Fleet Operators and Retreaders

1. Explain the current setup between fleet operators and retreaders. Why is it that nether has incentive to reduce costs in the conventional selling arrangement?

In the current setup the fleet operator pays the retreader ad fixed price per retreaded tire. Retreaders would ideally want frequent retreading of tires to improve sales. On the other hand, fleet operators want to run the vehicle more miles per retreading to reduce cost incurred due to retreading. This moral hazard leads to unrealized cost savings.

1. Explain the key steps involved in designing and implementing the shared savings menu of contracts.

1. Information exchange between retreader and fleet operators on historical tire costs, # of trailers and present condition of tires. Information pertaining to external factors influencing tire condition was also shared
2. Based on historical data and industry knowledge a best case cost-per-mile was developed by McGriff. This was done to gauge the acceptance of fixed rates by fleet operators and to reassure fleet operators about future cost. Often the fixed rates estimated by the fleet operator and McGriff were close.
3. Estimate for cost reduction with/without intervention fleet operator intervention is created
4. Based on the above two data point a menu of contracts is created. The contract consists of a fixed price and profit share fraction to McGriff. Fixed price was kept close to what the fleet operators would accept. The profit share was based on subjective probabilities assigned to different scenario
5. A multi year contract was drawn with different values for fixed price over the time horizon of the contract.

1. Why did McGriff decouple volume and profit from performance measures for management? Do you agree with the statement that retreaded tires are a cost and not a profit center?

Incentives for manager were not aligned with the new contracts signed. They were based solely on volume of sales. The old incentive structure would have defeated the purpose of the new contract. The new incentive structure brings in profit as factor in performance review and rewards managers who enable clients to realize greater savings. Yes, I agree that the new contracts should be seen as cost centers. The success of the new contracts depends on how the cost savings can be shared between McGriff and fleet operators. This is a huge point of differentiation for McGriff in the market and this can justify higher fixed price charged by Mcgriff.

1. What is the difference between diversifiable risk and systematic risk? How did McGriff deal with these risks?

Diversifiable risk is specific to a company or an industry and these can be reduced through pooling or diversification. Systematic Risk is the market risk and everyone in the market faces these. E.g. Inflation. These risk cannot be pooled. McGriff pooled the diversifiable risk associated with tire cost due to variable and unexpected usage by clients. This risk will be further reduced as more client adopt the new contract. For the systematic risk McGriff added an inflation index multiplier to all clients when calculating the cost.