“I got it the day after Christmas” or “I never got it at all” are two of cyber-shoppers most common complaints. Indeed, many organizations still don’t get right today, shipping, that is. Executives and managers confused and challenged by order fulfillment would do well to read this helpful article. According to the authors, consultants at McKinsey & Co., managers must consider and answer two key questions to sort out the fulfillment conundrum – and to avoid disappointing customers. They must first consider which performance capabilities will satisfy customers’ order fulfillment needs and deliver acceptable profit margins. Second, they must decide which of those capabilities a company should own and which it should outsource. Detailed solutions to these issues are the core of this comprehensive article on fulfillment.

The widespread use of the Internet has led to a lot of confusion around logistics and order fulfillment. To steer through the muddle, business leaders need to understand and predict customer needs, and scrutinize the economics of their available options.

A business leader considering the right strategy for order fulfillment—the process that moves customer orders to actual deliveries and accounts for re turns—faces contradictory options for every issue he or she must consider. Should you build facilities yourself or outsource? EToys started out by outsourcing order fulfillment, then invested in its own first-class facilities, bankrupting itself in the process. Wal-Mart, onthe other hand, chose to outsource the fulfillment of on-line orders, only to cancel contracts and pull operations back under its own roof later. Should you pick the high- or the low-tech solution? On-line grocer, Webvan, launched a billion-dollar building spree of highly automated picking centres, but scaled back when customers were slow to appear. On the other hand, U.K. groce r, Tesco, raises eyebrows with its low-tech approach, where order pickers at local stores fill a customer’s basket according to a paper pick-list.

Performance has been far from perfect. In on-line retail, for instance, many vendors stopped accepting Christmas orders almost a week before Dec. 25, knowing that they would struggle to keep promises. Despite this caution, according to the consulting firm Bizmetric, eight percent of packages did not arrive in time for Christmas.

Fulfillment performance matters. A Bain/Mainspring study of on-line retail customers showed that order fulfillment performance was one of the main factors affecting their choice of vendor. The study also showed that shoppers spend more on repeat purchases than on their first shopping basket. On average, on-line vendors spend $50 (all currency in U.S. dollars) to acquire a new customer, about three years profit margin for the average customer. This means that those companies that perform well enough to merit repeat visits are the ones that turn their initial outlay into a positive cash flow. Ultimately, fulfillment performance affects long-term profitability.

To win loyal customers and move quickly to profits, managers need to focus on two key questions:

• What performance capabilities are profit-effective, or, in other words, will satisfy customers’ order fulfillment needs and deliver acceptable profit margins?
• Which of those capabilities should a company own, and which should it outsource?

CUSTOMER NEEDS DICTATE THE NETWORK CAPABILITIES

According to a Bain/Mainspring survey of on-line buyers, critical customer concerns related to order fulfillment include accurate delivery, product availability and ease of returns. To perfect these steps re q u i res significant capabilities in logistics and order tracking. Where should you locate warehouses? How many should you have? Should you depend on ground transport or air freight to move pro d u c t s to and from the customer? And what happens when the shirt doesn’t fit or the spare part is no longer needed? What returns process best meets on-line customers’ needs? Customer expectations of delivery time, cost, and returns handling will dictate the optimal response.

Those expectations will, of course, differ by product:

• Grocery consumers expect an Internet vendor to provide a full line of products, including perishables like meat and fresh produce. And most want groceries delivered the same day or next day, within a narrow interval. Transportation costs are high relative to the value of the goods. These realities mean that products must typically be stored locally with fulfillment centres in major metropolitan areas. In the United Kingdom, Tesco has achieved one-day grocery delivery by simply treating local stores as “warehouses.”
• In contrast to grocery shoppers, book buyers seem willing to wait three-to-five days or pay a premium for overnight delivery. Transportation costs are lower relative to the value of the goods. And, critically, there is limited spoilage or product obsolescence (at least relative to bananas or computer chips). The lowest-cost network for suppliers of these products in the U.S. consists of four to six fulfillment centres around the country, enabling two-day delivery via ground transport. This is precisely the model that Amazon has targeted as it has grown.
• In consumer electronics, on the other hand, inventory carrying costs are a major consideration. High obsolescence costs—up to five percent of the goods’ value per month in many cases—dominate the economic equation. The sensible solution is often a single fulfillment centre with air-express delivery to meet urgent delivery requirements. And this is not only true for retailers delivering to the end customer. Suppliers structuring their distribution networks to get goods to stores may choose to have no network at all for the highest-value items. For example, Compaq and Hewlett-Packard supply personal computers directly from their factories to individual retail stores.

