1 - DePa

m~ Nature of Prndwf mow

mu-based pricZng polkies for indivzdualized
custornq function, and product servkes. Last,
we introduced a bottoms-up approach to
adapting supply chains to met changing
consumer values and the channek that
support them.
This white papw continues these thmws1
delwing deepw into our methodology for
creating individual supply chazns to support
dgerent trade channels' merehandise m& and
pricing strategies. The undwlying purpose of
the methodology is to enable suppliers to
provide the services diverse customers demand,
'hnbundle" or charge prices that reJect the
services they o fq and deuelop a least cost
mthod for every possible cornbinatwn of
product and service to customers.
The Nature of Product Flow
Previously, we described how consumer products'
distribution evolved in the U.S. Observing that
over the years many companies had become
complacent with their distribution methods, we
explained how more economic-based competition
was able to cut through many layers in the
existing system and, consequently, offer
consumers lower prices on product. As part of
our research we also found that distribution
methods across al1 industries follow the same
growth cycle.
For example, when a new market or
service is developed, its distribution is very much
like a spring that suddenly gushes out of the
earth, rushing to satisfy some great unmet need.
In this phase, no one really stops to think about
what flowpath would be the optimum, instead the
product simply flows in the most direct route. In
the second phase, as the product or service starts
to mature and competitive products begin to
trickle into the market, the river of distribution
begins to fill up, forcing it to bend under the
pressure of increased volume. Eventually, in the
third phase after years of repetition, companies
in an industry build up a lot of infrastructure
around their product's or service's distribution
and sediments of inventory pile up. While they 6
begin to obstruct the system, companies continue
to stockpile product in deference to customer
service. Inevitably, the river slows and
manufacturen and service providers start to
push new items into the channel to generate a
steady stream of sales. At this point distribution
begins to look like the Mississippi as it sluggishly

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WHlTE PAPEW
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moves through its huge curves and twists. Finally,
the river's meanders become so stagnant that a
breakthrough occurs, isolating huge cutoff lakes
of inventory.
In our analogy, these breakthroughs
represent new methods like continuous
. replenishment, product flow optimization, just-
in-time replenishment and other processes
designed to put inventory into motion. Likewise,
it corresponds to new, successful retail entrants
who, realizing that total supply chain costs have
grown too high, find a way to cut through the
system, pass the savings on to the consumer, and
maintain a reasonable profit margin.
At first read, this ckle sounds very
' fatalistic, dooming al1 companies to the same
evolutionary ebb and flow of destiny, but what if
companies could create breakthroughs in
distribution? What if they could make every
product's movement through distribution a
straight course? Wouldn'kthey be assuring
themselves of profitable margins by reaiming
their strategies and operations to deliver product
at the lowest net landed cost?
-
O p W Source and Flow
At this point you may ask, "If our river-like
distribution systems developed into their cur-rent
state by simply going with the flow of evolutjon,
aren't they the most natural fit for our products?"
To which we would reply, "No." In fact, that kind
of reasoning js exactly what fuels inefficiency,
increases operating costs, and facilitates the
entry of lower cost competition. What
distribution executives reallyneed to do is
identifywhich characteristics add to the ease of
a product's flow through distribution. They must
ask themselves questions, such as7How can we
use the supply chain to reinforce a product's
merchandising role or contribution to its
category? Based on the total cost of bringing a
a
Finding the straightest, easiest least cost method of dlstributIng product is exactly what
veating Individual supply chains for diffemnt merchandise mix and priclng strategies can
* 2-
,_- a
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" accompllsh. Because of itr similarity to the Chlnesu philosophy, we cal1 this strategy the
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F. -

product to consumers, how and where should
it be stocked? Will the margin on an item
support multiple handling steps? 1s the
package and count appropriate to the rate
of sale and handling methods of the channelspecific
supply chain partners? And how can
we build-in supply chain efficiency rather
than having to seek it out later?
Every product's handling characteristics,
reorder cycle, cube, value, volume,
and merchandising needs are different, and
dictate replenishment time and method. With
this in rnind, each player in the supply chain
needs to change his orientation and instead
focus on what is being swept along the
current-the product.
There are four product attributes that help
define the right distribution flow: missirm,
measurement, modulatirm, and
rnanagemmt. Each adds a layer of complexity
to determining the optimal source and flow.
r
try buzz words such as loss leader,
companion item, and today's
power sku," have al1 attempted
acturers and retailers articulate
ktrketplace role of each product.
Regardless of language used to describe this
process, it is very important that partners in
the supply chain not only group their products
around target customer purchasing preferences
and profitability, but that they consider each
product's relationship to other products in the
store. For example, within a chain drug store's
OTC assortment, there are a number of low
margin, core items that a store must offer.
Although there may be little profit to be made
on these items, retailers know that if a customer
walks into their store and they do not have the
leading toothpaste, for example, that customer is
going to walk out the door and down the street to
a competitor to buy toothpaste as well as
everything else on their shopping list.
As a manufacturer, you may think it
doesn't matter where the customer buys your
product because you will receive an ample return
no matter where the product is
purchased, but from the Taoist
perspective, that view
Ld
too narrow.

