Change Management: Paving the Cowpaths

Change management is one of the most difficult problems facing managers at all levels. All too often, managers focus primarily on defining the best end-state, and deal with the change process almost as an afterthought. If the end-state really is better, the logic goes, then people will find the vision compelling and migrate to it. Often this almost has the feeling of a “lay-down” hand in bridge.

This situation reminds me of the story of the math graduate student who woke up in the middle of the night and smelled smoke. He walked into the kitchen and saw that his stove was on fire. He looked at the water tap, looked at a bucket on the floor, said “a solution exists,” and went back to sleep.

Cowpaths

“Paving the cowpaths” is an expression often used to express disdain for weak change management programs.

The streets of downtown Boston are characterized by byzantine windings that seemingly defy logic – until one realizes that they trace the original cowpaths that cattle trod to skirt fields when ambling home from pasture in early colonial times. In downtown Boston, the streets are, indeed, paved cowpaths. In the newer section, Back Bay, planners had the luxury of laying out streets in a grid pattern on landfill.

The essence of “paving the cowpaths” is to point out the seemingly obvious folly of managing change by simply changing nothing of importance. Much later, the “reengineering” movement echoed this idea, noting that change managers should reengineer processes rather than simply automate them.

Yet managing programs of fundamental, sweeping change requires a unique process that is almost counter-intuitive. The reason is that change management most often takes place in a well-established organizational context.

Cowpaths revisited

I thought about the metaphor of “paving the cowpaths” this weekend, as I was reading a very interesting book, Wired For War, by P.W. Singer. This book is about the history of robotics, and the use of robots in warfare. The really interesting parts, however, are about the process of new technology adoption. This process seemingly defies logic.

For a number of years after robots were shown to be superior for certain uses, military leaders refused to embrace the new technology. For example, drone aircraft were demonstrably better at particular missions than manned aircraft. Yet because most top Air Force officers were former pilots, they rejected the new innovations and even used the new drone aircraft for target practice in training pilots.

It was not until relatively recently that external events created a situation in which the new robot technology began to be accepted. In the early 1990s, the tide began to turn. Singer notes that in the prior period, “It isn’t that the systems weren’t getting better, but that the interest, energy, and proven success stories necessary for them to take off just weren’t there.”  The situation began to change dramatically in the wake of the “Black Hawk Down” disaster, which generated a widespread public unwillingness to commit ground troops to the Balkans and Rwanda.

Not long after, the high injury and mortality rates experienced by our military personnel in Iraq caused a public outcry. The military responded in part by accelerating the deployment of robots in high-risk military missions, which enabled the new technology to break through the traditional military attitudes toward robots. This reversal led military leaders to convert the role of robots in warfare from one of “paving the cowpaths” to a much more sweeping role accomplishing powerful new activities –  like staying aloft for days doing surveillance – that simply could not have been done with manned technology.

A similar set of situations characterize the whole history of technology innovation. The moral of the story? Paving the cowpaths is often an effective first step in sweeping, paradigmatic change. The real questions are: (1) whether the initial formulation is flexible enough to support migration to a new system, and (2) whether the change managers have the vision and capability to create the conditions favorable for change, and to manage a multi-stage change process.

Business change management

Paving the cowpaths, in this context, is an important first step in major change. In fact, many successful IT system implementation projects start by mechanizing existing processes, but keep latent capabilities to support deeper change. Over time, as the organization experiences the benefits of the new system and as it becomes part of the company’s “plumbing,” change managers can roll out the more sweeping new capabilities. Because the system users experience the early benefits of the new system, they become much more willing and motivated to change their practices to take advantage of the powerful new possibilities.

The business school teaching case literature has great case examples of companies that instituted surprisingly sweeping change, by starting with piggybacking on current organizational processes and relationships. In my course at MIT, I teach one such case juxtaposed against another that features a sweeping change program implemented as a “big bang” all-at-once change. Not surprisingly, paving the cowpaths turned out to be the secret of success – enabling much more rapid and broad change when properly deployed and managed.

Profitability and change

One of the biggest problems –  and opportunities –  in profitability management is the scope and magnitude of the potential improvements. Virtually every company is 30-40% unprofitable by any measure, and 20-30% provides all the reported profits and subsidizes the losses.

Profit mapping, the core analytical tool of profitability management, shows the profitability of every product in every customer in a company. (I describe how to construct a profit map in my book, Islands of Profit in a Sea of Red Ink.) Profit maps show exactly where profit is flowing and where is it lost.  The problem is that the sheer quantity of information can be overwhelming, and often leads managers to wonder where to start.

The most effective profitability management programs start with a degree of paving the cowpaths. The key to success is to prioritize the profit opportunities against the difficulty of change, and to develop smart ways to accelerate the organization’s pace of change. I think of this as the “view-to-effort” ratio.

View-to-effort ratio

When our kids were young, we used to take them hiking in New Hampshire. They complained on the way up the mountain, but they loved the view from the top. This led us to rate hikes by their “view-to-effort ratio. By starting with small hikes with nice views, we were able over time to sharpen their interest in great mountain views, and this in turn allowed us to increase the size of the hike.

In short, we started with a “pave the cowpath” approach, and moved forward from there. Through this process, our children learned to love hiking and enjoy nature. Today, they are hiking on trails that would leave us breathless. Had we not started incrementally, we would not have experienced this result.

Smart change management

One of the most important keys to success in profitability management is smart change management. It is also the biggest stumbling block.

The well-known inventor and entrepreneur Ray Kurzweil notes, “About thirty years ago, I realized that timing was the key to success….Most inventions and predictions tend to fail because timing is wrong.” Singer observes, “Kurzweil has found that the challenge isn’t just inventing something new, but doing so at just the right moment that both technology and the marketplace are ready to support it.”

