementing CRP are clearly different from the
purely technological tradeoffs and issues involved with migrating through earlier levels
of connectivity; at this level, mid- or senior-level managers from individual functional
areas must, for the first time, involve themselves in investment and policy decisions
dealing 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 be
paid 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, through
a new charge-back or dispute resolution process, without disrupting the day-to-day flow
of ordinary invoices. The replacement of existing processes for payment thus requires
new financial management policies, the domain of the CFO rather than the CIO. Such
payment systems no longer simply apply technological innovations aimed at improving
process efficiency or provide easier access to information within the channel, but instead
represent new ways of supporting essential business activities for both customers and
suppliers. Firms move to this level to increase predictability and control those channel
processes which benefit from predictability more tightly.
Policy shifts towards integrated operations represent a change in perspective as
firms realize that they must move from private goals of cost minimization alone for their
operations 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 their
individual 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 of
designing, producing, distributing, and selling products to consumers. Direct production
cost 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 holdings
and as logistics costs decrease with information sharing, the channel becomes more
efficient (in terms of required inventory and shipping costs) as well as more effective
in meeting consumer requirements (delivering faster product introductions and lower
stockout 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 an

increase in the volume of data transmission and increased management time required for
establishing new processes and policies between firms. However, the production costs
savings for this level are much higher than in the prior level of connectivity, and marginal
gains in production-cost savings from integration and redesign of channel processes and
policies greatly exceed the increased transactions costs.
Even though the net cost reductions from this higher level of connectivity can be
quite 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 being
exchanged; in level 5, firms are conducting joint campaigns against inventory and ineffi-
ciency and restructuring their buyer-supplier relationships, raising the issues of shirking
and opportunistic renegotiation. HEB points out, for example, that initiating CRP re-
lationships with relatively small firms frequently does not pay; small firms claim to be
committed to overall cost and inventory reduction but instead practice trade loading, ei-
ther deliberately or tacitly due to insufficient investment in management and systems
capabilities – an example of shirking. (Of course, some larger firms may be similarly
poor risks.) The complexity of CRP systems also places great demands on cooperative
development between channel participants and outside technology vendors, who may
not have the same incentives for generating required system functionality or improving
existing systems.
CRP agreements, in which the vendor agrees to replenish those items actually sold
based on the retailer’s providing accurate demand data based on actual sales, clearly
prohibit 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-out
fraud by retailers who may take advantage of manufacturers’ willingness to accept their
self-reported quantities sold at face value. By misrepresenting these quantities, they may
be able to profit through conducting arbitrage (e.g., diverting) between favorable (but
constant) CRP prices and market prices (promotions) available to other non-CRP firms,
not only appropriating extra profits but also destroying the effectiveness of regional- or
quantity-based price discrimination tactics by the manufacturer.
Extensive time-series data about retailers’ true demand for manufacturer’s products
may also allow manufacturers to renegotiate pricing agreements to extract 100% (or
more) of the gains from channel efficiency. Once investment and buffer inventory is
eliminated from the channel, retailers rely on manufacturers on a day-to-day basis to
provide a continuous flow of product, and are thus potentially vulnerable to a strategic
embargo (or the credible threat of one backing up a price increase). EDLP prices may
thus be renegotiated upwards after retailers’ inventory positions are drained. Although
such 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 does
not 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 in
these situations benefits the partner with better outside alternatives, consistent with the
analysis provided by Williamson [70] and Klein et al. [45]. One partner in an alliance
might 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 discourage
adoption of new technologies and channel processes and thus forego mutually beneficial
opportunities. Transaction risks may limit the penetration of such adoption even when
some 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 leaders
in CRP adoption) was still below 50% of total sales in 1998. Many firms, including
dedicated adopters of these new processes, recognize that transaction risks increased
dramatically with these new 5th level interconnectivity changes in channel policies, and
hold back from potentially mutually beneficial process coordination because of lack of
alignment 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 channel
members, not the availability of technology. The sixth level of connectivity expands the
cooperative relationship beyond the ordering process to operations in general, and in-
volves meetings and discussions between firms’ representatives focused specifically on
improving the existing relationship and seeking new opportunities for further eliminating
costs and otherwise improving joint operations. To accomplish these highly integrated
tasks, the organizations must first invest in aligning their mutual incentives – a change
in 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 was
required to transition to this joint optimization relationship level.
This relationship-building stage, a shift from channel members’ perceiving of the
occupants of adjacent channel levels as rivals to perceiving them as partners [28], often
begins with the policy changes that enabled connectivity to move to the previous level
of the framework. All of the case-study sites enthusiastically supported developing this
type of exploratory relationship of mutually beneficial investment opportunities with
channel partners, but only with selected channel partners. Most retailers participating
the 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 to
extend this flexibility new and unproven innovations, even when the manufacturer urged
them 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 achieve
competitive costs and operating efficiencies, but remained unwilling to trust their sup-
pliers in a collaborative relationship to seek additional sources of savings or incremental
profits. Such retailers viewed channel management purely as a distributive negotiating
process [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 moving
to level 6 and especially to level 7 expanded the negotiation process to include creative
solutions, side payments for unusual expenditures on their partners’ behalf, and annual
balancing of major investments made in the success of the relationship. Reimbursement
for unusual expenditures are frequently supported by detailed information about costs
and benefits, but the decision to make the investment (and receiving reimbursement for
costs 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 transactions
costs (even as total costs declined). The direct marginal transactions cost of moving from
level 5 to level 6, however, is generally negative. All of the necessary technology will
likely 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 transaction
may be made obsolete because of a clear understanding that partnership between the
firms 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 resolved
through internal arbitration rather than legal action, the reduction in paperwork costs can
be significant.
Oddly enough, transaction risks also decline as organizations become close enough
to make basic decisions on one another’s behalf. The substantial efficiency gains from
close cooperation will be lost if the relationship sours, and thus, are held hostage to
good behavior (i.e., refraining from shirking, poaching, or opportunistic renegotiation) –
forming a wholly rational basis for interorganizational trust. Trust in these supply-chain
alliances must be constructed not through nebulous psychological trust-building exer-
cises, or through “cheap talk” claiming total commitment while secretly maintaining
options 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 open
standards can thus harm supply-chain alliance stability. Fixed investments in flexible
IT systems are no longer necessarily included in the assets whose value is held hostage
to good alliance behavior, as they can be easily redeployed to other purposes and their
value salvaged.
A significant incremental cost is the substantial increase in commitment of top-
tier management time required to structure a partnership between two separately owned
firms. Although this resource is generally not explicitly priced, as a constrained resource
its opportunity cost must be considered. It is certainly possible that, when this valuable
asset 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 close
relationships based on mutual trust, and become willing to disclose sensitive and pro-
prietary information which, when used correctly, benefits the channel overall. At this
level 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 ownership
structures [28]. Side payments, when required, can be made on a noncontractual basis
based on imperfectly observable or subjective estimation of benefits created [4]. None of
our case study firms had been able to implement virtual integration with more than seven
supply chain partners, and most senior executives felt that it would be nearly impossible
to 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 changes
to seeking new opportunities for creating mutual improvements in their operations. In
level 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 innovations
which may have limited benefits for the investing firm if the overall impact on the joint
profits for both firms is expected to be positive. Losses or shortfalls by one partner in
