never say i know

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THIS IS AN INTERNAL GOLDRATT GROUP DOCUMENT. IT IS NOT INTENDED FOR GENERAL DISTRIBUTION

Never say, I know! Page 1 Eliyahu M. Goldratt, 2006

Never say, I know!

Eliyahu M. Goldratt, 2006

If there is a rule that Mickey and I try to drill into everyone who is doingtwo-hour meetings, it is: check and cross-check the key data on whichour suggested solution is based. Last month I had to face a case whereit was apparent that I had deviated from that rule. Of course theconsequences were embarrassing, but that is not the reason Im nowforcing myself to sit down and write this document (Im not amasochist). The main reason is that the renewed analysis showed me(again) the extent to which there is no end to deeper understanding;

we have embarked on a journey that does not have an end, just

exciting and rewarding stepping stones.

Maybe I was hit by this case because the company is producingsporting apparel. If there is an industry that I fooled myself that I knowinside and out, it is the apparel industry. Nevertheless, the renewedanalysis yielded not one but three additions to the body of knowledge.

The importance of these additions can be evaluated by the fact that inthe past few weeks I have already used them effectively in two other

cases.

Here are the details. Eighty-five percent (85%) of the companys sales

is to brand companies (companies like BigBrand which was thesubject of the analysis described in a previous document). But unlikethe cases we see in China and other places, this company has over 10brand companies as clients, none of them dominating its sales.

Therefore I wasnt overly surprised to read that raw material out of theselling price is only 50%. (When you are in the hands of one dominateclient expect your prices to be squeezed and therefore expect thatmaterials will represent a higher percent of your sales.) The other 15%of sales are their own collection, their own brand, that they sell throughtheir own 10 shops and 4 franchised shops, all located in their smallcountry.

A text-book case. In the two-hour meeting I just verified that theirproduction lead time is two months (very common in the apparel

industry) and yes, they produce for the entire season in one batch. Ialso verified that every client has its own collection and as a result there

is no aggregation. The template was obvious; the new awakening of the


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brand companies will guarantee that they will welcome a VMI offer. Noreal risk here since it will be enough to convince just 3 or 4 of theexisting (huge) clients and we can increase sales as much as we want.Of course it will take one or two seasons for the clients to realize theamazing benefits a VMI contractor brings to them and as a result to getmuch more work.

There is no real set-up in production of sports apparel, so it should beeasy to cut the lead time to less than a week. Transportation time to

the central warehouses of all their clients is only few days. It should bea walk in the park to bring them to excellent performance on a VMIoffer.

Increasing capacity is easy; there is no shortage of inexpensive labor tosew the goods and the machines are just sewing machines. At 50%material out of selling price the VV seems relatively easy to reach,especially when we have four years. Next case please.

During the 4x4 it turned out that a key element was wrong raw-

material is not 50% of sales, rather it is 75%. This, as you know,changes the entire picture. Lets substantiate this last sentence. WhenRM is 50%, to reach a VV, we have to triple the volume. Baring in

mind, the existing access capacity and the substantial improvements webring in logistic (it is an A plant), the required increase in volume

translates into a manageable increase in just direct labor (~ 50% orless). But when RM is 75%, to reach a VV, we need to multiply the

volume by a factor of 5. Under the same realistic assumptions, that willnecessitate increasing direct labor by about 150%. Such major

increase will require increase in supervision, administration etc. That isno longer negligible in its impact on the company OE. To compensatefor the increase in OE, and since the margins are small to start with, weneed to increase sales much more. The downward spiral is evident.The only way to get out of this spiral is to find a way, not just toincrease sales, but to significantly increase margins as well. In short,kiss good-bye a VV which is based on straight VMI.

Two different questions should be answered. To avoid running again

into such a dead-end we need to know: how come such a basic piece ofdata was wrong? To ensure that we do have VV for contractors to

brands we should also try and answer a more interesting question: isthere a feasible way to increase margins?

As for the first question, it didnt take long to reveal the source of themistake. The number was derived from their financial statement andtherefore it represents an average over the two channels of sales.


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Even though the other channel direct sales through their own shops is relatively small (just 15%) it had a major impact on the averagepercent of RM. Simply, for the channel of direct sales, the TVCrepresents much, much less than 50% (margins in the direct saleschannel are composed of the huge markup of a brand plus thesubstantial markup of a shop). The other distortion was due to the fact

that they pay by piece for the people who sew, turning most direct laborinto (by TOC definition) raw-materials.

