Lego: Restructuring, Brick By Brick

Restructuring Lego’s supply chain ensures successful growth in newer markets

Troubles Masked by an Iconic Brand

When people think about the world’s most powerful brand, companies like Apple and Google are often at the forefront of the discussion. Surprisingly, the title belongs to Lego, a family-owned toys company headquartered in Billund, Denmark. For over 50 years, Lego products have populated toy store shelves globally, creating a massive toy empire that now stretches into film, amusement parks, and pop culture. Two key aspects that elevate the Lego brand are a wide target audience and technical expertise in quality toy production. Lego appeals to children from an enjoyment standpoint, while it offers educational or sentimental value to adults. In 2016, Lego generated $520-million in net profit, outpacing the aggregate profit of both its main competitors, Mattel and Hasbro. Amazingly, it was able to accomplish this at a sales volumes three times smaller.

Looking forward, Lego needs to question which strategies it should emphasize in order to maintain their industry reputation and strong financial performance. To date, Lego has focused on setting the foundation for international expansion. To sustain its historical double-digit growth rate, Lego intends to make ambitious investments to expand into developing Asian and Latin American markets. Lego’s continual expansion plans may be at best, aggressive, and at worst, unsustainable.

Lego has increased sales by an average of more than 15 per cent annually over the last 12 years, a rolling figure, which it would like to maintain. After enjoying years of double-digit profit growth, operating profit growth in 2016 slumped to 1.7 per cent. However, this profit decline was not alarming, as investments into infrastructure and human capital were made recently to supplement their anticipated expansion strategy. Around one in four Lego employees were hired in the last six months, with a substantial hiring influx from international localities.

Underlying Lego’s current operations is its inability to meet order fulfillments in legacy markets such as North America. While expansion presents an opportunity for Lego to further scale operations and improve brand perception, it does not address the storm of unfulfilled demand and supply chain inefficiencies. The year 2017 becomes a pivotal time for Lego as it attempts to meet demand in Europe and the United States, while expanding into new markets across the globe.

With expansion operations to facilitate international growth already in place, the concerns facing Lego seem to identify a lack of new revenue channels as the company’s major problem. In reality, repairing its unresponsive supply chain is critical to satisfy the increasing unmet demand, and creating a more sustainable expansion strategy Without addressing its current operations, international expansions could magnify Lego’s current supply chain issues. It will further prevent the company from meeting increasing demand, risk current financial standing, and jeopardize brand presence, in both its legacy and anticipated developing markets.

Reconstructing a Problem from the Past

This is not the first time Lego has faced an important growth decision; Lego’s turnaround from bankruptcy remains a case study on how a company can reinvent its business model, while retaining its core values. In order to capitalize on the increasing demand for its toys, in the early 2000s Lego rapidly diversified its piece types, outsourced personnel from its corporate base, and overstretched itself in a wide series of lackluster strategic partnerships and product lines. These moves proved strategically disastrous, as they reduced product quality, heavily diluted the Lego brand, and put massive strain on the company’s supply chain management. Lego was left on the verge of bankruptcy.

In dire need of a turnaround, Lego refocused on its fundamental strengths of construction sets; product lines such as Galidor which did not feature the traditional brick piece type were cut, as were supplementary products such as computer games. To rebuild a culture of innovation, Lego hired adult Lego fans to take creative leadership of product design. Now in 2017, successful brand partnerships such as Star Wars, and in-house product lines designed by the Lego creative team, such as Legends of Chima, and the worldwide appeal of the Lego Movie, have brought an avalanche of demand. New Lego sets have been spawning on shelves at a raid rate with more specialized pieces than ever before.

While Lego no longer faces the difficult task of stimulating demand, the operational problems from its past have resurfaced to an even greater scale. During its troubled years, Lego averaged 420 annual SKUs. With then entry into digitial devices, and a foray into video games with Lego Dimensions, Lego is projected to surpass 900 different SKUs by 2017.

A lack of a cohesive global strategy has long plagued Lego, especially during its turbulent times. Key functions such as direct-to-consumer business and its global supply chain were described by former CEO Jorgen Knudstorp as “highly dysfunctional and operating in silos.” While Lego has committed to investing into production infrastructure for 2017 expansions, much has been centered on the Asian market, despite ambitious expansion plans to capture demand in Oceania and Latin America. As a consequence, there is an imbalance among Lego’s global supply chain, potentially exposing Lego’s existing European facilities and ongoing Latin American operations developments to the risk of overstretched regional supply chain capabilities. Resulting in the fundamental inability to provide a consistent level of service and quality across the entire supply chain. Lego risks repeating the supply chain dysfunction that nearly took down the company before.

Lego Graphic 1 - Revenue Profit Comparison

Bottlenecks in Lego’s supply chain hinder production capacity, with the problem being magnified in light of the company’s current expansion efforts. Therefore, Lego must revamp its supply chain infrastructure to properly execute its current expansion goals. Additionally, it is crucial that Lego’s supply chain infrastructure investments be evenly distributed globally to avoid bottlenecks in certain markets, resulting in stagnate growth and additional expenditure. Failure to address this imbalance could potentially cripple its global supply chain, which not only damages its expansion prospects, but disrupt sales in its legacy markets. Without these considerations, Lego risks another poorly executed expansion strategy, leaving retail shelves empty and a decline in profits.

Piecing Together the Business

Lego’s previous near-bankruptcy experience was largely caused by the massive dysfunction in their supply chain. Specifically, it was due to the rapid expansion of product lines with highly variant piece types. The supply chain problem that Lego faces today is reminiscent of the past – constantly evolving consumer interests and demand have put strain on Lego’s supply chain and its ability to respond dynamically to demand shifts.