The key to success is to craft a change program that starts with “paving the cowpaths.” This essential first step allows the organization to see the power and feasibility of the new approach, which in turn creates the essential conditions for more sweeping change. 

Successful managers draw on their reservoir of wisdom and experience to craft the right formulation. This critical element makes all the difference between success and failure.

Great Summer Reading

Here are four terrific books that you might enjoy this summer. One is an enduring classic of nature writing. Two are great management books that are not technically about management. And the fourth is a very interesting brief overview of the history of mankind.

The Outermost House: A Year of Life on the Great Beach of Cape Cod,  by Henry Beston.

In 1927, Henry Beston spent a year living in a one-room house on the beach at Cape Cod. He wrote this wonderful book in longhand at his kitchen table. In it, he describes his observations about the changing moods of the beach and water, and the joy of living in solitude in a little room overlooking the North Atlantic and dunes. Beston originally planned to spend just two weeks in the house, but was drawn to stay for a whole year. Some great chapters: “Autumn, Ocean, and Birds”, “Night on the Great Beach”, and “Orion Rises on the Dunes”. How good is this book? First published in 1928, it is still on the shelves of most bookstores.

The Accidental Billionaires: The Founding of Facebook,  by Ben Mezrich.

This terrific book tells the story of Mark Zuckerberg’s founding of Facebook. Ben Mezrich’s fast-paced book narrates the engaging story of how Zuckerberg translated a relatively simple idea into the world’s most popular website – carving out a dominant competitive position in less than a year.  Look for the essential elements of Facebook’s positioning success: focusing on something everyone does all the time, offering a slightly more efficient solution, and network effects that spread like wildfire. Something to think about for the inner entrepreneur in all of us. This book is very well written, and much better than the movie.

Game Change: Obama and the Clintons, McCain and Palin, and the Race of a Lifetime, by John Heilemann and Mark Halperin.

This fascinating history of the 2008 U.S. Presidential election is both a great read and an insightful management study of one of the most incredible turnaround electoral victories in U.S. history. The book tells the inside story of how Barack Obama vaulted from relative obscurity to beat the clear frontrunner, Hillary Clinton. This is a story of his relentless, thoughtful management, juxtaposed against Hillary Clinton’s dithering approach. It is a study in the critical importance of management style and process. Also compelling – the story of John Edwards’s implosion, and of John McCain’s selection of Sarah Palin to be his running mate. Although Game Change is not technically a management book, it is one of the best management books written in recent years.

The Origin of Humankind, by Richard Leakey.

In this short volume, renowned paleontologist Richard Leakey systematically answers the question, “What made humans human?” Leakey surveys our knowledge of the prehistory of humankind over the past three million years. This story is fascinating. But more importantly, the book is a wonderful example of concise, insightful analytical writing: in 157 pages, Leakey frames the essential arguments over humankind’s prehistory, impartially weighs the evidence, and offers well-synthesized conclusions. It is a great example to managers of how one can systematically investigate and deeply understand a complex field. Besides, think about this: modern humans only emerged 35,000 years ago, and began to settle in villages only 10,000 years ago. Look at the technological progress all around us – it’s truly astonishing.

A Short Bonus

Check out David Brooks’s recent New York Times op-ed column, "The Unexamined Society".

It is a great explanation of the importance of clear thinking about things that managers and policy makers all too often take for granted. Here is his lead-in: “Over the past 50 years, we’ve seen a number of gigantic policies produce disappointing results — policies to reduce poverty, homelessness, dropout rates, single-parenting and drug addiction. Many of these policies failed because they were based on an overly simplistic view of human nature.”

Marsha joins me in sending our best wishes to you and yours for an enjoyable, relaxing summer.

Profit from Managing Returns. Yes, Returns.

What do a typical hospital and a typical retailer have in common? They both have a problem managing returns. Let me explain.

About a year ago, I spent a day with the President’s Cabinet of a major medical center. This is one of the most prominent institutions in the country, with a very talented and dedicated management team. During the day, we reviewed and discussed a number of important topics, ranging from prospective healthcare legislation to growth plans.

One comment in particular caught my attention. A senior physician noted that the hospital didn’t systematically monitor readmissions - patients who are discharged and soon return to the hospital for additional care.

I thought about a friend who had started a company to oversee the care of patients who had a particularly difficult chronic illness. He had done studies of patient care, and he found that a surprisingly large portion of hospital readmissions occurred because of simple logistical errors. For example, when many patients were discharged, the oxygen or other medical supplies were not delivered to their homes in time. This resulted in very costly readmissions.

A few years ago, I did a number of studies of product returns in retail and distribution companies. I found that virtually all companies viewed returns as a logistical hassle to be managed primarily to minimize the handling cost and maximize residual product value.

My studies showed something very interesting, however. When I compared retailers in the same industry, their rate of product returns varied significantly. Not only that, but even within the same retailer different associates had very different returns rates - even for the same product.

The conclusion: the returns rate was really a measure of the quality of the sales process. The retailers and associates who had low returns rates were very good at diagnosing a customer’s real needs, and had a good understanding of what supplemental instructions a customer typically needed. The others did not.

The traditional way of managing returns turned out to be to not manage them at all – just to handle them efficiently. The right way to manage returns is very different: to view them as a quality feedback loop that enables a manager to pinpoint the places where the sales process breaks down, and to formulate sharply targeted measures to improve the process.

