The Need for Third-Party Coordination in Supply Chain Governance

The last few decades have brought dramatic shifts in the manner in which business is conducted around the world. Companies have moved away from hierarchical, integrated supply chains in favor of fragmented networks of strategic partnerships with external entities. (See “The Disintegration of the Supply Network.”) This transformation has caused ripples throughout the old supply network. Many businesses are struggling to compete in the new landscape. However, it is not clear how sustainable the fragmented supply chain will be — particularly for small and mid-size enterprises. Following the period of disintegration, it will be only a matter of time before there is a compelling need for reintegration, which for many companies will have to be coordinated and facilitated by independent third parties.

As economies around the world become more integrated and geographical boundaries fall, it is not surprising that we are witnessing massive changes in the way business is conducted. Many of the starkest changes are visible in the fragmentation of supply chains. In the automotive industry, for example, both Ford Motor Co. and General Motors Corp. have divested some of the most cost- and labor-intensive parts of their manufacturing processes as semi-independent or wholly independent units. A fundamental reorganization is underway throughout the automotive supply chain, as companies everywhere radically revamp their approaches to system management with lean manufacturing and just-in-time inventory.

The same pattern is being repeated in many other industries, and it is particularly dramatic in apparel and textiles, and in electronics manufacturing and service. In recent years, global competition has shifted most of the apparel manufacturing away from developed countries to developing countries.1 In the past two decades, Asia has come to dominate textile and apparel exports, at the expense of producers in Europe. The United States, meanwhile, has become an increasingly major consumer of imported textiles and apparel; its role in this sector has largely evolved to that of designer, developer and marketer. In the electronics industry, the short product life cycle makes it challenging for a single company to remain on the technology forefront of all components and products, thus contributing to reliance on third-party specialists.

Forces Behind Fragmentation

Why have so many large, vertically integrated companies chosen to outsource or send portions of their supply chain offshore?2 Part of the reason is that capital and investments currently are being so closely managed that investors question the validity of noncore assets. Our research points to several other contributing factors as well, including the positive feedback cycle between better product quality and lower cost; product proliferation; the rise of retail powerhouses; and improved information technology. (See “About the Research.”)

Product Quality and Cost

The gradual relaxing of trade barriers, the emergence of new markets and the availability of skilled labor and reliable supply routes from Asia have combined to create a business climate where companies of all sizes and across many industry sectors have seen economic advantages in fragmenting their supply chains. Inexpensive labor costs in China and elsewhere in Asia have made the incentives of shifting production offshore all the greater.

Increasingly, suppliers are taking the lead in developing new production technology and designs for end products.3 As the technology becomes more stable and the manufacturing processes more commoditized, the processes and functions become more of a cost factor, as opposed to a revenue stream or strategic know-how. However, cost differentials by themselves do not fully explain the outsourcing and offshoring trend. Partnerships between global suppliers and U.S. giants have led to the ability to create better processes and technologies, which in turn led to higher-quality products and the ability to manufacture at lower cost and higher margins. This positive feedback cycle results in the strengthening of the supply bases and partially explains the outsourcing and/or offshoring phenomena.

Product Proliferation

Given the risks and the costs of product proliferation and mass customization, larger original equipment manufacturers, notably in the automotive and electronics manufacturing sectors, usually develop products in partnership with their major suppliers. Such collaboration is also common in the computer products industry, where companies based in Taiwan, elsewhere in Asia and in the United States provide design and manufacturing services to OEMs, which brand the end product.

Emergence of Retail Powerhouses

The consolidation of retail channels has had a profound impact on supply channels and has also redefined the traditional roles of manufacturers, retailers, wholesalers and distributors. With the emergence of retail powerhouses such as Wal-Mart Stores Inc., large manufacturers of consumer goods have found incentives in outsourcing cost- and asset-intensive operations to contract manufacturers, choosing to focus their own efforts on creating and sustaining their brands through design and marketing activities. Competition among retailers is now centered on cost, logistics and speed of innovation. These factors, along with the changes in the retail landscape, are having enormous impacts on the supply channels that feed the retail channels. Supply channels need to respond more quickly and efficiently to customer demand patterns. Retailers, in turn, are working to change their business models, frequently taking the lead in the design of products. In some cases, they are beginning to compete directly with their own suppliers.