We now understand the source of the mistake. But it doesnt help us toanswer the much more interesting question: what can we do to increasemargin?

Moving to rapid response is the first thing that jumps to mind,especially when one considers the current production lead-time of twomonths and the ease to cut the production lead time to be, at most, oneweek. Well, in their environment there is a limitation that makes it

difficult. Dying the fabric is a batch process. You need much more thanwillingness to pay slightly higher prices to convince a supplier to cut all

the batches to be in line with one week consumption (cutting thebatches to be less than one tenth of what they are now). Such achange will necessitate a super culture revolution. Moreover the

supplier is not willing to guarantee the same color in subsequentbatches.

Knowing the amazing benefits that moving from producing to forecast

to producing for replenishment brings the brand companies, I firstconcentrated on finding a way to solve the problem of large batches of

dyed fabric. Instead of buying dyed fabric in small quantities, maybewe can still buy it in the same large quantities and, relying on the factthat the same dyed fabric is used for more than one SKU, we can usethe fabric according to actual demand.

The extent to which we can do this depends on the magnitude of theaggregation that exists at the dyed fabric level. We know that there isaggregation since all sizes of the same model use exactly the same

dyed fabric. Unfortunately, in sporting apparel there are only five sizes

per model (as compared to over 30 sizes in formal suit jackets).Moreover, there is a high chance that if one size is a high-runner, the

other sizes are not slow movers; there is a correlation between thedemand for one size and the demand for another size of the same

model. Therefore, the aggregation that we get through different sizeswill not help us much there is no point to divert dyed fabric to onesize just to find, a month later, that we cannot provide another neededsize.


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So, it all depends on the commonality of the dyed fabric (magnitude ofaggregation) between different models where there is almost nocorrelation between the demand for one model and the demand foranother. For that I checked the number of different models theyproduce per year (35,000) and compared it to the number of different

dyed fabrics they use per year (4700). The ratio is one to seven. Is itenough?

We know that, in general, about 30% of the SKUs are depleted beforethe massive end-of-the-season clearance sale starts the high runners.Another 30% are sold mainly in the end-of-the-season sales (and in theoutlets) the slow movers. That means that in a group of seven

models there is a high chance that at least one model will be a highrunner while at least another model will be a slow mover. So eventhough we start with a given (forecasted) amount of dyed fabric, still, inmost cases, the magnitude of diversion that we can do (from the actual

slow movers to the actual high runners) will help. How much will ithelp?

To answer this question we have to realize the non-linear nature of thedamage shortages are causing. Suppose that a particular SKU has been

depleted after one month and the season is four months. How muchare the lost sales relative to the amount that was sold? One doesnt

have to be a trained mathematician to answer this question; the lostsales are 300% relative to the actual sales. What about an SKU that is

completely sold out after three months? The lost sales are just 33%relative to the actual sales (less, if one takes into account that in the

last month of the season prices are lower). That means that eventhough we work with restricted availability of the colored fabric we doget most of the effect, in terms of percent increase in sales, since mostlost sales are prevented. The same goes for reducing the bad effect ofobsolescence, especially when we consider that the longer it takes untilthe slow mover is sold the lower the price at which it is sold.

How can we take advantage of it? How can we turn it into a mafia offer

to the brand companies? Currently the brand companies order the full

amount per SKU and demand delivery before the beginning of theseason. Once they get the goods they immediately push about 40%

into the retail to fill up the pipelines with the new collection. Lets nottry to change these big companies. Lets give them an offer that does

not require any real change from their side and that the advantages ofwhat we offer will be apparent to them.


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What do you think about the following offer? As it is currently donewell get the orders per SKU (based on forecast) enough time before theseason. Based on the orders well buy the entire quantity of dyedfabric, as we currently do. But, we will cut, sew and ship only half thequantity of each SKU. Now we wait for the orders to come to the brandcompany from the retailers. The first orders are apparently orders for

high runners. We are informed of each order that the brand gets, and,as long as we still have that colored fabric, we will replenish within atime period which is very small relative to the period of the season (two

weeks should be enough for a system that is used to minimum twomonths). Six weeks before the end of the season, the brand shouldinstruct us what we should do with the residual fabric. Should we turnit into goods or should we hold it for the next year (on the brands

expense)? I think that if such an offer is presented well (in the SFSway) the chances are very high that each and every brand will gladlyaccept.

As a matter of fact, knowing that all brands are currently struggling tofind ways to increase their inventory turns I think that they will be

interested in such an offer to the extent that we can use it effectively toincrease our margins. Here Im going into the speculative mode; thefollowing should be checked with the brands and modified according to

their response.

