Supply Chain: The Best Defense Against Digital Giants

One of the biggest threats facing many companies today is the aggressive encroachment of “digital giants” like Amazon and Alibaba into the small-customer segment of their traditional markets. By focusing on serving smaller customers, the digital giants are rapidly seizing market share across an expansive range of product categories.

Amazon is the “poster child” for digital giant success. It has a laser-tight strategic focus: providing information-rich, arm’s-length services to small customers. The company has literally turned this strategy into a science with relentless, constant improvement. The core of Amazon’s strategy is twofold: use customer information plus algorithmic recommendations to micro-segment and capture this small-customer market; and serve that market with a supply chain that deploys scores of highly automated distribution centers linked to sets of dense, rapid-delivery routes.

In response to this disruptive trend, savvy incumbent companies are shifting their focus to defensible market segments—higher-service customers—where they have an advantage over the digital giants. They maintain that advantage by using supply chain integration and other innovative strategies to cement their premier customer relationships and turbocharge their profitability. This strategy requires supply chain managers to become adept at identifying the unique needs of their increasingly diverse customer segments and to tailor well-designed supply chain links to each of them.

In this new world, supply chain management is becoming the most important success factor as companies struggle to reposition themselves against the accelerating incursion by Amazon, Alibaba, and other digital giants. Supply chain managers will be critical to their companies’ success. They will have to not only create tailored links for each major customer segment but also command a broader role in driving their companies’ defensible market positioning and sustained profitable growth.

From mass marketer to strategic partner

The rise of the digital giants marks the turning point in the transition from the previous “Era of Mass Markets” to the current “Age of Diverse Markets.” The Mass-Market Era extended from the early 1900s to about 2000. In this period, transportation innovations like paved roads and transcontinental railroads enabled national markets to develop. Throughout this era, the key strategic imperative was to “get big” and trigger economies of scale in almost every function of a company, including production, distribution, sales, and marketing. This meant that the more product a company sold, the lower its unit cost, and the lower the unit cost, the lower the price. The lower prices, in turn, led to increased sales, creating a virtuous profit-generating cycle.

The key management imperative was to develop a winning business model and to make sure that the company’s functional departments stuck to top management’s plan, with only minimal interaction with each other. The centralized command-and-control organizations that typified most companies at the time were well-suited for this task.

To get big and remain profitable, companies largely structured their internal objectives and compensation to maximize revenues and minimize costs. Sales compensation plans told the sales reps that all revenues were desirable, and supply chain compensation told the operating managers that all out-of-line costs should be reduced. For most of this period, prices were relatively uniform (there was little real product differentiation), as was the cost to serve (products were dropped off at the customers’ receiving docks). Companies largely sold all the same products to as many customers as possible while minimizing their operating costs.

The Mass-Market Era began to shift in the mid-1980s with two important supply chain innovations: Baxter’s development of vendor-managed inventory (VMI) and Procter & Gamble’s (P&G’s) highly coordinated relationship with Walmart.

At the time, Baxter was trapped in chronic price wars with Abbott and other hospital suppliers. The company sold commodity-like products, such as intravenous (IV) solutions, to low-level pharmacy buyers, who focused primarily on price. Five-year contracts hinged on a few pennies per liter. In response, Baxter commissioned a team to try to find a way out of this no-win situation. The team scrutinized Baxter’s supply chain operations but found that they were quite efficient. Then they had an inspired thought: They wondered what happened to the product inside the hospital, after it was dropped at the dock.

The team spent several days in a major hospital, following the product from receiving to the patients’ arms. They were astonished to see that the process was very inefficient, both because the hospital did not have the scale to develop effective systems and because many steps duplicated Baxter’s activities. In response, Baxter developed a new business, now called vendor-managed inventory.

Baxter placed one of its own operations supervisors permanently in the hospital. This individual counted the product needed in the patient-care areas and clinics and transmitted this information to Baxter’s distribution center (DC). Previously, the hospital had been counting and replenishing every product daily; the Baxter team, however, analyzed the actual consumption patterns and reduced this activity by over 60%. Once the orders were picked in the DC (using automation), they were placed in totes earmarked for the individual hospital patient care and clinic locations and transported to the hospital. The on-site Baxter supervisor then put the products away in the storage areas in the hospital’s patient-care areas and clinics.

