Thursday, September 18, 2008

Supply Chain Strategy Trend One: "Rise of the Rest"

In the previous post, I highlighted the two emerging trends that will shape the future of the supply chains. This article follows up on the first of these two main trends that affect us. Quoting from Zakaria, I called the trend "Rise of the Rest" as it really summarizes the impact of this trend on the supply chains for the future.

Rise of the Rest is based on the premise that the world as a whole is evolving in all possible aspects: politically, financially, socially, and culturally. While all these aspects of this evolution are important the one we are most interested in evaluating is the economic aspects of this evolution. Growing economies around the world affect how the corporate supply chains will emerge and grow with it. It affects all aspects of the supply chains including sourcing, purchasing, suppliers, logistics, assortments, and selling.

As economies grow, so does the consumption. The new demand-supply equation affect the costs till the equilibrium is reached again. This change in costs and their management is one the trends that I believe will affect the supply chains directly.

The two largest components of costs for retailers are the cost of purchase, and the cost of distribution. Right now both of them are trending up, as they have done for most part of this year and the last year. While supply chains have always focused on costs, and cost savings through more efficient planning and operations has been their core value proposition -- till now, supply chain costs have been evaluated in isolation. I believe that is about to change. Pioneers will start looking at a more holistic picture of cost of "doing business" rather than focusing on specific supply chain areas such as logistics. This broader view of the costs will cause evolution of processes that go across merchandising, supply chain and sales; and would provide a common sense of cost and profitability to the corporations of tomorrow.

While these changes could be driven from various points of view, driving them from the supply chain point of view may be most logical as the discipline already provides a framework for modeling costs, networks, processes and leverages mathematical optimization.

The Rising Costs of "doing business"

We mentioned above that the two largest components of costs for Retailers are the cost of merchandise, and cost of distribution. Cost of distribution is easier to understand as it is largely related to warehousing and transportation. The rising cost of energy has kept the focus sharp and clear on this part of the cost equation. The other cost, namely the cost of merchandise is the one that is defined in very narrow terms today, and needs to be expanded and evaluated with sharper focus.

Most corporations with advanced supply chain teams focus on both of these costs through optimizing various supply chains functions such as Sourcing, Inventory Planning, Replenishment Planning, Warehousing and Transportation. The current processes, however evaluate these costs in silos and even when optimized, the models do not provide any global evaluation of these costs or any ability to compare scenarios and predict long term effect of decisions.

I believe that this the next big opportunity for cost savings. The continuing pressure on costs with a weak economy and resulting inability to pass on costs to consumers are going to drive the companies to evolve these processes further to squeeze as much cost from their eco-systems as possible. Today there is almost no visibility or understanding of the "total costs" of the merchandise and in fact, most retailers lack the information, inclination and the capacity to do this.

To provide a better context, we will borrow from the concept of "customer life-time value" (CLV). The objective of determining the life-time value of a customer is to focus on long term customer service/satisfaction for an overall higher profits from the relationship, rather than maximizing short-term sales revenues. And putting such programs actually work -- ask Harley-Davidson.

Total Life-time Cost

So what is the "total life-time costs" of a product? The question may not sound as interesting as CLV though it is a pertinent question to ask. The life-time costs of a product will include not only the cost of purchase, but cost of planning the assortment, planning the demand, sourcing and evaluating the suppliers, actual purchase costs over the whole season or life of the product, cost of distribution, cost of marketing, cost of mark-downs, cost of returns, cost of customer relationships due to gaps in the customer expectations and product functions, etc. This is what I call the "total life-time cost" picture for the merchandise and it is this picture that will be enabled by the processes of the new supply chains. It is this picture that will then become the basis for product portfolio and profitability analysis that should ideally drive the assortment decisions for the retailers in future.

Let us again go back to the "cost of distribution" for a minute. This has attracted and retained put attention not because it is the largest part of the cost ion the equation but simply because it is easier to measure and control. Most companies can track what they pay to their carriers, and how much doers of cost them to run their warehousing operations. Anything that is easily understood and measured gets our attention. Even though the "actual" costs of distribution for a specific merchandise is debatable due to crude cost-allocation practices, we at least know the total costs across the enterprise related to distribution. As far the cost allocations go, that will be the subject of another article.

Now let us look at the "cost of merchandise". Is this the cost that is paid to the suppliers against the purchase orders? What about the cost of creating and processing the purchase orders? What about the cost of planning the replenishments? What about cost of inventory planning that determines the final replenishment numbers? What about the cost comparisons among suppliers that have contracts with price-breaks going over a few seasons, and affect the total costs over the life of the product? What about the cost of signing a contract that goes bad and needs re-negotiating or legal action? What about cost fluctuations due to currency variations for merchandise bought foreign suppliers, and transported by foreign carriers? What about customer returns, mark-downs, marketing, cost of bad assortment decisions, etc, etc. There are just too many pieces to this cost that are very fuzzily defined in today's cost accounting processes, and therefore fail to provide any sense of "what does it really cost me". These processes need to be defined better and tied together in the definition of "cost of merchandise" so that a merchant can actually make decisions that are objective and based on data rather than instinct and experience.

Understanding these costs will affect almost all processes -- the way we assess the product profitability, assortments, sourcing, replenishment strategies, inventory policies and of course the logistics.

New View of the World

Another aspect of life that changes for supply chain strategist as a result of the "rise of the rest" is the procurement strategy. For almost two decades now, China has been the focus for cheap manufactured goods. Prior to that it was Japan. Cost equation simply worked that way. The depressed wages, cheaper energy prices, an abundance of labor, and almost non-existent middle class to drive local consumption -- all of these factors favored China to be the manufacturing hub of the world.

Almost all these factors have changed in recent years with consistent trends. Refer to my previous post where I have provided links establishing the facts. Wages in China have doubled, energy prices have quadrupled, commodity prices have almost doubled, and China's middle class has emerged as a substantial "consumer" in its own right.

The changes in each of these factors will cause changes in the procurement strategies. These changes will make the cost equation more equitable, and allow more regions of the world to participate in global commerce. What that means to the supply chain strategist is that the supply chains will grow to many more regions of the world, bringing in more complexity in ocean routes, port management, trade terms, compliance, foreign currency planning, cultural factors, financing and settlement. The increased complexity then will cause companies to re-evaluate the tools of the trade and invest in applications that help them address and grow with the new set of supply rules.

The Integrated View of Costs

Now imagine a hypothetical application that actually can project all the cost components mentioned above over the useful life-cycle of a product. And think how this will change the process of evaluating and launching a product. Also think about how such a process will have an integrated view of the currently siloed processes of product life-cycle management, merchandising and supply chains. You might shorten a season just a week to reduce the cost of mark-downs; you might split your purchases just so to optimize your seasonal ramp-down efforts in north-east that start a few weeks prior to ramping-down in south-east; you could just predict the total cost of merchandise procurement over the whole season because you know your projected demand at various nodes and command suppliers to use preferred warehouses for supplies; you could buy a week ahead to avoid the projected currency exchange rates that favor your supplier.....and so on.

Jog your imagination and see for yourself the possibilities of the future supply chain strategies and decide how to evolve to that next level.

©2008; Vivek Sehgal

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