Brands that operate on three seasons a year have about 6 inventoryturns. For them, increasing to nine inventory turns is a major

achievement, and I doubt that anyone in those companies thinks thattwelve inventory turns is realistic for his company. Therefore,

requesting a bonus based on actual inventory turns might fly,something along the lines of: right now, in sporting apparel you have6 inventory turns. With our offer, which is based on the mammotheffort that we have done to reduce our reaction time from over twomonths to less than two weeks (including transportation), we think youcan enjoy higher inventory turns. Lets take the conservativeassumption that fluctuations (and a lot of luck) might bring yourinventory turns on our goods to eight. So lets acknowledge our

contribution to your improved results only if inventory turns go up to

the delightful number of 9. But then compensate us for our uniquecontribution. For example, for each inventory turn starting at 9 give us

a bonus equal to just 5% of our price.

Since the mark-up of the brands is usually around 400% of the pricethey pay to their contractors and since increasing their inventory turnsis of such importance to them, such an offer has a real chance of beingaccepted (at least by 3 or 4 of the 12 clients the company has). Of


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course to conclude such a deal well have to climb the ladder, from thepurchasing person to a relatively high-level manager, so dont expect aquick deal.

What impact will it have on our margins? My founded expectation isthat such an offer will actually bring the inventory turns of a brand

(without any action from the brand to change the way it does businesswith retail) from 6 to 15* turns. The offer has the potential to doublethe companys margins while increasing dramatically its sales.

[*At first glance 15 inventory turns seems optimistic but, actually, it isvery conservative. Just consider that right after the beginning of a

season a brand currently holds 60% (100%-40%) of the goods (thisnumber is going down slowly during the season) while using our waythe brand will hold just 10% of the goods. So we can expect theinventory turns will increase five fold and that is without taking into

account that sales will go up 15 inventory turns is very conservative.]

You have probably noticed that I have some slight hesitations. Simplywe havent yet tried getting bonuses for improved inventory turns, oranything similar. So I kept on thinking of additional ways (to be done

in parallel) to increase the companys margin while increasingdramatically their sales.

How to get higher margins? I couldnt think of an additional way to get

a higher price from the companys clients - the brand companies. Sowhat about bypassing them and selling directly to the retail stores?

Usually, this avenue is not really feasible for a contractor since itactually demands building a new type of a company. It is one thing tohave the ability to cut and sew fabric into garments according to givendesigns, it is a totally different ability to design new collections ofgarments and to do it three times a year in pace with the changingfashion. But in this particular case our company already has this ability.They do have their own collections and in their country their collections

compete well with other brands collections. As a matter of fact, in their

country they are number three in selling their own sports apparel,ahead of many, much better known and much bigger brands. So if we

want to increase the companys margin, we just have to concentratemore on sales directly to the shops. And since they have almost

saturated their small country - they have their shops in every majorlocation - they will have to approach shops outside their country.Considering the markup of brands, this will not just increase thecompanys margins, it will explode them.


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Isnt it obvious? Well, from harsh experience, Ive learned to be verycareful in answering this question. On the one hand I do recognize thatall good solutions have one thing in common, they are obvious but onlyin hindsight. Always, once I finally verbalize a good solution to a majorproblem, Im disappointed with myself for wasting so much time until I

reached the obvious. But, on the other hand, I also learned not just torespect, but actually to admire, peoples experience and intuition. If thesolution is correct, if the solution is really so obvious, how come that

people havent used this solution a long time ago? It must be thatsomething, an erroneous assumption that they took for granted as anundisputable fact of life, caused them to dismiss this solution; blockedthem from even trying to implement it. So until I clearly recognize and

verify such a blocking assumption I dont know if my new solution isobvious, or just stupidly wrong.

Why hasnt this company tried to sell directly to shops outside its own

country? It must be because they have the name recognition, thebrand name, mainly within the borders of their own country (in other

words, outside their country they are a non-brand company). And themanagers of the company had learned that to build a brand-name takestime, a lot of time, and money, a lot of money. The bigger the country

the bigger the sums of money required. It is obvious that to build abrand name in a sizable country is beyond their current financial (and

managerial) abilities.

But why is having a brand name so important? Why are they convincedthat as long as the company hasnt yet established a real brand name,

in the territory in which a shop is located, it will not be economical totry and persuade the shop to carry the companys collection?