This new system produced three huge benefits: (1) the hospital’s supply chain costs dropped by over 30% as the new efficiencies took hold; (2) Baxter’s own supply chain costs plunged over 20%, as the company now controlled the hospital’s order pattern and inventory; and (3) sales shot up by over 35% in this hospital, one of the most highly penetrated (sales per bed) customers in the country.

This startling sales increase was powered by the system efficiencies and the relationships that developed between the on-site Baxter supervisor and the head nurses.

As the innovation was rolled out to other hospitals, the same opportunity arose: If the cost of a liter of IV solution was, say, $1 at the dock, the “landed cost” in the patient’s arm was about $7; of the $6 added in hospital, about $3 was addressable by Baxter’s new system. As more hospitals adopted Baxter’s system, the price wars simply disappeared.

The new system also helped the hospitals achieve their own goals for the future. Many of the hospitals wanted to open remote clinics and surgical centers, but their managements did not trust their supply chains to support those facilities. The new Baxter relationship enabled a hospital management team to open the new centers. As one hospital CEO observed, “We’re the health care experts, and Baxter is the supply chain expert.”

Baxter had not only transformed a hospital’s internal operations, it had also become a strategic partner in the hospital’s growth. In short order, Baxter’s supply chain innovation became the centerpiece of the company’s strategy.

When Baxter was rolling out this innovation, management discovered that, unlike its mass-market strategy, VMI could not be effectively deployed for all customers. There were several important problems: (1) different hospitals wanted different services; (2) some small, remote hospitals wanted highly integrated services that were not economical to provide; and (3) Baxter needed to establish a set of multi-capability teams comprising sales, marketing, and supply chain to develop and manage the relationships—and the teams’ supply chain managers were the most important members driving the sale and ensuring its lasting success.

Ultimately, Baxter needed to establish a market-mapping function to match hospitals with the relationships that they should have, not necessarily what they initially wanted. This required tight coordination between sales and supply chain managers, as the accounts’ qualification criteria included potential profit, willingness and ability to partner, and operating fit. Supply chain again found itself driving the most important customer relationships.

P&G had a similar organizational experience while developing its highly coordinated category management and streamlined logistics processes with Walmart. Ultimately, P&G sited a team of top managers from sales, supply chain, finance, and information technology (IT) at Walmart’s headquarters in Bentonville, Arkansas, to develop and manage the relationship.

Companies that are facing competition from digital giants can learn from Baxter’s and P&G’s examples. Instead of trying to compete for customers based on cost, they will have better success by focusing on market segments that value service.

New measures of profitability

As companies turn to higher-service strategies to build their presence in defensible market segments, they find that these fundamental changes require a paradigmatic change in supply chain strategy. Increasingly, supply chain managers will have to work closely with their sales and marketing counterparts to devise and manage complex services for fragmented market segments, or even for individual customers. Companies’ top-down organizations need to be replaced by decentralized sets of multi-capability teams that are agile, well-coordinated, and market-sensitive.

In this environment, broad cost-control key performance indicators (KPIs) are no longer appropriate. They must be more targeted, as higher-service strategies entail higher costs, which pay off amply in increased profits.

Today, traditional aggregate metrics like revenues and costs are no longer adequate for managers to make segment-level and customer-level decisions. In the Mass-Market Era, metrics based on averages like revenue, costs, and gross margin worked well. In the Age of Diverse Markets, by contrast, prices often vary from customer to customer and even within larger customers (reflecting the combinations of physical products and related services). The cost to serve varies greatly as well. This variation means that simply combining aggregate revenues and aggregate costs can tell you whether a company is making money, but not where it is profitable.

Instead, companies providing complex packages of products and services must use a new set of metrics, which we call “transaction-level metrics and analytics.” Because transactions (order lines) are the financial “atoms” of a company, creating an all-in profit and loss (P&L) measurement for every invoice line enables you to match every increment of revenue with the cost of producing it. This may sound daunting, but in practice, you can achieve highly accurate transaction P&Ls by directly using the company’s general ledger entries. For example, one innovative software-as-a-service (SaaS) profit solutions company can produce a full set of transaction-based metrics in two weeks or so, and keep these metrics updated monthly with the period financials.

Because every transaction has a known set of characteristics (for example, customer, product, store, day, sales associate, and so on), these characteristics can be combined to show the profitability of literally every nook and cranny of the company. Similarly, they can show the difference between the company’s best-practice profitability and any less-profitable transaction (controlling for customer and product type) and prioritize the “profit opportunities” for improving the business.