In a sense, the hospital readmissions rate is very much like the retail returns rate. Some patients legitimately need additional care, but many simply come back because they experience avoidable errors – most of which are not the hospital’s fault. And in most institutions, this critical measure is not systematically analyzed.

Both the hospital and the retailer had the potential to monitor their “returns” not just for handling efficiency, but more importantly to improve the quality and drive down the cost of their core organizational processes.

The big profit leverage that comes from managing returns – not just handling them efficiently – is that the returns rate offers a very important window into how well the institution or business provides service to its customers.

In both business and not-for-profit management, there are a number of “hidden” quality measures like the returns rate. The insightful manager will seek out these measures, and use them to maximize the overall performance and profitability of his or her organization.

Unlikely Sales Heroes - Supply Chain Managers

You finally landed your first orders from that really important high-potential account. When should you bring in your supply chain managers?

In most companies, the standard progression is for the sales rep to focus on ramping up the sales volume, with a courtesy call from the company’s local supply chain manager only when the account is “safe.” Wrong answer.

This “sales first, supply chain last” way of dealing with account development is an obsolete and counterproductive approach to customer management that stems from the past “Age of Mass Markets.”

For most of the past century, businesses operated in the Age of Mass Markets. In this era, companies sought economies of scale through mass production, and they distributed their products as widely as possible through arm’s-length relationships. Most of our current management processes were developed in this earlier era. During this period, managers correctly focused on aggregate revenues and aggregate costs, and the role of a logistics manager was to move and store products at the lowest possible cost.

Today, all that is changing. We are in a new era, which I call the “Age of Precision Markets.” In this new era, companies form very different relationships with different groups of customers, and these feature very different degrees of supply chain integration and coordination, with vastly different profitability. The big problem is that all too often supply chain managers are not systematically involved in creating and managing these relationships. Instead, many are still primarily focused on internal cost control – like the logistics managers of old.

The consequence of this deficiency is a pattern of profitability that I have seen in my research and consulting with leading companies in over a dozen industries over the past two decades. In virtually every company, 30-40% of the company is unprofitable by any measure, and 20-30% provides all the reported profits and subsidizes the losses.

How can a top manager change this? By making supply chain managers essential partners with sales and marketing at every stage of the account development cycle – and even before the sales cycle begins.

The key success factor is to get sales, marketing, and supply chain management on the same page in three key business processes:

Relationship structure. If your sales reps are free to agree to a wide variety of customer requests and demands, it places a huge cost burden on your supply chain. The answer is for sales, marketing, and supply chain management to agree on a set of perhaps 4-8 standard customer relationships – ranging from arm’s length to highly integrated. Each relationship should have measurable value for both parties, and a clear to-do list for each party. Then your supply chain managers can create a streamlined process to support each relationship.

Market mapping. This is the process of matching customers to relationships based on an assessment of where each customer should wind up. This assessment involves both sales and supply chain factors, like buyer behavior and capability to partner. This is very different from simply asking the customers what they want. Your sales process should be focused on moving customers to the right relationships.

Account management. In major account relationships, the account development process must involve both sales reps and supply chain manages from the start. In a well-integrated relationship, your supply chain managers can dramatically lower both your customer’s costs – and your own costs – by influencing your customers’ inventory levels, order patterns, and other key (mostly supply chain) factors. When you increase your customer’s profitability, it almost always drives sales increases of 35% or more, even in highly-penetrated accounts. As a top executive of P&G once noted at MIT, “Our customer is Wal-Mart’s CFO.”

The bottom line is that it is essential to bring your supply chain managers into your earliest sales efforts. They will naturally work with their customer counterparts to identify areas of cost reduction that will come from working together. In the process, your supply chain managers will identify and nurture allies within the customer, and together develop a strong business case for selecting you as the premier supplier-partner. Today, both supplier selection and revenue growth are rooted in the foundation of trust developed between your company’s supply chain managers and their customer counterparts.

I recently gave a presentation on “The Coming Revolution in Supply Chain Finance” to a national conference of supply chain management professionals. Here was my message:

In leading companies today, supply chain integration leads directly to sales increases of 35% or more, even in highly penetrated accounts. Supply chain management is the fastest and surest way to increase revenues.

At the same time, top companies that structure their sales processes to bring in revenues that fit their supply chain’s capabilities see cost reductions of 30-40% or more. All revenues are not equally profitable, and thoughtful sales discipline is the best way to create quantum increases in supply chain productivity and efficiency.

Welcome to the new world: supply chain management driving huge revenue gains; sales discipline creating massive new supply chain efficiencies. In the process, financial performance going through the roof.

Unlikely Operations Heroes - Sales Reps

A few weeks ago, I met with the top operations managers of a major multinational consumer products company. These executives were very interested in understanding how to become more innovative. What could they do? What have other companies done? What is the current best practice?

Innovation is a very broad topic that can apply to many different things, so what was their specific problem? The cause of their concern was that their production facilities were very efficient, but the company’s rate of product innovation was becoming so rapid that they were worried that they might not be able to support it without major changes. This is what they meant by innovation.

As we discussed the situation, they mentioned the company’s sales and marketing group as the source of this situation. Suddenly, the pieces fell into place.

The sales reps’ problem

A few years ago, I had an opportunity to work with one of the company’s major distributors on sales force productivity. I spent several days riding with several sales reps and understanding their situation. It turns out that these sales reps, also, were having serious problems with the company’s accelerating pace of product innovation.

How was this product innovation manifest? The sales reps were being bombarded by an endless stream of changes. A few were large, like the introduction of an important new product line. But most were small, almost trivial, like a new point of purchase display for a minor product.

