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December 16, 2017
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Finding the perfect fit

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In a world of increasing supply chain complexity, the "one size fits all" approach no longer works. Smart companies are segmenting their supply chains to match customers' needs —a practice that reduces costs and drives up service levels.

Over the past decade, product-selling companies have seen complexity increase in every link of their supply chains, from customers to retail channels to manufacturing processes, and all the way back to raw-material supply. Driving this added complexity is consumers' demand for products that match their needs, tastes, and lifestyles. At the extreme, this market fragmentation has fueled the growth of mass customization, with companies like Timbuk2 or Nike manufacturing bags and shoes to individual consumers' requirements. But mass-market producers have been affected, too. Nokia, the electronics giant, now produces as many as 170 handset variants and 250 sales packages based on a single product platform.

Such product diversity makes demand more difficult to forecast. The increasing "spikiness" in demand has been exacerbated by manufacturers producing short-lived "fast fashion" or seasonal products and by retailers using short-term price promotions to encourage customers to buy. Routes to market are also becoming more complex, with many companies now offering both conventional and online channels while continuing to support smaller outlets.

Article Figures
[Figure 1] Channels have differing needs
[Figure 1] Channels have differing needs Enlarge this image
[Figure 2] Segmented approach to supply chain design
[Figure 2] Segmented approach to supply chain design Enlarge this image
[Figure 3] Identify the sources of complexity
[Figure 3] Identify the sources of complexity Enlarge this image
[Figure 4] Narrow the list to relevant data
[Figure 4] Narrow the list to relevant data Enlarge this image
[Figure 5] Segmentation criteria
[Figure 5] Segmentation criteria Enlarge this image
[Figure 6] Segmentation criteria
[Figure 6] Segmentation criteria Enlarge this image
[Figure 7] Segment definition
[Figure 7] Segment definition Enlarge this image
[Figure 8] Value drivers for each segment
[Figure 8] Value drivers for each segment Enlarge this image
[Figure 9] Operational characteristics for two segments
[Figure 9] Operational characteristics for two segments Enlarge this image

Retailers have also driven complexity by increasing their service expectations. It is not uncommon for major retailers to demand instock levels in excess of 98 percent. At the same time, retail chains that are under severe working-capital pressures are demanding reduced inventories and higher delivery performance, thus eroding the buffers that traditionally protected against stock-outs.

Finally, the global nature of manufacturing and sourcing contributes to supply chain complexity, as companies juggle the tradeoffs between less costly but slow sea freight or higher-cost but faster air transportation. For many, the social and environmental impacts of these extended supply chains are also becoming important, adding yet another layer of complexity.

Segmentation offers an effective way to tame supply chain complexity. It allows companies to understand which elements in a complex network matter most to certain customers. Armed with that knowledge, they can design differentiated supply chains that deliver results profitably.

To successfully segment their supply chains, companies need to take a three-step approach: 1) uncover underlying drivers of operational complexity throughout the supply chain, from customers back to suppliers; 2) design differentiated supply chain segments tailored to address these unique complexities; and 3) create a customized end-to-end operational blueprint and performance metrics for each supply chain segment.

One size won't fit all
Traditional, "one size fits all" supply chains are creaking under the strain of so much complexity. For example, companies can work hard to build effective processes for their high-volume items in order to minimize overall supply chain costs. By doing so, however, they risk disappointing key customers by failing to respond to peaks in demand for slower-moving items. But when they take steps to avoid stock-outs at key customers, additional costs ripple quickly through the entire supply chain.

That is exactly what happened to one apparel brand, which found itself making extensive use of courier deliveries from factory to retailer in order to meet unpredicted demand. At one point the manufacturer was moving up to one-third of its shipments this way, at a cost up to 30 percent more than if it had used its own distribution center (DC) network.

Similarly, traditional supply chains attempt to apply one type of demand forecast to different categories of products and align supply to these forecasts. This approach, however, greatly strains the production system. Mature products with steady demand and those with highly variable demand require different approaches to keeping production costs down. In fact, it is fairly common to see a low rate of accuracy when forecasts are applied without differentiation, which leads to high production costs and inventory buildup.

In the face of these challenges, an increasing number of companies are abandoning their one-size-fitsall model in favor of a segmented supply chain strategy. Wal-Mart, for example, now runs separate distribution centers for its fast-moving and slower items. The retailer rolled out the segmented strategy across more than 100 DCs in the United States starting in 2005, after trials demonstrated reduced stock-outs, improved store efficiency, and increased sales.

In addition to improving service and costs, segmented supply chains allow companies to capture more value as different parts of their businesses grow at different rates. By segmenting its supply chain, a company can offer increased responsiveness for fastgrowing channels and product lines while providing better cost control in mature, stable segments.

