Buy now! Limited supplies!

Related to my post yesterday, the NY Times today has an article on retailers intentionally keeping stocking quantities low (NY Times, 11/19/09, Luxury Stores Trim Inventory and Discounts).  If the Brioni leather bomber jacket is what you need for that special someone this season, you better get to Saks fast because they have only 1 left – at a mere $5295! (And then you need to see a therapist to explore why you feel compelled to spend $5295 + taxes on an article of clothing which is not suitable for climbing Mt Everest or walking on the moon.)

The idea is simple – intentionally stock less than a “normal” amount so that you will not have too much inventory left over which needs to be discounted. Because if you have too much inventory left over, then customers may anticipate this and not plop down $5K to buy at the regular price, thereby certainly ensuring that you will have to discount.  Or, you are doing this to generate a sense of scarcity, and therefore desirability:

“What’s luxury retailing all about?” Mr Sadove said. “It’s about a scarcity of supply.”

Given that we are talking about ultra luxury products, I wonder if the scarcity argument holds water. If you are spending $5K on a jacket, then you better be sure that you will never see another person walking down 5th Avenue with that jacket on. But only people walking down 5th Avenue would be willing to spend that kind of money on a jacket (i.e., not everyone has the same probability of encountering another person with this jacket on). So unless that jacket is *unique*, it is not scarce enough.

Next, the standard approach to avoid markdowns with luxury goods is to not markdown! A $5K jacket probably has a very healthy margin (say $4,750), so if you have a few left over, then ship them back to the producer, take more time to sell them, or burn them. But whatever you do, don’t markdown the price! Having a few left over jackets that need to be sold in some other country with the label ripped out may be cheaper than stocking out when somebody wants to pay you an obscene amount (ok, I’ll stop harping about the ridiculousness of the price).

The article recognizes that the best approach is to start with a limited supply and then replenish only if necessary. This is feasible in some categories (contemporary apparel and women’s shoes) but not in others (European designers). Of course, this reminds us of Zara:

The graph above nicely illustrates the Zara strategy – start with a more reasonable price and a limited quantity, replenish if necessary, and don’t mark down all that much.  The net effect is that your total profit (light blue) can be higher.

And there is one key lesson from Zara that is missing in the discussion of Saks.  If Zara runs out of one item, they generally have another item available that is a close substitute. If you like a particular black bomber jacket at Zara, then you should buy it because (a) it will not be marked down and (b) if you wait then you will have to buy a different black jacket.  Either way, Zara gets the sale. In the NY Times article, they are suggesting that it can be better to simply stock out.  If you don’t have an adequate substitute, then that is really a costly strategy.  Being smart doesn’t mean you are willing to incur costs. Being smart is avoiding costs while maximizing revenue.

4Q is time for what’s hot and unavailable

Every 4th quarter there are stories about what is hot and hard to find. This year, it is the e-reader category, specifically Sony’s Daily Edition Reader ($399) and Barnes & Noble’s Nook ($259). (See WSJ 11/18/09 – Sony Says Some E-Reader Orders May Miss Christmas).  Sony is telling customers that they are now shipping orders on Dec 18th – a little tight to ensure being included as a stocking stuffer.

My favorite quote from the article is:

“The possibility that Sony, a huge electronics manufacturer, would be caught off guard by supply-chain issues is surprising, said Mike Serbinis, president of Shortcovers“

The presumption is that an experienced and large manufacturer should not have any trouble matching supply with demand. This simply ignores the fact that size and experience are no match for the uncertainties of the market.

Next, it is interesting that Sony is capable of quoting shipping dates:

“In October, the company told its first wave of customers that the Nook would ship Nov. 30. A second wave of customers was told it would ship Dec. 7; shipping dates of Dec. 11 and Dec. 18 were later given.”

This does demonstrate a sophisticated level of supply chain management, assuming their quotes are reasonably accurate: to be able to do this requires a significant amount of real-time information sharing across the supply chain and the skill to process that information quickly.

