How To Design A High-Profit Supply Chain

How to build a high-profit supply chain
A recent HSBC survey of over 2,000 executives found that 42 percent plan to transform their supply chains in 2023, and 47 percent view this as a priority in the near future. MIT’s Jonathan Byrnes has ideas on how to make sure yours maximizes profits in this first of a two-part response.

Most supply chain design projects have a fatal flaw: they assume that the objective is simply to minimize cost. Instead, the real high-profit objective is to maximize your profits by matching your supply chain design to the needs of your company’s profit segments (high-profit customers vs. profit-draining customers vs. minimal-profit customers)—because each profit segment has a very different management objective from the others.

This will enable you to minimize costs subject to meeting the strategic and profitable growth goals and needs of each profit segment, creating a supply chain that is both effective (meeting the needs of each profit segment) and efficient (doing this in the most cost-efficient way).

Enterprise Profit Management (EPM) is the key to identifying and managing your company’s profit segments. Over years of experience with EPM—a transaction-level SaaS profit improvement system that creates a full P&L on every invoice line—I have found that virtually all companies have a characteristic pattern of profit segmentation:

  • Profit Peak customers—typically about 20 percent of the customers generate 150 percent of a company’s profits;
  • Profit Drain customers—typically about 30 percent of the customers erode about 50 percent of these profits; and
  • Profit Desert customers—typically the remainder of the customers produce minimal profit but consume about 50 percent of a company’s resources.

The same pattern occurs in a company’s products, suppliers, orders, inventory, stores and most other company dimensions.

Profit Peak customers. These high-revenue, high-profit customers are generally very service-sensitive, and relatively price-insensitive if you provide a compelling value proposition. You should engage and serve them with a multi-capability team that can develop a high degree of intercompany integration through measures like vendor-managed inventory or joint category management.

Profit Peak customers often require special services like dedicated delivery routes and drivers. For example, a well-known furniture retailer used EPM to identify the zip codes in which its Profit Peak customers lived. It found that they were generally clustered in certain neighborhoods. In the past, the company simply assigned routes to drivers by driver seniority. When the management team saw a map of the Profit Peak neighborhoods, however, they separated the company’s drivers into two groups: “master drivers,” who were very experienced and service sensitive, and “regular” drivers who simply liked to drive trucks.

In this new configuration, the company assigned its master drivers to its Profit Peak neighborhoods, where they handled all on-premises customer deliveries. They had the regular drivers shuttle truckloads of furniture to the master drivers, who made the actual customer deliveries. In this process, the Profit Peak customers were given same-day deliveries and priority on scarce products.

The master drivers were specifically trained to note a customer’s furniture needs while they were in the customer’s home. They reported these observations to the customer’s sales rep, and this very often led to more sales. Also, they would load accessories in the truck so that during the delivery, they could chat with the customer and bring in some accessories to try with the new furniture.

Over time, the company sold a surprising amount of high-end furniture through this process. Without doubt, this was a more costly delivery process, but the company’s profits soared.

Profit Drain customers. These high-volume customers cause significant losses. In our experience, the problem usually is not below-market pricing, but rather high sales and supply chain costs. In fact, many of these customers actually have a relatively high gross margin—which, of course, leaves out the company’s substantial sales and operating costs. Most of these costs are rooted in supply chain factors, like overly frequent ordering, that are very important, but almost always unmeasured and unmanaged (unless the company has EPM, which tracks and highlights these issues). Most of these problems are costly for both the customer and supplier, and are relatively easy to fix.

For example, a hospital supply company was puzzled. In its distribution centers (DCs), hospital orders for its highest-selling intervenous (IV) solution had enormous variability, even though every hospital was on contract, and IV solutions were consumed steadily at the patient and clinic level. When the management team investigated this problem, they found that a number of their major hospital customers were ordering very erratically. They visited the hospitals and found that the sources of this order pattern were varied: sometimes a purchasing manager was busy with something else, sometimes the nurses hoarded supplies on the floors and so on.

This high-variance order pattern was causing severe problems throughout the company’s supply chain: DC inventories were too high, expedited service was often needed, production schedules were often disrupted and so on.

The simple answer was to institute a standing order system for major hospitals based on each hospital’s actual consumption. There were ample measures to override the standing orders if real emergencies arose. This was much better for the hospitals, because they could institute standardized procedures to receive the product on a given day and distribute the product directly to the hospital floors. Because the system was stable and predictable, everyone readily accepted it. The hospital supply company’s supply chain costs plummeted by over 30 percent, and the hospitals saw similar cost reductions. It was a costless win-win for both parties.

