The Triple-A Supply Chain    by Hau L. Lee

                   The best supply chains aren’t just fast and cost-effective.
                  They are also agile and adaptable, and they ensure that all
                  their companies’ interests stay aligned.  

                   During the past decade and a half, I’ve studied from the
                  inside more than 60 leading companies that focused on building
                  and rebuilding supply chains to deliver goods and services to
                  consumers as quickly and inexpensively as possible. Those
                  firms invested in state-of-the-art technologies, and when that
                  proved to be inadequate, they hired top-notch talent to boost
                  supply chain performance. Many companies also teamed up to
                  streamline processes, lay down technical standards, and invest
                  in infrastructure they could share. For instance, in the early
                  1990s, American apparel companies started a Quick Response
                  initiative, grocery companies in Europe and the United States
                  touted a program called Efficient Consumer Response, and the
                  U.S. food service industry embarked on an Efficient
                  Foodservice Response program. 

                  All those companies and initiatives persistently aimed at
                  greater speed and cost-effectiveness—the popular grails of
                  supply chain management. Of course, companies’ quests changed
                  with the industrial cycle: When business was booming,
                  executives concentrated on maximizing speed, and when the
                  economy headed south, firms desperately tried to minimize
                  supply costs. 

                  As time went by, however, I observed one fundamental problem
                  that most companies and experts seemed to ignore: Ceteris
                  paribus, companies whose supply chains became more efficient
                  and cost-effective didn’t gain a sustainable advantage over
                  their rivals. In fact, the performance of those supply chains
                  steadily deteriorated. For instance, despite the increased
                  efficiency of many companies’ supply chains, the percentage of
                  products that were marked down in the United States rose from
                  less than 10% in 1980 to more than 30% in 2000, and surveys
                  show that consumer satisfaction with product availability fell
                  sharply during the same period. 

                  Evidently, it isn’t by becoming more efficient that the supply
                  chains of Wal-Mart, Dell, and Amazon have given those
                  companies an edge over their competitors. According to my
                  research, top-performing supply chains possess three very
                  different qualities. First, great supply chains are agile.
                  They react speedily to sudden changes in demand or supply.
                  Second, they adapt over time as market structures and
                  strategies evolve. Third, they align the interests of all the
                  firms in the supply network so that companies optimize the
                  chain’s performance when they maximize their interests. Only
                  supply chains that are agile, adaptable, and aligned provide
                  companies with sustainable competitive advantage. 

                  The Perils of Efficiency 

                  Why haven’t efficient supply chains been able to deliver the
                  goods? For several reasons. High-speed, low-cost supply chains
                  are unable to respond to unexpected changes in demand or
                  supply. Many companies have centralized manufacturing and
                  distribution facilities to generate scale economies, and they
                  deliver only container loads of products to customers to
                  minimize transportation time, freight costs, and the number of
                  deliveries. When demand for a particular brand, pack size, or
                  assortment rises without warning, these organizations are
                  unable to react even if they have the items in stock.
                  According to two studies I helped conduct in the 1990s, the
                  required merchandise was often already in factory stockyards,
                  packed and ready to ship, but it couldn’t be moved until each
                  container was full. That “best” practice delayed shipments by
                  a week or more, forcing stocked-out stores to turn away
                  consumers. No wonder then that, according to another recent
                  research report, when companies announce product promotions,
                  stock outs rise to 15%, on average, even when executives have
                  primed supply chains to handle demand fluctuations. 

                  When manufacturers eventually deliver additional merchandise,
                  it results in excess inventory because most distributors don’t
                  need a container load to satisfy the increased demand. To get
                  rid of the stockpile, companies mark down those products
                  sooner than they had planned to. That’s partly why department
                  stores sell as much as a third of their merchandise at
                  discounted prices. Those markdowns not only reduce companies’
                  profits but also erode brand equity and anger loyal customers
                  who bought the items at full price in the recent past (sound
                  familiar?). 

                  Companies’ obsession with speed and costs also causes supply
                  chains to break down during the launch of new products. Some
                  years ago, I studied a well-known consumer electronics firm
                  that decided not to create a buffer stock before launching an
                  innovative new product. It wanted to keep inventory costs low,
                  particularly since it hadn’t been able to generate an accurate
                  demand forecast. When demand rose soon after the gizmo’s
                  launch and fell sharply thereafter, the company pressured
                  vendors to boost production and then to slash output. When
                  demand shot up again a few weeks later, executives
                  enthusiastically told vendors to step up production once more.
                  Five days later, supplies of the new product dried up as if
                  someone had turned off a tap. 

