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Are you falling out of fashion?

PC and fashion producers face the same key challenge: balancing the cost of lost sales and obsolescence. But Milanese fashion houses and Silicon Valley have made remarkable improvements.

American PC producers and Italian fashion makers are strange bedfellows.

But both are world leaders in industries with short-lived products, and both need to excel in supply-chain management to keep up with an increasingly dynamic marketplace. Both face ever-shrinking product life cycles, the globalization of sourcing and manufacturing, and a mushrooming of new products. And both are having to cope with more sophisticated customers demanding tighter delivery terms, as well as powerful suppliers dictating long lead times.

Consider fashion. A high-end fashion manufacturer offers up to 2 million or 3 million SKUs (stock-keeping units), 95 percent of which change every six months. Average sales are two or three units per SKU, so that forecasting is inherently unreliable. To make things worse, the typical lead time from fabric manufacturers is a full three months.

How do you manage such a business? Traditionally, the risk in the system was borne almost exclusively by retailers, who were required to place their entire order a full six months before the start of the season. But, as their power grows, retailers are demanding more flexibility and limiting their advance orders to less than 70 percent of their total volume.

Although computers are not as yet fashion goods, the PC industry is experiencing similar market dynamics thanks to the rapid and volatile evolution of supplier technologies. The challenge for PC makers is to integrate multiple unpredictable emerging technologies into a competitively priced "package" for the ultimate consumer. This task is becoming more and more difficult as the pace of technological evolution quickens.

Seventy-five percent of the current products of an average PC maker will have been launched less than three months earlier. Over the past decade, the average life cycle of a personal computer has shrunk from four years to less than nine months, while the number of SKUs has more than quadrupled. Seventy-five percent of the current products of an average PC maker will have been launched less than three months earlier. Manufacturers find themselves caught between powerful suppliers capable of imposing lead times as high as four to five months and retailers unwilling or unable to carry high inventories and bear the risk of unsold products.

The PC and fashion industries are not alone. Other industries also face many of the same problems, and may be able to learn from the strategies of leading PC and fashion producers.

For many years, these players focused on the basics: building brands and distribution channels, improving product design, and cutting manufacturing costs. A winners' circle of companies emerged: Compaq, Hewlett-Packard, Hugo Boss, Ermenegildo Zegna. Throughout the 1980s and early 1990s, most focused on positioning themselves as "high quality" or "latest fashion" companies. But over the past couple of years, they have shifted their focus to building operational excellence as the means to achieve the next quantum leap in competitive performance.

Their approach is founded on understanding and trying to minimize two major cost components that are often neglected or undermanaged: lost sales and obsolescence.

Lost sales and obsolescence
Missing a sale means losing a contribution margin that can range from 25 percent to 30 percent of the producer's sale price in the PC industry to 40 percent or 50 percent in the fashion industry. One leading U.S. PC manufacturer underestimated demand for two of its best-selling products; by the time it could gear up supply, it had lost around $300 million in potential sales. Worse still, the market for these products had disappeared.

Obsolescence costs are incurred when finished products or raw materials become obsolete and need to be cleared out. Though present in all businesses, obsolescence is particularly rapid in some. PCs on a shelf lose as much as 10 percent of their value a month, so that after seven months the value of a PC has fallen by 50 percent.

Lost sales and obsolescence costs are often so high that managing them effectively could yield huge benefits. In the fashion industry, end-of-season sales can involve discounts as high as 30 percent to 70 percent, which is why leading operators like The Limited and The Gap handle obsolescence by discounting slow-moving items continuously, rather than waiting to make massive mark-downs at the end of the season.

Though frequently overlooked, lost sales and obsolescence costs are often so high that managing them effectively could yield huge benefits. For a clothing manufacturer with $1 billion in sales, matching best practice performance could mean an improvement of $80 million in pretax margins. Any of the top three PC manufacturers might reap as much as $100 million to $200 million on a sales base of over $10 billion by managing obsolescence aggressively.

Lost sales and obsolescence are interdependent. It would be easy to achieve zero lost sales, for example, by stocking everything up to the hilt, but the obsolescence cost of this approach would be formidable. The challenge is to find the optimal tradeoff between the two factors, which will vary from business to business.