One consumer products manufacturer, for example, faced stagnant growth in its traditional, high-volume channels of food and convenience stores. While these channels remained important in terms of volume, others, particularly mass retailers and price-sensitive club stores, were expected to grow twice as much over the next three years. When the manufacturer examined these channels in more detail, it found that their needs were very different. The traditional channels still valued packaging that saved labor and cut restocking times. But discount clubs wanted product that would display well on the pallet, and mass retailers were increasingly asking for customized packaging options.

The company's response was to segment its supply chain design to meet the unique needs of each channel. Figure 1 summarizes the differences among the four channels.

How segmentation works
At its core, supply chain segmentation uncovers what matters most to a particular product, customer, or channel and finds ways to tailor operational characteristics to deliver against those needs. For example, everyone needs on-time and accurate delivery. However, volume flexibility and supply chain responsiveness are much more important to outlets that attract customer traffic with deep, temporary price cuts than they are to "everyday low price" outlets. Similarly, quick time-to-market matters much more to fashion-oriented, short-lifecycle merchandise than it does to long-lasting, core products.

In the consumer product manufacturer's example above, different customer priorities dictate the level of service needed. While traditional supply chains attempt to continuously deliver high service levels across the board, they often fall short due to profitability pressures. A segmented supply chain forces the question: Where would the investment in better service delivery result in the largest volume or margin growth?

In the example shown in Figure 2, a consumer packaged goods (CPG) company adopted a segmented supply chain approach, creating a new segment (1) specifically for its mass-merchandising customers. It allocated dedicated production lines for high-volume stock-keeping units (SKUs) and shipped from them direct to customers' distribution centers. The inventory for this dedicated segment dropped by 90 percent while service levels improved by 10 percent. At the same time, the company reduced its production costs by minimizing changeovers.

The example of a simple matrix of customer priority versus product demand behavior in Figure 2 identifies six distinct segments. For high-volume, low-variability demand, the manufacturer designed a cost-efficient supply chain. Production was smoothed, changeovers minimized, and dedicated production lines established to drive the lowest possible costs [1]. For high-volume product lines with high variability, priority ("A" and "B") customers were offered a responsive service [2], while providing a limited menu of options for less profitable "C" segment customers helped to reduce variability in that segment [3]. Lowvolume, low-variability products were supplied to high-priority customers from inventory using a basic replenishment service [4], while lower-priority customers were offered a more limited choice of SKUs [5]. Finally, tricky low-volume but high-variability lines were managed for high-value customers. The manufacturer offered the highest service levels only if it obtained other business benefits, such as access to test markets for new product launches [6].

A blueprint for transition
Making the transition from a "one size fits all" supply chain should follow a commonly used blueprint. In the first stage, companies identify how their business strategies and market conditions are putting pressure on their supply chains. Second, they decide how they will define their supply chain segments in a way that will allow them to respond to these pressures. Third and finally, they establish and tailor processes and infrastructure for each segment.

1. Identify supply chain pressures.
The basis for supply chain segmentation must be grounded in a company's corporate strategy and its business context. For example, segmentation to drive greater market share in a high-growth industry looks quite different from segmentation that is geared for cost efficiencies in a declining or mature industry. Therefore, the first step in supply chain segmentation is uncovering the underlying business dynamics that drive the supply chain's complexity.

An apparel manufacturer began this process with a list of criteria that were most relevant to its supply chain, as shown in Figure 3. These criteria included product attributes, channel and customer needs, demand variations, supply base, and logistics complexities. This comprehensive list was systematically narrowed by filtering out less important variables and combining interrelated variables. As shown in Figure 4, the company only preserved those criteria that were operationally relevant and had the potential to either reduce costs or enhance customer satisfaction.

The criteria chosen can vary widely across industries. A company in the high-tech industry, by contrast, selected customer lead time and product customization as the underlying drivers of its supply chain complexity, illustrated in Figure 5.

2. Define the best segments.
The second step in segmentation is defining the segments themselves. In the high-tech example above, the segmentation criteria were grouped to define four unique segments, shown in Figure 6. For this company, a mobile-handset manufacturer, the primary drivers were customers' requested lead times and the level of customization needed in the products. Customer priority and products with short shelf life determined by fashion trends were secondary drivers for the segments.

For customers that were willing to wait longer than a specified duration, the manufacturer defined an "order-to-order" segment, which operated with no safety stock in the system. For customers that were unwilling to wait, it defined three distinct segments. Trendy products for high-priority customers were delivered from safety stock to minimize lost sales. Safety-stock quantities were determined based on a "best case" forecast. Highly engineered products were delivered from a make-to-stock model in which late differentiation was applied to a base model once the customer order was received. In all other cases, reorder points throughout the supply chain controlled production signals.

Similarly, the apparel manufacturer created five distinct segments (see Figure 7) based on channel priority, product margins, demand volume, demand predictability, and sourcing location. Mapping the existing portfolio of products into each segment provided an indication of each segment's relative importance by sales and margins. The overarching strategy for each segment was based on which value drivers are important to that segment, such as increasing responsiveness or reducing cost-to-serve. Figure 8 shows the value drivers for each segment.