Lego Graphic 2 - Supply Chain

Lego currently has moulding, brick decorating, and packaging plants in Denmark, Hungary, and Mexico. Its plant in China specializes in moulding and its plant in the Czech Republic specializes in packaging. Within these facilities, production is done in independent teams based on products, which results in 70 per cent utilization. Sixty-five per cent of the production has to be completed in third quarter to prepare for the holiday season. Due to growing demand, Lego is forced to invest in working capital to expand inventory due to growing demand, as projections have to be made well in advance to account for production capacity.

As part of its mandate to continuously innovate, the shelf life of an average Lego set is under two years, with new sets and themes launching throughout the fiscal year. The hottest new Ninjago or Star Wars set of the season could very well be retired and replaced with a new product by Christmas. Short product life cycles and constantly evolving consumer interests create uncertainty in demand forecasting.

As a consequence of short product life cycles and shifting consumer interests, Lego’s production process is constantly evolving. A high variety of products with different models and colors require continuous process changes. The high costs associated with changeovers makes it difficult for Lego to quickly and effectively adapt to new consumer trends, and shifting demand.

Both Hasbro and Mattel adapted to developing markets by out-licensing its brand and production to third party vendors and factories in these markets. Historically, Lego attempted to outsource its simpler production to improve efficiency and focus its resources on growth and innovation in developing markets. However, Lego was not able to maintain product quality, and experienced outsourcing failures with partners such as Flextronics. This resulted in Lego ending their contracts prematurely. With fewer production facilities in place across the globe, raw materials and finished products have to be transported over long distances to reach their target market. This drives up transportation costs, resulting a 12 per cent increase in sales and distribution expense in the past year.

Lego’s current supply chain is not up to par with competitors Hasbro and Mattel in developing markets such as Asia and Latin America, creating inefficiencies in inventory management. Specifically, Lego’s days of inventory in these markets is 102 days, which is significantly higher than that of Hasbro or Mattel, which are 59 days and 71 days respectively. This concern is magnified when combined together with Lego’s failed efforts to resolve its existing supply chain and manufacturing bottlenecks within its legacy markets. It is a possibility that Lego’s high standards of quality control could be the cause of high days of inventory. However, the rapid improvement in Lego’s production technology rather implies the culprit to be poor inventory management due to management’s inability to accurately predict sales, seeing as work in progress inventory increased by 30 per cent in 2016. For Lego to succeed and sustain its growth in these markets, Lego must improve its ability to forecast demand in these areas and produce according to demand in each market.

Lego did not have a clear focus when it came to its product distribution strategy. Its undifferentiated service policies between small independent stores and large retail chains did not reflect the proportion of revenue generated from the two sources and often caused product shortages in large chain retailers. With developing markets in Latin America and Asia offering different makeup of local vendors, Lego will face significant difficulties in adjusting its service level between vendors. In addition, Lego lacks infrastructure to allow timely information flow to its vendors. This forced Lego to develop a multi-tiered inventory system which put further strain on its distribution channel and increased working capital investment. Work-in-progress inventory consisted of 47 per cent of Lego’s total inventory, while only 18 per cent for competitor Mattel.

Building Instructions for Lego

Investing in a more localized supply chain infrastructure will give Lego more areas to improve their supply chain globally. Sourcing from local suppliers will allow Lego to reduce costs for transporting raw materials, work-in-progress inventory, and finished product inventory. Additionally, creating local production facilities brings Lego’s production in close proximity to vendors, allowing Lego to better forecast their local demand and reduce overall statistical fluctuations, thereby decreasing lead time and improving inventory management. Each facility would have the ability to satisfy local customers’ needs for customization without affecting the capability of other production facilities to supply other markets, thereby allowing Lego to have more flexibility in production across each of their markets across the globe. This strategy simultaneously allows Lego to control and maintain its product quality by keeping production in house, as outsourcing has proven to be unsuccessful in the past. Ultimately, Lego will be able to operate on a more real time demand while holding minimum inventory.

Lego Graphic 3 - Inventory WIP Growth

Increasing the volume of information sharing and the speed of information flow is imperative to the success of a balanced global supply chain and enables Lego to make large scale operation decisions faster. Streamlined communication would allow for improved ability to match demand, and shift utilization appropriately to meet demand. Lego should aim to create relationships with its local retail partners through real-time information sharing to reduce risk of unmet demand. In addition, Lego’s recent partnership with the supply chain management software firm, JDA Software Group Inc., will improve the organization of the information flow for a more localized supply chain.

The goal of this strategic decision is to ultimately help Lego better predict its demand and drive sales by increasing the accessibility of its products to Lego’s customers in developing markets. Lego will be able to shorten its distribution channel and reduce material flow across markets and ultimately increase savings.

Lego’s Yellow Brick Road

By constructing two new production facilities in Latin America and APAC, Lego can relieve the demand pressure from its existing Mexico and China facilities, respectively. These new facilities would cost $215-million USD each, with similar production capacity to Lego’s Hungary plant post-expansion. If Lego is able to streamline its distribution channel within the next five years and bring its days of inventory down to 80 days, closer to a competitive level, Lego would be able to realize over $368-million USD in savings from working capital investments. In addition, Lego can achieve over $72-million USD of annual distribution savings through shortening distribution channels after the first year when the production facilities are operational. This will provide Lego a return on investment of 25 per cent and give Lego the potential to focus its resources on sales growth and product innovation in the future.

Investing in infrastructure in developing markets will allow Lego to align its supply chain structure with its growth strategy by matching production with sales geographically to better position itself for continuous growth in the global toy industry. If they can successfully revitalize their supply chain with a sustainable strategy to fulfill the immense demand for its product globally, Lego has the opportunity to pull away as the undisputed leader in the entire toy industry.