As I am writing this, in mid-2022, we’re living in pretty unprecedented times. The Covid pandemic is ongoing, tensions between major world powers are at a high, previously solid supply chains and business practices are crumbling, inflation is rising affecting all kinds of costs, politics are causing countries to become more insular and closed-minded, and shipping is still a mess. Today’s manufacturing businesses need to find suitable supply chain risk reduction strategies to help counter these risks. We’ll look at three options in more detail…
3 Supply Chain Risk Reduction Strategies
So, how can manufacturing businesses cope with this uncertainty and reduce supply chain risks? By implementing vertical integration? By going for supply chain diversification? By stocking more inventory as a fallback? Let’s explore 3 Supply Chain Risk Reduction Strategies that you might find helpful…
1. Vertical integration
The vertical integration strategy is where you take control of your supply chain, typically by internalizing more and more of the work done by suppliers, or even by taking over those suppliers and folding them into your group.
In the context of supply chain risk reduction, Tesla has recently been in the media as a shining example of how an automaker can ride the choppy waters affecting many of its counterparts by becoming more vertically integrated. Given that Tesla’s value is enormous compared to most other automakers, the Economist puts it at ‘$724bn, which is roughly as much as the next nine biggest carmakers combined,’ it’s unsurprising that other automakers who relied on outsourcing to various third parties for many/most of their parts and materials are now trying to alter course and become more vertically integrated.
The same Economist article shows why other CEOs are eyeing Tesla CEO Elon Musk’s work with interest:
“Jim Farley, Ford’s current boss, recently declared, “The most important thing is we vertically integrate. Henry Ford…was right.”
This reverses decades of outsourcing to big suppliers such as Bosch, Continental and Denso in order to concentrate on managing supply chains, integrating separate parts, design and marketing. Suppliers sold similar components to many customers using scale to keep prices low. This freed up capital for carmakers but put technological innovation at one step removed.”
Ford famously pioneered vertical integration by purchasing coal mines and rubber plantations in the early 20th Century in order to bring control of the resource supply chain in-house and protect the business from risk, although modern-day Ford has certainly strayed from this principle as it’s one of the automakers that has certainly been affected by semiconductor shortages among other disruptions to this day.
On the topic of vertical integration and its benefits, Musk said, “Tesla is absurdly vertically integrated compared to other auto companies or basically almost any company. We have a massive amount of internal manufacturing technology that we built ourselves … It’s like, okay, what are the things we want to make, design a machine that will make that thing, then we make the machine.”
Another benefit of such a strategy was that IP protection became easier: “[vertical integration] makes it quite difficult to copy Tesla… because you can’t do catalog engineering. You can’t just [say] I’ll pick up the supplier catalog, I’ll get one of those.”
Vertical integration also helps with transparency and speed, as I wrote before.
Finally, Tesla autos are some of the most technically innovative on the market precisely due to this in-house supply chain for their components: “We’re designing and building so much more of the car than other OEMs who will largely go to the traditional supply base and [execute] like I call it, catalog engineering. So it’s not very adventurous and it basically ends up like older products end up — looking the same because they’re going to the same suppliers.”
Like Henry Ford in the past, Musk now controls his supply chain and reduces risks by dealing directly with rare earth mines (for his EV batteries) and builds many of his own parts in-house. Combine this with Tesla’s ownership of its own distribution (have you seen any Tesla dealers?) and Musk has embraced a pretty thorough integration strategy for Tesla.
Other recognisable examples of companies that have embraced a vertical integration approach are Starbucks and IKEA. The former owns coffee plantations to produce its own beans as well as wildly popular global coffee shops to sell them in, and IKEA also keeps much of its supply chain and distribution in-house, too.
Should your business vertically integrate?
The ‘outsource everything you can and ditch all your manufacturing activities’ strategy has been dominant since the 1980s. All the Jack Welch followers have been working hard at it. Is in-sourcing the right strategy for you?
Basically, the question is, can you bring more of the supply chain under your control, and would it make sense for you?
