CALL TO ACTION
If you had a dollar or a euro for every time the words ‘supply chain’ and ‘resilience’ have been quoted in the media and boardrooms across the globe since the COVID-19 pandemic took over all of our lives, you’d probably be looking forward to a sun-drench retirement free of all of the headaches and hurdles facing business leaders right now and, let’s be honest, probably for many years to come.
Supply chain resilience continues to occupy the minds of the great and the good – and, it seems, there’s plenty of advice on offer if you’re looking for some new directions to head in. There’s certainly no shortage of ‘top 5 tips’ types of articles to set global commerce on the road to recovery. If only it was that simple.
In a world where we now seem to be tripping over a literal army of new-found ‘supply chain experts’ where can you go to find the most considered, logical, viable and most thought-provoking analysis of supply chains now and in the future; a virtual insight into the mindsets of the real supply chain experts.
A smart place to start might be McKinsey Global Institute’s (MGI) new report on ‘Risk, resilience and rebalancing in global value chains,’ published this month. Unlike many of the two-minute quick fixes made available elsewhere, it’s a detailed and fact-based analysis that may well inspire some fresh thinking by those who invest the time to consider the findings shared across the report’s 112 pages.
It follows on from earlier surveys which found:
- Even before COVID‑19 struck, businesses were reevaluating risk. When McKinsey surveyed 600 global executives in December 2019, 70% of them reported that they were reconsidering their supply chain strategies and global footprint. Indeed, at the time, US– China trade tensions and the United Kingdom’s pending withdrawal from the EU were major sources of uncertainty
- In May 2020, a survey of supply chain executives reported that an overwhelming 93% planned to take steps to make their supply chains more resilient, including building in redundancy across suppliers, nearshoring, reducing the number of unique parts, and regionalizing their supply chains
In this article, Vigilant shares extracts from the August 2020 report…
Manufactured goods take lengthy and complex journeys through global value chains as raw materials and intermediate inputs are turned into the final products that reach consumers. But global production networks that took shape to optimize costs and efficiency often contain hidden vulnerabilities - and external shocks have an uncanny way of finding and exploiting those weaknesses. In a world where hazards are occurring more frequently and causing greater damage, companies and policymakers alike are reconsidering how to make global value chains more resilient. All of this is occuring against a backdrop of changing cost structures across countries and growing adoption of revolutionary digital technologies in global manufacturing.
In recent decades, value chains have grown in length and complexity as companies expanded around the world in pursuit of margin improvements. Since 2000, the value of intermediate goods traded globally has tripled to more than $10 trillion annually. Businesses that successfully implemented a lean, global model of manufacturing achieved improvements in indicators such as inventory levels, on-time-in-full deliveries, and shorter lead times. However, these operating model choices sometimes led to unintended consequences if they were not calibrated to risk exposure. Intricate production networks were designed for efficiency, cost, and proximity to markets but not necessarily for transparency or resilience. Now they are operating in a world where disruptions are regular occurrences.
Averaging across industries, companies can now expect supply chain disruptions lasting a month or longer to occur every 3.7 years, and the most severe events take a major financial toll. This report explores the rebalancing act facing many companies in goods-producing value chains as they seek to get a handle on risk. Our focus is not on ongoing business challenges such as shifting customer demand and suppliers failing to deliver, nor on ongoing trends such as digitization and automation. Instead, we consider risks that manifest from exposure to the most profound shocks, such as financial crises, terrorism, extreme weather, and, yes, pandemics.
The risk facing any particular industry value chain reflects its level of exposure to different types of shocks, plus the underlying vulnerabilities of a particular company or in the value chain as a whole. We therefore examine the growing frequency and severity of a range of shocks, assess how different value chains are exposed, and examine the factors in operations and supply chains that can magnify disruption and losses. Adjusted for the probability and frequency of disruptions, companies can expect to lose more than 40% of a year’s profits every decade, based on a model informed by the financials of 325 companies across 13 industries. However, a single severe shock causing a 100-day disruption could wipe out an entire year’s earnings or more in some industries—and events of this magnitude can and do occur.
