The business landscape of the past few decades is littered with initiatives aimed at helping companies in their never-ending pursuit of efficiency. These campaigns have assumed forms both technological (distributed computing, enterprisewide solutions, and groupware) and process-related (just-in-time, reengineering, and total quality management).

To some extent, these programs have been successful. Companies worldwide are more productive and efficient than ever before, and they continue to improve their operations daily. But these gains represent only a small portion of what is attainable.

The problem with many of these popular business initiatives is that they typically focus on improving functions or activities within the company. They ignore the fact that the company's business operations comprise a network of relationships that extend far outside the company's four walls. Upgrading internal processes undoubtedly can help optimize individual segments of a company's operations. Such improvements do little, however, to eliminate waste and inefficiencies in other areas of the organization or in related areas within the operations of the company's trading partners.

An attempt to optimize manufacturing, for example, may focus simply on the cost drivers that are pertinent to a manufacturing operation. This might include pruning a product line to reduce the total number of setup changes, minimizing the number of times per year a product is produced to reduce setup costs and extend manufacturing runs, and operating at a fixed schedule throughout the year. But while the incremental unit cost savings of such actions may be large, they could be offset by costs incurred outside manufacturing's purview. Numbered among these costs are product spoilage and obsolescence, inventory carrying costs, and extra handling or transportation costs. Worse yet, the improvements made in the manufacturing operation may even cause costs in other areas to rise.

Certainly, formulas such as Economic Order Quantities (EOQ) can be used to identify and minimize total costs within an organization (so that unit manufacturing, inventory carrying, and set-up costs, for example, can be minimized concurrently). But even these equations ignore costs incurred in supplier and customer organizations.

The challenge for companies today therefore is not to make themselves the most efficient entity or even to link individually efficient organizations. Rather, it is to work in concert with their suppliers and customers to optimize the entire trading relationship—even if it means that individual portions of that relationship may not be optimized.

This supply chain view of operations represents the greatest opportunity for suppliers, manufacturers, and retailers to improve productivity and efficiency—and, consequently, revenues and profits. The key, however, is for trading partners to understand and agree on what constitutes the supply chain. The most robust definition of supply chain is all of the activities, spanning every industry segment, that are involved in supplying a product to the end customer. In many cases, this end customer is the consumer, who is distinguished from all other "customers" in the supply chain that sequentially purchase products either for re-sale or as ingredients in other value-adding activities.

By embracing this definition—and its concomitant view of the consumer as end customer—companies can use the supply chain as a way to integrate many of the business movements of recent years into a cohesive strategy for growth.

To date, several industries have experienced some success with supply chain initiatives, most notably in consumer-goods businesses. For example, in the mid-1980s, the domestic soft-goods supply chain adopted Quick Response (QR). This supply chain technique helped textile manufacturers, apparel manufacturers, and mass retailers boost sales by 20 to 40 percent while decreasing inventory levels by 20 to 30 percent.

In the early 1990s, the grocery-products supply chain adopted an initiative called Efficient Consumer Response (ECR), which was designed to generate $30 billion in cost savings by eliminating inefficiencies between trading partners. This savings represents 10.8 percent of sales in a supply chain that has for decades engineered a high degree of efficiency in component processes (such as manufacturing). Though ECR is still in the implementation phase, many companies have reported early successes in reducing inventories and streamlining processes.

Taking their cue from the grocery segment, the foodservice and healthcare products supply chains recently launched their own initiatives—Efficient Foodservice Response (EFR) and Efficient Healthcare Consumer Response (EHCR)—that also have the potential for dramatic sales growth and significant cost savings. An initial EFR study has identified $14.3 billion in potential savings in the foodservice industry. Early work in EHCR indicates equally substantial savings may be achieved in the healthcare supply chain, though a precise figure has yet to be determined.

