Originally published - March 12, 2008
If anything is certain in today’s global supply chains, it is the constant change and volatility that does not let anyone relax—not even for a moment. This unsettling pattern is the result of the globalization trend and its related evolution of supply chains.
Enterprises can choose one of two types of integration in the supply chain management (SCM) constellation: vertical or lateral (horizontal) integration. APICS Dictionary (11th edition) defines vertical integration as
the degree to which a firm has decided to directly produce multiple value-adding stages from raw material to the sale of the end product to the ultimate consumer. The more steps in the sequence, the greater the vertical integration, and a manufacturer that decides to begin producing parts, components, and materials that it normally purchases is said to be backward integrated. Likewise, a manufacturer that decides to take over distribution and perhaps sale to the ultimate consumer is said to be forward integrated.
In other words, vertical integration, or vertical SCM, refers to the practice of bringing the supply chain inside the four walls of one organization. Traditional vertical integration, or the ownership of most (if not all) parts of a supply chain, is the method of SCM that long preceded the relatively recently coined term "supply chain." By bringing most of the supply chain activities in house and putting them under corporate management, vertical integration has basically solved the problem of who should design, plan, execute, monitor, and control supply chain activities.
One often-cited example of vertical integration, as described in the APICS Certified Supply Chain Professional (CSCP) Learning System; Module One—Supply Chain Fundamentals (2007), is the automobile company built by Henry Ford, which often receives credit as being especially successful using this approach. In the early days of the automotive industry, Henry Ford pursued a strategy of owning and controlling as many links in the automobile supply chain as possible, from rubber plantations to raw material for tires, right on through to dealerships that distributed finished cars to the public. In an attempt to create a self-sufficient enterprise, the automotive giant also owned iron ore mines, steel mills, and a fleet of ships, as well as the manufacturing plants and showrooms that built and distributed the cars bearing his name.
The primary benefit of vertical integration is control, since a department or wholly owned subsidiary with no independent presence in the marketplace cannot, for example, deal with competitors to sell its components or services at a higher price. Its operations should, theoretically, be completely visible to the parent company, as well as be synchronized with other company functions by directives from the top. The corporation’s schedules, workforce policies, locations, and amounts produced (i.e., all aspects of its business) are controlled by the overarching management.
Vertical integration may still exist nowadays as a viable way of managing a supply chain. Wireless phone companies are an example of the type of business that operates this way. They purchase the phones, stock them at retail outlets, sell them, provide coverage, and handle warranty service.
Today’s SCM Trends: Horizontal and Virtual Supply Chains
Vertical integration generally went out of vogue as corporations expanded and as global supply chains became over-extended. Indeed, lately it has become quite difficult for any complex corporation to bring together the expertise needed to excel in all elements and countless activities of the supply chain. Therefore, most modern corporations have turned to outsourcing those aspects of their business in which they believe themselves to be least effective. Even Ford Motor Company, the pioneer of vertical integration, has been no exception to this trend. A couple of years ago, the company’s management publicly acknowledged that “the days of being 100 percent self-sufficient and capable in today's world of high technology and engineering are gone.”
Rather than bring all supply chain functions in house, large manufacturers and service providers are now more likely to adopt a horizontal, or lateral, supply chain strategy, whereby separately owned entities focus on their individual core competencies and deal with each other through discrete transactions or by longer-term contracts. The complexity and expense of managing all the activities in a global supply chain often drives top management to sell off assets not directly contributing to the core business. Ford divested itself of the production of many components in house, as did DaimlerChrysler in shedding its Mopar division, and General Motors (GM) in letting go its component supplier division.
Lateral arrangement has thus replaced vertical integration as the preferred approach to managing the many diverse activities in the supply chain. Once corporate ownership abandons the idea of vertical integration and turns to outsourcing various activities, it loses control of those aspects of the supply chain, and it has to deal with separately owned companies as suppliers or customers. Nevertheless, this has been the dominant trend in the evolution of SCM in recent decades in the Western world.