Recent trade tensions and now the COVID‑19 pandemic have led to speculation that companies could shift to more domestic production and sourcing. We examined the feasibility of movement based on industry economics as well as the possibility that governments might act to bolster domestic production of some goods they deem essential or strategic from a national security or competitiveness perspective. All told, we estimate that production of some 16 to 26% of global trade, worth $2.9 trillion to $4.6 trillion, could move across borders in the medium term. This could involve some combination of reverting to domestic production, nearshoring, and shifting to different offshore locations. Moving the physical footprint of production is only one of many options for building resilience, which we broadly define as the ability to resist, withstand, and recover from shocks.
In fact, technology is challenging old assumptions that resilience can be purchased only at the cost of efficiency. The latest advances offer new solutions for running scenarios, monitoring many layers of supplier networks, accelerating response times, and even changing the economics of production. Some manufacturing companies will no doubt use these tools and devise other strategies to come out on the other side of the pandemic as more agile and innovative organizations.
Globalization after COVID‑19
COVID‑19 seems to be accelerating some of the trends that were already manifesting within the world’s value chains, including the regionalization of trade and production networks, the growing role of digitization, and the focus on proximity to consumers. The increasing use of automation technologies in manufacturing is lessening the importance of low labor costs - and more automated plants could be more resilient in the face of pandemics and heatwaves (although potentially more vulnerable to cyberattacks). Companies and governments alike are reassessing the way goods flow across borders, and they may still make targeted adjustments to shore up the places where they see fragility. But the pandemic has not reshaped the world’s production networks in dramatic ways thus far. After all, global value chains took on their current structures over many years, reflecting economic logic, hundreds of billions of dollars’ worth of investment, and long-standing supplier relationships. A major multinational’s supplier network may encompass thousands of companies, each with its own specialized contribution.
Each value chain’s exposure to shocks is based on its geographic footprint and factors of production
Pandemics, for example, have a major impact on labor-intensive value chains. In addition, this is the one type of shock for which we assess the effects on demand as well as supply. As we are seeing in the current crisis, demand has plummeted for nonessential goods and travel, hitting companies in apparel, petroleum products, and aerospace. By contrast, while production has been affected in value chains like agriculture and food and beverage, they have continued to see strong demand because of the essential nature of their products.
All in all, the five value chains most exposed to our assessed set of six shocks collectively represent $4.4 trillion in annual exports, or roughly a quarter of global goods trade. The five least exposed value chains account for $2.6 trillion in exports. Of the five most exposed value chains, apparel accounts for the largest share of employment, with at least 25 million jobs globally, according to the International Labor Organization. Even value chains with limited exposure to all types of shocks we assessed are not immune to them. Despite recent headlines, we find that pharmaceuticals are relatively less exposed than most other industries.
Shocks exploit vulnerabilities within companies and value chains
Shocks inevitably seem to exploit the weak spots within broader value chains and specific companies. An organization’s supply chain operations can be a source of vulnerability or resilience, depending on its effectiveness in monitoring risk, implementing mitigation strategies, and establishing business continuity plans. We explore several key areas of vulnerability, including demand planning, supplier networks, transportation and logistics, financial health, product complexity, and organizational effectiveness. Some of these vulnerabilities are inherent to a given industry; the perishability of food and agricultural products, for example, means that the associated value chains are vulnerable to delivery delays and spoilage. Industries with unpredictable, seasonal, and cyclical demand also face particular challenges. Makers of electronics must adapt to relatively short product life cycles, and they cannot afford to miss spikes in consumer spending during limited holiday windows.
Other vulnerabilities are the consequence of intentional decisions, such as how much inventory a company chooses to carry, the complexity of its product portfolio, the number of unique SKUs in its supply chain, and the amount of debt or insurance it carries. Changing these decisions can reduce - or increase - vulnerability to shocks. Weaknesses often stem from the structure of supplier networks in a given value chain.