What was most striking about this situation was that each innovation, large or small, was accompanied by a new sales objective that became part of the sales rep’s bonus calculation. The reps actually had 15-20 different objectives!

I knew that a sales rep can’t simultaneously maximize 15 objectives, and the customers would balk at responding to all these changes. So what did the reps do?

Each rep picked the two or three objectives that he or she thought would make the most difference, and ignored the rest – and often these varied from rep to rep. How did this crazy situation arise?

I remember talking to the sales reps and customers, and thinking about the portfolio of product innovations.  I had an image of dueling product managers at headquarters, each producing a stream of product (or packaging) changes because each had to show “progress’. Each vying for slightly enhanced revenues.

And each product manager seemingly oblivious to the big picture, including the critical second-order consequences for both sales and operations.

Who’s driving the boat?

In our meeting, I related my experience with the sales reps. I suggested that if I had a room full of their sales reps, the sales reps would have expressed the same frustration with the company’s situation.

In this company, it appeared that product management was “driving the boat”. Each product manager was focusing on only one rather narrow primary measure: his or her product revenue or gross margin – without regard to the overall effect, or to the important (but hard to measure) second-order effects on both sales and operations, and on the customers. The operations and sales groups were stuck essentially “waterskiing behind the business”.

Why was this occurring? The answer stems from the transition we have been going through from one business era to another.

What happened?

In the prior Age of Mass Markets, which occurred throughout most of the twentieth century, revenue maximization was the win strategy. Companies had relatively uniform pricing  (for much of the period, manufacturers could actually set retail prices), cost to serve was relatively uniform as the product was just dropped at the customer’s receiving dock, and economies of scale meant that large production volumes led to diminishing unit costs. And diminishing unit costs meant more profits.

In this situation, product management was indeed driving the boat. Their job was to maximize revenues. Most consumer product companies were characterized by a relatively small number of high-volume brands. In this situation, the cost of the small “tweaks” in products and packaging were small compared to the huge gains in scale.

Over the past thirty years, however, our business system has changed enormously. We have entered what I call the Age of Precision Markets. In this new era, companies have instituted complex pricing varying from customer to customer, and even product to product. Cost to serve varies again by customer, and even by product within a customer. Products have proliferated into all ecological niches, and flexible manufacturing and outsourcing have enabled many niche products to achieve minimum efficient scale.

Today, profit maximization requires a deep understanding of the interaction between pricing and cost to serve on a very granular basis (individual products within individual accounts). It also requires the tight integration of product management with the groups responsible for the second-order costs it so often produces. Chief among these are the critical costs of sales inefficiency and operations complexity – just what the top operations managers and sales reps were so concerned about.

A natural alliance

In today’s business era, sales and operations have surprisingly aligned interests. They are poised to form a natural alliance to maximize profitability, often without realizing it.

Several months ago, I wrote a widely circulated blog post, “Unlikely Sales Heroes – Supply Chain Managers”. The thrust of the post was that the traditional way to sell to important accounts – sales rep ramping up sales volume, then bringing the operations manager in at the end for a courtesy call, or “sales first, supply chain last” – is an obsolete and counterproductive approach to account development that stems from the past Age of Mass Markets.

In today’s Age of Precision Markets, all this has changed. Leading companies have found that the most effective way to develop and accelerate sales in their most important accounts, their “islands of profit”, is to introduce their operations and supply chain managers to their counterparts in the key customers early in the account development process. The operations managers naturally bond with their customer counterparts, and together they quickly develop innovative ways to work together to create new efficiencies.

This process has two very important results: (1) the customer will become much more profitable handling and selling your products, and this will create huge, rapid sales increases for your company; and (2) in the process, you will lower your own cost to serve. Think about this: your operations team creating huge new revenue increases coupled with lower cost to serve. The best of all worlds.

In my graduate class at MIT and in my executive courses, I often ask whether in a company all revenues are equally profitable to serve. The answer is “of course not”. It is clear to everyone that some revenues fit the supply chain and operations, while others do not.

This leads to a very important conclusion. The most important way to achieve quantum increases in operations productivity is for the sales force to bring in revenues that fit the company’s supply chain and operations. This means that in a well-run company, the sales reps are primary determiners of operations productivity –  the unlikely operations heroes.

Does this mean that we must turn away important new sources of revenue because they don’t fit our current operation? Of course not.

It does mean, however, that both sales and operations have to develop a deep understanding of the complex interaction between revenues and costs on a very granular basis (individual products in individual customers), and they must have highly efficient processes to coordinate and align their sales and operations activities.

When your sales and operations are fully aligned, your revenues will be maximized and operations costs will be minimized. Today, your supply chain managers should be your most important sales heroes, and your sales reps should be your most important operations heroes.

What about the product managers?

Returning to the recent meeting with the consumer product company’s top operations managers, it became clear that the company’s product managers were maximizing a small portion of the company’s profit picture. They were not aligned with either sales or operations.

In the past, this was not a big problem, but today it was causing enormous headaches.

This led to a very important question. How could the operations managers (and sales force) change position from “waterskiing behind the business” to helping “drive the boat”.

The answer was that they had to shift their activities from a focus on finding ways to cope with an untenable situation (which they saw as a need for innovation), to a new focus on developing effective ways to partner with their counterparts in sales and product management in order to create alignment.

And this was nearly impossible to do when everyone was so busy fighting the fires caused by the counterproductive, over-rapid pace of product innovation.

The key to gaining alignment was to open a parallel discussion on how to work together over the next few years in order to maximize profitability and profitable growth. This would surely involve new coordinative mechanisms, new metrics, and new incentives.

The net result, the true definition of success: all three key groups “driving the boat” together.

