From Retailers to Manufacturers, Complexity in Products Begs the Question: How Much Is Too Much?Published: March 01, 2006 in Knowledge@Wharton
Try this for variety: In a recent advertising mailer, Kroger supermarket boasted having 300 varieties of beer and 1,800 varieties of wine. Kroger of Cincinnati, Ohio, is one of the largest U.S. grocery retailers with 2004 sales of $56.4 billion. What is the impact of all that variety on Kroger's costs? Moreover, with 1,800 varieties of wine, what will be the customer response -- confusion or delight?
"Using product proliferation as a strategy very frequently does not create value, and often destroys value even as it produces revenue," says Matt Reilly, senior vice president of client services at George Group, an operations and strategy consultancy. He says he wonders how much profit will be generated with this model, even if revenue climbs.
Other experts from George Group and Wharton agree that increasing product complexity in both retail and manufacturing is a very slippery slope: As a means of meeting evolving consumer demands or capturing new market share, expanded product portfolios can backfire because of the strain they place on already scarce resources, and because true profitability is masked. And, as companies expand their offerings, complexity can seep into internal processes, producing inefficiencies that can lead to customer dissatisfaction down the road.
"As corporations develop new marketing strategies to remain competitive, and as they develop new targeting strategies, complexity management becomes absolutely key," says Eric Clemons, Wharton professor of operations and information management. "Budweiser may have once made four or five beers, but will eventually end up making 400 or 500 beers. One website I visited doesn't have a complete listing, but it has about 350 different power bar brands. My point is: the retailer who used to sell power bars now has five pages of power bar listings, and has to manage that complexity." Clemons says complexity management will challenge retailers as they weigh options between product underage (inability to meet demand) and overage (inventory not sold or sold at a discount, or spoilage), logistics, warehouses, and so forth.
Complexity from Brand Extensions
Product manufacturers tend to leave the door open for complexity when they indulge in brand extensions. Stephen Wilson, director in George Group's Conquering Complexity practice, says in many situations, brand extensions could end up bringing a higher per-unit cost "than the single most popular item in the line." But brand extensions are popular because of their low entry barriers. "Brand extensions very often become a replacement for breakthrough innovations because you know they are a relatively safe bet," says Wilson. "You know they will generate some sales, even if they may well cannibalize some of your core products." But what is often ignored, especially in the consumer goods industries, is the army of support required from elsewhere in the organization in the form of marketing, manufacturing, distribution and the supply chain.
Size and breadth of a product portfolio can also leave a company strategically vulnerable, as illustrated in a George Group case study regarding an industrial manufacturer. "Because they were market leaders and had a broad spectrum of products, they left themselves open to niche competitors to come in and cherry pick," says Scott Epstein, a senior consultant at George Group. "Shorter lead times and on-time delivery had become important as product quality had become less of a differentiator in the marketplace." He says niche players had better systems and processes to respond to those changes in the market.
Epstein and his team advised their client to take a second look at internal processes to expedite decision making. "We asked them to make sure they weren't really spending a lot of time on administrative processes that weren't visible to the customer and didn't add value," he says. "In other words, we told them: 'Don't hold things up, don't hold up the pipeline.'"
Epstein says it is important to be responsive to customers, "but you want to make sure also that you are receiving value in return." The problem boils down to really understanding the "true cost of saying yes" to customers, not just from a variable cost perspective, but understanding the fixed cost component as well.
Keeping an Eye on Processes
Oftentimes, it's the unsatisfied customer who turns management attention to complexity, particularly in terms of company processes. Hundley Elliotte, a principal in George Group's Conquering Complexity practice, describes a case involving a global telecom equipment company that knocked on George Group's doors with a problem: Its customers were sending feedback that they weren't being served well.
Elliotte and his team started with a status check. The company had a strong brand in the telecom equipment business, and wasn't exactly losing customers. But it had some aggravated customers who had indicated that they were indeed considering switching suppliers. In fact, some large customers had gone as far as approving alternative suppliers, but hadn't pulled the trigger yet. A crisis seemed just one more false move away.