Complexity itself is not necessarily a weakness to the extent that it provides companies with redundancies and flexibility. But sometimes the balance can tip. Complex networks may become opaque, obscuring vulnerabilities and interdependencies. A large multinational company can have hundreds of tier-one suppliers from which it directly purchases components. Each of those tier-one suppliers in turn can rely on hundreds of tier-two suppliers. The entire supplier ecosystem associated with a large company can encompass tens of thousands of companies around the world when the deepest tiers are included.
Even within the same industry, companies can have very different supply chain structures - and significant overlap
Companies’ supplier networks vary in ways that can shape their vulnerability. Spending concentrated among just a few suppliers may make it easier to manage them, but it also heightens vulnerability should anything happen to them. Suppliers frequently supply each other; one form of structural vulnerability is a sub-tier supplier that accounts for relatively little in spending but is collectively important to all participants. The number of tiers of participating suppliers can hinder visibility and make it difficult to spot emergent risks. Suppliers that are dependent on a single customer can cause issues when demand shocks cascade through a value chain. The absence of substitute suppliers is another structural vulnerability.
Globalization has led to diversification of production across countries in some sectors, but others have grown more concentrated
Even in value chains that are generally more geographically diversified, production of certain key products may be disproportionately concentrated. Many low-value or basic ingredients in pharmaceuticals are predominantly produced in China and India, for instance. In total, we find 180 products across value chains for which one country accounts for 70% or more of exports, creating the potential for bottlenecks. The chemicals value chain has a particularly large number of such highly concentrated products, but examples exist in multiple industries. Other products may be produced across diverse geographies but have severe capacity constraints, which creates bottlenecks in the event of production stoppages. Similarly, some products may have many exporting countries, but trade takes place within clusters of countries rather than on a global basis. In those instances, importers may struggle to find alternatives when their predominant supplier experiences a disruption. Geographic diversification is not inherently positive, particularly if production and sourcing expands into areas that are more exposed to shocks.
When companies understand the magnitude of the losses they could face from supply chain disruptions, they can weigh how much to invest in mitigation. We built representative income statements and balance sheets for hypothetical companies in 13 different industries, using actual data from the 25 largest public companies in each. This enables us to see how they fare financially when under duress. We explore two scenarios involving severe and prolonged shocks:
- Scenario 1. A complete manufacturing shutdown lasting 100 days that affects raw material delivery and key inputs but not distribution channels and logistics. In this scenario, companies can still deliver goods to market. But once their safety stock is depleted, their revenue is hit
- Scenario 2. The same as above, but in this case, distribution channels are also affected, meaning that companies cannot sell their products even if they have inventory available
Our scenarios show that a single prolonged production-only shock would wipe out between 30 and 50% of one year’s EBITDA for companies in most industries. An event that disrupts distribution channels as well would push the losses sharply higher for some. Industries in which companies typically hold larger inventories and have lower fixed costs tend to experience relatively smaller financial losses from shocks. If a natural disaster hits a supplier but distribution channels remain open, inventory levels become a key buffer. However, the downstream company will still face a cash drain when it is time to replenish its drawn-down safety stock. When a disruption outlasts the available safety stock, lower fixed costs become important to withstanding a decline in EBITDA.
Today, much of the discussion in advanced economies about resilience revolves around the idea of reverting to domestic production as a “flight to safety.” The geographic footprint of production and supply chains does need to be reevaluated periodically as the environment changes, and heavy dependence on one geography can be a vulnerability. But companies and countries have a wide range of options at their disposal. Increasing local production is only one of them - and it is not a guarantee of robustness in and of itself, nor is it always feasible. The toolbox is much bigger than the current debate would seem to indicate. Practical strategies for making supply chains more transparent and resilient have been widely discussed for years, yet only a small group of leading companies have taken decisive action. Cautionary tales about past disasters have rarely spawned industry-wide changes. As the old saying goes, everyone talks about the weather, but nobody does anything about it.
Yet this time really might be different.
To download the McKinsey Global Institute’s (MGI) new report on ‘Risk, resilience and rebalancing in global value chains,’ and read its findings CLICK HERE