With transaction-based profit metrics, it will quickly become apparent that your customers and products fall into three broad profit segments:

• “Profit Peaks,” or high-revenue, high-profit customers, typically about 20% of the customers that generate 150% of your reported profits;
• “Profit Drains,” or high-revenue, low-profit/loss customers, typically about 30% of the customers that erode about 50% of these profits; and
• “Profit Flats,” or low-revenue, low-profit customers that produce minimal profit but consume about 50% of your company’s resources.

Profit-Segment Game Plans

Because a company’s profit segments are very different, each needs its own profit-improvement game plan—including distinctly different supply chain strategies:

Profit Peaks: Every company’s prime objective is to retain and grow this critical set of high-revenue, high-profit customers. As companies face threats from digital giants, these are the customer relationships that they should focus on defending. These customers should be primarily served by dedicated, closely coordinated, multi-capability teams that are experienced in creating innovative ways to integrate with their customers and grow their relationships. Because most of these innovations are supply chain-based, supply chain managers should lead these teams.

This structure is dramatically different from the one used for account management in the Mass-Market Era. In the past, major account relationships were the primary domain of sales representatives and purchasing managers. Once an account was secure, the sales rep would bring in a supply chain manager to coordinate the operational details of the relationship.

Today, supply chain managers should be the primary drivers of Profit Peak relationships at every stage of development. Baxter’s case example, in which supply chain coordination created 35% or more increases in account penetration (plus cost reductions), is a very common occurrence. This, of course, invites important changes in sales compensation: the most effective method is to compensate the whole team.

Profit Drains: This group of large, low-profit customers is problematic. In our experience, the problem is usually that there is an overly high cost to serve them, and not that they are being offered below-market prices. These customers often have unseen, unmanaged supply chain issues, like ordering too frequently. Fixing these problems usually is relatively easy and reduces costs for both the customers and suppliers—producing a win-win outcome.

Sometimes, the supply chain issue is more subtle, and thus more difficult to identify. For example, we recently worked with a major truckload carrier. The company had gauged its profitability based on whether it was making money on its head-hauls (its primary outbound loads), and it viewed the backhauls as simply opportunistic add-ons.

When the company looked instead at the combined movements, it saw that its most important profit lever was the lead time between when a load was booked and when it had to be picked up. If this lead time was several days, the carrier could then book a very lucrative backhaul, but if that time was short, then the carrier had to book a backhaul load on the spot market at low rates.

Companies should serve these Profit Drain customers through a different set of dedicated, multi-capability teams that are highly experienced in reducing operating costs. Again, this is most often a supply chain issue, so in most situations, supply chain managers should take the lead.

Profit Flats: These customers are small and low profit. This is Amazon’s target market (and one that is less defensible for traditional companies). The objective here is to match the cost to serve to the profit potential by using digital innovations like portals, menu-based services, and automation. This is where digital processes and deep supply chain automation pay rich dividends. The most effective way to manage this segment is to create a multi-capability team, in which supply chain managers have a central role, to develop these tools.

Drive the Boat

In the past, supply chain management was largely a supporting function. Today, supply chain management is at the core of effective companies’ success.

As company managers lose their small-customer segment to the digital giants, they must increasingly refocus their strategies on their defensible, higher-service market segments. In the battle to capture these higher-service segments, supply chain managers are essential at every stage: building innovative value-added services for their Profit Peak customers and reversing money-losing processes for their Profit Drain customers, while reducing the cost to serve their Profit Flats customers. Supply chain managers have to step up and take the lead, conceptualizing and driving their companies’ strategic success in each customer profit segment.

In order to drive your company’s strategy and profit growth, it is critical to navigate with profit as your beacon, and to transition from supply chain’s traditional role of cost containment or cost reduction. Profit metrics are key tools for enabling this transition. Through this process, supply chain management will become truly strategic, and not just tactical.

The challenge for supply chain managers today is to step up to their new essential role at the center of their companies’ strategy. The core capabilities of supply chain management are the essential success factors for the Age of Diverse Markets. Supply chain managers must now broaden their operating domain to include the new set of value-creation opportunities. They need to develop their change management skills to embrace leadership of the multi-capability teams that will forge the successful companies of the new era.

The window of opportunity to create first-mover strategic advantages is limited, and companies’ long-term success or failure depends on whether their supply chain managers can embrace their essential new role, or whether they choose to remain mired in the old paradigm of the fading mass-market era.

Their companies’ success—and their own—depends on their choice.