Unlikely heroes

In the Age of Precision Markets, the key to long-term success is to develop effective processes to tightly align your key functional areas – sales, operations, and marketing – in both your company’s day-to-day activities and in its positioning for the future.

In this new era, your supply chain and operations managers should be sales heroes, and your sales reps should be operations heroes – all working together to raise your company’s performance through the roof.

Channel Mapping for Profit

In my previous blog post, “Customer Intimacy vs. Operations Excellence: Why Not Have Both?” [http://islandsofprofitbook.com/2011/04/07/customer-intimacy-vs-operations-excellence-why-not-have-both/], I explained that leading companies are gaining market share and growing profits by focusing their resources on the customers that are giving them high sustained profitability, and finding new ways to coordinate with these accounts to increase these customers’ profitability.

When these astute suppliers increase their customers’ profitability, the customers give them much more share of wallet, and ease the pressure on the suppliers’ prices. Importantly, the improved operational coordination –  smoother order patterns, improved forecasting, elimination of redundant functions, lower inventories –  reduces the suppliers’ costs and increases the suppliers’ profitability as well.

This process creates a classic win-win: the customer wins and the supplier wins even more. The only losers are the competitors, who see their market share drop and are left wondering why.

This powerful profit dynamic is critical to profitability management, and a channel map is the key to success.

Mapping your channel

A channel map is one of the most important, but least used, elements of an effective profit improvement program. It is the key to big, sustainable increases in profits and growth, especially in your most important accounts. It also provides decisive competitive differentiation – building big barriers to entry based on customer knowledge, relationships, and trust. This enables you to secure and grow your most important customer relationships, and to penetrate and grow critical potential accounts.

The power of a channel map is that it gives you a detailed overview of the cost buildup as your products flow through your company, and into and through your customer’s company. The objective is to identify ways to increase efficiency and reduce cost. You also can use the same technique for coordinating with your suppliers to lower your own input costs.

The starting point in a channel map is to partner with a customer, and select a few representative products. I suggest that you “warm up” by developing a channel map with a relatively small, but very well-managed customer, in order to get comfortable with the process.

In developing the channel map, it is important to work with a willing, engaged counterpart manager from the customer. (This underscores the importance of developing relationships with your counterpart managers in key customers well before they are needed.) He or she will help you understand the customer’s operation and estimate the costs, and in the process you will develop a close working relationship with a customer manager who can help explain the process to his or her fellow managers, vouch for the results, and later help drive the change process.

The second step in channel mapping is simply to trace the product flow through both companies, identifying each step in the process. Very quickly, you will see important points of leverage. Typically, you will find a number of costly redundant functions, and you will be able to spot key points at which information that is readily available in one company will really help the other. This early, easy step is very eye-opening, and quickly shows everyone the value of the process.

The third step is to roughly cost out the steps in the process. As with profit mapping, “70% accurate” information is almost always sufficient. If you have developed an internal profit map of your own company, you will be very comfortable with this process, and it will go relatively quickly. My new book, Islands of Profit in a Sea of Red Ink, explains how to do this.

In this process, it is very important to be comprehensive in your view of cost. For example, channel maps were essential in the work that led to the development of one of the first, most widely-followed vendor-managed inventory systems, which Baxter developed in the hospital supply industry.

A work team from Baxter traced the product flow for representative products through a representative hospital, observing the steps in the process and roughly estimating the cost of each. The hospital’s management had simply assumed that they could gauge the cost of handling the hospital supplies by looking up the budget of the materials management department.

However, when the work team spent time in the hospital actually observing the process, they found that a surprisingly large portion of nurses’ time was spent in ordering and handling supplies, as well as in frequent trips to the hospital stockroom to obtain missing items. When they added in the estimated nurses’ time (based on interviews), it amounted to about half of the handling costs. This was a major issue because there was, and still is, a shortage of highly skilled nurses, and their time is really needed for patient care.

The channel map showed another critical hidden cost: Baxter’s sales reps had to spend an inordinate amount of time expediting product and addressing customer service issues stemming from poor intercompany coordination. In most companies, removing this needless problem in effect increases the company’s sales force by 20-30% - without any cost.

Opportunities for improvement

Once you’ve developed a step-by-step understanding of the intercompany product flow, and an estimate of the cost of each step, opportunities for improvement will literally jump off the page. Most companies are relatively efficient within their “four walls” internal operational processes, but they almost never see the true intercompany picture. This valuable new view almost always shows very easy, lucrative opportunities to quickly improve profitability for both companies.

Returning to the hospital example, the work team observed that the hospital’s metrics included inventory levels, but not handling costs, because the former was easy to measure and the latter was not tracked across multiple departments. Consequently, the hospital CFO managed the hospital’s inventory very tightly, but had no way to understand the essential trade-offs with other important costs. When the team completed the channel map, it became crystal-clear that by increasing hospital inventories slightly on low-value items, both the supplier and hospital could reduce their expensive handing costs enormously. 

As another example, the work team was surprised to find that the order pattern for steadily-used products was very erratic, and this was causing very high costs.  They decided that the simplest solution was to set up a standing-order process, in which the supplier would ship a predetermined amount of the steadily-used products to the hospital every week. The hospital could alter this standing order if needed, and receive the  product promptly. This radically lowered the inventory and handling costs for both channel partners.

It also had other important benefits. Because the standing orders covered the same high-volume products each week, the supplier could pack the products on the pallets in the way that was best for the hospital, usually put-away order. This made the shipment very fast and convenient to receive and handle. This seemingly small change was a huge benefit for the hospital’s personnel, and they strongly supported the new process.

