Wednesday, July 05, 2006

The need for slack.

When the chain breaks

The Economist
June 17, 2006
U.S. Edition

Being too lean and mean is a dangerous thing

IT BEGAN on a stormy evening in New Mexico in March 2000 when a bolt of lightning hit a power line. The temporary loss of electricity knocked out the cooling fans in a furnace at a Philips semiconductor plant in Albuquerque. A fire started, but was put out by staff within minutes. By the time the fire brigade arrived, there was nothing for them to do but inspect the building and fill out a report. The damage seemed to be minor: eight trays of wafers containing the miniature circuitry to make several thousand chips for mobile phones had been destroyed. After a good clean-up, the company expected to resume production within a week.

That is what the plant told its two biggest customers, Sweden's Ericsson and Finland's Nokia, who were vying for leadership in the booming mobile-handset market. Nokia's supply-chain managers had realised within two days that there was a problem when their computer systems showed some shipments were being held up. Delays of a few days are not uncommon in manufacturing and a limited number of back-up components are usually held to cope with such eventualities. But whereas Ericsson was content to let the delay take its course, Nokia immediately put the Philips plant on a watchlist to be closely monitored in case things got worse.

They did. Semiconductor fabrication plants have to be kept spotlessly clean, but on the night of the fire, when staff were rushing around and firemen were tramping in and out, smoke and soot had contaminated a much larger area of the plant than had first been thought. Production could be halted for months. By the time the full extent of the disruption became clear, Nokia had already started locking up all the alternative sources for the chips.

That left Ericsson with a serious parts shortage. The company, having decided some time earlier to simplify its supply chain by single-sourcing some of its components, including the Philips chips, had no plan B. This severely limited its ability to launch a new generation of handsets, which in turn contributed to huge losses in the Swedish company's mobile-phone division. In 2001 Ericsson decided to quit making handsets on its own. Instead, it put that part of its business into a joint venture with Sony.

This has become a classic case study for supply-chain experts and risk consultants. The version above is taken from "The Resilient Enterprise" by MIT's Mr Sheffi and "Logistics and Supply Chain Management" by Cranfield's Mr Christopher. It illustrates the value of speed and flexibility in a supply chain. As Mr Sheffi puts it: "Nokia's heightened awareness allowed it to identify the severity of the disruption faster, leading it to take timely actions and lock up the resources for recovery."

There are two types of risk in a supply chain, external and internal. As in the Ericsson case, they can conspire together to cause a calamity. This seems to be happening more and more often. It is not just that inventory levels are getting leaner, but the range of items that companies are carrying is also growing rapidly, points out Ted Scherck, president of Colography, an Atlanta-based logistics consultancy. Just look around a typical supermarket. Where it once stocked mainly groceries, it now also sells clothing, consumer electronics, home furnishings and many other items.

This compounds supply-chain problems. "In many cases shippers have gone too far in implementing the lean supply chain and have found themselves virtually out of business because of a by now annual catastrophic event," says Mr Scherck. As examples, he cites a dock strike in California, a typhoon in Taiwan, a tsunami in Asia and a hurricane in New Orleans. More recently a huge explosion at the Buncefield oil storage terminal in Britain's Hertfordshire caused widespread problems for businesses not just locally but across a large part of England.

In 2003 a number of companies suffered serious disruption because of severe acute respiratory syndrome (SARS). Even though SARS turned out to be not as virulent as influenza, and only 8,000 people got infected, with one in ten dying, it still cost an estimated $60 billion in lost output in South and East Asia. The latest worry is the spread of avian flu. If the virus concerned were to mutate and become infectious for humans, the consequences could be far more devastating.

Sometimes even a political wrangle in Brussels will bring a supply chain to a shuddering halt. Last autumn some 80m items of clothing were impounded at European ports and borders because they exceeded the annual import limits that the European Union and China had agreed on only months earlier. Retailers had ordered their autumn stock well before that agreement was signed, and many were left scrambling to find alternative suppliers. A compromise was reached eventually.

However, most supply-chain disruptions have internal causes, says Vinod Singhal, a professor of operations management at the Georgia Institute of Technology (see chart 3). His research on the effects of supply-chain failures shows that they can be immensely damaging. This emerged from an investigation into what happens to shareholder value when companies announce supply-chain problems, based on a sample of 800 such announcements big enough to generate news in the financial press. The disruptions ranged from a delay in 2000 of shipments of workstations and servers by Sun Microsystems to a parts shortage at Boeing in 1997 that the company said would delay some deliveries.

Typically a company's share price dropped by around 8% in the first day or two after such an announcement. This is worse than the average stockmarket reaction to other corporate bad news, such as a delay in the launch of a new product (which triggers an average fall of 5%), untoward financial events (an average drop of 3-5%) or IT problems (2%). And the effects can be long-lasting: operating income, return on sales and return on assets are all significantly down in the first and second year after a disruption.

"It's like having a heart attack," says Mr Singhal. "It takes a long time to recover." And have the dangers increased in recent years? Like other experts, he believes that some companies may be running their supply chains a little too lean: "It's great when it's working, but too much leanness and meanness can actually hurt you."

The financial information analysed for this study came out before the terrorists attacks on America on September 11th 2001 and the subsequent massive tightening of security around the world, so global supply chains today are subject to many more potential hold-ups. Still, it is impossible for customs officials to search every container, box or package entering every country, so the responsibility for security and import declarations rests with the shipper and the company carrying the goods. In effect, the system works by a process of pre-clearance. The details of everything contained in a shipment now have to be sent ahead electronically, and customs and security officials at ports and cargo hubs divert anything they want to take a closer look at.