Enhanced Information Technology

Over and above enabling more reliable production processes, information technology is driving fundamental changes in supply chain behavior and corporate governance structures.4 The transformation over the past two decades has been significant: Data storage costs have plummeted, and the volume of data available for business analysis purposes has increased dramatically. Transaction costs and networking and communication costs within supply chains have fallen as well, while the proliferation of new products and IT in general have increased considerably. The changes in IT (particularly business communication technologies) have played a critical role in enabling companies and supply chains to operate on a global scale. Without IT as an enabler, managing a complex supply network would be inconceivable.

Feasibility of the Disintegrated Model

At first glance, it appears that the disintegrated supply chain offers clear advantages over the integrated model. If a company’s decision to outsource is based primarily on cost, and if there are obvious players that can assume responsibility for the strategy, planning and control of the operations, the fragmented model might offer significant benefits. In practice, however, many companies decide to fragment their supply chains for the wrong reasons — to address problems of incompetence and inefficiencies. Although a globally dispersed fulfillment model may be cost-efficient, we believe a high degree of disintegration cannot be sustained. Eventually, aggregate players need to emerge to manage a subset of the disintegrated value network, including enabling the coordination and governance of supply chain segments in keeping with the objectives of the larger supply chain; enabling or sustaining the heterogeneous models of collaboration among the decentralized supply chain agents; facilitating rapid integration of new partners into existing supply chains; coordinating communication and other activities among players to meet overall objectives; and paying special attention to the needs of small and mid-size enterprises, which operate on the periphery of networks dominated by the larger agents.

The Consequences of Disintegration

Prior to the disintegration and fragmentation of supply chains, companies were responsible for coordinating their own value chains and ensuring proper alignment of incentives for supply chain agents. Companies had clear financial incentives to play this role. However, as vertical supply chains break apart, the question emerges: Who is responsible now for the coordination of activities and for setting the appropriate incentives for the supply chain agents?5 In the new network configuration, the requirement for interaction and coordination increases substantially, even though the number of layers in the overall supply chain may remain the same. In addition, ownership and control of the assets and functions changes hands, frequently leading to a subdivision or redistribution of responsibility for handling and transforming materials, and for delivering the end products to customers. These changes present new challenges, including how to manage a large number of supplier and distributor relationships and how to allocate resources among multiple entities. The costs of coordination — often with external entities — make it more challenging for companies to exert the same level of control and influence on their supply chains.6

As supply chains disintegrate, OEMs need to find ways to manage the flow of goods both inbound from outside suppliers and outbound to distributions and customers. (See “Flow of Goods From Contract Manufacturers to Retailers.”) A neutral third party (for example, one capable of aggregating suppliers from various locations around the world) could contribute significant value. Two examples of this type of role already present in the electronics industry are United Parcel Service Inc. and FedEx Corp., which have airport facilities for warehousing clients’ products for rapid shipment to end customers. When customers submit orders, the products are sent directly from the airport; in some cases, repairs are handled at the airport as well.

In our research, we found that smaller OEMs had to pay particular attention to the logistics side of the business because they tended to have significantly less leverage with suppliers than larger OEMs. They absorb a disproportionate amount of the uncertainty created by supply chain disintegration. Many were willing to share information about capacity, inventory positions and capabilities, and they were open to having a third party assist them in managing inbound sourcing, selling excess production capacity, identifying customers who they do not have access to and finding new sources of capital. In short, they wanted assistance with almost every aspect of their operations.

Emerging Opportunities in the New Landscape

The clamor for experienced outside help presents opportunities for those able to meet the needs. Future supply chains will no longer consist of serial interactions between buyers, suppliers and logistic players, but will be more dynamic and malleable. They will operate as value networks in which all players will need to work collaboratively to acquire, process and distribute information to maximize productivity and efficiency.

Our field research identified three main drivers that support the concept of value networks: working capital availability, visibility and velocity.7 While these drivers are by no means new, it is important to understand them in the context of the new landscape.

Working capital

The past 20 years have seen numerous strategies for freeing up working capital and increasing liquidity — among them, just in time, total quality management and customer relationship management. But with fragmented value chains, today’s challenges have become more complex. Rather than simply managing their warehouses, companies need to manage a complex matrix of material management issues on the inbound side of their businesses, which might involve keeping tabs on hundreds of suppliers across several continents.

Visibility

In addition to knowing the location of necessary materials at all times, companies also need visibility into the inventories of other players in the value network. This allows them to monitor overstocking and understocking of component parts, coordinate production strategies and set pricing strategies based on available information about supply and demand.

