Designing Supply Chains for the "Click-and-Mortar" Economy

By Laura Rock Kopczak -- Supply Chain Management Review, 1/1/2001

As traditional companies strategize about how to transition to the new economy, they must rethink the ways in which they engage the customer. For many industries, sales will be made through both traditional mass-merchandise channels and new Internet-based "one-to-one" channels. Accordingly, companies are adapting by learning to sell and supply product through multiple channels supported by multiple supply chains. And because for many industries, the bulk of Internet sales will be made by traditional companies, it is the traditional companies that will, in the end, define how customers will be approached in both the old and new economies. The essential challenge for these companies is how to design effective supply chains for a new "click-and-mortar" economy.

The sales process and supply chain come together to create the customer experience—it is here that the opportunity exists to either delight or dismay. Thus we hear that the most successful e-tailer, Amazon.com, strives to be customer-centric in both its go-to-market approaches and its order fulfillment. As traditional companies strive to emulate Amazon's customer focus, they are recasting the way they convert barely aware eyeballs to loyal buyers through new approaches to marketing—that is, new ways of managing product, price, promotions, and place. At the same time, they are redesigning their supply chains to support the new environment, while continuing to enhance operations that serve the traditional environment. Companies that manage this transition well will benefit from faster, more profitable growth in both environments.

This article describes the issues that companies must consider as they redevelop their supply chain strategies to respond to the new economy. These issues fall into three broad categories—supply chain design, product design/variety management, and demand-supply matching.

Supply Chain Design

As companies move to Web-based sales, they are designing new supply chains to support those sales. This includes defining what capabilities are required; deciding who will fill what roles in the supply chain; and setting up the necessary physical, information, and financial processes. In many cases, a new small-order fulfillment capability must be established, and decisions about the extent to which the small-order fulfillment process can leverage traditional (large) order fulfillment processes must be made. Companies also are evaluating what role they would like to play in the "last mile"—the consumer interface.

Marshaling the Capabilities

The Internet poses a challenge to traditional thinking about what capabilities a supply chain must provide and how they will be provided. When Internet-based sales first started to take off, there was much talk about the issue of "disintermediation" and "reintermediation." In constructing new supply chain solutions, buyers and sellers need to ensure that they provide for all the intermediary (channel) functions required to transact business. These include:

For Buyers	For Sellers
Product information	Customer information
Assortment	Access to customers
Order processing	Offering solutions
Ownership transfer	Ownership transfer
Financing	Financing
Delivery	Order fulfillment
Returns processing	Returns processing

Improved information and communication technology allows these functions to be separated—they may be performed at different times, in different places, and by different players. This is in contrast to the traditional retail store, or "vending machine" model, in which the buyer assessed the product offering, placed the order, took possession and ownership of the item, and paid for the item all at once. Under the traditional method, these activities all took place within a short span of time, and the buyer interacted with only one intermediary. Today, shopping, ordering, payment, and delivery may each occur at a different time and place and be done by different entities. So, as companies redesign their supply chains, they now have more room to develop creative solutions involving new combinations of players and processes to achieve cost and service breakthroughs.

For example, a high-tech company wanted to establish a more direct relationship with its U.S. value-added resellers (VARs) and thereby eliminate distributors from the sales and fulfillment processes. The company engaged a catalog fulfillment house to handle a Web-based order fulfillment process that is structured as shown in Exhibit 1. The VARs now place orders over a Web site that is jointly managed. Meanwhile, a contract manufacturer builds product in Singapore to forecast and replenishes inventory held by the fulfillment house near Dallas. The inventory is owned by the high-tech company. The catalog fulfillment house extends credit to the VARs, takes orders, ships the product, invoices and collects payment, and pays sales tax to the U.S. government. The high-tech company originally thought that it would hire a logistics provider and bank to handle the intermediary functions but found that the catalog fulfillment house had additional credit processing and tax payment capabilities that other players (including the high-tech company) lacked. Under the new design, then, the catalog fulfillment house is providing capabilities that would have traditionally been handled by distributors, a logistics provider, and a bank.