In industries with high fixed and low variable costs, obsolescence is not expensive, and the tendency is to "overshoot"--which is why publishers regard unsold goods amounting to 20 percent of a print run as acceptable. By contrast, in industries with high variable costs, the rule is caution. Before the introduction of new models in consumer electronics, for instance, inventory levels of old models are brought down as low as possible, even at the risk of losing sales. Where both variables are important, as in the fashion industry, a delicate balancing act is needed.

Traditional methods of logistics management, such as economic order quantity, are not helpful in this respect. They treat highly volatile and unpredictable items in exactly the same way as more predictable ones. As a result, they tend to clog a system with high inventories of the "wrong" products, impairing service and increasing obsolescence. How is it, then, that the companies that excel in supply-chain performance manage to limit lost sales and obsolescence? Essentially, they do five things:

• Measure the "unmeasurable"--namely, obsolescence costs and lost margins on missed sales, both their own and the channel's.

• Minimize complexity while preserving the richness of the offering.

• Rethink product development technology to cut time to market.

• Optimize risk sharing with supply-chain partners.

• Manage the operating cycle to mitigate forecast error. Measure the unmeasurable
When manufacturers consider logistics costs, they typically think of warehousing and physical distribution. Many (though not all) measure and control the costs of inventories and their own obsolescence costs for finished goods and raw materials. But few measure the opportunity cost of lost sales, and only the very best are aware of the costs of the channel in both lost sales and obsolescence.

The best performers in supply-chain management adopt a number of measures:

• Running periodic consumer surveys at the exit points of key retailers to estimate lost sales. If they are above 5 to 10 percent, something needs to be done.

• Making sure that estimates of internal obsolescence costs are sufficiently aggressive and based on actual inventory levels and projected clear-out discounts, not on standard financial assumptions.

• Obtaining information from key customers about the channel's obsolescence costs and, if possible, about lost sales. By involving your channel partners in your decision-making in these two key areas, you can create benefits for both sides. Fixing your own problems will fix your retailer's, as your lost sales are also its lost sales.

Minimize complexity
Weeding out your marginal SKUs and reducing product variety are a couple of conventional wisdoms that simply do not work in either PCs or fashion. Armani cannot offer its suits in just blue or gray. Similarly, if a computer company were to eliminate SKUs that account for less than 5 percent of total volume, it might forfeit sales to entire countries, as with Finnish keyboards or Swedish modems.

Fixing your own problems will fix your retailer's, as your lost sales are also its lost sales. In both industries, a high degree of complexity is a necessary cost of doing business. Indeed, manufacturing to a lot size of one is already a reality in fashion, and becoming so in PCs. However, the best companies keep complexity under control, allowing for it only when it makes a perceptible difference to the ultimate consumer--and the consumer is willing to pay for it. These companies avoid changing basic fabrics every season or components every new model, and limit the proliferation of variants to the product segments where the market is willing to pay for the extra choice.

In PCs, a change of 1 centimeter in the width of a laptop display screen can make a huge difference in readability, and consequently in the price the market will bear. The best manufacturers of portable PCs focus their engineering design creativity on features that customers value, such as screen readability and keyboard ease of use, not on things that are unlikely to influence purchase, such as performance at high altitudes.

Rethink product development
Over the past decade, reducing time to market has been a top priority for most industries throughout the world. For PC and fashion companies, getting this process under control has always been a must. If your new fashion collection is not out in time for the trade shows, you go out of business. Being slow to market with the latest PC technology can hurt a manufacturer's market share and ultimately force it out of entire segments.

Leading companies are rethinking their underlying product development technology to cut development time by up to 70 percent. At present, development can be a lengthy process in some of the short-product-life industries. In PCs, it ranges between 12 and 18 months.

Compaq and other leading PC manufacturers adopt a similar approach to the design of application-specific integrated circuits (ASICs). Traditionally, this involves several iterations between the computer maker and its chip suppliers. Getting the design right usually entails three or four prototype "spins," each requiring silicon fabrication taking four to six weeks. As an ordinary PC contains up to a dozen ASICs, some of them designed sequentially, the development of these circuits takes up much of the total PC development time.

By using improved electronic simulation techniques, Compaq can isolate a large proportion of "bugs" early in the design process, before progressing to silicon prototypes. This means that fewer prototype spins are needed to complete the design cycle, and development time is compressed.