It is, probably, because shops know that merchandise that carries aknown name will sell and they are reluctant to take the risk of buyingnon-brand merchandise, merchandise that might not sell well enough.The shops' reluctance is logical because the constraint of most shops isdisplay space (and cash). Carrying merchandise that might not sell well

is actually wasting the constraint (the opposite of exploit) and

therefore reduces the throughput of the shop.

We can proceed from here in two ways. One is systematic, logical andmeticulous. The other is bold, aggressive and not less logical. (Actually

there are many ways to proceed, but since they are not logical Illignore them.)


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Do you know Robert Frosts poem The road not taken?

Two roads diverged in a yellow wood,And sorry I could not travel bothAnd be one traveler, long I stoodAnd looked down one as far as I could

To where it bent in the undergrowth.

First, lets look down the meticulous road as far as we can (it is

meticulous and also boring, so please dont fall asleep before we start totravel the other, much more exciting, road).

Shops might be reluctant to carry non-brand goods but it is a fact that

many shops do carry a lot of products which are non-brand products.So, it must be that the managers of our company know that it ispossible to sell to shops outside their country but they don't really try todo it because they are convinced that it might lead to losses rather than

profits. Let's carefully examine this conviction because the alternativeis simply to give up on the idea of selling directly to shops.

First, let's get rid of the more banal way. If the shops are reluctant tobuy non-brand merchandise because it is too risky, the company should

reduce the shops' risk by offering the goods on consignment. This is alousy suggestion. Offering the goods on consignment is very risky for

the supplier, since there is a high chance that most of the merchandisewill be shipped back at the end of the season. And it is bad for the shop

because, consignment or not, blocking a shelf with merchandise thatdoesn't move well is reducing the throughput of the shop.

The shops that do carry non-brand merchandise are aware of the risk ofholding too much slow-moving merchandise. They reduce the riskthrough lowering the price of those goods to the end consumer; theyincrease the chance of sales of the non-brand products by fixing the endprice of non-brand products to be substantially lower than the brandsprices. But, at the same time, the shops are also making sure that theirmargins will be adequate, which means they are willing to pay much

lower prices to the non-brand providers. How low can our company go,

and still make nice profits?

Currently, as we said, most of the sales of the company are not toshops but to the brand companies. The current sales price of a garment

to the brand companies is (lets say) P, on which the companysmargins are about 0.25xP. The markup of the brand is about 400%which means that the shop is buying that garment at 4xP. The markupof the shop is about 100%, which brings the price the end consumer


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pays for that garment to about 8xP (the margin of the shops is about50% of the selling price). As we discussed, when the company sellsdirectly to a shop which is outside their country, the garment is a non-brand garment and therefore, to increase the chance of selling thesales-price for the end consumer must be substantially lower than 8xP.Half the price can be reasonably called: substantially lower. That

means that to allow the end selling price to be just 4xP the companyprice to the shop will have to be just 2xP. Since the totally variable costof the company is 0.75xP it leaves a margin of 1.25xP, a margin which

is 5 times bigger than the current margin. This straightforwardcalculation suggests that the company could make a fortune by sellingdirectly to the vast number of shops located outside their country.

Lets not be too hasty to jump to such a conclusion. Remember, themanagers of the company do have a lot of experience and intuition.Therefore, we can assume that they are oblivious to the obvious only incases where we clearly pin-pointed an erroneous assumption that

blocked them from seeing the obvious. In our case, did we identifysuch a blocking erroneous assumption? No! So it must be that

something is wrong; that Ive ignored something essential in doing theabove calculation.

We are so used to getting much more from existing resources that forus it is natural to first consider just the Variable Cost (TVC) just the

margin. But that doesnt mean that we are blind to the fact there arecircumstances where Operating Expense (OE) must be increased and

therefore must also be considered when evaluating impact on net profit.Is the move to sell to shops in other countries associated with an

increase in OE? Of course it is. Sales costs will go through the roof.Will they go up to the extent that it will consume the huge difference inmargin? Unlikely.

Are we sure? The expected margin is based on the assumption that thelikely selling price to the shops will not be less than 2xP. Is this crucialassumption solid?

As we said, when the company tries to sell in other countries it is a non-

brand company; it does not have any real competitive edge. Are thereother non-brand companies that sell in those countries? Many. Many

non-brands, none having a competitive edge, create the ideal conditionsfor the buyers of the shops to try to squeeze down the purchase price.