Key to the gains achieved by initiatives such as QR and ECR, and to the promise of EFR and EHCR, is the notion that cooperation—both between supply chain trading partners, and to some extent, competitors—paves the way to success. But more specifically, as one studies each of these initiatives, it becomes clear that they all share a number of common principles that, when applied across the entire supply chain, can result in effectiveness and efficiency never before experienced. These principles, or habits, embody process quality, process efficiency, integrated demand planning, risk pooling, managed variety, asset utilization, and value-aligned revenue and incentives.

HABIT 1Recognize that achieving quality in the supply chain process requires changes in fundamental business practices—both inside and outside the company.

A quality supply chain process crosses the bounds of two or more business entities and operates with minimal errors, exceptions, or re-work. Consider the revenue cycle process. In the revenue cycle, the buyer initiates an order and communicates it to the seller, which ships the product and produces the invoice. The invoice is communicated to the buyer, which pays the seller for the product. Theoretically, quality is achieved when the entire process is completed without a hitch. Unfortunately, however, this is a case in which theory rarely matches reality.

In the revenue process, quality can be compromised in a host of areas, beginning with when the order reaches the seller's desk. Initial review of the order can reveal header information—such as "ship to" and "bill to" addresses—that does not match what appears on the customer master file. Item numbers can be incorrect, reflecting the buyer's item-numbering scheme, not the seller's. The quantity ordered may be non-standard (a box of 10 is desired when the items come in boxes of 12). Unit prices can be outdated or incorrectly reflect a promotion. Any of these conditions requires re-work, re-coding, and review between buyer and seller to correct the discrepancies.

Continuing on in the process, it may become apparent that, because the items ordered are not in stock, the order either is shorted or a substitution is made prior to shipment. Then, when the buyer receives the shipment, the receiving process bogs down because the items and quantities received no longer match the original order. If the seller has made changes to unit pricing or promotion information on the invoice, the invoice does not match the original order, so the buyer creates a deduction. Now the payment received by the seller no longer matches the invoice—which did not match the original order to begin with. This requires additional processing by the seller to research and reconcile the payment, the invoice, and the deductions.

Obviously, in this example alone, opportunities for improvement abound. However, no single business entity can attack this problem on its own. To truly correct the problems, both the buyer and seller must change their practices. The root cause of the errors was poor synchronization of product, price, and promotion information between buyer and seller. If the buyer had written the order using the seller's database or a current copy of the price list, the correct item numbers and current prices would have been used, the order quantity would have reflected the appropriate multiple, and in the case of items in short supply, the buyer would have either downgraded the order quantity or made the substitution decision based on its view of the demand.

Another example involves a major food-products manufacturer that discovered nearly 70 percent of its invoices resulted in a buyer's unauthorized deduction. Knowing there was a gold mine in these deductions if they could be minimized, the company contemplated implementing a new system that could communicate accurate and timely product, price, and promotion information.

But when its feasibility study concluded that this new system would require a seven-figure investment, the company's senior executives were stunned. What these executives did not realize at the time was that the task really was not so simple. In fact, the company's aggressive promotional approach to selling products—which involved "constructing" a promotion using any combination of 124 different variables—was the reason for the high cost of the prospective system. Furthermore, even if the system were implemented, it was unlikely that the company's customers would have the necessary systems in place to interpret the business rules for constructing a promotion—which means the company would end up making little progress in reducing deductions.

The message here is that process quality issues often are rooted in fundamental business practices, not in the failure of individual activities or the technology employed.

HABIT 2Eliminate activities that do not contribute value to the end product or service, or that duplicate effort.

Closely linked to quality is the concept of efficiency, which promotes minimizing resource consumption to achieve an end goal. But efficiency is only truly useful when quality is in place. In the revenue-cycle case, it would do little good to make the process efficient without first making it better.

Rather than investing in automated work-flow systems that streamline high-volume deduction processing, for example, the buyer and seller first should eliminate the root cause of the bulk of the errors—i.e., reduce the volume of deductions. They then should focus investment on the core processes of buyer-seller communications and fulfillment. To do otherwise risks creating supply chain processes that are highly efficient at creating and correcting errors.