                  The shocked electronics giant discovered that vendors had been
                  so busy ramping production up and down that they hadn’t found
                  time to fix bugs in both the components’ manufacturing and the
                  product’s assembly processes. When the suppliers tried to
                  boost output a second time, product defects rose to
                  unacceptable levels, and some vendors, including the main
                  assembler, had to shut down production lines for more than a
                  week. By the time the suppliers could fix the glitches and
                  restart production, the innovation was all but dead. If the
                  electronics company had given suppliers a steady,
                  higher-than-needed manufacturing schedule until both the line
                  and demand had stabilized, it would have initially had higher
                  inventory costs, but the product would still be around. 

                  Efficient supply chains often become uncompetitive because
                  they don’t adapt to changes in the structures of markets.
                  Consider Lucent’s Electronic Switching Systems division, which
                  set up a fast and cost-effective supply chain in the late
                  1980s by centralizing component procurement, assembly and
                  testing, and order fulfillment in Oklahoma City. The supply
                  chain worked brilliantly as long as most of the demand for
                  digital switches emanated from the Americas and as long as
                  Lucent’s vendors were mostly in the United States. However, in
                  the 1990s, when Asia became the world’s fastest-growing
                  market, Lucent’s response times increased because it hadn’t
                  set up a plant in the Far East. Furthermore, the company
                  couldn’t customize switches or carry out modifications because
                  of the amount of time and money it took the supply chain to do
                  those things across continents. 

                  Lucent’s troubles deepened when vendors shifted manufacturing
                  facilities from the United States to Asia to take advantage of
                  the lower labor costs there. “We had to fly components from
                  Asia to Oklahoma City and fly them back again to Asia as
                  finished products. That was costly and time consuming,”
                  Lucent’s then head of manufacturing told me. With tongue
                  firmly in cheek, he added, “Neither components nor products
                  earned frequent-flyer miles.” When Lucent redesigned its
                  supply chain in 1996 by setting up joint ventures in Taiwan
                  and China to manufacture digital switches, it did manage to
                  gain ground in Asia. 

                  In this and many other cases, the conclusion would be the
                  same: Supply chain efficiency is necessary, but it isn’t
                  enough to ensure that firms will do better than their rivals.
                  Only those companies that build agile, adaptable, and aligned
                  supply chains get ahead of the competition, as I pointed out
                  earlier. In this article, I’ll expand on each of those
                  qualities and explain how companies can build them into supply
                  chains without having to make trade-offs. In fact, I’ll show
                  that any two of these dimensions alone aren’t enough. Only
                  companies that build all three into supply chains become
                  better faster than their rivals. I’ll conclude by describing
                  how Seven-Eleven Japan has become one of the world’s most
                  profitable retailers by building a truly “triple-A” supply
                  chain.

                  Fostering Agility 

                  Great companies create supply chains that respond to sudden
                  and unexpected changes in markets. Agility is critical,
                  because in most industries, both demand and supply fluctuate
                  more rapidly and widely than they used to. Most supply chains
                  cope by playing speed against costs, but agile ones respond
                  both quickly and cost-efficiently. 

                  Most companies continue to focus on the speed and costs of
                  their supply chains without realizing that they pay a big
                  price for disregarding agility. (See the sidebar “The
                  Importance of Being Agile.”) In the 1990s, whenever Intel
                  unveiled new microprocessors, Compaq took more time than its
                  rivals to launch the next generation of PCs because of a long
                  design cycle. The company lost mind share because it could
                  never count early adopters, who create the buzz around
                  high-tech products, among its consumers. Worse, it was unable
                  to compete on price. Because its products stayed in the
                  pipeline for a long time, the company had a large inventory of
                  raw materials. That meant Compaq didn’t reap much benefit when
                  component prices fell, and it couldn’t cut PC prices as much
                  as its rivals were able to. When vendors announced changes in
                  engineering specifications, Compaq incurred more reworking
                  costs than other manufacturers because of its larger
                  work-in-progress inventory. The lack of an agile supply chain
                  caused Compaq to lose PC market share throughout the decade. 

                   By contrast, smart companies use agile supply chains to
                  differentiate themselves from rivals. For instance, H&M,
                  Mango, and Zara have become Europe’s most profitable apparel
                  brands by building agility into every link of their supply
                  chains. At one end of their product pipelines, the three
                  companies have created agile design processes. As soon as
                  designers spot possible trends, they create sketches and order
                  fabrics. That gives them a head start over competitors because
                  fabric suppliers require the longest lead times. However, the
                  companies finalize designs and manufacture garments only after
                  they get reliable data from stores. That allows them to make
                  products that meet consumer tastes and reduces the number of
                  items they must sell at a discount. At the other end of the
                  pipeline, all three companies have superefficient distribution
                  centers. They use state-of-the-art sorting and
                  material-handling technologies to ensure that distribution
                  doesn’t become a bottleneck when they must respond to demand
                  fluctuations. H&M, Mango, and Zara have all grown at more than
                  20% annually since 1990, and their double-digit net profit
                  margins are the envy of the industry.