Continuing process, continuing value

Channel mapping is not a one-time event. It should become a core component of your profitability management process – especially for the key accounts in your “sweet spot.” This is how you secure and grow your islands of profit; it is one of the most important arrows in your quiver.

Every element in the process is hugely beneficial. As you work with your key customers on the channel map, your managers will develop close, trusting relationships with their customer counterpart managers. This trust is immensely important: it is the precondition to later change management and a huge barrier to entry.

As your managers and their counterparts use your channel map to discover opportunities for profit improvement, a broader set of managers in both companies will develop comfortable patterns for working together. They will have many opportunities for informal talks in which they will get to know each other’s deeper hopes and concerns. This will naturally lead both to work together to develop new ways to create mutual value.

In this way, channel mapping, which starts as a way to develop operating efficiencies, transforms naturally into a core element of an extremely productive strategic partnership. When you achieve this, both you and your customers will strongly and steadily grow your market share and profitability for years to come.

And remember, you can develop the same ultra-productive relationships with your key suppliers as well, harvesting huge profit and strategic benefits for years. Upstream or downstream, channel mapping is the key to ongoing success.

Customer Intimacy vs. Operations Excellence: Why Not Have Both?

Several years ago, popular business books trumpeted the importance of focusing your company by choosing a distinct business model. One best-selling book offered these alternatives: (1) customer intimacy – delivering what specific customers want; (2) operations excellence – delivering quality, price, and ease of purchase and use; and (3) product leadership – creating the best products and services.

While strategic focus is an appealing idea, my long experience working with companies on profitability management suggests that there are other dimensions that are much more subtle and powerful. And much more profitable.

Take the example of the choice between customer intimacy and operations excellence.

It seems obvious that a company cannot both provide individual service to customers and drive operating costs down. After all, individual service is custom-tailored and expensive, while operations cost-minimization requires extreme standardization. How can you have both?

Islands of profit

The answer lies in the central message of my book, Islands of Profit in a Sea of Red Ink. Every company I have seen is 30-40% unprofitable by any measure, while 20-30% provides all the reported earnings and subsidizes the losses.

The core reason why this occurs in so many companies is that managers so often serve all their customers in an “all the same” way. They standardize on a business model, and simply assume that it will fit all their customers (otherwise, they wouldn’t fit as customers).

Leading companies today, however, have shattered this approach to business strategy. And they are reaping enormous, lasting benefits – leaving their competitors in the dust.

Several months ago, I participated, along with the heads of operations of P&G, Chiquita, and Pepsi, on a panel on Supply Chain Transformation. These three leading companies have been creating enormous new profits and market share gains, even in the depth of the recent recession, by doing exactly what the old popular business books disparaged – combining customer intimacy with operations excellence.

All three companies are pursuing a similar strategy. They have analyzed their profit maps, and they clearly understand which customers are providing them with high sustained profitability – their islands of profit. They have the insight and discipline to invest considerable resources in securing and growing these customer relationships.

It turns out that the best way to secure and grow a key customer relationship is to integrate your operations with those of your customer – in a highly individualized and effective way. When you do this well, you lower your key customer’s cost and increase the customer’s profitability. This pulls through surprisingly large sales increases, often 35% or more, even in highly-penetrated accounts.

As a P&G vice president once observed in an MIT workshop, “We sell to Wal-Mart’s CFO.” That’s why P&G’s account team in Bentonville Arkansas includes a very strong component of financial managers. Their job is to calculate Wal-Mart’s increase in profitability created by P&G’s supply chain and marketing integration, and use this information to pull through even more product sales.

What’s happening here? Customer intimacy combined with true operations excellence driving customer profits, and creating big revenue increases.

Virtuous cycle

But that’s not all. At the same time that these three companies are creating huge customer gains through custom-tailored operations integration, they are radically lowering their own operations costs. How? By smoothing order patterns, tuning customer inventories, deploying substitutes in carefully-selected situations, and other measures.

These initiatives shift the focus of supply chain efficiency initiatives from optimization solely within the vendor’s “four walls,” to optimization of the joint vendor-customer supply chain. This shift creates enormous new efficiencies – for both companies.

Fortunately – well, insightfully really – all three companies invest a major portion of their operations efficiency gains into deepening their key account relationships, especially operations integration. This smart move renews the cycle, enabling them to create even more customer profitability, to further grow their market share, to gain new operational efficiencies for themselves, and to gather even more resources to invest in making their key customers ever-more profitable – renewing again this endless virtuous cycle.

The key to success: customer intimacy merged with operations excellence.

Sea of red ink

But that’s not the whole story. There are two keys to success. The first, described above, is the ability to use custom-tailored operations excellence to lock in and grow your most profitable business – your “sweet spot” in the market, your islands of profit.

The other key to success is to create differentiated serving models for your other segments. For customers who are important, but not willing or able to partner well, you can develop other, more appropriate relationships backed by clear, distinct service models. For yet other customers who did not warrant integrated relationships, you can offer more standard, menu-driven approaches. (I cover this thoroughly in the Operating for Profit section of Islands of Profit in a Sea of Red Ink.)

One major company even told its smallest customers that unless they could order a truckload of product a week, they would only serve them through master distributors (who specialized in serving small order customers very efficiently). This enabled the company to draw back a major portion of its resources, and channel them into more rapidly growing its “sweet spot” customers.

Multiple parallel service models

What does this mean for the profit-maximizing manager?

You have to move beyond the old “one size fits all” approach to business strategy, and understand that within your book of business, you have a number of very different types of customers – and that each type of customer, or market segment, requires a different, appropriate, cost-effective service model (and degree of operations integration).