Optimize risk sharing
Risk taking is intrinsic to both fashion and PCs. With entire product lines turning over every three to six months and long lead times from suppliers, it is virtually impossible to avoid running out of stock for some "hot" products, and producing some "wrong" products that don't sell. The traditional approach to managing this risk was to try to get rid of it by passing it on to the weaker players in the supply chain, usually the retailers. But there are several problems with this approach.

Companies are rethinking their underlying product development technology to cut development time by up to 70 percent. First, it leaves on the table the value that both manufacturers and retailers can capture by optimizing the risk along the entire chain. Second, pushing risk to the retailer has become much more difficult as channels consolidate and their bargaining power grows. Consequently, best practice companies focus on the relationships they build with their retailers and suppliers.

Working with retailers makes it possible to minimize the quantity of inventory in the supply chain by changing its nature from finished products sitting at sales outlets to unassembled components or fabrics located with the supplier or manufacturer. Where the remaining finished goods inventory should be placed depends on the relative positions of retailer and manufacturer.

In fashion, large retailers are best placed to assess their market, so they should hold a bigger portion of the finished inventory risk. Where smaller retailers are concerned, the manufacturer usually has a better feel for the market; moreover, with its much larger volumes, it faces lower demand volatility. The manufacturer should therefore assume the inventory risk, passing it on to the retailer in the form of higher prices.

The other means of optimizing risk is to reduce suppliers' lead times and increase their flexibility.

Best-practice companies in both the fashion and PC industries go further than the usual "work with your suppliers" and "exchange information via EDI" practices. To slash supplier lead times, they are revolutionizing the way they organize their purchasing, moving from spot purchases to long-term capacity booking, and programming their buying in a way that allows suppliers to be flexible but still keeps costs down and permits economic production of small lots.

This approach relies on the manufacturer having a deep understanding of its supplier's production processes and economics. Consider an example from the PC industry. To the PC manufacturer, ASIC purchasing represents a conflict of interests with the supplier. The manufacturer is aiming to maintain supply flexibility across a range of chips that are low-volume parts; the supplier's objective is to maintain high capacity utilization.

The best PC companies understand that the ASIC "fab" process includes multiple silicon "layers," about half of which are common to all ASIC parts. They consolidate their ASIC purchasing with a small number of suppliers--up to three--and commit to minimum "base wafer" volumes. This allows the suppliers to start producing silicon wafers before they know how many ASICs of each type their customer will ultimately require.

Such an intimate understanding of a supplier's production processes also brings benefits in product design and development. In computers, the manufacturing process for microprocessor chips centers on a specific clock speed "sweet spot," but will yield devices with a range of different clock speeds. The sweet spot clock speed is the one that is the most cost-effective for the supplier to produce--the point of maximum yield. Successful PC manufacturers design their products to support the sweet spots of their suppliers' production processes.

Manage the effect of forecast error
Forecasting is never perfect. In fashion and PCs, with their legions of SKUs, manufacturers must manage forecast errors that are sometimes in excess of 100 percent. Best-practice companies both reduce forecast error and manage it.

First, they use test and sell-out data to improve their sales forecasts. Even fashion goods can be market-tested. "Quick and dirty" test data is particularly helpful in identifying future winners--the products that will become the best sellers in a given product line.

Sell-out data, on the other hand, is most useful in tracking down slow-moving products. Compaq uses sell-out data from key channel partners to identify items where initial orders are still sitting in retailer inventories and customer sales are below forecast.

As well as improving the quality of their forecasts, best-practice companies in these industries organize their manufacturing and delivery systems to improve flexibility on volatile and fashion products, while maintaining low-cost production for basic, more predictable items.

Compaq is moving to a production system that builds most of its products only on receipt of a customer order. It will use the basic products for which there is steady demand to level out factory capacity and smooth day-to-day order volatility.

Finally, the most successful companies proactively manage forecast errors. Compaq begins its sales forecast process with a snapshot of its overall supply capabilities. The process establishes a rapid two-way communication between sales and manufacturing. The sales force devotes its efforts to products where supply exceeds projected demand within lead times, and lets the "hot" products sell themselves.

For more insight, go to the McKinsey Quarterly Web site.

Copyright © 1992-2001 McKinsey & Company, Inc.

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