Re-evaluating the supply chain post-Japanese earthquake

Japan’s devastating earthquake, tsunami and nuclear accident have served as a wake-up call across the world to show just how fragile global supply can be. With almost 9% of the world’s economic output coming from Japan, these events have had a direct impact on many companies that rely on Japan for manufacturing parts, and have caused countless disruptions across the global supply chain.

It has been reported, for example, that Apple was facing tight supplies on the lithium-ion batteries used in its iPods. The bottleneck was traced to Kureha, a relatively obscure Japanese chemicals manufacturer which had to shut down its factory near Iwaki following the disaster. Although the company’s factory had remained intact, it was the damage to the ports that was creating the blockage in the supply chain.

How does a company that outsources its production deal with unexpected events ranging from Japan’s catastrophic earthquake and tsunami to unprecedented floods in Australia or an Icelandic volcano? Until recently, many corporations entrusted their supply chain operations to middle level management. The chief purchasing officer, if he/she existed, usually reported to the CFO, CIO or COO. CEOs had relatively little exposure and experience in dealing directly with supply chains. Often, the purchasing officers paid more attention to cost and product quality than to the risk factors in sourcing. The earthquake in Japan is changing all of that since many global supply chains have been disrupted to varying degrees.

The global supply chain is the natural consequence of a rational attempt to remain “asset light,” in other words, focusing on a company’s core competencies and outsourcing the rest by taking advantage of low-cost sourcing. No one questions the value of the concept or of just-in-time manufacturing, but it is increasingly apparent that the approach works best when the global economy is stable, protectionism is not prevalent and strong, and there are few natural disasters. The global economy has become increasingly integrated, and the growing frequency and intensity of natural catastrophes, such as what took place in Japan need to be factored into strategic planning.

All of these factors have changed the rules of the game and created a radically new environment which requires a fundamental shift in thinking with regard to the supply chain.

From “cost and value” to a “cost, value and risk model”

Most companies see their mission in terms of producing the highest value for customers at the lowest possible cost. Asset-light and just-in-time manufacturing maximize efficiency, but the missing part of the equation is the risk that some part of the chain could malfunction.

A notable example of miscalculated risk is BP’s inadequate assessment of the potential danger from a deepwater oil leak in the Gulf of Mexico. Since BP had subcontracted its engineering to Halliburton, it assumed that the risk of a spill would be borne by Halliburton. As the public saw it, BP’s management was ultimately responsible despite the fact that the source of the mishap was outsourced. The miscalculation ultimately cost BP’s CEO his job. Outsourcing is still a valid strategy, but supply risk needs to be factored into the model.

Lego, the Danish toymaker famous for its plastic bricks, took a more enlightened approach. The company pondered outsourcing its production to an Asian supplier specialized in plastic injection molding for computer printers. A deeper investigation revealed that the two companies had radically different philosophies concerning the molds. The Asian supplier favored low cost, light-weight molds that were changed frequently as new printer designs came on line. In contrast, Lego, which depends on all its components interconnecting, sometimes uses the same molds for 40 years or more. A minor variation in the specifications risked making Lego’s bricks unusable leading to poor results for the company. In Lego’s case, it made more sense to in-source its production, even if it was slightly more expensive. The global supply chain is only as strong as its weakest link, and it is crucial to know where the weak links are.

From arm-length financing to joint financing

Another variable of risk is expensive credit in the post-financial crisis world. Large corporations like Cisco and General Electric normally enjoy preferential credit because of their size and dependability. Smaller companies are riskier propositions to banks and loan institutions, so credit is likely to be more expensive and limited. For smaller suppliers, this can mean bankruptcy if the cash flow dries up, and for a large corporation that outsources the lion’s share of its production, that can spell disaster.

Large corporations are learning that they can no longer ignore the credit conditions experienced by their key suppliers. At the basic level, major corporations can serve as loan guarantors to see that suppliers stay in business. More enlightened corporations have begun using their size to negotiate preferential terms for their key suppliers.

Honda is an example of a corporation that uses its heft to negotiate preferential prices on the steel used by its suppliers. Other corporations have used their size to convince banks to extend credit to suppliers at the corporations’ preferential rates. By securing cheaper rates for suppliers, the corporation reduces its own costs. The banks come out ahead since they face substantially reduced risk.

Another approach is for a corporation to simply extend credit on its own without going through a bank. When Toshiba wanted to build a new factory to ramp up its production of flash memory, Apple prepaid Toshiba $500 million for its chips so that the company could speed up the project. In the process, Apple ensured that it was not caught short and Toshiba eventually produced a third of the flash memory that went into the new iPad.

In the current climate, product life cycles are accelerating. The advantage to a company of being the first to launch a new product may be as little as six weeks. If a company misses that window, it will be unable to reap the full benefits of its R&D investment to bring new products to the market first.

Re-thinking the supply chain model

Given the enormous impact of the supply chain on a company’s bottom line, executive input at the highest level of the corporation’s management team is increasingly important. The transition from mere purchasing function to outsourcing requires expertise in managing external relations. While it is easy to quantify sales and production, deciding what weight to attribute to risk is more difficult, and it requires a different skill set and different metrics, as well as a new mindset.

Professor Carlos Cordon is the LEGO Professor of Supply Chain Management at IMD and Professor Winter Nie is Professor of Operations and Service Management at IMD. They both teach on IMD’s Managing the Global Supply Chain program.