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The COVID-19 contagion has had a major impact on Chinese manufacturers, and because of the central role many Chinese companies play in the supply chains of other companies, the impact is being felt around the world. The disruption is particularly acute in the electronics and auto industries, but it is also affecting pharmaceuticals, metals, and a wide range of consumer and industrial products, including surgical gowns and masks.
How did we end up with such complex interdependency in our supply chains — and what should managers be thinking about once we get through this?
Over the past three decades, supply chains have become increasingly global. This change has been driven by the dramatic increase in the number of goods and services that are tradable. Tradability is determined by the extent to which items can be produced remotely from the market where they are intended to be consumed. The main factors in tradability are transportation costs and product perishability. Thus, for goods with high value relative to their size and shipping cost, it often makes sense to manufacture them in a low-cost region and ship them. A steady decline in those costs (coupled with improved efficiency in international transportation) has encouraged many companies to shift to a global sourcing model, allowing them to take advantage of lower costs for labor and materials, land, and other factors.
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Another factor in the growth of global supply chains has been the increased use of subcontracting. Subcontracting has become more prevalent for a number of reasons, including the increased sophistication of components, manufacturing processes that require specialists, and the desire on the part of producers to have more flexible capacity that can be turned on and off depending on demand. The result is deeper tiering of supply chains whereby suppliers draw upon their suppliers who in turn draw on their own networks of suppliers in multistage production networks. In fact, it isn’t uncommon to have four or more tiers of suppliers; this complex “fan out” means it’s extremely difficult for companies to have visibility into who all their suppliers actually are. This is one of the reasons we continue to have surprises when a major disruption occurs.
The transformation of supply chains to global multistage production networks took place in a benign environment of falling trade barriers and an implicit willingness to accept increasing interdependence and the associated risks. But over the past decade, we have had a number of black swan events. Although such occurrences are supposed to be exceedingly rare, in the past decade we have had several of them: the introduction by China of export quotas on rare earth elements in 2010; the 2011 Tōhoku East Japan earthquake and tsunami; the flooding in Thailand later that year; the U.S.-China trade war; and now the coronavirus contagion. Following the 2011 episodes, some companies made adjustments and set up second sources, particularly for semiconductors sourced from the Naka district of Japan. But many became complacent again. Even in the wake of the recent trade war, many companies fell back to the status quo, believing that it was going to be nearly impossible to replace their key suppliers in China.
The disruption unleashed by the new coronavirus is different in that it has highlighted country risk at an unprecedented scale. Nobody could have foreseen what would happen when the world’s second-largest economy went offline and completely shut down external logistics connections. And because of supply chain tiering and the delays inherent in ocean container shipping, many companies are only now coming to grips with the depth of their dependencies.
Reassessing Supply Chain Risk
What the current situation exposes is that the risks associated with supply chain fragmentation and globalization have been unpriced and largely ignored. For many companies, the combination of lean production and global multistage supply networks is leading to crises. This should be a wake-up call for managers who need to understand their supply chain’s strategic vulnerabilities. A number of potential actions come to mind:
Consider regionalization. The U.S.-China trade war has already put regionalization of manufacturing back on the table. While production moves have begun in many cases, localizing the supplier base is also worth considering. When Toyota pioneered lean production in Japan back in the 1970s, its suppliers facilitated this by being colocated nearby. Chinese manufacturers did the same as they evolved their operations during the 1990s and early 2000s. Yet many companies, lulled by efficient and relatively inexpensive logistics and transport, have been applying lean and just-in-time production methods that span global networks. The current crisis exposes the vulnerability of this approach. Notably, Toyota continues to practice localization to a greater extent than many of its competitors. In fact, for its Georgetown, Kentucky, factory, more than 350 suppliers are located in the United States and more than 100 inside the state of Kentucky.
Develop second sources or additional safety stocks. Although there are costs to adding alternative supply sources and increasing safety stocks, the long-term benefit is greater supply chain resilience. The difficulty, however, is that supply concentration is often driven by scale economies in manufacturing, the unique capabilities of a supplier, or the location of specific resources. Depending on the circumstances, it’s important to reassess how much safety stock is needed. If it doesn’t take too long to develop an alternative (albeit at higher cost), you can get by with less; if you are looking at a complex manufacturing process that needs certification, you are apt to need much more. (Novo Nordisk, which manufactures half of the world’s supply of insulin at its Kalundborg, Denmark, facility, offers a good example of the latter: Given the essential role insulin plays in managing diabetes, it maintains a five-year reserve.)
Relying on suppliers with unique capabilities presents serious challenges. Consider semiconductors. Taiwan has around 22% of the world’s semiconductor integrated circuit wafer fabrication capacity and more than half of the foundry capacity. A single company, Taiwan Semiconductor Manufacturing Company (TSMC), accounts for some 67% of Taiwan’s capacity and has by far the largest global market share of the most advanced chipmaking processes. Companies like Apple and Qualcomm are completely dependent on this company for their most advanced chips. To its credit, TSMC has geographically diversified its capacity across three science parks on the island, but the company as a whole is still dependent on a single Dutch supplier for its advanced lithography systems. That supplier, ASML, is in turn dependent on a single factory in Germany for its optical engine. Developing an alternate source of supply is beyond the scope of chip design companies. Addressing this critical dependency is actually one of the pillars of the Chinese government’s Made in China 2025 initiative (which underlines the magnitude of the challenge).
In some cases, supply concentration has been the result of companies focusing narrowly on price at the expense of supplier diversity. Such has been the case in securing a supply of manganese for steel production, rare earth elements used in things like batteries and magnets, and active pharmaceutical ingredients. The manufacturers’ unwillingness to buy from higher-cost producers has led to a concentration of supply in China. This is a complex problem that will take time to correct. Assessing the level of safety stocks and establishing strategic reserves may be the only near-term course of action. Ultimately, the only way to diversify sourcing is through purchasing commitments: For example, it may be unrealistic to ask a new supplier to match the price of an existing scale player. But long-term purchasing commitments that reflect production learning will give alternate suppliers the incentive to invest, and it could help ensure competitive pricing over time.
Rethink scale and product mix. Some production processes, such as automobile assembly, benefit from minimum efficient scale, ideally producing a quarter of a million units of the same basic vehicle per year. This is why many companies have relied on focused factories that manufacture model variants on a single platform and then ship the finished products between countries. BMW, for example, builds a number of its X Series models in Spartanburg, South Carolina, for the whole world. Some 70% of these cars are exported to Europe, China, or other destinations. (The trade flow is balanced by other models produced in Europe and elsewhere.) This focused factory approach has long been popular in many industries, such as fast-moving consumer goods or electrical appliances, because it maximizes efficiency. Figuring out how to handle a broader mix of products within individual factories — something that we have seen at a BMW facility in Germany — will enable regionalized production, or at least more optionality when disruption strikes.
The disruption to supply chains is likely to continue for many months, and it will be exacerbated by fear, shortage gaming, and the difficulty of restarting logistics and raw-materials suppliers. Managers should consider the extraordinary costs they are facing and identify actions now that will improve their resilience to future shocks.