Marshall Fisher prescribes a framework for assuring that supply chain
design is appropriate for a product.1 Fisher points out that supply chain
design depends on the nature of the product demand. He divides products
into functional and innovative categories. Functional products, as the name
implies, are the staples of life — toothpaste, groceries, and commodities of all kinds. Competition is fierce for these products, and margins are relatively thin.
Innovative products, on the other hand, are differentiated in the market. They have advanced technological features or styling. They carry higher margins — but demand is uncertain. Examples include this year’s latest fash- ions and automobiles with novel features. The first minivans and sport utility vehicles fit this category.
For those who aren’t certain which products fall into which category, Fisher offers a guide, shown in Table 6.1. Uncertain demand and higher profit mar- gins define innovative products. Functional products are also equivalent to categories B and D on our product position grid introduced in Chapter 5 and repeated here as Figure 6.1 for reference. The C quadrant will likely be almost exclusively innovative products. Many products in the A quadrant will also likely be innovative.
For many, the costs of the supply chain are those we typically think of as “logistics” costs. Components include the cost of inventory, packaging, ware- housing, transportation, and the associated labor. These are connected with the physical movement of goods from supplier to customer. Many consult- ants in logistics focus on reducing these costs. Distribution executives often have jobs that depend on keeping these costs within bounds. A frequently
Linking the Supply Chain with the Customer 45
encountered measure of distribution executive performance is “supply chain cost per dollar of sales.” This line of thinking, Fisher argues, is dangerous if the type of product — functional or innovative — isn’t considered.
Fisher recommends fundamentally different supply chains for functional and innovative products. For innovative products, Fisher considers what he refers to as “market mediation” costs in designing the supply chain. Market mediation costs arise from mismatches in demand and supply. These occur because forecasting demand for innovative products is especially difficult. If
there is too much product, it must be marked down. This market mediation
cost is the product of the markdown discount times the number of units
marked down. If there is too little product, the company incurs another type
of market mediation cost — that of lost sales. This cost is equal to the unit con- tribution margin multiplied by the volume of lost sales.
TABLE 6.1
Functional Versus Innovative Products: Differences in Demand
Functional (Predictable Demand)
Innovative (Unpredictable Demand) Product life cycle > 2 years 3 months to 1 year
Contribution margin 5–20% 10–60%
Product variety Low (10–20 variants per category)
High (often million of variants per category) Average margin of error in
forecast at time production is committee
10% 40–100%
Average stockout rate 1–2% 10–40%
Average forced end-of-season markdown as percentage of full price
0% 10–25%
Lead time required for made-to- order products
6 months to 1 year 1 day to 2 weeks
Source: Reprinted by permission of Harvard Business Review. Exhibit from “What is the Right Supply Chain for Your Product” by Marshall Fisher, March-April, 1997. Copyright 1997 by the President and Fellows of Harvard College; all rights reserved.
FIGURE 6.1
Market position of products.
46 Handbook of Supply Chain Management An example illustrates the potential impact of market mediation cost on supply chain design. We’ll use a hypothetical “widget” manufacturer and distributor for our illustration. The widget is a new product, and its product plan embodies management expectations for the first year’s sales and profits. Figure 6.2 illustrates the case of the product with expected sales and costs for a “widget” product as shown below:
The plan calls for a sales price of $100 with an attractive gross margin before distribution costs of $40. Distribution costs are expected to add $10 per unit to cost. It’s likely that the supply chain manager is measured on whether the costs of distribution meet the $10 expectation. The first-year sales forecast calls for 100,000 units, producing revenues of $10 million. However, this is an innovative product, so actual demand is likely to be uncertain. Demand, in the case of the widget, may in fact be significantly more or less than the fore- cast of 100,000 units.
Let’s assume that our widget manufacturer has little flexibility in its supply chain. Commitment to a production volume must be made at the beginning of the year. So the plan becomes very important as a determinant of the wid- get’s success. In cases like that of the widget, one of three outcomes is likely if the supply chain manager produces the 100,000 units called for by the plan:
Widget Sales Price $100
Gross Margin (excluding distribution cost) $40 Unit Distribution Cost (transportation, warehousing,
transportation)
$10
Widget Sales Forecast 100,000
FIGURE 6.2
Hidden supply chain costs.