To determine the right e-logistics for your product or products, think through the freight and inventory-holding costs relative to the value.

PROFIT-EFFECTIVENESS IN PRACTICE

Of course, the lowest-cost-possible approach to fulfillment still may not be financially viable. If vendors are to generate profits from their sales, fulfillment costs plus the price they pay for the product need to total less than the payment they receive. In some markets, there may be no such “profit effective” solution.

On-line grocery in the U.S. may turn out to be an example. Responding to customer expectations of convenient, scheduled deliveries, Webvan ships orders from giant warehouses to local substations in large trucks, then delivers them to homes in small, refrigerated vans. This is expensive, and Webvan has struggled to attract sufficient regular customers to cover its costs while pricing groceries competitively. Analysis indicates Webvan needs to attract about five percent of households, ordering weekly, in order to become profitable; this appears to be larger than its entire potential market. The result has been a stock-price disaster for Webvan in the face of continuing losses.

Interestingly, the answer may prove to be different in the United Kingdom. The grocery market there is in the hands of just a few competitors, earning two to four times the net margins of leading U.S. retailers. This, along with the fact that much of the U.K. is very densely populated, may change the economics just enough to make a grocery delivery service an option.

INFORMATION TECHNOLOGY CAPABILITIES

The next challenge after mapping out the ideal physical fulfillment network is to assure that there is an appropriate information technology (IT) infrastructure to support it. On the consumer side of e-commerce, there is an increasing desire for detailed information on product availability. Buyers want instant quotes, including taxes, duties and freight costs. And they want to track the progress of their orders on-line. For business customers, such information is considered not just desirable, but essential, and the list of IT capabilities needed to meet the minimum requirements is continually expanding. Bricks-and-mortar vendors need to invest in IT to provide the services that their customers demand, and integrate their on- and off-line organizations for a seamless response.

And remember that you are investing in an industry still in its infancy. Today’s model is a crude iteration of what will exist in a few years. Customers’ expectations are rapidly increasing as their Internet sophistication grows and competitors’ logistics improve. The minimum standard for IT capabilities is rising accordingly.

Today, even Amazon’s current systems typically give only general guidance about availability, such as “usually ships within 24 hours.” Other on-line retailers are still operating in the world of “allow four-to-six weeks for delivery.” They can’t tell you if an item is in stock or, if not, when it will be. Customers are accepting this, for now. But companies like i2 and UPS are creating supply-chain software and services that will change expectations.

Indeed, UPS has launched an e-commerce fulfillment operation, UPS e-Logistics, designed to help businesses deliver cutting-edge availability and fulfillment information to downstream recipients. Its goal is to allow vendors taking Internet orders to promise precise delivery dates—and hit them, while customers will be able to check their order’s exact whereabouts at a mouse click. Such technology soon will become the benchmark by which customers judge all vendors.

PHASING OUT INVENTORY

One important benefit of emerging Web-based technology is that it helps suppliers reduce inventory and become more efficient. For example, if retailers share their insights about expected end-customer demand, suppliers can schedule production more effectively. In turn, suppliers can provide retailers with helpful information about production schedules and shipment dates, reducing the amount of inventory the retailer needs to carry. One major retailer attributed 17 percent of inventory costs, representing over $200 million per year, to delivery failures. The retailer eliminated these problems through more effective processes supported by new IT systems. Fixing these problems by sharing information on-line also allowed the company to raise service levels substantially.

On a deeper level, Web technology may enable companies to redesign their supply chains. Present systems typically move out a pre-manufactured supply of goods to asset-intense stocking locations. Suppliers “push” goods towards customers and then respond to orders. The Internet allows real-time, customized interactions between the supplier and customer, giving accurate, specific information about what customers want. Dell, the computer manufacturer, has made the change towards “customer pull,” where goods are supplied to meet individual consumers’ specifications. Dell assembles computers to individual specifications and ships them on the same day.

This switch from “customer push” to “customer pull” offers high potential for efficiency improvements, but it is hard to do. Also, making the “pull” system work depends on the nature of your business. It’s hard to imagine zinc miners, for example, digging a new shaft every time a customer calls a trader to place an order!