Profit Desert customers. These customers are low-revenue, low-profit. Some are large companies using you as a tertiary supplier, cherry picking a few bargains or using the threat of ramping up your volume to discipline their primary suppliers. A few others may be development accounts in which you can grow the relationship. But most are simply small customers, and many of these are prime targets for Amazon and the other digital giants.

The objective for your Profit Desert customers is simply to keep costs as low as possible. This is where your digital transformation will pay rich dividends, as you engage these customers with portals, menu-driven services and other similar cost-saving measures.

High-profit supply chain design

Each of the three profit segments described above has a very different objective and management game plan, and each requires a very different supply chain. In designing a supply chain in the context of this complexity, it is important to bear in mind that supply chain management has two core components: physical distribution and materials management.

Physical distribution is all about physical activities like trucks, DCs and other assets (whether owned, leased or rented). Materials management concerns the logic of where you put products and the decision rules that determine how they linger or flow through your supply chain. In addition, a well-functioning supply chain requires a solid IT infrastructure, comprised of some core elements like product visibility, and certain elements that are uniquely needed by individual profit segments like the need in a Profit Peak vendor-managed inventory system for detailed, accurate information on customer inventories throughout a customer facility.

The connection between physical distribution and materials management is that a variety of materials management processes can be run through a unified set of physical assets. For example, a sophisticated DC can be configured to support the each-picking that typifies vendor-managed inventory, as well as the bulk case or pallet picking and handling that is common in serving Profit Drain customers. The critical difference is that each profit segment needs an appropriate, and different, set of materials management decision rules (often supplemented by some segment-specific information).

This essentially creates multiple parallel supply chains, all running through the same set of physical facilities. This contrasts sharply with the old paradigm of a company having an all-the-same supply chain designed from end-to-end to minimize cost.

Example: hospital-supplier supply chain

For a hospital supply company, two critical dimensions provide the key to structuring a high-profit supply chain: hospital profit segment and product order pattern variance (whether the order pattern for a particular product is relatively steady or highly variable). Again, all products in all segments are run though the same facilities, but each segment/order-pattern has a different set of materials management decision rules (here, service interval—the number of days from supplier order receipt to customer product receipt—which, in turn, determines the inventory levels in your local and central facilities).

  • Profit Peak hospitals are the company’s most important customers. If possible, the supplier should coordinate closely with these critical customers (using integrated measures like vendor-managed inventory) both to lower costs and to build switching costs. For steady demand products, like intervenous solutions and examination gloves, the supply chain should be a “flow through” configuration, with very little safety stock inventory needed at any point. For variable-demand products, the supplier should keep adequate safety stock in the local DCs and give these important hospitals absolute priority. The service interval should be either same-day or overnight.
  • Profit Drain hospitals are large, money-losing customers. For steady demand products, the supplier should run a flow-through supply chain, which will minimize costs. It should not be necessary to keep more than a small amount of safety stock for these customers and the service interval on these products should be overnight. For variable demand products, however, the supplier should set a longer service interval, perhaps two to three days. These products usually are not needed urgently. This allows the supplier to source from local DCs if possible, and if not, to bring the products in from a central DC.
  • Profit Desert hospitals are small, low-profit customers. The supplier should set the service interval at two or three days for steady products, and four or five days for variable-demand products. If there is adequate stock in the local DC, after the needs of the Profit Peak and Profit Drain customers are met, the supplier can send the product quicker; but this longer service interval will ensure that the supplier can source product from the central warehouse, if needed, minimizing the inventory holding costs in local DCs.

One instrument, many songs

The image that this system brings to mind is a well-constructed piano on which a brilliant composer is creating and playing a variety of songs. The physical distribution system is like the piano: it is thoughtfully constructed and very well-run. The materials management system is like the variety of wonderful “songs” that can be run through the physical and information assets by aligning the materials management decision rules with your profit segments and product order patterns.

Fueling profitable growth

Developing a thoughtful, multi-purpose physical distribution system supporting a well-designed set of materials management decision rules aligned with your profit segments and product order patterns is the key to creating a coherent set of high-profit supply chains that are both effective and efficient. They will be resilient and flexible in the full range of your changing circumstances, and they will fuel your company’s competitive strength and profitable growth for years to come.

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