For your most important “islands of profit” customers, you may need to customize individual, highly-integrated supply chains. For other customers, you probably need a relatively small number of standardized serving models tailored to each of your market segments. How many? Old Byrnes family recipe: perhaps 5-10.

This more subtle understanding of your business will enable you to secure and grow your islands of profit, and convert your sea of red ink into a very lucrative expanse of business.

Customer intimacy or operations excellence? False choice. The right answer is: the right blend in the right places.*

 

* Thanks to Brent Grover of Evergreen Consulting for pointing out this terminology when we participated, along with Klein Steel’s Laurie Leo, in a panel at the recent Waypoint Analytics Advanced Profit Management Conference.

What are Bad Profits?

Yesterday, I had a lengthy conversation with the Vice President of Finance of a major company. He was immersed in the capital budgeting process, and wanted to discuss ways to evaluate investment proposals.

Our conversation started with a discussion of the cost of capital, which is an important ingredient in evaluating investments. After all, what could be more logical than ranking investment opportunities by their projected returns, taking into account the cost of capital, and putting money into the most lucrative opportunities?

In my writing, I argue that all revenues are not equally desirable – some produce high profits, and some actually produce losses. Profitability management is all about figuring out which is which, and how to get more profits from an existing business.

But are all profits equally desirable?

The answer is no – and the key to understanding the difference between “good profits” and “bad profits” is the Investment Decision Matrix, pictured below.

The desirability of an investment is not just a function of the likely returns, but also and more importantly, the strategic relevance (whether the investment moves the company’s strategy forward).

Two quadrants of the matrix are easy, the other two take some thought. Let’s start with the easy ones. The upper right, high returns and high strategic relevance, is an obvious winner. The lower left, low returns and low strategic relevance, is a pretty poor bet.

Think about the upper left, high returns but low strategic relevance. This quadrant is quicksand. These investments look very attractive, but take the company’s capital and focus away from its main line of business. All too many companies have unclear and unproductive positioning because they lack the discipline to say no to attractive-looking investments that don’t fit. Ultimately, companies that do this get picked off by highly-focused competitors. These are the investments that produce “bad profits.”

Let’s look at the lower right, low returns but high strategic relevance. These are investments that would show up at the bottom of a simple capital budgeting ranking, but are essential to moving the company forward. Here, the watchword is “courage.”

For example, I remember meeting with the top officers of a major telecom company several years ago when telecom companies first began to develop video capabilities that could compete with cable TV. The company had a study that showed that an early investment in video would not pass the company’s investment hurdle rate. The question was whether to invest.

After discussion, the officers saw that the real question was not whether this initial video investment produced high enough returns. Rather the right question was whether the company was willing to remain the dominant communications channel into millions of customers, or whether it was willing to open the door for a host of competitors to get a foothold in all of their customers. Fortunately, the management team made the right decision.

The moral of the story: If investments in the upper left quadrant produce “bad profits,” investments in the lower right produce “good losses.”

How is this possible? Investments are virtually always part of larger business or strategic initiatives. The correct frame of analysis is the overall initiative, not just the component investment.

Within this strategic context, capital budgeting is a useful way to evaluate alternative ways to accomplish a strategic goal (e.g. which machine to choose), but you can’t use capital budgeting to determine strategy.

This is why it is so important that CFOs and other top finance managers be broad-gauge strategic thinkers, as well as disciplined business managers. Their company’s future depends on it.

What's Wrong With a 95% Service Level?

Customer service level is a core measure of company performance. This measure seems completely obvious: after all, if you increase your line-fill or case-fill from 94% to 96%, your customers will surely be much more satisfied. And satisfied customers will buy more from you, increasing your profits. Right?

This seemingly simple logic has critical flaws that are very important for your company. Is your objective simply to maximize average customer satisfaction? Or is your objective to maximize your company’s profitability and growth? These are not necessarily, or even often, linked.

Think about the following questions, in the context of a company with a 95% service level.

• Which customers get the bad 5% of your service measure? How would you feel if your best customers – the customers in your company’s “sweet spot” (those that produce the most profit and have the highest growth potential) – received unreliable service 10% of the time, while your marginal customers enjoyed 99% service? How would you feel if both your best customers and your marginal accounts received the same poor service 5% of the time – after all, this is what the measure indicates.

• How bad is the 5% deficiency? Is it hitting key customers running a VMI or cross-dock system with one week delays, or is it hitting customers carrying ample inventories with an overnight delay? Is it hitting critical products or commodity-like products with many substitutes?

• What price are you paying for making promises you can’t keep? If you always made realistic customer service (order cycle) promises that you could keep virtually 100% of the time, would your customers trust you with a slightly longer order cycle, or are they simply insisting on very tight cycles to give themselves “breathing room” for your service deficiencies?

When you focus on aggregate measures of customer service, in reality you are maximizing what’s easiest to measure, not what gives you the most profitability and lucrative growth. This is another artifact of the Age of Mass Markets, when companies distributed as widely as possible, customers had plenty of inventory, and computers were in their infancy.

Service differentiation is a much more effective way to frame and measure customer service. In a nutshell, you should make different order cycle promises to different customers depending on your customer relationship and the nature of the product.

Consider a simple 2x2 matrix, with core and non-core customers, and core and non-core products. A core customer is a significant steady customer, often one whose supply chain is integrated with yours. A non-core customer is a smaller, occasional customer, or even a large, high-potential customer that uses your competitor as its primary supplier. A core product is either a high-volume product or a critical product with no substitutes. A non-core product is a slow-moving product, not critical, and often with ample substitutes.