One of the many reasons traditional companies are looking for new partners is the new demand for small orders delivered directly to the customer. In choosing these partners, companies may link up with distributors from within their industry that are more capable than they are at filling small orders. Ingram Book Company, Grainger, Graybar, and Ingram Micro, among others, perform this role. Alternatively, companies may hire catalog fulfillment houses, many of which have supported mail order fulfillment for apparel and other product categories for years but are now expanding the range of industries that they support. Examples include OrderTrust, Direct Alliance, Priority Fulfillment Services, and Fingerhut Business Services. Or they may put together a solution involving a logistics service provider, a Web-systems house, and a bank, which together would perform the intermediary functions. As the company assembles a solution, a key decision will be whether small orders will be fulfilled from stock or built to order. This will affect the choice of partner, as some companies can handle flow-through or merged orders, while others specialize in filling orders from a few stock points.

e-Fulfillment Models and Multiple Supply Chains

As new supply chains are implemented to support small-order delivery, companies must carefully consider opportunities to leverage assets, processes, and relationships from traditional supply chains.¹ On the one hand, dedication and customization of processes for each channel may result in a high cost to serve if product volumes are not high enough to achieve scale economies for each customized process. On the other hand, sharing processes may result in an average process that does not serve any customer particularly well because it has to handle a broad range of products and a variety of service requirements.

The issue of how retailers should incorporate small-order fulfillment into their traditional supply chains is a complex one. Retailers may choose consumer-direct fulfillment of small orders placed over the Web from either the current (large-order) distribution centers (DCs), new dedicated small-order DCs (that may be in-house or outsourced), or from product manufacturers. Or the retailer may leverage stores by having customers pick up Web orders at the store. In that case, product may be delivered to stores in large quantities on a replenishment basis from the current DCs or product manufacturers, or delivered "ready for pickup" from dedicated DCs.

In managing multiple supply chains, synergies between new and existing supply chains may exist in the following areas:

• Supplier strategy and supplier management: Sharing may reduce procurement, overhead, and linkage costs. Care, however, must be taken to establish goals and measure the supplier's performance in each supply chain that it supports.
• Degree and location of assembly and customization: Sharing may improve asset utilization and reduce manufacturing overhead costs, provided that it does not create too much complexity.
• Order fulfillment: Sharing may improve asset utilization and reduce fulfillment costs, if the shared process is able to handle both small and large orders efficiently.
• Returns processes: Sharing may make the returns process easier for the customer and may reduce returns processing costs and cycle times. Such an arrangement, however, must be able to handle the combined volumes, and the different channels must have compatible inspection, sorting, and disposition procedures.

In thinking about sharing supply chains, companies should consider the implications to supply chain performance (cost, service, and flexibility). They must also consider how different strategies may affect the company's positioning of fulfillment as part of the "whole product" being offered to the customer and the company's relationships with customers and channel partners.

Reinventing the Last Mile: Home Delivery of Assortments of Goods

The new economy presents an opportunity to reinvent "the last mile," the crucial delivery of an assortment of products to the customer's home. How a company handles the last mile can enhance or aggravate the customer relationship. Key to the reinvented approaches is the assumption that consumers will value the separation of shopping, ordering, and payment activities from assortment creation (pick-and-pack) and delivery. If this assumption is true, customers will prefer to shop "anytime, anywhere" without having to travel to a physical store and without being constrained by store hours. Assuming that orders are placed electronically, the door is then open for new assortment creation and delivery options.

Opinions vary about whether home delivery of everyday consumer items, like groceries, can become a profitable business. Profitability depends on the density of delivery—how many stops are made in each square mile of a delivery route and the value of goods delivered to or removed from each stop. A home delivery company may be able to increase density by dominating a geographic area and/or by expanding the range of goods that it handles.

Opinions also vary about whether companies doing Web-based selling of home-delivered products must perform the delivery themselves to secure the relationship. In the 1997 book Net Gain, John Hagel argues that, in the new economy, successful companies will pursue only one of three strategies:

• Innovators will leverage value from a steady stream of innovative products and services.
• Infrastructure providers will build scale in operations across multiple value chains or across industries.
• Customer relationship managers will leverage information to capture ownership of customer segments across multiple value chains.

This suggests a shift in the retail industry. Retailers would no longer serve as both the customer relationship manager (product and customer knowledge) and the infrastructure provider (DCs and stores). Instead, for Web-based sales, home delivery would be performed by a specialized delivery company that has no product or customer knowledge. Although some Web-based companies are relying on express delivery companies like UPS, FedEx, and the U.S. Postal Service, others are taking on home delivery themselves in order to control the final contact with the customer.