Companies that put a lot of effort into ensuring the safety of the goods they are sending, or carrying on behalf of others, are likely to be rewarded by seeing them pass swiftly across borders. Customs clearance is itself a huge business. "Information and technology is the only way to accomplish this," says Ed Clark, chief executive of FedEx Trade Networks. These systems also need to be able to cope with unplanned events. For instance, if a cargo aircraft has to divert to another airport because of bad weather, centrally held electronic versions of the necessary "paperwork" can be transmitted to a new port of entry.

Sometimes even computer systems will not alert a company to a problem. For instance, Toyota is upgrading its business-interruption planning to a higher level in response to the filing for Chapter 11 bankruptcy protection last year by Collins & Aikman, a big American-based supplier of trim items for cars. The parts company had been supplying Toyota in Europe, which had an inkling that something might be wrong and started to arrange alternative supplies to be on the safe side.

"We realised that through good communication and contacts we had managed to identify a risk in good time and take action," says Mark Adams, Toyota's European purchasing manager. It was a lesson the company wanted to apply more widely, so it launched a weekly get-together for managers, sometimes by videoconference, to discuss any new rumours and potential risks—and work out a recovery plan just in case.

Toyota builds more than 600,000 cars a year in Europe, where it has some 200 first-tier suppliers operating more than 400 factories. They work with second, third and fourth-tier suppliers, so the overall number grows exponentially the further you go down the chain, where problems can be harder to spot. This means the suppliers themselves have to be involved in the risk-management process.

Mr Adams says a supplier may find it difficult to tell the company that it has a problem. But Toyota emphasises that given the co-operative nature of a supply chain, with early knowledge there is more chance of putting things right. Mr Adams explains that as a first step the company would seek to help its suppliers solve their own problems. "We are hugely more competent at this than we were a year ago," he adds. And so far, Toyota has been able to act swiftly enough to prevent any supply problems holding up production.

Is a lean, flexible and highly outsourced supply chain like Toyota's any safer than the vertically integrated production methods of old, as practised at Henry Ford's giant River Rouge manufacturing complex near Detroit? At its zenith in the 1920s, ships carrying raw materials such as iron ore and coal—often from Ford-owned operations—would unload directly into the plant. Steel was produced on site, then cast, pressed and machined into all the components needed to assemble a car. The process was inflexible—which is why Ford's cars could be any colour as long as it was black—as well as rather inefficient. Toyota has turned that process on its head, making its manufacturing system far more capable of responding to change. That is one of the best insurance policies a company can have.

"You are always looking for flexibility, particularly as you manage risk," says Cisco's Mr Mendez. Again, transparency is important. "Once you understand where you are, you can begin to design and budget for contingencies," he adds. The risk-management budget should perhaps be seen as separate from the operating and capital budgets, he suggests, to allow risks and their potential costs to be dealt with more directly.

Are competitive pressures pushing companies towards running their logistics operations ever leaner? "They are galloping there," replies Michael Cherkasky, the boss of the company that owns Marsh, the world's largest insurance and risk specialist. "I don't think many understand the risks that are involved." He is concerned that companies are outsourcing not only peripheral activities but many core functions too. That makes it difficult to pick up the pieces when things have gone wrong.

Britain's Cranfield University is running a research programme into the fragility of supply chains, prompted by the British government after protests over high fuel costs in 2000. Lorry drivers blockaded fuel-delivery depots, bringing many businesses to a standstill. "I reckon this was the first time the government realised there were such things as supply chains, and just how fragile they had become," Mr Christopher told a recent conference.

Some people even suggest that supply chains should be regulated, a bit like public utilities, because countries have become so highly dependent on private-sector production infrastructure. Barry Lynn, author of a book on this subject, "End of the Line", thinks that perhaps companies should be required to limit their outsourcing and use more than one supplier of essential items. In his book, he argues that globalisation and outsourcing provide only a temporary benefit to consumers because the companies that form part of supply chains will buy each other up in pursuit of ever greater efficiency, and thus lose most of their flexibility.

There are signs that some companies are already alert to these concerns and may be planning to reorganise their supply chains to make them safer. That process could speed up if disruptions become more common. Mr Sheffi is in no doubt that the best way to achieve a resilient supply chain is to create flexibility—and that flexible companies are best placed to compete in the marketplace.

"Customers are rethinking their global supply chains for a lot of their products," says Mr Scherck. For bigger firms, that could mean adopting what he calls the "continental strategy": having a spread of suppliers in different continents for added flexibility, as Dell and Cisco do. Smaller firms may not be able to achieve a geographical spread. But in any case, companies do not want to go back to carrying lots of inventory in different locations. "So you need to do something in-between," concludes Mr Scherck. "You will have to carry a little more cost than an absolutely lean model, but you get protection."

"There are very legitimate, very good business reasons not necessarily to complete and ship from Asia," says Flextronics's Mr Wright. Companies may consider other options in other parts of the world even though these may look more expensive. "Sometimes you might have to go to a higher cost structure to make your supply chain more robust and reliable," observes Mr Singhal.

So the limits of globalisation may end up being defined by the management of supply-chain risk. And unfortunately the world is unlikely to become any safer. There will always be natural disasters, as well as corporate mistakes. In order to insulate themselves from the consequences, companies will have to spread their risks more widely. That does not necessarily mean fewer aircraft will be queuing up to land at Louisville and Memphis, or that fewer container ships will set sail from Asia's bustling ports. But it does mean that in future companies may spend rather more to maintain a number of different supply chains, and some of those may be closer to home.


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