And they are experts in squeezing. Under the reality of a price-warmarket, can we safely assume that the selling price to the shops will be2XP? Lets ask it in a different way. Are the existing non-brandcompanies making a fortune? Not at all. Some make a living, some


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struggle, some are going out of business, but rarely do we hear aboutnon-brand companies in apparel making a fortune unless theysucceeded to build something specific that gives them a competitiveedge in a niche market. A price of 2xP seems a little too optimistic.

What is behind the bent in the undergrowth? The tendency is to still

do some checks. To check the price the shops are paying for non-brandgarments, to check what will be the cost of putting a sales force, etc. Itwill take time, efforts and some investments but there is a chance that

as a result of such extensive checks the conclusion will be that it is a(somewhat) viable road.

Now lets go the other way, the aggressive one.

As we said, the main reason that shops are reluctant to buy from a non-brand company is that the risk that the merchandise will not sell wellenough is much higher than for brand merchandise. Lets not try, as

before, to reduce the gap between the respective risks. Instead letsshoot for a much more ambitious target, a target that seems impossible

lets try to reverse the gap. In other words, lets try to find a way tomake the risk of the shop buying from our company to be much smallerthan the risk that shops take when they buy brand garments.

Aggressive? You bet. If we succeed then there is no doubt that wehave found an excellent solution. Choosing this way, lets concentrate

on the only remaining question. The big, very big, question: Is itpossible?

To answer this question we'll have to first assess the risk the shops are

taking when they carry a brand garment.

Is there any risk for the shop when it buys a brand garment? If wethink in terms of exploit the shelf space, there is definitely a risk. Wedo know that even when we deal with brand garments there are a lot ofrelatively slow movers, some are so slow that a shop has to carry themfor a few months and even then, for a major portion - about 30% of allmerchandise - the shop is able to sell (at a loss) only through the end of

season clearance sales.

Knowing the TOC solution for distribution the company can offer a much

better deal. Using replenishment, return for full refund and themechanism of return this, take that instead we can reduce the shops

risk to a bare minimum, while improving substantially the exploitationof shelf space. This will ensure that (when the sale to the shop is donein the SFS way) most shops, which are not dedicated to specific brands,will accept the companys offer. Most probably, they will start with a


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test collection but within weeks that test will expand creating a happy(and loyal) outlet.

For those of you that are still not convinced lets do some calculations.We know that the amount of shortages the shop has in the middle ofthe season is about 30% (to prove it to the shop it is enough to take

the list of SKUs the shop is supposed to hold and compare it to theactual inventory the shop has). When we use the TOC replenishment,shortages drop to almost zero and as a result sales increase by over

30%. Yes, eliminating 30% shortages increases sales by over 30%because the missing SKUs are the high runners (otherwise they wouldnot be missing).

On top of the sales increase due to elimination of shortages, salesincrease even more because of another reason. Conventionally, as wesaid, the shop carries a lot of slow movers. When the shop realizeswhat SKUs are the slow movers it will do whatever is necessary to sell

them. That means that there is great pressure to give the slow moversmore and better shelf space and more attention by the sales force.

Since shelf space is the constraint this is done at the expense of thebetter moving SKUs. Using the TOC replenishment mode the amountof slow-moving inventory is dramatically reduced. Less slow moving

inventory, less pressure to waste the constraint and therefore moresales. Add to it the mechanism to replace slow SKUs with faster

moving SKUs and you get an effect on sales which is probably largerthan the impact of eliminating shortages.

Lets conservatively estimate the total increase in sales to be just 50%,

what is the impact on the shops profitability? Even though most shopsmark up the price by 100% the vast majority of the shops do not makemore than 5% net profit on sales. For such shops, a 50% increase insales means that their profit will increase by at least a factor of five.With the understanding of such an impact do you doubt that: mostshops, which are not dedicated to specific brands, will accept thecompanys offer.? Most probably, they will start with a test collectionbut within weeks that test will expand creating a happy (and loyal)

outlet.

What about our companys investment? With such a mafia offer, the

company should choose to concentrate its sales efforts on a denselypopulated area that can be served by one regional warehouse. The

amount of sales (potential sales are larger than several times what theircapacity can supply) and profits will easily dwarf the relatively smallinvestment in inventory.


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We are not the first one to look for a solution to selling non-branddirectly to shops. Many, who are not less bright or less meticulous thanus, have tried to solve it. How come that we have succeeded wherethey all failed? They tried to find the way to reduce the gap. We haveapproached it differently. We first increased the challenge to the levelof impossibility instead of trying to reduce the gap, we dared to think

about reversing the gap.

Two roads diverged in a wood, and I--

I took the one less traveled by,And that has made all the difference.

never say i know

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