After building quality into a process, a company can use a number of tools and techniques to make that process more efficient. It can conduct an activity-based analysis of the process to identify activities that either do not contribute value to the end product or service or that duplicate effort. For instance, in an arrangement called Evaluated Receipt Settlement (ERS), the buyer's payment is triggered not by the receipt of an invoice, but rather by the receipt of goods that involves a firm agreement on the transfer pricing. This arrangement eliminates the need to create an invoice.

Additionally, the company may consider a consignment arrangement, in which a supplier retains legal title to merchandise until it is sold to the end consumer by a retailer. This practice also renders many activities in the revenue cycle unnecessary. Finally, the company can use technology such as Electronic Data Interchange (EDI) to improve efficiency. In a revenue cycle that has been streamlined, pared down to essential activities, and operates at a high level of quality, EDI can be applied to reduce process costs even further. Rather than having a purchasing system print out an order that will be sent and re-keyed into a fulfillment system, the order is sent electronically and is updated automatically in the seller's systems.

HABIT 3Integrate demand planning across all activities.

Because all demands in a highly effective supply chain derive from the single objective of satisfying the end consumer, companies must ensure that they properly orchestrate all activities to meet that need. Integrated demand planning (IDP) plays a critical role in this orchestration.

A simple way of viewing IDP is as an extension of the Materials Resource Planning (MRP) concept. Traditional MRP uses a bill of material that describes the assemblies, sub-assemblies, components, and parts included in the finished product. The demand for parts is not planned for independently, but rather is tied to the forecast of the end item. Auto manufacturers, for example, do not forecast the need for tires independent of their planned vehicle output. Instead, they forecast how many cars they will sell and multiply that forecast by five (four plus a spare) to determine the total tire needs.

IDP applies this same logic across multiple organizational boundaries in the supply chain. The forecast for the sale to the consumer ultimately should filter back to derive forecasts for raw materials at the start of the supply chain. The forecast horizon and level of detail should be appropriate for each level in the total supply chain bill of materials. In applying IDP in this way, each segment avoids independently forecasting and planning for the needs of the next customer in line. Without such a view of demand, the series of independent forecasts—each of which tries to second-guess the actions of the other—results in severe distortions and disconnects between supply and demand. Often this produces a "bullwhip effect," in which errors get amplified as they move up the supply chain.

The case of a sporting-goods company illustrates this point. This capacity-constrained manufacturer introduced a new model that was being sold through a nationwide retail chain. Because capacity was a scarce resource, it was important to load the plant with product that would sell at a high margin. Initial orders from the retailer indicated that the new model was going to be a much larger success than anticipated. In response, the manufacturer quickly re-allocated plant capacity to produce more of the new model at the expense of other models—which had lower margins but still were selling briskly. This meant that orders for these established models would be shorted so that the new model could be produced in greater quantity.

After several weeks of continued brisk sales, orders for the new model stopped cold. However, the plant was in motion and inventory of the new model began to build rapidly before the spigot could be turned off. Again, the plant capacity was reallocated to cease production of the new model. Several weeks later, the orders started up again at a rate that was just about what was originally expected. After the new model excess inventory had sold down, the plant was again re-scheduled to produce that model at moderate rates very close to what had been planned originally.

The problem was that the manufacturer had no view of sell-through to the consumer. The initial surge in orders represented the retailer's stocking up to meet expected demand. The retailer's forecast for the new model exceeded that of the manufacturer, and the retailer stocked up accordingly. Then when consumer sales took off at a rate slower than the retailer expected, it went through a sell-down period. When its inventory reached a steady state, the retailer again resumed ordering to replenish product as it was sold. This is a classic and very real example of the bullwhip effect.

