The Agony of Defeat

Cutting-edge supply chains are double-edged swords. Wielded with skill, they can slice open new markets. Improperly handled, they lead to deep, self-inflicted wounds. For all the advantages that can come from getting the supply chain right, getting it wrong can be catastrophic.

By the end of the 1990s, Kmart Corporation’s supply chain was crippling its ability to match the prices offered by Wal-Mart and Target, and in the discount retail business price is everything. Worse, when the company did manage to lure back customers with its Blue Light specials, the products weren’t in the stores when people came in to buy them; the supply chain couldn’t deliver them in time for the sale, even with plenty of advance warning. Kmart was floundering, and it decided that it needed new technology to solve its problems. In May of 2000, the company announced an unprecedented $1.4 billion investment in software and services to overhaul its supply chain, including warehouse management software from EXE Technologies and planning systems from i2 Technologies.

A year and a half later, before the systems ever went live, Kmart announced that it was abandoning most of the software it had purchased and taking a $130 million write-off. What went wrong? Nearly everything, it seems, but the company did admit to a lack of clarity about its strategy, saying it needed to rethink its supply chain strategy first before implementing its systems. This was the right idea, but it seems to have arrived late and left early. Not long after the write-off, Kmart announced that it was buying $600 million worth of warehouse management software from Manhattan Associates, and that this purchase would solve its problems. Perhaps in a further effort to take some pressure off its supply chain, Kmart also announced that it was closing 250 stores.

Even companies that once got it right can still to get it wrong. After years of success with its SCORE program, Chrysler completed the famous “merger of equals” that led to DaimlerChrysler. Like the merger itself, the SCORE program quickly degenerated, and relationships with suppliers soured. The company has now resorted to demanding unilateral price reductions from suppliers in order to stave off mounting losses. Chrysler’s moment in the sun has passed.

Nike, the virtual enterprise that became the world’s largest shoe company, has also managed to get itself into trouble with its supply chain. In February of 2001, the company announced that it had lost $100 million in sales the previous quarter because of snafus in its supply chain. The debacle came right after the company went live with i2 Technologies’ planning system. After a year of installation work, Nike decided it was time to throw the switch, and the new system immediately created havoc across the chain. Nike blamed i2, with the chairman complaining to analysts, “This is what we get for our $400 million?” (quoted in Computerworld; see the Notes on Sources). The vendor, in turn, complained that Nike had pushed the system into service too quickly and had required too many customizations. Whoever is to blame, both companies lost big. Nike’s stock dropped 20% the day it made the announcement, and i2’s fell 22% that same day.

Even Cisco Systems, the paragon of supply chain management, is capable of the occasional misstep. In May of 2001, the company reported that it had to write off some inventory as unusable—to the tune of $2.2 billion, the largest inventory write-down in the history of business. The problem stemmed from a breakdown in communication up the supply chain (Figure 1.2). Cisco was competing for large contracts in a booming market for Internet hardware. Having no production capacity of its own, Cisco passed all its anticipated demand directly on to its contract manufacturers. Those contractors added this to the demand they saw coming from Cisco’s competitors, some of which were bidding on the same business, and each contractor looked at the demand independently, leading to double and triple counting of the same demand. The result: Component suppliers worked overtime to fill orders that were never placed, and Cisco wound up holding the bag.

Figure 1.2 Cisco’s $2 Billion Blunder

As these examples illustrate, supply chain failures can be devastatingly expensive. But there is an even bigger price to be paid than the immediate impact on cash flow. Nike and i2 both lost a fifth of their market value the day Nike went public with its problems. The size of these drops is exceptional, but their occurrence is not. A recent study conducted at Georgia Tech examined more than a thousand news reports of supply chain problems between 1989 and 1999, looking to see whether these reports had an impact on stock prices. The answer they got was a resounding yes: Companies reporting problems suffered an average drop in their stock price of 7.5% the day of the announcement. When the researchers examined the prices six months before and after the announcement, they discovered that the prices actually began to fall well before the announcement, suggesting that the bad news had a tendency to leak, and the prices showed no signs of recovering after the fact (Figure 1.3). The total drop over 12 months was 18.5%.