'
&se evew tradingpartner bax a
$Eds,tiin the SricGess of eaoh pi.adüct,
1 7p,f@$&t~ars cq help lower the retailer's
@@eo:$l'i~lf net landed cost, retailers in various
1 ~annels xknot oniy be more profltable, theg
wil1~bmore:willing to protect manufacturer's
'
l
ahelfspaceFor exarnple, praeious end cnps,
C K ~ ~ hpurtant ~ E I to low cost clistribution of pre-
11 To pkevent aay S'~tagonistio sjtuations and,
1
Tímp~~aaitly, to 'cepita1ize.an each and every
#-
@T&ft, su~p1y chalr partneoinust xefipect ihe
méfent role of a producfs'sprofitability and aZign
1 t;helr operational strategy around how to 1
1 effi~iently distribute it.
,
ther it is bi& hulky, ~low-
able like an applianse@~ small,
1
a great selle$ i:ke7a botrtkd
aids,Shml~ P~F~hiaoqgh thgt sme system,
uc es: uniqu8,~b~acte~istiCsr
1
'Xke indi~duali~odillc6~han~q~
1 1 eube, and
~determinin$~th~~~ayih~is
, .'
volume chanctteristim OT th-ei&o are so vastlv
mmed~through thesupply chain. By mwurbq
' 1J' -un .
different Wat ihe,compwf ould not delimr it
qu.arít'i?fiable characteristíes like cube,,%eight,
s&e, supply lead the, and value-reJative80 size,
tradingpartners dan begin to determine tFie mPst
efficient %ay to move products basedton their
total supply chain costs. Moreover, produ~ts ~5th
dissimilar characteristi~should not be forced
through distribution sgstems~hhat have b'een
prkeated for vastly different produets. Por .
rex@rnple, just because a consumer goods
.
'
at the lovesh nef ,im&dl co~t Bit tried to force
the syitem t@ aacomg@e thers'ewpr~hucY,.
Rgfhe~ cpmp%ili'~s
MuBt e9ramine"fhe physical \
dimensioxis aEd chwaateris'tfcs crE.@aC:h
aad evemp-r!oduot md fime out the m " Sizitwzal
and sfficientwq for thm to, fl'ow.
,
Typi~ally, this kind of analysis compares .
T
product profitability by follohg the lagic

our net profitability principle
(Figure 1). Here gross margins of products are
calculated after the cost of the good sold and
al1 deals and allowances have been taken into
consideration. In this case, the profit of the
branded product is $.53, representing a gross
margin of 17.796, compared to $.60 or 30% gross
margin for the private label version of that
product.
A gross margin comparison is a limited
method of pinpointing what products will
contribute to net profit performance and may
mislead retailers and manufacturen in thei
search for ways to maximize the net profit of
a category. We argue that manufacturen an
retailers have not gone far enough in their
scrutiny of costs. By examining costs associated
with distribution center processing, DC
inventory, store delivery, store inventory, and
damage, both manufacturer and retailer will have
a much more accurate assessment of a product's
net profitability, In some cases, the costs
associated with distribution may even be
significant enough to alter a manufacturer or
retailer's decision that was based solely on DPP
and category management data.
For example, using the same products
analyzed in Figure 1, if we account for the DC and
store handling, inventory, processing, delivery, and
damages unique to each product, we arrive at a
net profit of $.448 for the branded product and
6.465 for the private label (Figure 2). While thefe
is significant variance in each product's net profit
as a percent of sales, their penny profit is virtually
identical. Given the new data regarding

distribution costs, one can't help but wonder if the
retailer would re-think its decision to handle the
private label product and if the supplier would
increase promotional allowances to push product
profitability for the retailer.
compelling gross margin attrac-
M&JO&~ t .sd - ,-,vate label product can quickly
ipply chain factors that are often
red in gross margin-only calculations.
of a product refers to the
frequency and quantity of its replenishment. In
considering a product's distribution, supply chain
partners not only need to regard products as
static elements, they must also extend their
thinking in multiples over time. Put another way,
they must determine whether the distribution
system they create will need to carry only one
leaf or float an entire log jam of product.
In our previous example, if the retailer
had to commit to a significant (2 month's supply
vs. the DSD of 1 week) quantity of inventory, the
profit analysis would have told a different story
because of the additional inventory expense for
carrying (i.e. DC & Store Inventory), housing,
and handling product.
The higher the value of the product, the
greater the threat holding inventory is to
profitability. Therefore, very high value products
like computers or cosmetics should be metered
through the supply chain in small quantities to
minimize inventory. This may require significant
value-added labor, for example, to assemble store
.arder quantities at plants or DCs. Conversely,
paper and charcoal is usually better shipped to
the store in full pallets even if inventory must be
held in the back room to optimize the supply
chain cost.
I
I
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, , .
. . , "