After some time, both parties recognized that the manufacturer had a better understanding of demand for the product than the retailer did. The manufacturer's original forecast was essentially correct; but without a view of consumer pull-through, manufacturing decision makers had no way of leveraging their knowledge to achieve better results. Eventually, the two parties agreed on a system in which the retailer—instead of sending orders to the manufacturer—sent weekly snapshots of its on-hand inventory positions and the sales that had occurred during the past week. The manufacturer, in turn, wrote the order to itself to keep the products flowing to the consumer.

HABIT 4Pool risks among supply chain partners.

Risk pooling builds upon the first three habits. This success trait can help a supply chain position inventory to minimize total levels, reduce uncertainty, optimize service to the consumer, and keep the supply chain flexible in its ability to react to changes in demand. Risk pooling tends to run counter to traditional views on where and why inventory is maintained because it ignores the incentives that individual supply chain parties typically follow. To illustrate, pushing inventory through the supply chain so that the bulk of it is on the store shelf often is rationalized with the notion that "products sell off shelves, not from warehouses." While essentially true, this idea misses the point that pushing inventory down to shelf level requires an allocation of product based on a very granular level of forecast—a very difficult exercise. To determine how much inventory to place in each store, managers first must estimate the demand that will be placed on each store. If there are 100 stores in the chain, then 100 estimates are needed to plan the 100 piles of inventory—each of which would include some safety stock to cover the error in the forecast. (At this fine level of detail, forecasts can be very wrong, thereby necessitating a large amount of safety stock.) Assume that each store needs 10 units of safety stock to cover the uncertainty. That means there are 1,000 units (10 × 100) of safety stock in the system.

By removing the store from the equation, managers can produce an aggregate forecast that is much tighter—principally because store-level fluctuations in demand begin to cancel one another out. Now let us assume that the replenishment leadtime mandates a need for only two units of safety stock in each store (in addition to the safety stock in the central pool). Because multiple forecasts have been pooled and the level of total uncertainty has been reduced, much less safety stock in the central pool—say, 500 units—is needed. With these 500 units, plus the two units in each of 100 stores, the total safety stock in the system is now 700. This compares to the 1,000 units when all of the safety stock was held at the store level.

Besides reducing the costs associated with excess inventory, such pooling makes the overall supply chain more flexible. If demand takes off in one store, the central pool can react with larger replenishment orders to compensate. Conversely, if all of the inventory had been pre-allocated to the stores, then the store with heavy demand likely would have sold out and lost additional sales—even though another store may have had excess inventory.

Risk pooling works when supply chain partners recognize why inventory exists, where it can be positioned most effectively, and how much is required to achieve a desired service level. It helps companies move beyond the inventory-management shell game, in which supply chain partners offer incentives to one another to hold inventory to get it off a balance sheet or to prop up sales for a period. Because it tends to push inventory upstream at lower stages of value added, risk pooling both reduces the cost to carry inventory (lower per-unit cost) and aggregates multiple demands into a single demand with less uncertainty. The end result: shared risk and lower quantities of inventory.

HABIT 5Distinguish between desirable product variety and costly duplication.

Most supply chains feature multiple products geared to essentially the same consumer demand. Pasta products are a good example. There is spaghetti, rigatoni, linguine, fettucini, angel hair, lasagna, and so on. These items come in different brands, dry or refrigerated, and in a variety of sizes. All fill a somewhat narrow niche of consumer demand and all are somewhat substitutable. If the 8-oz. box is not available, two 4-oz. boxes or even one 12-oz. box will do. Such categories exhibit a tremendous degree of intra-group competition but little sparring with other product groups. In other words, there is little competition between a pasta item and a fruit-juice item.

An effective supply chain walks the fine line between variety that is good for customers and duplication that is costly and undesirable. A supply chain manager can more effectively discover the optimal product mix by analyzing two main factors: the profit contribution of each item in his portfolio and the item's value to the supply chain's overall offering to the customer.