Finally, I can’t help but speculate on whether they intentionally kept supplies short. Suppose you think you could sell 100,000 units. If you make 75,000, they you are likely to run short. If demand turns out to be 120,000, you are really short and you get lots of free press about how hot your product is. But to make that strategy work, loosing thousands in sales has to cost you less than the free advertising. Hard to say if it is worth it.  Then again, it is entirely possible that if your new techno gadget isn’t “hot”, then it becomes “stone cold”. For example, if “natural” demand is 100,000 but you make 75,000, then actual demand turns out to be 125,000.  If “natural” demand is 100,000 but you make 100,000, then actual demand turns out to be 60,000 because who wants to buy a product that isn’t popular.

The diamond supply chain

Some retailers like to vertically integrate. For example, in clothing the two large players (Gap, Inditex/Zara) are vertically integrated into production (though not to fabric production). Other do not. For example, in athletic shoes (Nike/Adidas), the firms like to outsource production and do not reach all of the way back into the production of materials (such as cows for leather). The Internet giant, Amazon, doesn’t make the stuff it sells (I suspect it outsources production of the Kindle) and the physical world giant, Wal-Mart, also primarily sticks to retailing.

The supply chain for diamonds is special, in particular due to the existence of the “legal cartel”, De Beers. The WSJ yesterday (Diamond Industry Makeover Sends Fifth Avenue to Africa – 10/26/09) reported how Tiffany’s has invested in diamond cutting and polishing in Botswana. Why would they do this?

The technology for diamond cutting and polishing doesn’t seem to be particularly complex or proprietary (protected by patents, etc.). It isn’t a very capital-intensive step in the process(unlike mining), which is reason to get into it (i.e., it isn’t a big investment) and reason to let others get into it (there must be lots of competitors due to the low capital requirement). There doesn’t seem to be evidence of a cartel at that step in the process or substantial barriers to entry.

One theory is that controlling the diamond supply chain facilitates branding, and in particular avoiding the tarnish of “conflict diamonds” (see Blood Diamonds).  But, to quote a quote in the article:

“We really want the focus…to be on the quality of the diamond ring, not how it came to be,” said Mr. Kowalski, the CEO.

In other words, they are not investing in Botswana cutting and polishing to convince consumers that their diamonds are “clean”. In fact, they want to completely avoid the discussion of where their diamonds come from.

Hence, it must be that (i) the ROI on this investment is at least as high as opening up new stores and (ii) the ROI is high because vertical integration into this step creates efficiencies that cannot be had from buying cut and polished diamonds on the open market. (i) is plausible if they are running out of good places to put their stores, but they might not want to signal that to Wall Street. (ii) is plausible if the market is not sufficiently efficient to drive down margins.  Alas, the article doesn’t provide enough information to know if these theory holds water or not.

It isn’t your father’s PC industry anymore

My first PC was an IBM PC with an Intel 8088 microprocessor, two floppy disk drives and a whopping 64K of RAM (not 64MB or 64G, the 64,000 variety) – and it cost about $4000 in 1985 (but my father worked for IBM so we got it for the employee discount price of something like $2700). HP is currently selling a laptop through WalMart for $298 (or $148.47 in 1985 dollars, http://data.bls.gov/cgi-bin/cpicalc.pl). 

The PC industry has gone through many stages in which one firm was on top. Apple started it, then IBM took over. IBM tripped in the early 90s and Dell took over. Dell started to stumble about 5 years ago and now HP is on top as we see in the following graph reported in WSJ (HP wields its clout to undercut rivals, 9/24/09):

So how is HP able to do this. First, they are working with small margins, razor thin 4.6% margins. Next, the article gives some other clues to their strategy.

 (1) “Simplifying the specifications of the product”

i.e., reduce product variety so that contract manufacturers can have higher volumes and thereby offer lower prices. This is a standard recommendation in an OPs class.

(2) ”By getting orders in earlier, H-P could save on component and manufacturing costs, which are cheaper if they’re ordered far in advance.”