With this in mind, consider three companies, each of which is entering the home-delivery—based retail space and is defining how it will handle "the last mile." The strength of each competitor will be determined in part by its reputation, brand, and product offering and in part by its ability to provide the consumer with reliable, cost-efficient assortment and delivery. As shown in Exhibit 2, each has its own strategy regarding assortment creation and delivery.

First up is WebVan, a company that is investing $1 billion to develop its own delivery infrastructure—DCs and delivery fleets. By creating assortment at DCs rather than at stores and by performing the delivery with its own trucks, WebVan positions itself to offer value along four dimensions: a megastore selection of products, the world's freshest food, everyday supermarket prices, and convenient, reliable home delivery. WebVan argues that by owning the delivery infrastructure it will guarantee a superior customer delivery experience and so, dominate the market. The company expects that once it reaches scale, its economics will be far superior to those of traditional store-based retailers as shown below. These economics, however, are yet to be proven.

WebVan Economics

	WebVan	Store-Based Retailer
Gross Margin	32%	32%
DC G&A	18%	8%
Delivery Costs	5%	0%
Store Costs	0%	20%
Operating Margin	12%	4%
Revenue per Capital Expense Dollar	$9.4	$3.5
Inventory Turns	24	10
As presented by CEO Louis Borders 2

Two other companies participating in the home-delivery—based retail arena are Wal-Mart and Amazon. Wal-Mart has two major advantages over Amazon—its huge base of loyal customers and its understanding of those customers (what, how, and why they buy). The retail giant has chosen to market products from all in-store categories on its Web site, with a wider selection of high-priced items like digital cameras. Even though Wal-Mart is an expert at logistics, it has little experience with small-order fulfillment. So Wal-Mart has chosen to partner with Fingerhut and Books-a-Million to do order fulfillment. Customer returns, however, are handled by the retailer's 2,500 stores.

Amazon, on the other hand, has the advantage of being Web-savvy and has accumulated a lot of experience in selling and fulfilling orders for specific product categories. Amazon's reach is much smaller than Wal-Mart's; the e-tailer serves a segment that is connected and active on the Web. Amazon has extended its product line into music, video, pharmacy, pet products, groceries, toys, and consumer electronics.

Both Wal-Mart and Amazon have chosen to outsource delivery. Thus, they rely on logistics companies for the physical link to the customer. Although Wal-Mart has outsourced order fulfillment, Amazon has chosen to fill orders from its own DCs. Because Amazon is supplying different types of products from different locations, it does not require that the entire order be delivered in one shipment. Furthermore, unlike WebVan, Amazon's delivery agents do not offer time-definite deliveries.

To summarize, although all three companies are acting as retailers (developing product understanding and customer relationships), WebVan has also chosen to perform its own home delivery logistics and, in doing so, offers an enhanced service to the customer. It will be interesting to see how the future evolves. As home delivery takes off and density of delivery increases, the express delivery companies may choose to adapt their delivery networks to be more like WebVan's network, which can coordinate delivery of a wide range of goods with different requirements (for example, refrigeration) and can make time-definite deliveries. WebVan may continue on its path as an integrated retailer (understanding products and customers and performing the logistics), or it may move away from its retailer roots and focus on logistics, performing home delivery for a wide range of retailers. The evolution of home delivery will depend on how delivery density and economics evolve and on how retailing and customer relationships change as home delivery grows in popularity.

Product Design and Variety Management

In the new economy, improved information technology makes it possible to offer broader product and service variety in the marketplace—and to manage variety differently. Traditional constraints on variety—such as the leadtime required to publish information on new products and to position inventory at points of sale—are much less severe for Web-based sales channels. Companies are free to rethink variety, but in doing so they must re-examine what customers want vs. what is possible. They also must consider the sales and fulfillment processes for Web and traditional channels and supply chains to take advantage of synergies and to provide a consistent message to customers. Additionally, companies will have to adopt a product-design strategy that can easily accommodate this demand for variety. This section discusses new ways of thinking about product design and variety.

Managing Product Design

In considering product design, companies should seek out opportunities to achieve mass customization and product digitization. Mass customization may be used in combination with Web-based sales channels to extend the range of products being offered by traditional store-based operators. Selling and taking orders over the Internet makes the front end of mass customization easier to manage and less error prone. Customers can be guided through product selection and configuration, and the variety offered to particular customers may be customized based on their demographic or past purchasing behavior. To support mass customization, products must be designed for easy configurability. In addition, an IT infrastructure must be set up to link orders to the fulfillment system easily. Similarly, customers can be offered customized services, including supply chain services. These offerings, however, must be supported by the IT infrastructure.

