The Leaders' Edge: Driven by Demand

By Kevin O'Marah -- 5/1/2005

Supply chain leadership drives business value; there's little debate about that proposition. But what exactly is business value in the 21st century? AMR Research argues that it's more than operational cost efficiency. We believe that value today is derived from new metrics that consider not just operational cost efficiencies but also innovation. Going forward, supply chain leadership and the business value it delivers will be found in a new model that incorporates excellence in both operations and innovations while leveraging the right information technology (IT) tools. We call this new model the demand-driven supply network (DDSN). In this article, we'll define the demand-driven supply network and explain its core components. We'll also explain the key metrics involved as well as the central role that the right technology plays in creating a demand-driven approach. The relationship between excellence in the DDSN and market value also is explored. Finally, the article presents a list of those industry leaders that are realizing value from the supply chain—the AMR Research Supply Chain Top 25. Driven by Demand AMR Research defines the demand-driven supply network as a system of technologies and processes that senses and reacts to real-time demand across a network of customers, suppliers, and employees. Reflecting on this definition, it's clear that the DDSN model differs from the supply chain model that has ruled most industries for decades. In large part, that may explain why so many companies have difficulty fully embracing the new approach. What's the difference between the new and old models? First and foremost, the 20th century was all about the factory. What marvelous advances were possible through the application of mass-production techniques! In the 1920s and 1930s, Henry Ford's fabled River Rouge auto plant was a legend of production efficiency —rubber, glass, and iron went in one end, and cars came out the other. Plus, you could get any color you wanted..."as long as it's black." The biggest oversight of this type of factory-centered supply chain was the management of consumer demand. Specifically, end-user demand was only casually considered and hardly ever managed aggressively. The lingering effects of this oversight are reflected in certain deficiencies that exist to this day—all of which suggest that the supply chain still largely serves the factory and not the consumer. Among those deficiencies are: The bullwhip effect—Disruptions downstream ripple back ever more loudly, creating tremendous demand uncertainty. The result: About $3-trillion worth of inventory is locked in U.S. and European supply chains as of June 2005. Failure to account for variability—Variability may not be a serious problem in a factory with known task cycle times, but it can have a devastating impact across a network of flexible-production facilities. Variability—which is exacerbated by the use of linear optimization techniques—today accounts for a 20-percent order-error rate across U.S. industry. No support for product innovation—The "black box" approach to research and development assumes that new products go through the same chain as existing ones. This assumption creates slow, wasteful, and error-prone product launches, which result in a 75-percent new-product-failure rate globally. Here are some additional metrics from AMR Research's Benchmark Analytix Service that underscore the lingering effects of the traditional factory-based, push orientation. Median time to market for a new product in the consumer packaged goods industry: 27.5 months. Median days of supply on hand for semiconductor manufacturers: 190 days. Median order-error rate for industrial electronic equipment suppliers: 26 percent. Demand-Driven Networks Are Different Demand-driven supply networks replace the factory-driven, push model of the 20th century with a customer-centric, pull model. This model embeds product innovation in the supply network, proactively manages demand, and utilizes stochastic optimization methods to deal with variability. It's a circular, self-renewing approach that never takes its eye off end-user demand. The result is a nimbler business that takes advantage of intellectual property and more quickly seizes fleeting business opportunities. (Exhibit 1 depicts the key differences between the two models.) One big difference between a DDSN and a traditional push supply chain are the metrics used. Traditional supply chain metrics include things like plant utilization, labor costs, and freight-handling costs. The metrics that matter most in a demand-driven approach, however, are a handful of overarching process measurements. These measurements cut across traditional functions like manufacturing, engineering, and sales and relate more closely to business value and actual demand. They span two key dimensions: operational excellence and innovation excellence. Operational Excellence: On the dimension of operational excellence, the two measures that work best are perfect order fulfillment rate (orders received at the right place, at the right time, in the right quantity, and at the right price) and total supply chain management (SCM) cost. The first metric is a strong blanket measure of customer service; the second accurately captures the cost of service. AMR Research's benchmarking of supply chain operational performance across several industry peer groups details how these metrics are defined and how best-in-class, worst-in-class, and median performers currently grade. (See "The Hierarchy of Supply Chain Metrics" by Debra Hofman of AMR Research in the September 2004 issue of Supply Chain Management Review.) Two important insights emerge from the data collected in this research. The first is that the leaders' clear operational superiority rolls up to a substantial (5 percent of revenue) overall cost advantage, proving that supply chain performance does go directly to the bottom line. The second insight is that best-in-class supply chains seem to consistently manage the trade-offs between cost and level of service by accepting slightly