3. Build processes and infrastructure.
The last step in defining the segmented supply chain is establishing operational characteristics and tailoring performance metrics by segment. For example, a retailer might choose a "test and chase" strategy for its new product segment, releasing limited quantities of product to market while holding stock at the distribution center for a quick response to outlets in which the items prove popular. Its steady, high-volume segment, meanwhile, would be configured for pull-through replenishments to the channel outlet.

The end-to-end supply chain characteristics for the apparel manufacturer were configured based on the overall strategy for each segment. The supply chain for "Fast Fashion" merchandise, which typically sells at high margins, was configured for small-batch production with expedited downstream logistics capabilities and tight upstream design collaboration. On the other hand, the "Everyday Basics" segment was configured for minimum/maximum replenishment triggers with minimal production changeovers or downstream expedited logistics. Figure 9 compares the operational characteristics for both segments.

The secrets of success
Defining and implementing a segmentation strategy can be daunting, and companies frequently stumble. Following three basic lessons, however, can help them to avoid common pitfalls and keep them on the road to a successful segmentation strategy.

Lesson 1: Pick the right number of segments.
Every product and every customer is unique. As a result, it can be tempting to create many different segments in an attempt to reflect all of these diverse needs. Too many segments, however, can be impossible to manage, and overly complex segmentation strategies rarely make it off the drawing board. In practice, most of the companies that successfully implement a segmentation strategy narrow their options to between four and six different segments —enough to offer a reasonable match to various customer and product requirements without introducing an overwhelming level of complexity. For example, one consumer packaged goods company initially identified more than 40 segments. The company refined that to a list of 10 and eventually brought it down to a final list of four segments. Each segment included enough SKUs and represented enough revenue to justify the time and effort required to implement it as a separate segment yet was homogenous enough for the company to execute a coherent strategy.

Lesson 2: Let customer requirements determine your focus.
Supply chain segmentation traditionally has focused on products, but successful companies also consider customers when they segment their supply chains. More importantly, those companies understand their customers' requirements and use them to drive implementation of the segmentation. For example, one company recognized that customers in its seasonal segment —the primary revenue driver —valued availability of certain items and were unwilling to wait for those products to be restocked. It therefore focused on speed-to-market when it executed the segmentation for seasonal goods. Moreover, when redesigning its operations, the company chose flexibility over capacity utilization for this segment. This allowed the company to systematically grow its business and capture share in key channels and customer segments. Along the way, it reduced overhead costs by 20 percent, reduced out-of-stocks by 75 percent, and grew seasonal revenue by 2 percent.

Lesson 3: Implement segmentation in steps.
Coordinating a massive supply chain reorganization requires significant resources and could increase delivery problems in the short term. That is why it's best to implement segmentation in steps, focusing on the areas of highest impact first and creating "wins" to build momentum and keep the organization engaged.

Prioritization of areas for implementation will vary by industry. Companies have multiple options for starting points, from the sales and operations planning (S&OP) processes, to manufacturing assets and production processes, to distribution networks. Many CPG companies focus on their production processes first, especially when capacity limitations exist. For example, one food manufacturer faced a critical capacity limitation when executing its segmentation strategy. By focusing first on freeing up production capacity, it was better prepared to implement the remaining changes. Similarly, another CPG company focused first on aligning its production strategies between high-utilization and high-flexibility segments to ensure its ability to deliver. In contrast, a high-tech company needed to focus first on its S&OP processes to ensure delivery with minimum inventory, given its high inventory costs and risk of product obsolescence.

Segmentation brings rewards
Companies that embrace supply chain segmentation are reaping the rewards of operations that are tailored to specific channel needs and costs. The benefits vary across industries, since the focus of segmentation is quite different depending on the industry.

In high tech, where it is common to see short product lifecycles and unpredictable trends and component availability, segmentation typically improves service levels by 5 to 10 percent while reducing inventory levels by 15 to 20 percent. The focused allocation of inventory successfully frees up working capital that can be reinvested in software and hardware capital expenditures.

In the food processing industry, where seasonality of supply and demand is important, segmentation can produce inventory reductions of up to 40 percent while dramatically raising service levels for the most important customers. Lower inventory and smaller batch sizes have also decreased total landed costs, leading to higher product margins.

Retailers face the double-edged sword of excess inventory and markdowns on the one hand and outof- stocks and lost sales on the other. Successfully deployed segmentation has helped improve margins by 5 to 15 percent on selected merchandise while lowering overall logistics and warehousing costs by as much as 15 to 20 percent.

Supply chain segmentation has produced similarly impressive results across industries. It is not surprising, therefore, that in the midst of the current economic challenges, even more companies are rethinking their supply chain organization as they seek a distinctive edge over their competition.

Daniel Swan is a principal at McKinsey & Company. Sanjay Pal is an engagement manager at McKinsey & Company. Matt Lippert is an engagement manager at McKinsey & Company.

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