“Act Vertical” vs. “Go Extinct” Retailers - Part 3

Part 1 of this blog series set the historical background for supply chain management (SCM) evolution and presented the advantages and shortcomings of vertical vs. horizontal integration. The analysis then moved onto the generally embattled retail sector, where a select group of innovative retailers has found a “happy medium” approach to stay well above the fray.

Kurt Salmon Associated (KSA), the leading global management consulting firm specializing in the retail and consumer goods industries, dubbed this strategy “Act Vertical” in its seminal research study. The firm presented the highlights of the study at the National Retail Federation (NRF) Annual Convention & EXPO 2009 (also known as the Retail Big Show) in January in New York City. The accompanying slide deck can be downloaded here.

Part 2 of this blog series then outlined the five drivers for retailers to act vertical, and the three key tenets of the approach. The post explained in depth the following first two requirements for acting vertical:

  1. Effectively bring unique and compelling products and services to consumers; and

  2. Offer differentiating customer experiences through multiple, integrated channels.

This final part will focus on the need for retailers to collaborate and synchronize internally and externally with customers and suppliers, often via customized agile supply chains, as necessary.

This supply network agility and flexibility is critical to creating products based on the attributes of smaller consumer segments and “fast tracking” greater numbers of products to respond to ever-shorter selling time windows. Different products have different supply chain requirements, given that many products’ variables may combine in different ways, each variable suggesting its own type of supply chain strategy.

Different (Supply Chain) Strokes for Different Folks

In his Harvard Business Review 1997 article entitled "What Is the Right Supply Chain for Your Product?" Marshall L. Fisher distinguished two types of products that call for different supply chain strategies: functional and innovative. They differ as follows:

  • Functional products, like canned soup and blue jeans, have longer life cycles (perhaps more than two years), relatively low contribution margins, and little variety. Because demand for them is stable, they are fairly easy to forecast, with a margin of error in the 10 percent range, very few out-of-stock situations, and no end-of-season markdowns.

  • Innovative products differ from functional products in every aspect. They have unpredictable demand, relatively short life cycles (e.g., three months for seasonal clothing), and high contribution margins of 20 to 60 percent. They may have millions of variants in each category, an average stock-out rate from 10 to 40 percent, and end-of-season markdowns in the range of 10 to 25 percent of the regular price. The margin of error on forecasts for innovative products is as high as 40 to 100 percent, but the lead time to make them to order may be as low as one day and is generally no more than two weeks.

The idea that the same type of product can be either functional or innovative implies that one company might have more than one supply chain. And that's the contention of Jonathan Byrnes, a professor at MIT. Writing in the Harvard Business School's Working Knowledge 2005 article entitled “You Only Have One Supply Chain?”, Byrnes also asserts that one supply chain is not enough: two, three, or more would be preferable.

"One size fits all" supply chains may have been sufficient in the past, he believes, when that was the competitive norm, but modern IT makes it possible to have multiple, dynamic chains that can accommodate different product and information flows. Byrnes breaks apparel products into the following three categories: staples, seasonal products, and fashion. These products have very distinct design and replenishment characteristics.

Much like Fisher's functional products, staples (e.g., white underwear) have steady, year-round demand and low margins. He advises stocking them only in retail outlets in small quantities and transporting them in truckload quantities (a full truck is more cost-effective for the shipper than a partially loaded vehicle, i.e. less-than-truckload [LTL] shipping.) Fashion products are like Fisher's innovative items with unpredictable demand.

Consequently, Zara, the famous Spanish clothing manufacturer, has two supply chains, one for staples and the other for fashion clothing. To get the fastest response time, Zara uses pricey Western European suppliers for the fashion items. But for the more predictable demand items, it uses Eastern European suppliers, which have poorer response time (not a major concern here) but at much lower cost.

In addition to varying the supply chain by product type, Fisher recommends several other variables to consider, such as store type and time in the season or product cycle. Demand varies considerably over the life cycle of many products, whereby the same item might have infrequent demand at first, more stable demand in its maturity phase, and falling demand at the end of its life cycle.

With more than one supply chain, a master retailer can move its products from one chain to the other in response to changing variables, such as type of channel or life-cycle stage. Yet most retailers still move all three types of items to their stores through the same supply chain. Conversely, leading vertical retailers have multiple supply chains, based on a combination of factors such as service levels required, type of demand (e.g., basic products should never be out of stock), and display.

By having a variety of tailored supply chains, retailers that Act Vertical can actually reduce supply chain costs by streamlining the flow of goods. KSA points out one unnamed multibillion-dollar retailer that expects to boost earnings by US$40 million annually and generate more than US$100 million in cash next year by replacing one inefficient supply chain with three streamlined ones.

You Can Control Only What You Measure

Moreover, to Act Vertical, retailers must also change the way they measure supply chain performance, which should be in a holistic, balanced scorecard manner. Namely, many retailers today manage with the goal of achieving the lowest transportation and logistics costs. However, that can increase inventory levels at the store, in the truck, at the distribution center (DC), on the boat, or in the factory.

Excess inventory often then needs to be marked down, and lower margins from markdown sale items can greatly reduce profits and wipe out the cost reductions achieved in transportation. Instead, retailers that Act Vertical track their supply chain performance according to “net-realized-margin,” which takes into account the total profitability and total landed costs of getting products from the factory to the store, including their selling price.

