Reasons for success in the machinery industry are changing with astounding speed. Five years ago, factors such as cross-functional development teams, single sourcing and group work differentiated the best performing companies from the weaker ones.¹ However, a new McKinsey survey² of the European and US machinery industry reveals that these factors became standard practice among companies that survived the recession of 1992 to 1994, when markets in the industry shrank by an average of 2.5 percent per annum. What now differentiates the leaders from the laggards is their relationships with their customers and their suppliers.

The leaders in the industry are erasing the traditional corporate boundaries that separate companies from their suppliers and customers, so that suppliers’ economics and customers’ needs are an integral part of their strategy. Managing the complete value chain in this way is what we call virtual vertical integration. Leading companies realize that the more closely they work with both suppliers and customers, the better the benefits are for all concerned. Supply management and customer orientation—the two interfaces between the company and the outside world—therefore represent the new opportunities for differentiation.

Erasing the company-customer boundary

A high level of customer satisfaction manifests itself in high market share and market share growth. Leading companies achieve this by making sure they respond to their customers’ needs, which means being able to identify those needs and integrating them throughout the company, from R&D right through to sales and services.

The task of customer integration falls upon the marketing department, which is organized quite differently from the marketing departments of the laggards. Leading companies have fewer marketing staff than laggards, and use them differently. Their marketing staff spend less of their time troubleshooting or attempting to generate orders (55 percent for laggards versus 32 percent for leading companies). Those tasks are left to the salesforce. Neither do they write brochures, prepare for trade fairs, or act in any other way as a general backup for the sales department. Instead, they concentrate on understanding their customers in order to improve the company’s value proposition and identify new markets.

Better understanding comes from spending more time with customers (Exhibit 1), and from meticulously investigating the reasons for lost orders. Leading companies also use focus groups four times as frequently as laggards, interview key accounts three and a half times more often, and talk to service technicians twice as often.

Customers’ needs are also met by marketing being involved in R&D activities. Marketing findings are fed into the product line right at the conceptual stage and are included in performance specifications. To focus R&D activities and exploit synergies between product applications, the right market segmentation is key. Leading companies use market findings on the acceptable degree of product standardization to segment the market right at the beginning of development. Laggards, however, tend to segment the market by product application. Such an approach (and one followed by 86 percent of laggards), tends to divide resources between narrowly defined market niches, without taking customer benefits into account. The result is higher complexity.

Erasing the company-supplier boundary

Leading companies ensure purchased parts are of high quality, at the same time as cutting supply costs. Those in the survey managed to cut supply costs by 3.1 percent per annum, whereas laggards achieved cost cuts averaging only 1 percent.

One important cost-cutting method is to reduce complexity. On average, leaders work with 4,840 purchased parts per $100 million, whereas laggards require 8,290 parts for the same volume. Leaders also use more standardized parts, while laggards have a high share of modified standard parts, an approach which leads to higher complexity without any significant additional product differentiation (Exhibit 2).

To reduce complexity, leaders work closely with their suppliers. They conduct joint simultaneous engineering projects with 20 times the frequency of laggards, and quality projects 10 times more frequently. Other cost savings and quality improvements are, of course, often revealed in the process.

To select the right suppliers for such project-driven relationships, leaders use criteria such as skill and willingness to enter into redesign projects, while laggards use competitive bids almost exclusively. Leaders are also willing to source globally in the pursuit of excellence: they buy 30 percent of supplies abroad, laggards only 4 percent (Exhibit 3). The laggards’ emphasis on low costs rather than competence ignores the important role competent suppliers can play in problem solving.

All this effort with suppliers doesn’t lead to big purchasing departments, as leaders concentrate on core suppliers, of which they have about 100 per $100 million purchasing volume versus 300 for laggards. But it does lead to the reduction of faulty purchased parts. Leading companies cut the number by 31.3 percent per annum on average, compared with the laggards’ reduction rate of 6.9 percent.

Some companies have found inventive ways to integrate their suppliers into the company. A Japanese auto manufacturer, for example, has set up a supplier association in the US offering seminars and mutual training in quality, supply, and cost management techniques.

Another manufacturer has moved its engine supplier onto the premises to work alongside its own engineers. This "shop within a shop" has enabled the two companies to eradicate many duplicated functions and to cut costs dramatically.

Incentives

Improving both customer orientation and supply management depends on employees at the interface with the outside world: marketing and purchasing personnel. Both groups therefore need a clear stake in bottom-line results if these often intangible operational and organizational principles are to be enforced. The most successful companies therefore relate a large chunk of their marketing and purchasing employees’ pay to performance-related targets.

The purchasing managers’ position is in effect upgraded, as staff are required to have analytical skills for evaluating suppliers, scientific skills for their R&D involvement, and foreign languages for development of global strategies. Leading companies also tend to recruit university graduates, rather than in-house employees, to their marketing department. These young people bring a fresh perspective to the business that can more easily accommodate a new, holistic view of the company’s interests. Some 57 percent of new hires in the marketing departments of the leading companies are university graduates, compared with 8 percent in the marketing departments of the laggards.

Ultimately, the study shows that although restructuring has been important to companies surviving the economic downturn of the early 1990s, the challenge of the future will be to alter the relationship companies have with the outside world. No amount of internal reorganization will be able to achieve that. The difference can only be brought about by a new way of thinking about customers and suppliers. Once that is enforced, traditional corporate boundaries will slip away. It is a lesson that companies in many other sectors may find beneficial.