such a relationship would be discussed and covered by some form of transfer of value
periodically, but detailed negotiations of value and cost sharing need not occur prior to
innovation adoption.
At this level, firms involved are willing to invest in improving the overall economic
value 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 accurately
projecting 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 prior
to implementation. Effectively capturing the benefits from these fortuitous investment
opportunities requires an umbrella agreement between the partners that require firms to
make small investments to benefit the other, with settlements of a fair sharing of value
created 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 senior
managers for the first time, and involves sharing of information traditionally considered
proprietary and very sensitive (e.g., information on costs, margins, or plans for product
introduction). The limited availability of top management attention and the time required
to develop the trust necessary to support this level of interdependence and connectivity
combine 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 3
Management implications and tradeoffs from increasing connectivity levels.
Level of connectivity Relative advantages of adoption Relative disadvantages of
of this level adoption of this level
1 (Physical paper) – Connectiv- Vertical integration is the only Limited disadvantages, espe-
ity is established between firms alternative to some form of cially since coordination costs
connectivity, and there are large are declining and the risks of
benefits of some outsourcing. linking with other firms can be
managed.
2 (Fax/Phone) – Electronic au- Time savings can reduce stock- Limited disadvantages, espe-
tomation outs, increase sales, and reduce cially as the costs of communi-
channel inventory and product cations have declined over time
manufacturing costs. and as reliability has improved.
3 (EDI) – Computer to com- Additional savings in cycle- Reliance on third-party vendors
puter data sharing time and reduction in ordering may increase, which could be
errors will generally more than a problem if some very sensi-
offset any incremental costs. tivity information needed to be
shared.
4 (New processes) – New ap- Dramatic inventory and fac- The information shared can be
plications requiring additional tory cost reductions often result used to shift balance of power
data sharing from increased sharing of infor- within an industry, so value cre-
mation between firms. ated may not be shared by all.
5 (New policies) – Operational New channel policies and In addition to power shifts,
integration and channel BPR processes enabled by sharing firms may not implement new
of additional information channel processes well, so part-
create large incremental cost ners must be carefully selected
savings. for success.
6 (Channel optimization) – Improvements in efficiency As the benefits and successes
A cost reduction partnership across the entire channel re- from integration expand, risk
lationship can provide large can decrease, but the manage-
savings for cooperating firms. ment time involved can become
significant.
7 (Virtual integration) – A joint- Profit optimization instead of Senior management time and
profit focused partnership cost minimization opens up commitment is required; these
new opportunities for value cre- relationships will require large
ation and improved effective- investments of executives’ time.
ness.
marketplace provides a natural limit to the number of level 7 relationships that any one
firm can handle. HEB, one of the grocery retailer case sites, implemented the 3rd level
of 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 4th
level of connectivity entirely because they were unwilling to supply manufacturers with
data on HEB sales and inventory levels without a commitment from the manufacturer
to 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, only
15–20 of these firms could be accurately described as level 6 relationships which sought
mutual 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 studies
indicated 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 time
and 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-line
managers in the companies (rather than top-level executives) and the investment of these
managers’ time could thus be justified by productivity improvements in the channel re-
lationship. Although HEB led retailers in CRP penetration, senior management viewed
CRP 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 channel
partnerships as essential to maintaining a market leadership position and to continued
reductions in costs and improved efficiency. HEB management furthermore viewed im-
provement of channel efficiency as a continual process that required ongoing investments
in 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 potential
competitive advantage and actively invested in developing stronger coordination link-
ages with many of its suppliers. Hannaford management also viewed CRP as a means
to develop these “Joint Optimization Relationships” (JOR) with vendors. Twelve manu-
facturers had committed to investing in JOR linkages with Hannaford by late 1994, but
only three of these JOR partners were considered strategic alliances that would fit within
the seventh level of the connectivity framework [60]. P&G and Campbell also described
differing levels of partnerships and interdependence with their customers, with no more
than ten customers meeting the characteristics of level seven alliances with either man-
ufacturer. While both manufacturers had many customers at level 3 and many retailers
at level 4, each had fewer than 40 customers at the 5th level and fewer than 25 at the
6th level of connectivity. Campbell management offered several examples of firms that
had moved to the 4th level of connectivity, sharing data on warehouse inventory levels
to prepare for or to test CRP capabilities, but who proved unwilling to make the policy
changes required to implement CRP. For these retailers, allowing the manufacturer con-
trol over determining ordering quantities and placing orders was the real barrier; sharing
the 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 of
efficiency in ordering due to the requisite increased dependence on the manufacturer.
These retailers remain stuck at level four, with little hope of advancement. Wholesalers
were particularly reluctant to make the shift to CRP processes, as the required policy
changes involved extensively renegotiating contract terms with their retailer customers
to maintain existing wholesale margins, but removed traditional profit opportunities that
had 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 customers
required these firms to move more slowly on CRP adoption to survive the transition.
These wholesalers and some retailers, for example, were working with manufacturers to
develop alternative pricing and shipment policies that would enable them to realize ben-
efits from CRP benefits without eliminating the “inside margins” that had resulted from
traditional pricing and procurement policies in the channel. Without a pre-negotiated
industry plan for distributing the gains from improved channel efficiency, wholesalers
feared that CRP process would first arbitrage the very economic inefficiencies in the
traditional ordering process that had provided the wholesaler with profits.
The barrier to increased supply-chain connectivity for wholesalers was not lack of
technology or even lack of awareness of process innovations, but the difficulty in making
the fundamental policy changes required to take advantage of these new technological
and process innovations. Even so, one wholesaler had invested extensively in developing
relationships 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 site
had pursued a strategy significantly different from that of most wholesalers in that the
company had aggressively marketed its services to large chains and large manufactur-
ers as a potential outsourcer, who could provide a more efficient way of accomplishing
distribution 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 the
wholesaler. By acting as, in effect, the in-house distribution arm of several of these
firms, this innovative wholesaler developed strategic relationships at either the sixth or
seventh level of the connectivity framework. These relationships required extensive in-
vestments of senior management time and attention, the limits on which comprised the
most serious limitations on revenue growth. Even so, investing in developing high levels
of 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 complex
information for the shift from level 3 to level 4, and adoption of new policies and new
processes for the step to the 5th level of connectivity. The transition to the sixth level
of connectivity comes when the scope of the interdependence relationship shifts from a
focus on one or two processes to a focus on each company individually recognizing the
importance of their role in the relationship as a means to improve operations for both
firms in multiple areas. Buoyed by their success in a narrow arena, both firms strengthen
their relationships through investments in time, effort, and capital across all areas of
interaction.
Our theoretical framework, inspired by case studies and survey research, gives rise
to several empirically testable assumptions. Only collection of further firm-level data
can determine whether this model possesses the internal structural coherence required
to generate accurate predictions of future behavior. These hypotheses, deliberately set
forth in terms of provocative alternative hypotheses which might be invoked to reject a
maintained 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 management
time 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, 5
and 6; no single dominant design will emerge, even when technology is available
and cheap.
(9) Information sharing in the absence of cooperative ventures is of sharply limited
value; cooperative ventures require management coordinative resources in addition
to 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 may
be 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 connectivity
can 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 trust
and mutually agreed upon standards or terms of agreement to be established before the
top two or three levels of the connectivity hierarchy can be realized. Establishing this
trust 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 are
voluntarily 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 management
of both firms.
In spite of power differences and intense price/margin negotiations between firms