Digitization allows products like books, music, videos, and knowledge to be distributed instantaneously and at very low cost. This technology also gets new versions and products to market quickly and extends reach. Although many products are physical and cannot be digitized, they often have components that are information-based and so lend themselves well to digitization. For example, consumer goods such as food and personal-care products consist of the product itself, the packaging, and the information printed on the label and package (such as ingredients, directions for use, and recipes). If the size of the label and packaging did not limit the amount of information printed, consumers might like to see more of it. Thus, companies are developing sites that provide additional information about where products are made and which products are best for an individual consumer based on information that the consumer provides. The logistics of information then becomes separate from the logistics of the physical product.

Digitization and its effects are apparent in the evolution of greeting cards offered by e-Greetings Network.³ In 1995, the company started selling paper greeting cards over the Internet, just in time for Valentine's Day. The first day it received 20 orders, which took six hours to print and mail. Noting the opportunity to sell digital greeting cards over the Web, between February and July 1997 the company converted the business from paper to digital cards. By January 1998, more than 70,000 paid digital greetings had been sent. In 1998, e-Greetings experimented with a new revenue model, in which cards were given away and revenues came from referrals. For Valentine's Day and Mother's Day, it partnered with Godiva Chocolates and PC Flowers to have the companies sponsor greeting cards. More than 10 percent of PC Flowers' traffic on Mother's Day was generated by referrals from the e-Greetings site. Based on these early successes, e-Greetings switched over entirely to the free subscription model. Thus, e-Greetings evolved from selling paper greeting cards to selling digital greeting cards to using free digital greeting cards to generate referral income.

Managing Product Variety

In managing product variety, companies must decide for each category what channel(s) and order fulfillment mechanism(s) will be used. (Exhibit 3 presents the typical options for a traditional department store.) For most categories, a selection of products would be offered in stores, with the sale and handover occurring at the store (upper right quadrant of the exhibit). Home furnishings would be sold in the store, perhaps with floor models and sample fabrics, and then delivered to the home. High-end cameras might be sold exclusively through the Web, to facilitate the communication of product information and to limit inventory and sales effort, and would be delivered directly to consumers. Women's clothing might be sold both in the store and on the Web, with perhaps a larger selection on offer on the Web. The buyer would pick up the items at the store, encouraging store traffic and building a relationship between the store and buyer.

Managing product variety dynamically can become very complex. Issues that companies will have to address as Web sales become a larger portion of sales volume include:

• New product introductions. Will products be introduced on the Web prior to store introduction because leadtimes for introduction are shorter on the Web, or should introductions be synchronized?
• Fad products. Will hot fad products be sold only through the Web? Will the Web be used to place early (pre-release) orders that can then be picked up at stores on the on-sale date?
• Fashion seasons. Will product categories like fashion apparel be sold on the Web as seasonal collections, with fixed seasons during which products are advertised and available? Should Web "seasons" be synchronized with store "seasons"?
• Experimental products. Will a strategy employing experimental products be adopted? Will such products be introduced on the Web, monitored, and then rolled out to stores?
• B channels. Will Web-based channels be used to sell off damaged, returned, or excess merchandise, and how will these channels be coordinated with regular channels?

Demand-Supply Matching

Web-based channels offer some unique opportunities to match supply with demand. The availability of product to the various channels may be adjusted to accommodate changes in availability of supply or the relative attractiveness of the channels. Demand for one product may be converted to demand for another product that is more readily available. And information collected on the Web as part of the sales process may be used to understand consumer preferences and forecast demand better.

Demand-Supply Matching Across Channels

In matching supply and demand, companies may decide to change the allocation of products or the price of products sold through various channels as supply conditions change or channel profitability shifts. For example, in late 1999 the Rio MP3 music player was being sold through several Web-based channels, including Amazon, eBay, and Mercata (see Exhibit 4). The three channels had different pricing strategies: Amazon sold the product at a fixed price, eBay auctioned the product (used products), and Mercata sold it at a price that declined as the number of registered buyers increased. Rio might have asked itself at that time, "Based on the supply availability and current and projected profitability of the Amazon vs. Mercata channels, what allocation of product should be offered to those channels and based on what discount structure?" Rio also might have considered whether it would like to buy back old Rio players and resell them as used equipment.