                  Agility has become more critical in the past few years because
                  sudden shocks to supply chains have become frequent. The
                  terrorist attack in New York in 2001, the dockworkers’ strike
                  in California in 2002, and the SARS epidemic in Asia in 2003,
                  for instance, disrupted many companies’ supply chains. While
                  the threat from natural disasters, terrorism, wars, epidemics,
                  and computer viruses has intensified in recent years, partly
                  because supply lines now traverse the globe, my research shows
                  that most supply chains are incapable of coping with
                  emergencies. Only three years have passed since 9/11, but U.S.
                  companies have all but forgotten the importance of drawing up
                  contingency plans for times of crisis.

                  Without a doubt, agile supply chains recover quickly from
                  sudden setbacks. In September 1999, an earthquake in Taiwan
                  delayed shipments of computer components to the United States
                  by weeks and, in some cases, by months. Most PC manufacturers,
                  such as Compaq, Apple, and Gateway, couldn’t deliver products
                  to customers on time and incurred their wrath. One exception
                  was Dell, which changed the prices of PC configurations
                  overnight. That allowed the company to steer consumer demand
                  away from hardware built with components that weren’t
                  available toward machines that didn’t use those parts. Dell
                  could do that because it got data on the earthquake damage
                  early, sized up the extent of vendors’ problems quickly, and
                  implemented the plans it had drawn up to cope with such
                  eventualities immediately. Not surprisingly, Dell gained
                  market share in the earthquake’s aftermath.

                  Nokia and Ericsson provided a study in contrasts when in March
                  2000, a Philips facility in Albuquerque, New Mexico, went up
                  in flames. The plant made radio frequency (RF) chips, key
                  components for mobile telephones, for both Scandinavian
                  companies. When the fire damaged the plant, Nokia’s managers
                  quickly carried out design changes so that other companies
                  could manufacture similar RF chips and contacted backup
                  sources. Two suppliers, one in Japan and another in the United
                  States, asked for just five days’ lead time to respond to
                  Nokia. Ericsson, meanwhile, had been weeding out backup
                  suppliers because it wanted to trim costs. It didn’t have a
                  plan B in place and was unable to find new chip suppliers. Not
                  only did Ericsson have to scale back production for months
                  after the fire, but it also had to delay the launch of a major
                  new product. The bottom line: Nokia stole market share from
                  Ericsson because it had a more agile supply chain.

                  Companies can build agility into supply chains by adhering to
                  six rules of thumb:

                  • Provide data on changes in supply and demand to partners
                  continuously so they can respond quickly. For instance, Cisco
                  recently created an e-hub, which connects suppliers and the
                  company via the Internet. This allows all the firms to have
                  the same demand and supply data at the same time, to spot
                  changes in demand or supply problems immediately, and to
                  respond in a concerted fashion. Ensuring that there are no
                  information delays is the first step in creating an agile
                  supply chain.

                  • Develop collaborative relationships with suppliers and
                  customers so that companies work together to design or
                  redesign processes, components, and products as well as to
                  prepare backup plans. For instance, Taiwan Semiconductor
                  Manufacturing Company (TSMC), the world’s largest
                  semiconductor foundry, gives suppliers and customers
                  proprietary tools, data, and models so they can execute design
                  and engineering changes quickly and accurately.

                  • Design products so that they share common parts and
                  processes initially and differ substantially only by the end
                  of the production process. I call this strategy
                  “postponement.” (See the 1997 HBR article I coauthored with
                  Edward Feitzinger, “Mass Customization at Hewlett-Packard: The
                  Power of Postponement.”) This is often the best way to respond
                  quickly to demand fluctuations because it allows firms to
                  finish products only when they have accurate information on
                  consumer preferences. Xilinx, the world’s largest maker of
                  programmable logic chips, has perfected the art of
                  postponement. Customers can program the company’s integrated
                  circuits via the Internet for different applications after
                  purchasing the basic product. Xilinx rarely runs into
                  inventory problems as a result.

                  • Keep a small inventory of inexpensive, nonbulky components
                  that are often the cause of bottlenecks. For example, apparel
                  manufacturers H&M, Mango, and Zara maintain supplies of
                  accessories such as decorative buttons, zippers, hooks, and
                  snaps so that they can finish clothes even if supply chains
                  break down.

                  • Build a dependable logistics system that can enable your
                  company to regroup quickly in response to unexpected needs.
                  Companies don’t need to invest in logistics systems themselves
                  to reap this benefit; they can strike alliances with
                  third-party logistics providers.