less than top performance on subsidiary or contributing metrics (for example, plant utilization and logistics costs) in order to maximize performance at the higher level (total supply chain costs). Innovation Excellence: Less reliable data has been gathered on the dimension of innovation excellence. The most common metric traditionally applied here is some version of time to market. In recent years, however, shorter product lifecycles have forced some industries to define this metric differently. In the high-tech and semiconductor industries, for instance, time to volume is often used. The reason: The ramping up of a reliable, high-yield manufacturing process is a more strategic consideration than getting a viable first version to market. In today's demand-driven environment, we propose time to value as a blanket measure that captures these kinds of complexities and puts time in a business context, rather than strictly in engineering or product-development terms. Time to value is defined as the total elapsed time between a new-product concept receiving its first formal development budget and the time it achieves breakeven with all development and launch spending. In addition to a metric on speed of innovation, the DDSN model calls for a metric on the success of that innovation. While measures like patents issued or new-product sales are widely used today, they are incomplete as gauges of innovation success. The ideal measure should reflect the business impact of blockbuster products as well as line extensions and should roll up failures with a full cost allocation. Further, the measure should help managers look at product-innovation efforts as a portfolio of initiatives. The metric that meets all of these requirements is overall return on new-product development and launch (NPDL). The cost allocation of NPDL is a critical consideration here. Specifically, launching a product, as opposed to simply "introducing" one, implies readiness for market rather than merely existing as some sort of prototype. A product launch means the company has allocated costs for sales training, marketing, promotions, and documentation and has populated the channel with launch inventory. The ideal numerator for return on NPDL is contribution margin by product. Operational and innovation excellence along the metrics discussed above can drive value in the business in the form of higher cash flow, profits, and price/earnings (P/E) multiples. (See Exhibit 2.) AMR Research has documented this value in our research as well in our observations of the industry leaders. IT Matters...A Lot In addition to the proper metrics, IT capabilities play a crucial role in the demand-driven supply network. To get a better sense of what that role entails, let's begin by revisiting the definition of a DDSN: A system of technologies and processes that senses and reacts to real-time demand across a network of customers, suppliers, and employees. The key information technology elements of this definition are "system" and "network": System. A DDSN needs system architecture that can scale without compromising flexibility. Such as system should comprise technology that incorporates applications and databases with business-process tools like workflow, analytics, and reporting. Network. Contract manufacturers, outsourced design and development activities, and third-party logistics providers are all part of the rapid transformation of the supply chain away from vertically integrated corporations toward core-competence based networks of businesses. For such a network to succeed, standards and communication must be pervasive and reliable. DDSN pioneers have discovered that building the required system across the network calls for sharing ever richer and fresher information about both demand (orders, forecasts and change requests) and supply (leadtimes, capacity, and compatibility). This is where IT comes into play as an enabler of the demand-driven processes. Some early successes with IT in enabling DDSN include: Electronic engineering change management pioneered by Agile Software among high-tech original equipment manufacturers (OEMs) and their contract-manufacturing partners. Component and supplier management solutions like those from i2 Technologies that drive down sourcing costs in aerospace, automotive, and high-tech industries. Price optimization analytical tools from DemandTec, ProfitLogic, and others that yield higher margins in retail sectors like grocery and fashion apparel. These implementations have often been very successful in terms of the project's return on investment, with a payback that is both measurable and dramatic. And as indicators of how IT is improving labor and asset productivity in the supply chain, they point to big operating-margin advantages for leading adopters. Taking a broader perspective and viewing the U.S. economy as one big supply chain, consider the key information flows that drive value creation in manufacturing sectors. At the most basic level, manufacturing industries start with some raw material, typically sourced from suppliers known as fixed-capital managers that build and maintain large fixed-capital facilities. Outputs from these producers flow to tiers of manufacturers ("tier n") that make and deliver the components that go into final products. At the consumer end of the chain are the demand creators. These OEMs conceive new products, line up a supply network to produce them, and sell through channels to the ultimate consumer. The fundamental business issues for each type of manufacturer are very different, and the information flows specific to each interaction are therefore very different, as suggested by the graphic in Exhibit 3. Back in 2000, we extrapolated anecdotal data from the field to estimate where IT was ready to contribute to margins and by how much. The estimates were broken down according to several broad buckets of applications including collaborative supply chain management, direct materials sourcing, product lifecycle management, and sell-side e-commerce. In the five years since that initial analysis, we have continued to drill down into these opportunity