Linking the Supply Chain with the Customer 47 1. The plan is accurate. 100,000 units are sold, and the product result
closely matches the plan. The supply chain manager is a hero. 2. Sales falter; only 70,000 units are sold. The widget maker must
dump 30,000 units of inventory. The inventory must be sold at discount prices. The product manager is a goat; the supply chain manager is okay, since distribution costs are within budget. 3. Demand exceeds the plan; 130,000 units could have been sold.
Customers are disappointed, and sales are lost. The supply chain manager is fired; the product manager gets a promotion.
Figure 6.2 uses numbers to illustrate these outcomes. We see that the actual sales range extends from 70,000 to 130,000. When sales fall below the expected 100,000 level, discounts must be employed to move the merchan- dise. In this case, a 70,000-unit sales level brings a markdown of $50. The resulting profit if only 70,000 units are sold is $1.8 million instead of the stan- dard profit of $2.1 million for 70,000 units, a “cost” of an unresponsive supply chain of $300,000.
When sales go above expected levels, the company is at risk for lost profits. If actual sales are 130,000, for example, the profit potential is $3.9 million instead of the budgeted $3 million, a market mediation cost of $900,000. Notice that, when market mediation costs are taken into account, the added cost of a poorly designed supply chain can be substantial compared with the distribution costs of getting the product to market. Most measurement sys- tems ignore this reality.
The important message is that supply chain cost under uncertain demand has two components. The first is the traditional cost associated with physical distribution, shown in Figure 6.2 as “Distribution Cost.” But distribution cost doesn’t fully capture the economic impact of supply chain design decisions. One should also consider the effect of price markdowns and lost profit opportunities.
As the widget example illustrates, a problem for a company is having a mismatch between the supply chain design and the nature of product
demand.2 The grid in Figure 6.3 is Fisher’s summary of the four states in
which a company might find its products and supply chains. The product type and the supply chain are either matched or mismatched. It’s rare for a company to have a mismatch in the lower left quadrant of Figure 6.3. This is because most companies focus on cost reductions, so their efforts may already have produced a low-cost supply chain. Or they only market func- tional products and have supply chains designed for efficiency to deliver those products.
It isn’t rare, however, to have a mismatch in the upper right quadrant. Companies in this quadrant commit a common error. That error is to manage the supply chain to achieve the efficiency appropriate for a functional prod- uct — when the product is essentially innovative. In fact, a successful execu- tive who has managed the supply chain for a company with functional
48 Handbook of Supply Chain Management
products may not recognize the differences in the products of a new com- pany. As we mentioned earlier, it’s not uncommon to measure performance for a logistics or supply chain manager by the percent of gross revenues spent on the supply chain. Such a person may mistakenly apply the “efficiencies” to a new company with innovative products — and earn a bonus for doing so! A more appropriate measurement would include market mediation costs in the calculation.
For many products like automobiles, there are both functional and innova- tive supply chains. Fisher notes that a “functional” car like a Taurus should use a functional supply chain with as much cost squeezed out as possible. But a high margin convertible could earn more profit with an innovative supply chain.
So making money out of the supply chain, applying Fisher’s model, has two branches. For the functional product, it means innovations to reduce the supply chain cost associated with distribution. For the innovative product, it means reducing total costs, including market mediation. This is a more com- plex equation as we demonstrate in the widget example. It involves not only the traditional costs but also those associated with mismatches in demand and supply. Companies like our widget-maker have to decide if the extra FIGURE 6.3
Matching supply chains with products. (Reprinted by permission of Harvard Business Review.
Exhibit from “What is the Right Supply Chain for Your Product” by Marshall Fisher, March- April, 1997. Copyright 1997 by the President and Fellows of Harvard College; all rights reserved.)
Linking the Supply Chain with the Customer 49 profit to be gained from a flexible, responsive supply chain is worth the cost of putting it in place.
Fisher describes some of the differences in design criteria for the two
types of supply chain.3 Table 6.2 lists thosecriteria. In a later section on
costs and the supply chain, we describe techniques that recognize these dif- ferences in product demand.