These retailers also use different measures to track the performance of products in the stores, based on different in-stock goals and service strategies by product category. According to Module One of the APICS CSCP Learning System, the appropriate supply chain for functional products should emphasize predictability and low cost with key performance indicators (KPIs) such as the following:

  • High average utilization rate in manufacturing;

  • Minimal necessary inventory with high inventory turns;

  • Short lead times (consistent with low cost);

  • Suppliers chosen for cost and quality; and

  • Product design that strives for maximum performance and minimal cost.

Conversely, the supply chain for innovative products should emphasize market responsiveness rather than physical efficiency, with KPIs such as the following:

  • excess buffer capacity and significant safety stock (buffer stock) of parts or finished items;

  • aggressive reduction of lead times;

  • suppliers chosen for speed, flexibility, and quality (rather than cost); and

  • modular design that postpones the customer order decoupling point (CODP) decision (and differentiation) as long as possible.

The KPIs for each supply chain differ because the products’ characteristics differ too. Aggressively reducing lead times, for example, is appropriate for innovative products but would be irrelevant for functional products that can be manufactured and delivered on predictable schedules in high volumes.

On the other hand, inventory reduction makes good sense as a KPI for supply chains if the product is functional but not if it's innovative. Because profit margins are low on functional products (those markets tend to be very competitive), cost reduction in the functional supply chain is essential.

Innovative products, however, with their high margins and unpredictable demand, justify extra expense for holding costs. In addition, manufacturers of innovative products can look for other solutions to the problem of unpredictable demand, such as to aggressively reduce lead times and build products to order rather than in a made-to-stock (MTS) manner.

The same class of product, the author argues, can be either innovative or functional. For instance, coffee can be functional (e.g., for business meetings, at gas stations, or on airplanes), in which case it should be available quickly at a low price with perhaps cream and sugar as options. At an upscale coffee shop, on the other hand, patrons are willing to endure longer lead times and pay more money for their coffee, but they want variety in return. As a Starbucks addict, I can vouch for the latter case.

All of the above practices increase the likelihood of delivering the right product to the right place at the right time, and at the right cost (and price). Basically every retailer will have to act vertical over the next few years to react quickly to more-demanding consumers whose tastes are changing faster than ever.

The Seven Magic Core Competencies

So how were the abovementioned act-vertical retailers able to create and execute distinctive and compelling offerings and customer experiences, and what exactly did they do to achieve superior financial performance? First, KSA points out that they have a clear retail-brand strategy: a sharp articulation of their target customers and the kind of offering and experience they would deliver to them.

Second, these retailers have developed the following seven core capabilities that enabled them to deliver unique and compelling offerings and customer experiences:

  1. Market research that identifies emerging customer needs and product opportunities. Research that PetSmart Inc. conducted in the late 1990s opened its eyes about how critical pet services were to pet owners. Aeropostale Inc., the mall-based specialty retailer of casual apparel for young people, empowers its employees to travel extensively to see what its core young teen segment is wearing.

  2. Product design and development that balances creativity and commercial appeal. Both Coach Inc., a leading American designer and maker of luxury lifestyle handbags and accessories, and Aeropostale, make sure that the quantitative analyses don’t dominate the design creativity.

  3. Extensive consumer testing that shapes the offerings and customer experiences and reduces the risk of product innovation. For example, Coach spends US$5 million annually on such consumer research, including 70,000 in-depth interviews.

  4. Tight relationships with sourcing vendors, which enables manufacturing capacity to scale up quickly and quality to be maintained. This accelerated manufacturing cycle also allows the delay of key product decisions to accommodate consumer and fashion changes in the nick of time. In addition to Zara’s abovementioned example of two supply chains, Coach works directly with leather suppliers to ensure its handbags meet its exacting standards.

  5. Inventory management (assortment, allocation and replenishment) capabilities that can rapidly move products to places of greatest demand and maximized pricing.

  6. Design and execution of an engaging and consistent brand experience across all shopping channels stores, catalogs, and the Web. Apple organized its stores (which have the highest per square foot sales in retailing) not by technology categories but rather by how customers use them. Its about 250 stores group hardware, software, and accessories in sections such as music, movies, photos, and children.

  7. Marketing that communicates the brand promise across all channels and showcases how the retailer’s offering and experiences enhance their customers’ lifestyle.

More details and examples can be found on KSA’s website.

The Act Vertical Imperative as the Conclusion

Part 2 outlined the reasons that are driving retailers to Act Vertical, i.e., control over most decisions about the products that flow through their stores. These drivers are not abating; if anything, they are increasing.

Indeed, consumers have a fast-expanding variety of shopping choices, and Internet-based retailing continues to take a bigger slice of the pie. And in a global world, the number of product brands consumers can choose from continues to grow in categories from high-tech gadgets to apparel.

Therefore, all retailers must radically change their business models to keep once-loyal consumers from defecting. Retailers that can adopt and embrace an Act Vertical business model will increase their influence on the design, development, manufacture, and distribution of the goods they bring to market. They will be then able to put a differentiating and recognizable stamp on those products, as well as on how consumers experience them, thereby distinguishing their stores (and online storefronts) from the pack.

It is interesting to note, thought, that most retailers have put just a few Act Vertical elements in place. Only a few have created the three-part foundation (outlined in Part 2) that is essential to creating a successful act vertical business model.

But despite their rapid and profitable growth, none of the retailers that KSA has studied had mastered all seven components of acting vertical. This might present considerable opportunities both for laggard retailers that have yet to pursue an act vertical model and for retailers that are already operating this way.

Future blog posts will analyze how leading retail supply chain management (SCM) providers can help retailers with their Act Vertical forays. Till then, what are your thoughts and comments in this regard? What are your experiences in dealing with the abovementioned retailers? What particular software applications do you think can help these companies in their Act Vertical efforts?
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