areas and have seen our original estimates validated with countless case studies and rigorous benchmarking. The estimates have also been validated at the macro-economic level by huge and persistent gains in productivity, which have driven higher corporate profits. Updating our margin-impact estimates to reflect the known gaps between best-in-class, median, and laggard performers, we find that the overall gains from full exploitation of these tools amount to hundreds of basis points. After correcting for double counting of benefits and excluding the still-unproven revenue effects of some key customer-facing applications, the overall margin impact on companies runs as high as 1,200 basis points. If this range of impacts is applied to 2003 U.S. sales across industries clustered into three broad sectors at the four-digit SIC code level (fixed-capital managers, tier-n manufacturers, and OEMs), the potential incremental profit creation adds up to hundreds of billions of dollars. Exhibit 4 shows the DDSN leaders' margin advantage and their macro-profit potential. The gains inherent in those numbers may be competitively reflected in lower prices or rolled back into the business as investment in new markets, brands, products, or capabilities. As a basis for building a business case, however, these numbers offer some idea of the real value of IT in enabling demand-driven supply chain initiatives. One key takeaway from this analysis is that measurable benefits depend heavily on IT's ability to improve the richness, freshness, and depth of information exchanged between businesses in an increasingly interconnected supply network. Gains in operations or innovation stem largely from enhancing specific supply-demand balancing points with IT applications, and very few of these applications are truly universal. For these reasons, real gains come from targeted projects that change processes, tools, and data. Looked at another way, gains do not come from systems that are merely dropped on users. Further, the credibility and sustainability of supply chain improvement efforts are far higher when the starting point is an unacceptable operating benchmark and the finish is a validation of an improvement trend in that same benchmark. If the goal is to quickly capture operating-margin benefits, then companies should first consider targeted projects. These projects often involve packaged software solutions that earn their payback as they proceed—as opposed to a platform or suite of application licenses.Who Should Lead? Within the organization, who should take the lead in defining the right metrics and using the IT tools in a targeted fashion? Put another way, who should be the champion of the demand-driven supply network? CEO sponsorship is essential to have, but it's not enough. To make the DDSN transition, the practitioners' knowledge of the product, supply, and demand domains of the business is essential. In fact, it is the continual interplay of these three domains that drives growth and renewal in the DDSN model. Executive ownership of demand-driven initiatives should fall to the leaders of these three domains of the demand-driven supply chain: Supply. Among our clients, the most common executive sponsor of demand-driven initiatives is the vice president of supply chain. This role is best suited to be accountable for such major business metrics as total supply chain costs and perfect order fulfillment rate. Purchasing, manufacturing, and logistics all need to be included in this domain to enhance chances of an initiative's success. Product. In our six-plus years of research into product lifecycle management (PLM), we have seen many different potential leaders for the product domain. These have included engineering, R&D, product development, marketing, and even supply chain itself. Product-domain leadership is so fundamental to developing a demand-driven supply network that management may need to create a position accountable for time to value and return on new-product development and launch. Toward that end, some forward-thinking companies have created a "chief innovation officer." Demand. The obvious starting point for the leader of this domain is the head of sales. But the marketing and service functions also are critical to managing demand. Appropriate business metrics to assign to this domain may include market share, total revenue growth, and gross margin. Reviewing this ownership lineup, the obvious question is, What about the CIO? The chief information officer has overall accountability for technical infrastructure supporting the DDSN. This means enforcing standards, identifying critical enablers, and setting the timing and sequence of their availability. It also means charting a path that leaves existing systems in place wherever possible. Ranking the Leaders The principles and practices of the demand-driven supply network have been outlined above. Now let's take a look at the leading practitioners of this emerging model. We have identified the AMR Research Supply Chain Top 25—companies that excel at both operations and innovation—and in so doing, lead the demand-driven evolution of their industries. (The sidebar on page 35 lists these companies along with our comments on their accomplishments.) These companies exemplify how setting and managing to goals like perfect order rate, total supply chain costs, time to value, and return on new-product development and launch makes all the difference for competitiveness and growth. These leaders also disprove the notion that information technology doesn't matter. They have redefined supply chain strategy in their businesses by utilizing the tools and new business models made possible by IT. The companies were selected based on a set of criteria that included known operational activities, publicly reported business results, and direct field research and observations by AMR Research analysts. (For more detail on the evaluation criteria and the survey, access the full report titled "The AMR Research Supply Chain Top 25 and the New Trillion-Dollar Opportunity" at www.amrresearch.com.) With this report, we hoped to shed light on which companies