within the grocery channel that make the evolution of cooperation possible, cooperation
can evolve in the repeated multi-player environment where the benefits of cooperation
are 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 be
simultaneously sustained by any specific company in the industry. This provides lead-
ing companies that are actively working with channel partners to create these high level
connectivity relationships with an effective barrier to entry for firms seeking to develop
these high-level channel relationships later. Thus, the benefits from investing in channel
relationships and coordination may prove to be more sustainable than many investments
that 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 as
firms adoption the 3rd and 4th levels of channel integration. As firms shift into the
5th level of connectivity, costs again begin declining more rapidly, as technology and
process 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 into
the two highest levels of connectivity and integration, trust and management integration
becomes the driver of change and the potential benefits from the integrated relationships
become 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 interviews
within 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 the
good being transferred in the channel was edible (or had any other particular characteris-
tic of consumer packaged goods). These results (and the hierarchical connectivity model
of IT mediated by coordinated relationships) thus ought to generalize to other sorts of
general merchandise shipped in case quantities, sold through many distributed retailers,
branded by relatively few manufacturers holding substantial bargaining power. Many
industries, including low-end apparel, hardware, hospital supply, computers and elec-
tronic components, auto parts, office supplies, books and music distribution, and mass
merchandising of miscellaneous items face similar issues of maintaining inventories of
myriad SKUs from scores of suppliers.
Only leading wholesalers and manufacturers were included in this study, and a
broad 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 wholesaler
to manufacturer. The model might also be extended to include relationships between
retailers and “store door delivery” vendors. This research focused on U.S. firms, and
may have limited applicability to non-US contexts where antitrust regulations restricting
procurement 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 nine
hypotheses 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 an
industry, e.g., industry characteristics of concentration, competitiveness, profitability,
etc. A later study could also combine data on organizational performance measures with
survey data on level of coordination to examine statistically the relationship between
increased coordination and improved channel or firm performance. We hope that our
model of increasing levels of supply-chain connectivity, and its associated set of testable
hypotheses, 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 the
Uniform Code Council and the Harvard Business School Division of Research for their
generous support of this research.
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A Hierarchical Model of Supply-Chain Integration