This line is intriguing. If component prices are falling, then ordering early is a disadvantage, not an advantage. This suggests several possibilities. First, component prices may not be falling rapidly and HP is better off giving suppliers a long lead time to get an advance purchase discount from them. Second, component prices are still falling but it is cheaper for HP to take on that risk than to let the suppliers take on that risk – i.e., if they take on that risk then they have to charge more, which is passed on to HP.

As I said, it isn’t your father’s PC industry anymore. What makes me think it could be entirely different in another 5 years?

Production smoothing on a grand scale

It was just reported that the US GDP fell at an annual rate of 3.8% in the fourth quarter of 2008 but it would have fallen 5.1% had it not been for the inventory adjustment – demand “fell off the cliff” but firms kept producing, thereby causing inventories to rise.  One might interpret this as a nice demonstration of the production smoothing strategy on a grand scale – it is costly to shut down production, so keep producing and build inventory with the assumption that eventually demand will exceed your production and you can then draw down your inventory.  Production smoothing is particularly effective for coping with seasonal demand because then the firm has a good sense that demand will indeed return during the high season.  Now it is a little bit different. The drop in demand is not seasonal but systematic and it is not clear when demand will level off or at what level it will converge to. In particular, if the economy is still producing above the new long term rate of demand, then further adjustments to production will be needed.

The depth of the downturn may hinge on firms’ willingness to hold inventory. If they want to reduce their current inventories to their levels over the past five years, then they will need to really slam on the break (in effect, we have already produced for future demand and to return to equilibrium requires stopping production so that demand can catch up).  However, if firms are willing to hold on to their additional inventories, then the adjustment need not be so severe – in that case all that is necessary is that the firms align their current production with their current demand rate.

These issues are exhibited on a more “micro” scale at Chrysler. They stopped production in December 2008 because their inventories were higher than they could manage (or wanted) and continuing to produce would have only increased them further. They only just resumed production. If their current production rate equals their current demand rate, then their inventory level will remain unchanged. If they want to reduce their inventories, then they will have to produce at a rate that is lower than demand for some time.

So this raises the question of whether inventories are stabilizing or destabilizing to an economy.  You can tell a story for either one, and some additional data collection is needed to resolve the conflict.

Wall Street Journal, Jan 31, 2009, Economy Dives as Goods Pile Up

Is JIT dragging us down?

We all know these are tough economic times, but do we know why the economy is struggling so mightily? One theory is that JIT (and other lean manufacturing practices) are to blame. See, for example,

http://jamesfallows.theatlantic.com/archives/2008/12/pensee_dept_followup_on_the_no.php

The metaphor is simple, animals with stored fat are more likely to survive in times of scarcity than thin animals.  Alternatively, think of a group of hikers on a glacier. JIT means they all tied together with very short ropes so when one falls, they all fall in quick succession.  Are these metaphors correct? Is lean manufacturing the cause of our woes? There is reason to believe it is in fact the scapegoat.

Consider the auto industry and GM in particular.  Their demand is now much lower than their capacity.  (Actually, it has been for a long time, just now there is a very large discrepancy.) If they maintain production at their capacity, then their inventory continues to build, converting cash into inventory. This can work for a little while but eventually you run out of cash, risking bankruptcy.  This is the problem they currently have.  The alternative is to stop production, but then you pay your workers to do nothing, so you still burn through cash but then have no product to show for it. This is very costly – in theory, inventory can eventually be converted into some revenue.  

Now consider the role of lean production in this mess. If you turn back time to one year ago, had GM been less lean, then they would have had less cash and more inventory.  Consequently, they would have had less of a buffer to weather the current storm, so their problems would have hit earlier or would have been more severe.  If they had been even leaner, then they would have had less inventory at that time and more cash, thereby giving them a bigger cushion to survive the downturn.  Based on this reasoning, their current problems are as bad as they are because they weren’t lean enough, not the other way around. 

It is possible to defend JIT in another way – if JIT were the problem, then we would expect the leanest of the auto manufacturers to be suffering the most.  Toyota and Honda are among the leanest, and they are suffering, but not by as much, which is again consistent with the notion that during this crisis, being lean is a help and not a hindrance. Maybe the better metaphor is the following.  Two people are thrown overboard a cruise ship and nobody notices, so they need to fend for themselves. They see an island in the distance and start to swim for safety.  Who is more likely to make it, the fit and lean person or the “master of the buffet” person?