I
..decisions
--
ripple through a company, impacting other functions and
Itimately the entire company's profitability.
.. T - J.'
r,
potential to meet your service specifications at
the lowest net landed cost? What is the most
productive use of your supply chain assets? What
are your supply chain-related business policies?
Just what are you willing to do for customers?
And, finally, how should your processes be
managed and by whom?
Unfortunately, this is an area where few
companies excel. In fact, most executives aren't
even aware of how selective decisions ripple
through a company, impacting other functions'
and ultimately the entire company's profitability.
Severa1 examples of the ripple effect are:
the retail buyer who in an attempt to meet
gross margin targets takes on a large number of
new products to capture their slotting allowance,
only to compromise distribution and store
operating costs by forcing an already flooded
system to handle those items
wholesaler salespeople who promise equal
levels of seMce to al1 customers, then throw the
burden of profitability on the merchandising staff
who must accommodate the mix, the distribution
staff who must pick smaller orders, and the
accounting staff who must track and invoice
customers, spending more in processing costs
than the average profit per order
the manufacturer whose marketing department
creates promotions that whipsaw manufacturing
operations into making larger quantities of
product, lowering availability of other items by
consuming finite capacity, only to have sales
cannibalized by retailers who buy product in
volume and resell it to opportunistic customers
in other markets.
Clearly, as companies dam-up the flow of
information, they dam-up the flow of product as
well. While there are literally hundreds of other
examples we could cite, the real issue is how to
avoid these obstructions to the flow of product.
Companies can smooth out ripple effects
by consolidating total supply chain responsibility
in a team, or by selecting a manager for a family
of products. Category management can be an
effective way of accomplishing those objectives.
Whether performed by the retailer, wholesaler, .

I
or manufacturer, category management is an about and built a supply chain based around the
attempt to understand and react to al1 consider- product's mission, measurement, and modulation
1
ations within a given product category. The - the mail order fulfillment program. Now, with
1
I
category manager takes on the authority and
---
responsibility to use the supply chain cost
effectively, understanding everything from
the help of information technology, pharmaceutical
products can take a much more direct route to the
consumer. What's more, those companies with mail
1
operating requirements to the competition. order fulfillment programs pass their supply chain
b
To do M, he/she must share data and operating savings along to the consumer in the form of lower
1 cost information between functions. prices.
3 . r Similarly, much has
inallv. the sum of the four Ms
" S
pltes that affect supply chain
I up to a fifth M-maximization.
-1n tMturkii, won't be enough to just develop
a new product or service offering without a
companion strategy to serve customers at the
lowest possible net landed cost. Indeed,
innovative strategies to deliver traditional
products at lower costs have been key to
remarkable business successes in industries
ranging from pharmaceuticals (e.&!.
Medco
Containment, now owned by Merck & Co., Inc.)
to auto parts (Autozone).
Less than a decade ago the pharmaceutical
retail industry exhibited al1 the outward signs
of having matured in its distribution of product.
Then, new players questioned what the
pharmaceutical industry was really
been written about how
electronic marketing will
soon revolutionize
consumer shopping
practices and retail, but
without breakthroughs in
supply chain capability it
may not be practica1 or
profitable to deliver low
value, perishable groceries
to consumers. As our example in the Measurement
section illustrated, the higher margins estimated
for selling product electronically could be wiped-
out by service costs for deliverywithin confined
time windows, small order sizes, and low value
:oducts. What's more,

if the electronic marketing concept is even
maginally successful, many retail stores,
deprived of 5 or 10% of today's sales, will fa11
below the break-even level.
rvivors must identgg the niche
channels they are best suited to serve.JJ
identify the niche channels they are best suited
to serve and develop operating strategies to
support these channels.
Finally, manufacturers who may be
The wholes'ale industry, still vital for tempted to short cut traditional trade channels
distribution of everything from groceries to with factory outlets or deep regional promotions
,
pharmaceuticals and auto parts, must redefine that foster diversion must take into account the
how it fits into the
-
new supply chain paradigm affect cannibalized demand will have on overall
that only rewards low cost providers. Inaccurate profit sources.
costing and anachronistic upcharge pricing now Faciiitating Product Flow
distorts the lenitimate " value-addedrole of these Integrating our supply chain costing principles
important supply chain links. Survivors must and maintaining a Taoist perspective of product
flow and service strategies will increase any
company's potential for success. l)qically, any
given supply chain participant will not have
already established distribution through al1 the
possible combinations of services that would
de a superior fiow for a pmduct. Therefore. in < P
1 some cases, a company will have to build the
.?'ti
'-.
systems and facilities they need or form
partnerships and alliances with vendors that
,.-d
can provide the services a product requires. #
Methods of establishing new trading
:elationships and gaining what is important to
your company in the negotiation process will be
the topic of our next white paper in this series.
Finally, we would like to leave you with a
verse of Chinese wisdom written by one of the
fathers of Taoism, Lao %e:

'7 hen thq hear of the Wi,
The highest mindspractice it;
Be averape mi& think about it
And tty it now and thm;
The lowest mi& laugh at it.
.y tney did not laugh at it,
It wouM not be the Wq.
-1540 TSE

'7 hen thq hear of the Wi,
The highest mindspractice it;
Be averape mi& think about it
And tty it now and thm;
The lowest mi& laugh at it.
.y tney did not laugh at it,
It wouM not be the Wq.
-1540 TSE

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