Generally, the more flexible your production capability, and the higher the cost of storing goods, the more worthwhile it will be to shift your supply chain, or parts of it, towards the “customer pull” model (see Figure 2). There will always be people who want ready-made fast food instead of a sandwich made to their specification. The winning strategy may consist of two approaches. Some suppliers will carry lots of stock and eat the inventory cost to win on service, typically selling low-specification, low-depreciation or frequent-use products. Examples are Staples selling stationery or Tesco selling groceries. Others will eliminate stock and ship from manufacturing sites on a just-in-time basis. These vendors will sell high-value, multi-specification pro d u c t s like bicycles, cars, or computers, as Dell does. Vendors providing a broad range of products may need to do both.

THE ECONOMICS OF “MAKE VS. BUY”

After determining your order fulfillment strategy, a key issue becomes whether to outsource all or some of the steps in implementing the strategy. Do you make or buy? To answer this question, you’ll need to calculate the minimum scale required to amortize both warehouse space and the investment in IT required to keep you on the cutting edge of customer service. In more and more cases, companies will find outsourcing the most economical option. Consider the following: According to a Bain analysis, warehouses become scale-efficient beyond about 15,000 transactions per day (Figure 3), or about 250,000 square feet. If your e-commerce order fulfillment strategy re q u i re s four warehouse locations, it’s not cost-effective to build your own facilities unless you anticipate over 60,000 total transactions daily, or roughly a million square feet. Amazon, the largest pure-play on-line retailer, is only now approaching this scale; other on-line vendors average just a few thousand transactions per day. Typically, smaller vendors will have to outsource or piggyback on other customers’ use of the same warehouse. If the IT is right, you can achieve cost savings and still provide customers access to inventory and order tracking information in multiple locations.

On the other hand, mail-order companies, through the integration of their catalogue and on-line operations, have the scale to own and enhance order-fulfillment assets cost effectively. Lands’ End (150,000 transactions per day), L.L. Bean (125,000) and J. Crew (95,000) have some of the most successful on-line sites. Some bricks-and-mortar companies, like Tesco, will find a short-term solution by using their stores.

Leading-edge order-fulfillment and tracking technology is very expensive and difficult to integrate with existing IT systems. At the same time, some logistics companies, like UPS, are in a position to invest and offer their systems to customers on a “pay per drink” basis. If you’re not far down the learning curve on logistics, it may pay to let specialists do the development work and outsource to the best.

At first glance, the choices some players are making today may not make sense. Why has Wal-Mart, the master of distribution logistics, taken so long to start bringing order fulfillment in-house? Why did Webvan invest multimillions in logistics while its on-line grocery volumes remained low? Because the “make versus buy” decision is not treated strictly as an economic issue. Strategic intent and time-to-market are important criteria, and companies have other reasons for keeping control, including:

• Fulfillment is the core competency of the company. Webvan vowed to build 26 high-tech warehouses around the country, geared to the same-day delivery of groceries and other urgent goods. The company built this infrastructure itself because it simply didn’t exist elsewhere. More importantly, with these capabilities, Webvan planned to expand into other product categories and make money through cross-selling or becoming a fulfillment provider itself. But this approach is a big risk. Webvan may have miscalculated the size of the market for its services and seems likely to run out of cash before it can realize its vision.
• Speed to market is critical. Wal-Mart chose to subcontract—in the beginning. It paid a premium for fulfillment capabilities, but also bought the chance to test the water and understand demand. Now that Wal-Mart has gained experience in on-line retailing, it’s better positioned with its in-house, scale-based capabilities.
• Demand is hard to predict. Tesco’s approach to order fulfillment, although clumsy—imagine Internet customers’ “shelf-pickers” crowding the aisles and check-out stands alongside conventional clientele—has allowed the grocer to move on-line without overinvesting. The economics of additional fulfillment facilities depend on the number of customers who shop on-line. Rather than place a heavy bet on the Internet, Tesco chose to test the market using existing facilities. For now, the low-tech option appears to be the best solution. U.K. grocery competitors have all hesitated to build warehousing dedicated to their on-line services, and customers are dribbling on-line rather than flooding.

When the Internet marketplace matures, its true winners will be cost leaders. They will also be those with enough control of order fulfillment capabilities to build a back office that enhances sales and marketing. For example, Amazon increases site hits by allowing customers to track order fulfillment. The Gap and Nordstrom increase traffic in their stores by allowing customers to return Internet purchases at street level.

For now, the urgent task is to keep up with changing expectations, and to avoid disappointing customers or making expensive investments that become obsolete before they show a return. Managers who continue to short-change order fulfillment will eventually surrender their customers—and revenues—to those with superior infrastructures. They will cede business to competitors who assemble “profit-effective” capabilities that build customer loyalty, and to those who correctly determine which capabilities should be owned and which outsourced.