Figure 1.3 The Market Reaction to Supply Problems

These percentage drops are obviously large, but the full impact is better conveyed by actual valuations. On the day of the announcement, the average drop in shareholder value for the company making the announcement was $143 million. Over the course of a year, the average loss was more than $350 million. But even this figure underestimates the total loss because prices were rising at 15% per year during that period, so the real impact may be nearly twice the calculated amount. But even at the most conservative calculations and considering only the one-day loss, the researchers conclude that the 1,131 supply chain problems they examined in their study caused a loss of more than $160 billion in shareholder value. Clearly, the market doesn’t react well to supply chain failures.

The study also revealed that investors don’t really care who caused the problem. When the reporting company accepted the blame for the incident, its stock dropped 7.1%. When it blamed its suppliers, its stock dropped 8.3%. And when it blamed its customers—usually for changing their requirements during the lead time—the company’s stock dropped 10.9%. The message is clear: If a company reports a problem with its supply chain, it’s going to get hammered in the stock market, regardless of who’s at fault. If anything, pointing the finger at a trading partner only increases the punishment.

A High Stakes Game

Why does getting the supply chain right have such a big impact on success? Because the stakes are so high: Holding and moving merchandise is a very expensive proposition. Collectively, U.S. companies spend a trillion dollars a year on their supply chains, just under 10% of the nation’s GDP. About a third of this cost is for holding inventory and the rest is for moving it around, with a bit of change left over for administration. As large as these figures may seem, they used to be substantially higher, totaling about 15% of GDP at the beginning of the 1980s. Deregulation of the transportation industry coupled with inventory reductions brought the total down to 10% by the early 1990s, and it has remained stable at that level ever since.

The same percentage holds good for individual companies, which spend an average of just under 10% of their gross income on supply chain functions. What is striking about the figures for individual companies is the tremendous advantage that some companies have over others in this regard. A recent survey of supply chain costs across a variety of industries yielded an average of 9.8% of revenue devoted to supply chains, a perfect match to the overall value. But the survey also revealed that the top quartile—the 25% best performers —had an average cost of just 4.2% of revenue. These companies spend less than half as much on their supply chains as the competition, giving them a full five-point advantage in profits. Continuing surveys reveal that the gap is not closing, but widening. The message is clear: If your company is on the wrong side of the supply chain gap, the sooner it makes the leap the better.

Actually, the advantage is more dramatic than these figures might suggest, because in business a penny saved isn’t really a penny earned. Depending on profit margins, it is usually closer to a nickel or a dime. Suppose you’re running a company with $100 million in sales, 10% supply chain costs, and a 10% gross profit, as shown in the first panel of Figure 1.4. How could you increase your overall profit by 50%? One way is to increase sales by 50%, as shown in middle panel of the figure. The other way is to imitate the best-inclass companies and bring your supply chain costs down to 5%, as shown in the last panel. At the level of gross margins, this $5 million savings is the equivalent of $50 million in additional sales. This is not to suggest that you wouldn’t prefer to get the profit from growth rather than cost reductions. But the fact that a 5% reduction in costs can produce the same increase in profits as a 50% increase in sales is certainly a valuable insight.

Figure 1.4 Supply Chain Costs and Profit

Here is a real-world, albeit anonymous, illustration of how supply chain savings translate into profits. A major electronics company found that it had $500 million in excess inventory. Its carrying costs were 50% of the purchase price, so it was paying $250 million a year to hold the extra material. Given the company’s profit margin of 10%, it would need $2.5 billion in additional earnings to equal the bottom-line benefit of eliminating that excess inventory. In the retail sector, where profit margins of 2% are common, the impact of savings in the supply chain can be even more dramatic. With margins that thin, reducing supply chain costs from 10% to 8%— still nowhere near best-in-class performance—can increase profits as much as doubling sales.

Given the enormous stakes involved, the pressure to pull time and cost out of the supply chain is becoming relentless, and the demands are only going to increase as everyone gets better at the game. In addition to the financial drivers, several other factors are combining to put pressure on supply chains, including shorter product life spans, faster product development, rising globalization of sourcing, increasing demand for customization, and intensive quality initiatives such as the Six Sigma program. Given the challenges involved in getting the supply chain right, this may not be a game you are eager to play, but nobody gets to pass on this one. Every company that touches a product is part of a supply chain, and every company that is part of a supply chain has to deal with these problems sooner or later. The only choice you have is whether to tackle the problem now or wait until it tackles you.