Considering the financials of variety, the first task is to rank the products in descending order of contribution margin. Most often, this exercise results in a typical Pareto distribution: 20 percent of the items generate 80 percent of the total margin contribution.

After these contribution margins are cumulated, an activity-based cost is assigned to each item. This cost is typically constant across the top-selling items. However, as more items are added to the mix, the incremental cost of each item begins to skyrocket. This could be due to fixed constraints—such as space on the shelf or number of pallet positions in a distribution center—or limitations in an item-numbering scheme.

In conducting this analysis, managers will see that at some point, net profit contribution peaks. Beyond this point, incremental item sales do not compensate for increased costs and actually erode total profits. If this is the case, then incremental units are not expanding total category sales but, rather, are cannibalizing sales of other items in the grouping. At this point, it becomes apparent that there is duplication in the mix and the duplicate items are candidates for pruning.

Before pruning individual items, however, one must first take a "marketbasket" look at the item. Even though an item may not justify its existence within a category, it may do so in relation to the total offering to the customer. For instance, a store may sell only 10 units of premium baby formula per week even though it sells 500 units of baby formula in total. Yet the 10 units of the premium brand go into the basket of shoppers who specifically visit this store because of the premium baby formula's availability. These shoppers typically spend $300 per week in the store on a collection of items with a high total margin. Assuming that each of these shoppers purchases one unit of the premium formula, removal of this item solely based on its performance in the category puts at risk $3,000 in weekly store sales. Only after such an analysis is completed can an item be pruned safely.

If, on the other hand, the profit curve continues to rise to the last item on the list, it could mean that consumer demand has not yet been sated. This is often the case in new categories created by an innovative product line. Fat-free snack items are a clear example of this phenomenon. Nabisco's Snackwell cookies created the category, and as new items were added, sales of fat-free cookies in total continued to grow.

By actively managing variety, an effective supply chain "sops up" as much demand as possible while, at the same time, avoiding excessive costs associated with variety.

HABIT 6Improve asset utilization by working with supply chain partners to ensure that goods are produced at roughly the same rate they are consumed.

Not surprisingly, highly effective supply chains utilize their assets to a great degree. This seems like common sense, but many supply chains have a tremendous level of unused assets on their balance sheets. Trucks that travel long distances with less than full loads, plants that have capacity to meet peak periods of demand but are either idle or underutilized during other periods, and distribution centers that have space to hold surges from production or purchasing...these all represent opportunity areas to become more effective.

A number of factors can contribute to poor asset utilization; some are avoidable, some are not. For instance, natural cycles—such as a harvest that happens once a year—mandate the availability of equipment, plants, and capacity to handle this surge in volume. Likewise, extremely seasonal items such as Easter candy, turkey baking bags, and Christmas-tree ornaments are examples of items for which no amount of planning could smooth out extreme peaks and valleys in demand.

In many more cases, though, surges in capacity utilization (or non-utilization) are simply the result of poor planning or ineffective cooperation between supply chain partners. For example, at the end of a quarter a manufacturer looks to prop up quarterly sales figures by offering a promotion, which pushes a glut of inventory downstream. This, in effect, borrows sales from future time periods and actually artificially escalates costs. Plants must run at full tilt, often using extra shifts for which a premium is paid. Product is pushed through DCs that also must operate using extra shifts and overtime to meet the shipping deadlines. Added trucking capacity needs to be obtained—often at a premium—to get the product shipped. And, at the receiving end, the glut of "forward bought" product must be stored, many times in off-site facilities that add additional incremental costs.

When the push is over, demand ceases for a period as the customer consumes or sells the excess product that has been purchased. Plant, shipping, and transportation assets remain idle. Then, as replenishment activity resumes and fill-in orders are received, they are in much smaller quantities than would have been the case if the large lump of inventory had not glutted the system. In the end, this effectively voids any economies of scale.