If you think about each quadrant of the matrix, it becomes clear that each quadrant’s customer/product characteristics logically suggest a different order cycle.

The core-core quadrant requires fast, completely-reliable service, and here a 95% service level is particularly deadly. For non-core customers ordering core products, you might offer guaranteed 2-3 day service, but always keep your promises. This will allow you to produce 100% reliable fast service for your core customers (from local stock), while gaining the leeway to source product from centralized stock to meet the occasional spikes in demand that non-core customers sometimes produce with occasional large orders. The alternative is to carry a huge amount of costly safety stock in the effort to treat all customers the same.

There are important exceptions. If a non-core customer is a high-potential account that a sales rep is working intensively, it can be bumped into the core category, as long as you reexamine this after a period to see whether the relationship has changed.

The service differentiation logic is similar for your non-core products. By definition, non-core products are those not needed urgently. When a core customer orders a non-core product, most of the time it can be sourced from local stock, with an order cycle of perhaps 1-2 days.

The big cost drain occurs when non-core customers order non-core products. Here, you will need a massive amount of local safety stock to meet an aggregate measure like 95% service level (with short cycle time). The correct course is to make an order cycle promise of perhaps 3-4 days, so you can source the product from a centralized pooled inventory.

Three important customer service principles emerge: (1) you should match your order cycle promise to the nature of the customer relationship and the product characteristics; (2) you should make different promises to different segments of customers for different segments of products; and (3) most importantly, you should always keep your promises.

The right measure of customer service is not aggregate line-fill and case-fill: it is always keeping your promises. Service differentiation will enable you to maximize your profitability and to develop high sustainable profitable growth. The classic dilemma of trading off between cost and service is an obsolete, misleading concept. It assumes that all customers and products are the same.

You can have your cake and eat it too if you have clarity, focus, and follow-through – and you let go of the tacit goal of trying to be everything to everyone.

Think about another common measure of customer satisfaction: net promoter score. This is a commonly-used measure that compares customers who would recommend you against customers who would not. The problem is that this is another aggregate measure with all the flaws of an overall measure of customer service level.  (Aggregate surveyed customer satisfaction has the same problem.) Clearly, the customers in your “sweet spot” should have net promoter scores off the charts, or your islands of profit will be sinking beneath the waves.

What about the rest of your customers? If you implement service differentiation effectively, they should also have a very high net promoter score. They will have a clear understanding of their relationship with you, they will trust you to always keep your promises, and they will know exactly what they have to do to change their relationship and therefore their order cycle.

In business, the worst news is not knowing what to expect.

Three Missing Steps in Supply Chain Optimization

I just finished an interview with a journalist who is writing on the importance of supply chain optimization. This writer is addressing a set of distributors of products that have relatively low value for their weight and volume. This makes supply chain costs really critical to their profitability.

As I thought about the topic, it struck me that there are two very different ways to approach the problem. The traditional way is to assess the software and automation possibilities that could be deployed, and then to think about ways to get the operating personnel to “buy into” the solution. I could visualize the usual checklists of software packages and capabilities.

Certainly, a number of terrific software packages and warehouse automation systems have been developed, tested, and put into widespread use. But the real question is what to do with them.

In this slow economy, customers are minimizing their inventory, and increasingly depending on distributors for fast service. This enables strong distributors to increase business, but it also places a big cost burden on them. In the particular industry the journalist was writing about, this cost dynamic was having an extremely strong impact on profitability.

When I considered the deeper question of how to optimize this supply chain, three steps seemed especially important – steps that are all too often left out of the process.

First. Divide the business (logically) into core and non-core customers, and core and non-core products. Usually, your core customers and products are characterized by high-volume. If you think of this as a 2x2 matrix, each quadrant has very different characteristics, and each requires a different supply chain.

For example, core products for core customers should flow like a river from suppliers through distributors to customers, with minimal inventory (relative to sales) and minimized handling. Think about how radically this differs from core products sold to occasional customers, or from non-core (sporadically-ordered) products even sold to core customers.

The most important initial step in optimizing a supply chain is to understand that the right supply chain solution (decision rules, inventory levels, physical process) for each quadrant can and should be very different.

Second. Work with your customers – especially your core customers. Many customers do not have a sophisticated knowledge of how to set inventory levels and reorder patterns. You can make a big difference in both your profitability and your customers’ profitability by helping them. This is especially critical in these difficult times.

I recall working with a major distributor a number of years ago to reduce supply chain costs. After a little investigation, we figured out that there were only three or four inventory/replenishment systems that the customers used, and that most customers did not know how to keep them set correctly. We created a small team that worked with the core customers to readjust their systems. After a month or two, the cost savings were surprisingly large.

Third. Get the sales reps involved. In most distribution businesses, the sales reps are the primary link to the customers. In my experience, sales reps in many companies have an overwhelming number of objectives, ranging from revenues to promotional programs to brand introductions to point-of-purchase displays. While some companies include gross margin in sales objectives, net profitability, per se, is almost never an objective.

In many distribution businesses, supply chain costs are a critical determinant of profitability. These costs can vary considerably from customer to customer and product to product. They are deductions from gross margin in profitability calculations, so a simple focus on gross margin eliminates a major source of profit improvement.

It is very important for the sales force to understand the profit impact of customer orders and other supply chain costs, and to be given a fairly simple program to selectively improve customer profitability. Here, creating a simple “red-yellow-green” color-coding designation can provide terrific results.

For a sales force to be productive, the reps must have at most 3-4 clearly understood objectives. Profitability maximization must be one of them.

All too often, managers instinctively reach first for technology solutions, focusing primarily on the selection and implementation processes. But the real profit impact comes from changing the business.