Saturday, August 31, 2013

The efficiency improvement role of insurers

The organizational efficiency of retail product and service delivery chains in the US and elsewhere is truly impressive. I am referring to the remarkable ease with which large retail chains - whether selling consumer durables, or burgers, or hair cuts - run their business, many of which span across hundreds, even thousands, of locations spread over a continental geography.

A simple standard answer is that these private firms are very efficient. But I think that a more accurate explanation would be that the transactions undertaken within each location of a retail chain are embedded in a highly incentive compatible eco-system. Let me explain.

Consider McDonalds. There are many moving parts within the black-box. Each location has an elaborate mechanized kitchen and a few other equipments. It employs a few people. It receives a daily stock of cooked and uncooked food intermediates that go into making the burgers and other items. It delivers both the physical burger and associated service delivery environment, all with a remarkable, even boring, degree of standardization in both quality and appearance. 

In other words, stripped to its basics, these locations appear just like the mid-day meals kitchens in Indian public schools. Like them, here too a number of things could go wrong - a kitchen oven could stop working, the sanitary fitting in the restroom could fail, one of the employees could fail to turn up that day, one of the food intermediates could go bad, or the truck bringing the day's meat stock could get delayed early morning. But these problems appear to have been surmounted. It is too much of a stretch to believe that the management (or franchise owner) has anticipated every eventuality and planned for them.  

I think there is one important factor that may have played an important role in aligning incentives in this giant exercise at logistics and work-flow management - insurance. The conventional wisdom is that insurance cushions the buyers (of the insurance) from unexpected and one-off high expenditure incurring events. But insurance may also have an operational efficiency enhancing feature.

Insurance services force providers to clearly defining service and product standards, besides putting in place adequate redundancies and slack to cover for various exigencies. Therefore once all the transactions involving equipments, man-power supply, trucking, etc are insured, it aligns incentives among all sides to a contract.

The flip side is that it piles on layers of costs, which ultimately get reflected in the high price of many services. There is also the possibility that distortions will creep in, especially if sellers of services can pass-on the high cost of insurance to willing buyers, like with health care in the US.

In any case, it will be interesting to examine the respective contributions of these less-discussed environmental factors as against the internal management effectiveness of firms to improving their operational efficiency?

This may also partially explain why it is difficult to establish such large supply chains in countries like India. The development of a similar eco-system will be constrained by the price-sensitive nature of these markets. 

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