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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:

DAVID C. CROSON crosond@wharton.upenn.edu

WILLIAM T. SCHIANO wschiano@bentley.edu

The potential for interorganizational systems (IOS) to fundamentally redefine rela-

The economics literature on motivations for the formation of strategic alliances

3. Research design and methodology

Site Type Location 1994 sales Industry Case study reference

4. Research model and finding

Figure 1. Seven levels of organizational interconnectivity.

For our comparative analysis of relative levels of interconnectivity between firms,

4.1. Level 1: physical data transfer

2 (Fax/Phone) – Large decrease: Minimal increase: Minimal increase:

3 (EDI) – Computer Moderate decrease: Moderate increase: Minimal increase:

4 (New processes) – Large decrease: Moderate increase: Very large increase:

6 (Channel optimiza- Very large decrease: Moderate decrease: Large decrease:

4.2. Level 2: technology-supported order transmission

means of transmission to substitute for physical transportation of a paper-based order

4.3. Level 3: electronic data interchange

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

organization, it is frequently difficult or impossible to procure on the open market – and,

4.5. Level 5: new policies and integrated operations

nectivity. The increase in coordination costs relative to level 4 connectivity is due to an

by transforming a previously arms-length transaction must also be taken into account.

4.6. Level 6: joint channel optimization relationships

4.7. Level 7: virtual channel integration

4.8. Limits to supply-chain coordination

4.9. Testing the model: summary of distinctions among levels

5. Conclusions and managerial implications

In spite of power differences and intense price/margin negotiations between firms

6. Opportunities for extending research

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