There are some compelling reasons for relying on a lateral supply chain, starting with the ability to achieve economies of scale and scope. Namely, regardless of how large and resourceful a corporation is, its internal supply chain functions lack economies of scale when compared with the potential capacity of an independent provider of the same product or service. Another reason is the ability to improve business focus and expertise, since vertical integration in a globally competitive market brings about the complexity of managing disparate business units spread across international borders, time zones, continents, and oceans. Conversely, an independent partner company that focuses entirely on its particular business can develop more expertise than an in-house department can, leading to more attractive pricing, higher quality, and quicker time to market.
Additionally, with the advent of the Internet and advanced communication technology, many of the traditional barriers to doing business at a distance and in a distributed manner have been eliminated. Near instantaneous communication means that information can be shared collaboratively through, for example, videoconferencing, instant messaging (IM), or voice over Internet protocol (VOIP), around the globe. Thus, as the world becomes one single, huge marketplace, it makes sense to deal with established companies that intimately know their local markets. Horizontal supply chains are also the logical extension of outsourcing, as they are closely related to the “virtual corporations” trend.
In the virtual corporation, the firm capabilities and systems are merged with those of the suppliers. This results in a new type of corporation, one where the boundaries between the systems of the master firm and of the suppliers disappear. Virtual manufacturing is the changed transformation process that is usually found in the virtual corporation. Because the firm’s and the suppliers’ systems are merged, the components provided by the suppliers are not related to the firm’s core competency; however, the components managed by the firm are related to core competencies. One of the many benefits of the virtual factory is that it can restructure itself quickly to respond to changing customer demands and needs. Likewise, the dynamic nature of a virtual corporation also allows for change to its relationships and structures in response to the customer’s changing needs.
Virtual Supply Chains Have Their Limitations
Although it may be easy to become infatuated with the attractiveness of lateral supply chains and virtual organizations, the unfortunate fact remains that synchronizing the activities of a network of independent firms can be extremely challenging. What each member enterprise might gain in scale, scope, and focus, it may lose in the ability to see and understand the multitier supply chain processes and their interdependencies, as well as the ability to control them.
Horizontal integration indeed brings about the complexity of the global supply network, with multiple connections around the world and information shared on networks, all connected along the chain. The outsourcing of manufacturing operations is a growing trend, and it offers numerous cost-savings and other benefits for original equipment manufacturers (OEMs) and brand owners. However, there is a trade-off, as outsourcing manufacturing operations also increases complexity because it creates virtual enterprises, where data and operations reside within the disparate systems of third parties.
Further challenging the channel masters is the increasing volatility of customer demand. This unpredictability makes it critical for the supply chain to be more agile and responsive in order for companies to be successful. Brand owners are accountable for their brand, quality, and customer satisfaction. Meeting the increasing number of compliance regulations requires them to coordinate their trading partners’ activities as well as to quickly and confidently respond to any and all changes. To do this, brand owners need multi-enterprise visibility across their supply chains, both internal and external.
The electronics industry is a good example of a business sector that has been particularly affected by the increase in outsourced manufacturing. Brand owners, OEMs, and contract manufacturers (suppliers) all face the implications of growing global competition; shorter product life cycles; intense innovation, which results in the constant launch of new products into the market (despite failure of most of these products); complexity of products’ features and distribution operations; and unpredictable demand.
These days, the electronics industry (like most industries) must operate in an evermore challenging consumer climate: product or service quality must be a given; product price often gives way to availability or special product features; and hard-to-please, well-informed consumers are a mere click away from learning about competitive offerings or from posting their dissatisfaction with a seller’s poor service at heavily visited consumer advocacy web sites.
Because of this new and demanding consumer environment, electronic and hi-tech brand owners have learned a couple of hard lessons lately: 1) a supply chain’s agility, speed, flexibility, adaptability, and innovation are imperative for success, and 2) customer loyalty is becoming more and more evasive. Customer satisfaction and confidence have to be earned repeatedly, and perfect order delivery must be confirmed through every individual transaction (see The Perfect Order—Inside-out or Outside-in?).