In effective supply chains, natural limits (for example, harvest cycles or seasonal demand) represent the only factors that determine peak-to-average asset-utilization rates. Other scenarios, such as the one just outlined, can be avoided when the partners work together to smooth out supply cycles so that the supply chain produces product at roughly the same rate as it is consumed. In this way, other artificial factors are eliminated and total costs are minimized.

HABIT 7Recognize how and where consumer value is added in the supply chain and align revenue-generation and incentives accordingly.

The final habit of highly effective supply chains is probably the most difficult to conceptualize—and often even harder to implement—because it can contradict years and even decades of business practices. Essentially, this principle espouses recognizing how and where end consumer value is added in the supply chain and aligning revenue generation with these activities. Another way of looking at it is that value-aligned revenue and incentives provide a mechanism for supply chain partners to offer one another incentives to "do the right thing." And once the right thing is done, they all share in the gains.

This concept is important because many actions detailed in the previous six habits fundamentally alter who does what in the supply chain and how things get done. If the investments required to implement a change—or the operating costs associated with the new practices—do not naturally align with where the gains accrue, a stalemate can occur.

In the vendor-managed inventory (VMI) scenario discussed earlier, for example, the retailer benefited by having less inventory and shifting the replenishment activities to the supplier. The supplier, in turn, had to invest in a system to support the change and add a new position (VMI manager). As a result, the costs and benefits accrued on different P&Ls. With no gain-sharing mechanism in place, it is fairly obvious who gets the better end of the deal. Although total supply chain costs did drop, the supplier could rightly state that its costs rose with no incremental gain. The retailer, on the other hand, could boast a large gain against a small cost.

In this particular case, the supplier justified the investment because it could realize a related benefit: By getting sell-through data from the retailer, it could manage inventory and assets much better. However, if this back-end benefit had not been available, a gain-sharing mechanism—such as a supplier-levied "service charge" for each order—would have been required.

Operating under a system of value-aligned revenue and incentives is often the most overlooked habit of effective supply chains because it requires that partners check their years of business traditions at the door. One trading partner may very well have discovered a means of reducing total cost (perhaps by implementing an efficient EDI system). However, to get takers to sign up and use the system requires an incentive ... perhaps a pricing discount that shares the efficiency gains, a quid quo pro that provides a win for the other players, or a penalty or service charge for those that choose a more inefficient means of conducting business. For individual businesses within a supply chain to benefit and to make the entire supply chain more effective, all players must operate as an integrated whole.

In conclusion, effective supply chains are created when one looks beyond the four walls under the direct control of any individual segment and views these as parts of a whole. To do otherwise misses a tremendous opportunity to make the supply chain more effective at fulfilling consumer demand, generating revenue, and, finally, maximizing profits.

In their endless pursuit of efficiency, effectiveness, and profits, companies continually must strive to avoid the trap of becoming too preoccupied with internal operations. An emphasis on creating an effective supply chain with trading partners—while maintaining a focus on the end consumer of the product or service—is the key to genuine business growth.

To this end, an effective supply chain strikes an optimal balance in three areas:

• Cost structure. Minimizing total costs—in conversion, handling, inventory, transportation, and administration—is critical.
• Product mix. To a high degree, effective supply chains fulfill the total demand that exists through a managed variety of products. In achieving this goal, a supply chain also must continually fine tune the variety of products offered and effectively tap into new customers.
• Consumer sales revenue. In a free-market economy, the goal of any business is to balance the value of its offerings to the end consumer with its desire to maximize profits. An effective supply chain plays a critical role in helping companies continue to provide products and services to consumers at a price and cost that satisfies both parties.

Of course, no relationships are without their warts—even among those partners that display all seven success habits. However, history shows us that the most successful unions are those in which the needs and desires of all sides are acknowledged and respected. Perhaps Charles Horton Cooley, in Human Nature and the Social Order, said it best: "The general fact is that the most effective way of utilizing human energy is through an organized rivalry, which by specialization and social control is, at the same time, organized cooperation."