"The problems -- not getting back to customers with information about delays or poor service -- were symptoms," says Elliotte. "The key was to trace those back to the root cause." What his team found was an organization with "very inefficient and disconnected processes." The good part was the company was willing to acknowledge the problem without losing time.
The situation was grim: About 60% of all orders had some type of error -- they were either recorded incorrectly or miscommunicated to operations, or not produced according to customer specifications. As a result, customer service was deluged with complaints and the product development process was clogged with numerous "engineering change orders" to rectify quality errors.
Elliotte's team identified specific drivers of complexity and variations such as organizational hand-offs, non-value added steps and a poor understanding of customer requirements. It also started improvement efforts to strengthen communications, product development and innovation. At a broader level, efforts were made to increase awareness about the impact of complexity on fixed costs, asset utilization, inventories and account receivables. "A slower process might result in increased days of outstanding receivables, and when your accounting systems aren't designed to give a true profitability view of your products or services, you could very easily underestimate the true cost of a product if you have complexity," Elliotte says.
Pricing for Value
In a case involving a global commodity and specialty chemicals company, Reilly's team had to get creative in understanding customer requirements, which is essential when tackling complexity in a customized solutions environment. "Asking customers what they would pay is always a bad idea," he says. "So you have to do that through some indirect questioning around competitors' pricing and features, and how much they value these features: 'What if [a product] had certain features, and they were priced at X -- would that still be attractive?'" The results were startling: Customers said they would have paid a premium of 7% to 12% for the product.
That, says Reilly, is a classic case of a company pricing its products lower than what it could have actually captured. "They didn't understand what the real customer need was in a commodity-minded business," he says of the company in question. "They were pricing to keep the plant full, and didn't have a value-pricing mindset." He says the bottom line is that when companies with a highly revenue-oriented approach try to price their products -- particularly when they have a lot of fixed assets -- they tend to price them based on volume targets, not on value targets or margin targets. Reilly finds that particularly true in cases when a company is expanding its portfolio by launching a new product to gain market share. "When you enter into a relationship hunched over, it's very difficult to stand up later," he says. "I find so many companies go out to the market with a low price, and it's virtually impossible to raise it later, especially in the mature, asset-intensive industries."
Complexity Brought on by M&As
Organizations that are masters in acquisitions and successfully integrating them are all too wary of the dangers of complexity. Wilson points to GE, which he says has a "very good, repeatable process" for integrating the companies it acquires. He notes that in its 2004 annual report, GE highlighted complexity and innovation as two of the three major initiatives for the following year. "They are looking for more organic growth, because the field for acquisitions has dried up somewhat," says Wilson.
While acquisitions may make companies prone to complexity, there's a positive side in the timing. "There is a window of opportunity when you acquire a company to really make the changes you want," says Wilson. But he also finds that in many cases as companies acquire other companies, brands and capital assets, they don't act quickly enough to consolidate. His advice to companies before they finalize mergers and acquisitions: As part of the due diligence before an acquisition, understand the impact of integrating new products in the portfolio. Getting a grip on the complexity drivers could force management to acknowledge that 5% to 15% of their portfolio actually drives all the value creation. If they take that advice all the way to streamlining their plant capacities, they free up a lot of trapped assets, says Wilson.
On the process side, Saikat Chaudhuri, Wharton professor of management, says the "mistake that everybody makes [in integrating merged companies] is they try to find one model rather than having a contingent set of processes to think about." He says while one school of thought claims to have a model for integrating companies effectively, the other says "it's an art" and that no standard process can be built. "I stand in between," says Chaudhuri.