Velocity

Visibility has little value unless the information can be put to use swiftly. Players in the value network need to be able to exchange pertinent information on a real-time basis and adjust as necessary to a new market environment.

Although the value drivers we have identified address an important set of market needs, we found widespread industry disappointment in the current capabilities of logistics companies. This may reflect their historic strategic focus on moving goods from pointA to pointB. In that role, logistics providers have had limited visibility into the internal processes of other players in the value chain, making it difficult for them to conceptualize the whole value network from the perspective of their customers. Logistics providers need to find ways to make the supply chain more flexible and lean by offering enhanced services that leverage the relationships they have with other players in the chain. By moving deeper into the value chain rather than remaining as a peripheral player, LPs are in a unique position to assume the new role of facilitator.

In order to succeed in this new role, LPs must help companies collect, process, interpret and use information effectively. (See “Listen-Check-Deliver.”) They must learn to communicate in real time with players throughout the supply network to facilitate purchase orders, production processes, order fulfillment and movement of goods among players. The new system needs to be designed so that all players not only have the power to trace materials, but also the ability to modularize and reconfigure subsystems so that transparency and visibility can be achieved across the entire network.

The Maestro Model

Drawing from the set of capabilities we have outlined for LPs, we anticipate a brand-new role in the value network for a neutral third party — a “maestro” that can coordinate the entire network and align the incentives for all the participating players. Large companies are not likely to surrender control of all their suppliers to a maestro; in many cases, they are capable of managing suppliers themselves, and will not need to rely on an outside party. However, many companies embrace a modified version of this role — something we call the “mini-maestro.” A mini-maestro controls a portion of the supplier network while the company retains control over the remaining suppliers. (See “The Mini-Maestro Model.”)

In order to appreciate how a mini-maestro operates, it is helpful to examine the Li & Fung Group, a Hong Kong-based company that serves private-label apparel firms in Europe and North America. Li & Fung, with revenues of $7 billion in U.S. dollars in 2005, operates what might be called a “smokeless” factory. Over the years, it has evolved from a trade broker between the West and China into a multifaceted coordinator of manufacturing. Although it maintains a network of 10,000 suppliers in 40 countries, it does not own any of them.8

Upon receipt of an order, Li & Fung divides the process into two subprocesses: the front end (sales and design) and back end (logistics and banking); and the middle portion (which is made up of the more labor-intensive activities). The front and back ends are often performed in Hong Kong, where the necessary skills are usually available. For the middle portion, Li & Fung uses its knowledge and experience to select the best factory to perform each function. It may source the flax from France; spin and weave the yarn in Shanxi, China; dye the fabric in Quangzhou, China; produce the garment in Dongguan, China; and then inventory the finished goods in Hong Kong, before transporting them to their final destinations.9

Li & Fung coordinates each process in the supply chain: raw material sourcing, factory sourcing, manufacturing control, shipping consolidation, customs clearance and local forwarding logistics.10 Using its buying power and the trust it has developed with its supply base, Li & Fung can shrink the delivery cycle for time-sensitive products considerably. This allows customers to make purchases closer to their target completion dates, providing them with substantial savings in the form of fewer inventory markdowns and quicker reaction to shifts in demand.

Flextronics International Ltd., headquartered in Singapore, offers another model for the integrator role. (See “Comparing Li & Fung and Flextronics.”) With 2005 revenues of $15 billion in U.S. dollars, it is a leading electronics manufacturing services company, operating in 32 countries and five continents. The company provides complete design, engineering and manufacturing services that are vertically integrated with component capabilities to optimize its OEM customers’ operations and time to market. Microsoft Corp., for example, developed its Xbox by working closely with Flextronics, which had complete responsibility for manufacturing the end product. As part of its global strategy, Flextronics operates in six industrial parks in low-cost regions around the world. Each park functions as a manufacturing center, producing all the components needed for the final system assembly. The parks also integrate strategic suppliers on-site to reduce material procurement costs and accelerate new product introductions.11 In addition, Flextronics operates two “super sites” in Asia, with access to established local resources and suppliers, and maintains “high competency centers” in North America and Europe that specialize in high-tech services.

Players such as Li & Fung and Flextronics offer insights into what a coordinated supply network can accomplish. In the current supply environment, a pure push system is not likely to be optimal: It initiates production without much coordination among the various suppliers in the network. However, a pure pull network has limitations as well. A mini-maestro can design and coordinate networks where push and pull mechanisms coexist. In formulating these networks, corporate managers can begin to move away from the push and pull mentality, and strive for optimal resource allocation among nodes in the network.