Honda’s Flexible Plants Provide Edge

This has been a tough year for most auto makes :  so far this year sales are down 24% at Chrysler, 18% at GM, 15% at Ford and 7.8% at Toyota.  But U.S. sales at Honda are up 1.7%.  There are two reasons for Honda’s success. (1) Honda’s product mix depends less on SUVs and pickups than the others (i.e., fuel efficient models make up a larger portion of their portfolio). (2) Honda has some of the most flexible plants in the U.S. To illustrate that flexibility, Honda is able to switch from producing  Civics to CR-Vs with only 5 minutes of downtime!  Honda has achieved this flexibility through many different decisions.  For example, the Civic and CR-Vs were designed to be manufacturered in the same sequence of steps, so the same step (such as a door installation) can occur at the same location on the assembly line.  Honda did have to invest $400m several years ago to improve its flexibility.  That looks like a good investment in the current climate.  

Wall Street Journal, Sep 23, 2008 – Honda’s Flexible Plants Provide Edge

Dell likely to shrink its network of factories

For years, Dell has been show-cased for its operational excellence. Because of its make-to-order production, the computer maker managed to work with very low inventory. And, because of its market power and close supply chain integration, it had an extremely short cash conversion cycle – in fact, for many of its products, Dell collected the money from its customers before paying its suppliers.

But, times are changing. In the computer industry, the make-to-order model works brilliantly for corporate customers who want their PCs built according to a very specific configuration. But the recent growth in the industry was fueled by consumers, who want cool notebook computers as part of their mobile lifestyle, most of them do not care if they run processor x123 or x124. In response to this change, Dell now sells a significant part of its computers through BestBuy and Wal-Mart.

However, if you purchase 500,000 computers to then ship them to Wal-Mart, the benefits of a flexible, US-based make-to-order production disappear. Cost is critical – customization is not. Hence, you might as well source the lap-tops in big batches from Taiwan.

Dell’s story reminds us that there exists no one-size-fits-all operation. As firms adjust their strategy in response to a changing world, the constantly have to rethink their operations. That’s what makes Operations Management interesting!

For more on Dell’s recent cost cutting, see: New York Times “Dell likely to shrink its network of factories” September 5, 2008

Supply chain coordination snags Airbus and Boeing

Although airlines in general are having a hard time turning a profit now, there remains brisk demand for new aircraft from Airbus and Boeing. (Possibly because new aircraft are more fuel efficient.)

With a full backlog and a price tag around $200 million per aircraft, these companies do not want to delay delivery of any new aircraft.  But apparently they have had to park nearly finished aircraft due to some missing parts. For example, Boeing couldn’t deliver several 777s to Emirates because they didn’t received customized galleys from Snell, a German producer. 

The problem is that Snell didn’t anticipate the increase in volume and consequently didn’t build enough capacity. This is a good example of how a supplier’s capacity decision can have significant financial consequences for a buyer.

Wall Street Journal, Aug 8, 2008 – Lack of Seats, Galleys Delays Boeing, Airbus

How local will we become? – fuel costs and international sourcing

The cost of oil seems to be influencing everthing these days.  A recent report by CIBC World Markets, as reported in the NY Times, finds that the cost of shipping a container from China to the U.S. is now about $8000, up from $3000 earlier in the decade. In fact, the cost of transportation is now larger than the cost of tariffs.

What does this mean for supply chains – it is intuitive that higher transportation costs should lead to more localized production.  Instead of producing something in one location in a far off place, companies will start to choose to produce in multiple locations, closer to consumers.

Will this trend continue? One reason for international sourcing is wage rate differentials. If they continue to decrease (because wages in countries like India and China increase) and energy costs continue to decrease, then we may be looking at a long term trend to reverse globalization.

NY Times, Aug 3, 2008 – Shipping costs start to crimp globalization
http://www.nytimes.com/2008/08/03/business/worldbusiness/03global.html