He points to some underlying principles for avoiding process complexity as a fall out of mergers. "The trick to success in integration is to align the integration strategy with the type of challenge and the objectives you have at hand," he says. He notes that there are three dimensions of integration -- one is the organizational integration, or the structure; the second is processes; and the third is joint projects and knowledge sharing. Higher levels of integration on the organizational or structural side allow for greater coordination and economies of scale and scope, he says. At the same time, lower levels of integration are useful for preserving the routines of functioning -- the processes -- and also for preserving flexibility.
How Complexity Can Work
Delivering customized solutions doesn't necessarily add to complexity, says Clemons. "It really depends on your product design," he says, citing Dell's success in managing myriad combinations of computers, peripherals and software. He says Dell manages product complexity essentially with "combinatorial assembly" -- a mixing and matching of existing options to meet customer preferences, such as screen size, disk size, memory, etc. "Dell has hundreds of thousands of ways it can respond to your request, but no individual request is any more complicated or any less complicated than the others."
Combinatorial assembly, says Clemons, is among the proven techniques in complexity management, as is "versioning," or repackaging existing products for different contexts. "A lot of the software that goes into Photoshop Elements is the same that goes into Photoshop," he says. "A lot of what goes into a discount coach seat is the same as a regular coach seat but with some restrictions placed on you." Another production strategy, he says, is "veneering," which leverages existing resources to create different products, such as a brewery that makes British and Belgian ales. "At the front end you use different grain and different yeast, and at the back end you use a different label, but you use the same tanks, the same bottling line, the same labeling line," he says.
Higher complexity can work wonders, if it offers a compelling value proposition to customers. A telling case of how that played out between Ford Motors and General Motors in the early 1900s is documented in detail in the book Conquering Complexity in Your Business (McGraw-Hill, 2004), co-authored by Wilson and George Group chairman and CEO Michael George. Henry Ford's Model T car -- available in "any color you want so long as it is black" -- is noted by the authors as the first milestone in complexity reduction in corporate America. Ford's ability to convert iron ore into an automobile in just 33 hours made him the world's richest man. Ford also had a commanding 65% share of the low-cost car market by 1921. Between 1908 and 1916, the company's revenue had surged from $4.7 million to $207 million.
Meanwhile, Ford's rival General Motors and its president Alfred Sloan struggled with an assortment of 20 different car companies acquired in earlier years, and was on the brink of bankruptcy. Sloan noticed a market niche for utility transportation, which at the time was occupied by used Model T cars. He employed a strategy of both cutting and adding complexity, to great effect. George and Wilson recount how Sloan eliminated 15 of GM's 20 brands, and introduced the "model year" concept. By 1925, Ford's Model T sales began crumbling with the GM offensive, and three years later, the Model T was withdrawn.
The book's authors say the Ford-GM clash points up three important rules of complexity. One, eliminate complexity that customers will not pay for. Two, exploit the complexity customers will pay for. And three, minimize the costs of complexity you offer.
Decades later, Ford had to relearn its complexity lessons at the hands of Toyota, which along with other Japanese car makers had begun making inroads into the U.S. car market in the 1960s. Toyota's chief weapon in delivering customers value at low cost was a complexity reduction strategy which eliminated waste in internal products and processes -- those were the early days of standardization. Yet, its culture of "deep functional expertise and excellence in design" allowed it to handle complexity, say George and Wilson in their book. Toyota currently builds its car and truck brands on just 13 platforms, while Ford uses 18 platforms. (Ford plans to prune that to 12 platforms by 2010.) They point out that of the roughly 200,000 cars it puts out each month on U.S. roads, about 40,000 variants are produced at or near the lowest cost in the world. (In 2005, Toyota's U.S. sales were 2.24 million cars, out of 8.25 million worldwide, versus GM's tally of less than 9 million. In 2006, it plans to overtake GM to become the world's largest automaker.)
Complexity management is all the more vital these days, says Clemons, because of the costs of carrying inventory. But he would look at other places beyond the balance sheet for red flags, which he calls a "crude tool that tells me I have a problem but doesn't tell me where to look." He says the complexity warnings will show up in time to introduce new products, overage, underage and the inability to respond to changing market conditions.