In other words, in the cutthroat and competitive marketplace of the electronics industry, electronics companies are realizing that the factors upon which they compete (so called “order winners”) are changing. With numerous competitive options and vast consumer resources to research and compare products, no selling company will survive with an inferior product, unjustifiably high prices, or a non-responsive supply chain (i.e., suboptimal customer service).
Furthermore, while outsourcing and lateral supply chains provide the nominal price advantages of sourcing from low-cost countries (see Understanding the True Cost of Sourcing), on the downside, they often come with longer order lead times and frequent disruptions because there are so many intermediaries between the brand owner and the contract manufacturer (such as distribution centers, inventory hubs, regional sales centers, consignment inventories at retailers, etc.).
Add to this frequent customer requests for product configuration changes (often after the initial order has already been placed) and frequent in-house engineering change requests (ECRs) due to the need for constant innovation and ever shorter product life cycles, one could only imagine the ramifications for enterprises still relying on inadequate, traditional, forecast-based planning and related push-oriented manufacturing strategies (i.e., along the “if we build it, they will come” mantra).
Electronic companies that still rely on such outdated concepts can certainly “pick their poison” (means of failure): decreased customer satisfaction (increasing customer erosion); missed revenue or earnings per share (EPS) goals, which, in turn, lead to inability to win new bids; poor key performance indicator (KPI) metrics (in terms of poor inventory turns, wrong inventory mix, excess and obsolete inventory, margin erosion, etc.), and so on.
The electronics industry today is made up of the type of virtual enterprises mentioned earlier, where brand owners, contract manufacturers, and lower-tier suppliers are interconnected partners in a coordinated operation. In such an environment, one member's actions will affect many other members, and as such, major decisions cannot be made in isolation. In fact, decisions require consultation and input from all those that can influence or be influenced by them. Thus, the market drivers discussed above have made the supply chain an increasingly influential part of a company's success or failure, but they have not made the supply chain manager’s job any easier.
Internet-based technological advances have not necessarily changed the “old” mind-sets and practices of relying on traditional supply chain applications, which have major visibility and information gaps. Namely, while “the best laid plans of mice and men” can be made, typically, as the saying goes, they “often go astray,” meaning everything unravels when “the rubber meets the road” (when those plans are executed). Only those manufacturing, distribution, and supply chain environments that are extremely fortunate might experience only minor or manageable changes occurring between the planning and execution stages. Unfortunately for most companies, such changes are hardly ever minor. Rather, they are endless variances between planning and forecasting (the “ideal world” of ivory towers) and fulfillment (which takes place in the treacherous “real world” of the manufacturing and distribution trenches).
For all the investment made in sophisticated demand management tools, almost proverbially, the only sure thing about a forecast is that it will be, by and large, wrong. Forecasts routinely miss actual demand (in fact, they are rarely better than 70 percent accurate, according to some findings within industries with volatile demand, such as consumer electronics). This can result in disastrous inventory pileups, missed financial targets, and supply chain conflicts among brand owners and their supplier networks. Overly optimistic forecasts can lead companies to lose touch with actual demand signals, and leave billions of dollars in excess inventory in the pipeline. The example of Cisco Systems’ multibillion-dollar write-off of obsolete inventory in the early 2000s still speaks volumes in this regard.
Conversely, a lesser-known fact is Apple's overly pessimistic forecast of the initial iPod sales a few years back. Although some might think that discovering that the actual demand for your product far exceeds your forecasted demand is a good problem to have, it was only because of Apple’s lean and flexible supply chain structure that the runaway success of iPod has not turned into an embarrassing disaster.
Thus, since alignment of demand and supply is an increasingly difficult challenge in the unpredictable electronics environment, companies should not spend a great deal of time and resources trying to predict customer demand. That is to say that planning has become less effective. A much more important capability for organizations now is to be able to rapidly and astutely respond to what is happening at the moment.
This is part one of the five-part series Who Could Object to Faster, More Responsive Supply Chains? Part two takes a closer look at the software systems manufacturers currently use to manage their complex supply chains.