Implications of the Mini-Maestro Model

As with any model, it is critical to understand both the potential and the limitations. We explore here some of the main implications of the mini-maestro model.

Allocation of Costs and Benefits

Given the fragmented and competitive nature of the supply chains, diverse players within the network need to align themselves with the objectives of the supply chain and the end customer. Thus, issues of supply chain governance and leadership become critical for mini-maestros, whose success hinges on support from network players. The mini-maestro must develop ground-level mechanisms for allocating and sharing the net costs and benefits of partnering, recognizing that business processes changes can impact some players more than others. For example, the decision to postpone manufacturing in one location may mean that a distribution center has to carry more inventory. The mini-maestro must find ways to compensate the distribution center for the additional expense. Similarly, network players that enhance network performance through innovation need to be rewarded for their contributions.

Successful coordination requires maturity, patience and deep knowledge of network operations. Flextronics, by owning portions of the supply chain, is able to coordinate using traditional means. Li & Fung, on the other hand, coordinates independent suppliers using financial incentives and an elaborate benchmarking system, which allows Li & Fung to track the performance of each player in the supply network. As a result, players tend to focus on a small but core set of activities — those in which they have developed truly distinctive capabilities. Players that consistently outperform others get rewarded with steady work; those that underperform can use the feedback to make improvements.12

Mutual Dependence and Trust

The mini-maestro needs to cultivate mutual dependence among network players and foster a sense that they need one another to be successful. Mutual dependence helps build enduring relationships. Li & Fung tries to consume 30% to 70% of its suppliers’ production capabilities, a range that allows it to get priority while avoiding complete dependence on the suppliers. Li & Fung cultivates supplier trust by visiting them several times during the production process.13 The first visit occurs prior to the start of production, to inspect raw materials. Other visits take place during and after manufacturing, to ensure that product quality is at par. Li & Fung’s suppliers receive continuous training to develop the knowledge and skills required to succeed, reinforcing the notion that Li & Fung is committed to the network players. Flextronics cultivates trust differently because of its structure. Network players are analogous to divisions within a company. There is a high level of dependence between different divisions. The nature of the organization and delegation of responsibility among divisions generates a high degree of trust and responsiveness.

Systems, Standards and IT

One of the dangers of pulling together a final product from different sources within the network is a lack of uniformity. To guarantee uniformity, the interfaces between players in the supply network need to be well defined. The network itself also needs to be extremely malleable; the players should be “hot-swappable” — weaker players should be easily swapped out with the stronger ones, without disrupting the network. This constant reconfiguration leads to optimal productivity and responsiveness.14

Li & Fung, for example, defines the requirements that partner companies must meet in order to become part of the network. It also defines each service provider’s role and specific job allocation. Li & Fung manages the network at a macro level but does not manage the day-to-day operations of the network players. In this loosely coupled network, the service providers can focus on their tasks and capabilities without costly intervention from the orchestrator.

Social Contract

The disintegrated supply network needs to operate without the traditional top-down hierarchy. The resulting social contract is one that encourages individual players to reach their potential. This manifests itself in two ways: First, there is a sense of equality within the various ranks; and second, there is a commitment to allowing people to take initiatives and maximize their potential.

At Li & Fung, customer-focused divisions are small and entrepreneurial, and each is managed by a lead entrepreneur who receives financial resources and administrative support. All the business decisions that go into coordinating a production program for the customer get made at the division-head level.15 Li & Fung has several dozen divisions, and senior management creates or eliminates divisions in response to the market. The company has a similar approach toward its suppliers: They are part of a network that is highly malleable, and each is encouraged to pursue opportunities wherever they exist. Similarly, at Flextronics, the dynamic and flat corporate structure ensures that a “we all think and we all do” mentality permeates the organization.

Reintegration Calls For Well-Managed Networks

As the process of disintegration and reintegration continues, there is an emerging need for entities that have the knowledge and skill to manage functionally diverse and geographically dispersed supply networks. Such players can bring innovation and efficiency to their networks by orchestrating the flow of goods, information and funds among multiple entities, and by dynamically reconfiguring how networks are organized. It is important to understand the critical impact these aggregators will have on their industries — determining how the networks are designed, how they are governed, how suppliers are evaluated and rewarded and how networks continue to meet new competitive challenges over time.