                  • Put together a team that knows how to invoke backup plans.
                  Of course, that’s only possible only if companies have trained
                  managers and prepared contingency plans to tackle crises, as
                  Dell and Nokia demonstrated.

                  Adapting Your Supply Chain

                  Great companies don’t stick to the same supply networks when
                  markets or strategies change. Rather, such organizations keep
                  adapting their supply chains so they can adjust to changing
                  needs. Adaptation can be tough, but it’s critical in
                  developing a supply chain that delivers a sustainable
                  advantage.

                  Most companies don’t realize that in addition to unexpected
                  changes in supply and demand, supply chains also face
                  near-permanent changes in markets. Those structural shifts
                  usually occur because of economic progress, political and
                  social change, demographic trends, and technological advances.
                  Unless companies adapt their supply chains, they won’t stay
                  competitive for very long. Lucent twice woke up late to
                  industry shifts, first to the rise of the Asian market and
                  later to the advantages of outsourced manufacturing. (See the
                  sidebar “Adaptation of the Fittest.”) Lucent recovered the
                  first time, but the second time around, the company lost its
                  leadership of the global telecommunications market because it
                  didn’t adapt quickly enough.

                   Adaptation of the Fittest

                  The best supply chains identify structural shifts, sometimes
                  before they occur, by capturing the latest data, filtering out
                  noise, and tracking key patterns. They then relocate
                  facilities, change sources of supplies, and, if possible,
                  outsource manufacturing. For instance, when Hewlett-Packard
                  started making ink-jet printers in the 1980s, it set up both
                  its R&D and manufacturing divisions in Vancouver, Washington.
                  HP wanted the product development and production teams to work
                  together because ink-jet technology was in its infancy, and
                  the biggest printer market was in the United States. When
                  demand grew in other parts of the world, HP set up
                  manufacturing facilities in Spain and Singapore to cater to
                  Europe and Asia. Although Vancouver remained the site where HP
                  developed new printers, Singapore became the largest
                  production facility because the company needed economies of
                  scale to survive. By the mid-1990s, HP realized that
                  printer-manufacturing technologies had matured and that it
                  could outsource production to vendors completely. By doing so,
                  HP was able to reduce costs and remain the leader in a highly
                  competitive market.

                        The best supply chains identify structural shifts,
                        sometimes before they occur, by capturing the latest
                        data, filtering out noise, and tracking key patterns.

                  Adaptation needn’t be just a defensive tactic. Companies that
                  adapt supply chains when they modify strategies often succeed
                  in launching new products or breaking into new markets. Three
                  years ago, when Microsoft decided to enter the video game
                  market, it chose to outsource hardware production to
                  Singapore-based Flextronics. In early 2001, the vendor learned
                  that the Xbox had to be in stores before December because
                  Microsoft wanted to target Christmas shoppers. Flextronics
                  reckoned that speed to market and technical support would be
                  crucial for ensuring the product’s successful launch. So it
                  decided to make the Xbox at facilities in Mexico and Hungary.
                  The sites were relatively expensive, but they boasted
                  engineers who could help Microsoft make design changes and
                  modify engineering specs quickly. Mexico and Hungary were also
                  close to the Xbox’s biggest target markets, the United States
                  and Europe. Microsoft was able to launch the product in record
                  time and mounted a stiff challenge to market leader Sony’s
                  PlayStation 2. Sony fought back by offering deep discounts on
                  the product. Realizing that speed would not be as critical for
                  medium-term survival as costs would be, Flextronics shifted
                  the Xbox’s supply chain to China. The resulting cost savings
                  allowed Microsoft to match Sony’s discounts and gave it a
                  fighting chance. By 2003, the Xbox had wrested a 20% share of
                  the video game market from PlayStation 2.

                  Smart companies tailor supply chains to the nature of markets
                  for products. They usually end up with more than one supply
                  chain, which can be expensive, but they also get the best
                  manufacturing and distribution capabilities for each offering.
                  For instance, Cisco caters to the demand for standard,
                  high-volume networking products by commissioning contract
                  manufacturers in low-cost countries such as China. For its
                  wide variety of mid-value items, Cisco uses vendors in
                  low-cost countries to build core products but customizes those
                  products itself in major markets such as the United States and
                  Europe. For highly customized, low-volume products, Cisco uses
                  vendors close to main markets, such as Mexico for the United
                  States and Eastern European countries for Europe. Despite the
                  fact that it uses three different supply chains at the same
                  time, the company is careful not to become less agile. Because
                  it uses flexible designs and standardized processes, Cisco can
                  switch the manufacture of products from one supply network to
                  another when necessary.

                  Gap, too, uses a three-pronged strategy. I

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