are set to gain ground and what is expected in the future from these leaders. Essentially, the companies in our Top-25 ranking are ones that are rising to the opportunity. They understand that cost control alone offers limited competitive value in a world where new markets and opportunities spring up faster than traditional silo-ed organizations can handle them. These leaders have started to tackle both operational and innovation excellence within a single, unified supply chain strategy. Innovative approaches like Procter & Gamble's consumer-driven supply network, to cite one example, are changing behaviors across the network—extending well beyond traditional, supply chain functions in logistics, sourcing, and manufacturing. Although these companies will concede that much remains to be done, all are on the path toward building new operating models that are designed to drive day-to-day decisions out of a fundamental understanding of demand. The principle they are following represents a dramatic reversal of industrial logic from the traditional 20th-century push model. Lessons from the Leaders What's the message behind the DDSN gospel we preach and its validation by the top supply chain practitioners? Certainly, a key one is that supply chain leadership today means more than just efficiency. Growth and the ability to create profits depend on a level of agility that is available only to those who operate with demand-driven supply networks. Getting on track starts with measuring operational and innovation performance and reporting that performance to the market. Making lasting impacts on margins requires the targeted use of IT tools to build and maintain a system that connects and supports the supply network. Such a system can only be effectively built through a campaign of projects headed by business leaders representing supply, demand, and product domains. Following leaders in this case is a wise course of action—provided you understand what these leaders are doing. The AMR Research Supply Chain Top 25 all have successfully embraced change in the form of the demand-driven model. Going forward, these are the companies worth emulating. The AMR Research Top 25 Supply Chains Company Comment 1. Dell The defining DDSN business. Growing 17% in the PC business on a $40-billion revenue base is phenomenal. 2. Nokia Historically a great innovator; supply chain best practices turn ideas into profitable business. 3. Procter & Gamble P&G's consumer-driven supply chain is the defining architecture for large consumer companies. Best practices in product innovation and supply chain effectiveness are tops. 4. IBM IBM is growing the equivalent of a $10B business every year and has overhauled its hardware supply chain and product- development processes to the tune of 70% better, faster, and cheaper. 5. Wal-Mart Everyday low prices defines the customer demand driving this and, increasingly, everyone's supply chain. 6. Toyota Lean is one of the top three best practices associated with benchmarked supply chain excellence. Toyota literally wrote the book. 7. Johnson & Johnson J&J shows consumer and life-sciences leadership delivered with embedded innovation into multiple channels. 8. Johnson Controls Little known but much admired, Johnson Controls has pioneered such principles as product platform strategies in the hyper- complex engineering challenge of the auto industry—all the while making money and growing. 9. Tesco The UK-based grocer was the first to really succeed with direct-to-consumer sales while maintaining killer inventory turns and growth. 10. PepsiCo Pepsi's consumer-centric business "senses and responds" to the pulse of demand with product innovation and lean supply chains. 11. Nissan Lean and stylish, Nissan combines much of Toyota's execution with its own, highly successful design. 12. Woolworths The supply chain operations of this Australian retailer are regarded as pioneering in the use of 21st century supply chain principles. 13. Hewlett-Packard The IT megaprovider combines some units in transition (Server Division) with others that are world class (Printer Division) and has merged the CIO and Global Supply Chain function in a single individual. 14. 3M Diversified is putting it mildly for this industrial- and consumer-products leader. Its extraordinary combination of the practical and the cutting edge has units like Industrial Services operating in a DDSN mode. 15. Glaxo-Smith-Kline Maybe the strongest big pharmaceutical player to emerge from the industry's current troubles, GSK innovates not only on discovery but also on industrialization and commercialization of new drugs. 16. POSCO The Korean steel giant has begun to garner attention for its extraordinary success in managing a hugely capital- intensive business. 17. Coca-Cola Like archrival Pepsi, Coke knows how to quickly cycle consumer needs, tastes, and trends back to the market with winning products; witness the Dasani bottled water success story. 18. Best Buy The ultimate short-lifecycle retailer, Best Buy sells cutting-edge electronics to the gadget enthusiast. By realizing the DDSN principle, the retailer has radically leaned inventories and delivered enviable in-stock positions. 19. Intel By working across the electronics value chain, Intel has managed what few could—to be massively asset intensive and yet nimble in the market. 20. Anheuser-Busch Born-on dating is no marketing ploy. It is a supply chain challenge that other brewers can't easily meet. No one has taken real-time demand responsiveness further than AB. 21. The Home Depot A pioneering category killer, The Home Depot is on the cutting edge in logistics and innovative services. 22. Lowe's Lowe's faster growth challenges nemesis The Home Depot via a consumer-friendly shopping experience. 23. L'Oreal By telling consumers they're "worth it," L'Oreal has shaped demand and delivered. 24. Canon The world's largest maker of copiers has engineered a new supply chain and rapid growth. 25. Marks & Spencer A pioneer in the use of RFID in stores, M&S manages to grow and stay lean. Author Information Kevin O'Marah is vice president of research at AMR Research Inc.