Companies also are starting to use multiple channels to buy and sell component parts used in the manufacture of their products. With the advent of Web-based auction channels, many high-tech companies are experimenting with the sale of excess component parts or purchase of scarce component parts through these channels. Some of the auction channels, such as eHi Tex and e2open, are being championed by major players. The use of these channels will change the way these players manage their raw-materials supply. They will view procurement as a dual-sourced process performed in two steps: (1) make and execute firm purchase commitments to buy materials at fixed prices with advance notice directly from strategic suppliers and (2) buy short materials and sell excess materials as needed through "trusted" auction sites. The fact that Step 2 will be easier, faster, and less costly than it had been under traditional processes will influence how the decision about what quantities to purchase in Step 1 is made.

Thus, demand-supply matching across multiple channels includes both "buy side" (component procurement) and "sell side" (product sales) elements. As companies gain experience, they will eventually coordinate strategies on the buy side with strategies on the sell side on a real-time basis.

Conversion of Demand

Some companies are managing product availability by working with Web-based customers to steer them to products that are more readily available. So, for example, if the customer tries to purchase a computer with a particular disk drive that is in short supply, the Web sales agent may, after checking inventory, suggest an alternative disk drive at an attractive price and close the sale.

As companies try to develop their demand-conversion capabilities, they must consider that satisfaction with new search/buying processes may be influenced by customers' expectations. Customers may expect very high availability on the Web—higher than what they expect in stores. Thus, a strategy of temporarily de-listing unavailable products from the Web site may not work because customers may be upset that a product they saw on the site the day before is no longer available.

To convert customer awareness to purchase and loyalty, the company must be able to assess and understand the individual's preferences with respect to price, availability, and features (see Exhibit 5). In developing the Web-based sales process, the company must define at what points in the search/buying process customers will be given a chance to make the tradeoffs. It also must determine how many alternatives will be presented. For example, in selling automobiles over the Web, dealers first go through some basic questions such as the body style, number of doors, manual/automatic, air conditioning or not. They then give the customer a choice of models. Color and seat options, however, affect availability. At this point, the Web-based sales agent may give the buyer a choice between, say, color and seat combination A to be available in six weeks or combination B, which is available now at the same price. Or it may offer combination C at a different price and availability. The customer is allowed to make the tradeoff.

Although demand conversion helps companies "sell what they make," companies must also take care to collect the information needed to help them "make what will sell" in the future. If conversion of demand occurs in significant quantities, the companies will face a challenge in differentiating what customers bought (sales after conversion) from what customers desired (true demand). Companies will also need to understand to what extent profit was sacrificed to avoid losing individual sales. If supply and demand are to be better matched in the future, these challenges must be overcome.

Using the Web to Improve Demand Forecasts

Information gathered on the Web during the buyer's search/buying process may be used to develop a better understanding of customer preferences and to generate demand forecasts for newly introduced products. As customers navigate the Web site, information collected on the time they spend collecting information on various product options may reveal level of interest. Information about when customers abandon the purchase process or the types of additional data they collect when they return to the site to complete the purchase may shed light on their thought processes as they buy.

For some fad products, such as the book Harry Potter and the Goblet of Fire, data on how many people signed up to purchase the product each day over time may be useful in estimating the peak and lifetime sales volumes. Similarly, data on trends in purchases of music CDs may be useful in identifying hits early on and estimating of their sales trajectories. This understanding may also be combined with a demand conversion strategy. If sales cannot be met, potential buyers may be offered an option of waiting an additional week for the product at a reduced price to smooth demand.

Goal: Superior Customer Experience

The new economy is still very new, and companies are still in a phase of developing and testing new strategies for selling and fulfilling orders through multiple channels and supply chains. As companies gain experience and as Web sales grow, approaches to supply chain and product design, product variety management, and demand-supply matching will continue to evolve. At the same time, new approaches to understanding and engaging the customer will change how companies manage their relationships with customers. Throughout this evolution, providing customers with superior experiences will continue to be critical to company success. Going forward, supply chain management will continue to be at the root of customer experience.

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Author Information

Laura Rock Kopczak is a senior research fellow at the Stanford Global Supply Chain Management Forum.

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Footnotes

1Sengupta, Sumantra. "Strategic Options for the 'Clicks and/or Walks,'" Supply Chain Management Review, July/August 2000, 58–63.

2Presentation at Stanford University, Feb. 10, 2000.

3Mendelson, Haim, and Seungjin Whang. "E-Greetings Network," teaching case, Stanford University.

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