Multinationals may have the funds and reach to set up factories, purchase suppliers, or deal directly with material suppliers like mines. SMEs often don’t have those options. At the very least, I’d venture that, if you don’t see yourself as a manufacturing company, you should probably not get into that activity…
2. Supply Chain Diversification
Supply chain diversification is another one of the supply chain risk reduction strategies. Let’s say 100% of your components and assembly are in China. What happens when your suppliers and/or assembler are closed down due to localized Covid lockdowns?
Obviously, your supply chain is disrupted to the maximum.
On the other hand, let’s say that you produce 70% in China, but another 30% in India, Vietnam, and/or Mexico. As long as you’re able to source the key components from outside of China, there’s no reason why a disruption there needs to shutter your supply chain completely…and that’s why many businesses are diversifying this way in 2022.
By doing this, you certainly don’t ‘own’ the supply chain in the same way as Tesla does, but you’re at least partly insulated from the many issues mentioned at the top of this article.
Let’s look at a good example, Apple moving some of its manufacturing to India. This has actually been going on since 2017 and is unsurprising as during the Trump presidency American attitudes towards China have cooled significantly and remain frosty. Couple that with Covid disruptions in China that are still a risk (as we’ve seen in the recent very long Shanghai lockdown) and it would seem that Apple’s decision was a wise one:
Apple has also been diversifying its production away from China to avoid trade disputes and other issues that might come with a heavy reliance on that country. Indian production could help Apple weather temporary disruptions at Chinese plants [due to Covid]. The company was also reportedly set to move some AirPod and MacBook manufacturing to Vietnam.
A large amount of Apple’s production is still in China and, for most electronics brands, that’s probably not going to change in the short term as China has the most mature supply chain for electronic components, although that’s not to say that countries like India are (slowly) catching up.
SMEs need to note that there’s a difference between assembling in a different country than China to avoid tariffs and having a mature supply chain in a different country.
Apple, for example, may benefit a great deal financially by assembling products across the border from China in Vietnam so they can be labelled as ‘Made in Vietnam’ even though many parts are still coming from China… this wouldn’t reduce your supply chain risks. It adds the Vietnam risk to the China risk.
In order to indemnify yourself against disruptions caused by one key manufacturing base going out of action, you need to be able to assemble and source key components in the other country/ies.
How does your business diversify supply chains?
As many observers would urge, like our podcast guest Andrew Hupert in this episode: Should North American Importers Leave China For Countries Like Mexico or Vietnam?, yesterday was the best day to start diversifying, but if that didn’t happen then now is the second-best time!
This is arguably a more easily achieved solution to reduce supply chain risk than vertical integration for SMEs. The investment is usually much lower. You can still carry on business as usual in China (if that’s your main supply chain base as it is for many readers, and especially if it is a significant market for your company).
Over time you can place some test orders for smaller quantities with your new supplier in, say, India, and ramp up over time, while still doing the bulk in China. Then, if things do hit the fan in China, your Indian supplier should be up-to-speed and able to take on more work reasonably quickly.
3. Building up more inventory
An old-school approach to weathering supply chain risks and disruption is to keep more inventory in stock. These may be finished units, or they could be components or materials.
We already saw how automakers like Ford have been and still are gravely affected by semiconductor shortages caused by Covid, Russia’s invasion, and more, but not every automaker had this issue.
Toyota learnt its lesson after the 2011 earthquake in Fukushima that knocked out many of its sub-suppliers and caused a lot of disruption to the company. Before then they’d relied on a Just-In-Time approach for many parts which led to shortages when their suppliers weren’t operating due to the earthquake and resulting tsunami and power outages.
After this, they focused on supply chain risk management which stood them in good stead for a time when Covid hit.
As I wrote in this post:
So, what did Toyota do right? How did they develop that early-warning system?
“Toyota asks its Tier 1 suppliers to input detailed information about their most obscure parts and materials providers in a complex database that it maintains. Using this system to glean information about, say, a single headlight Toyota purchases for one of its cars, it can get information as granular as the names and locations of the companies that make the materials that go into surface treatments used on those headlights’ lenses and even the producers of the lubricants used on the rubber pieces in the assembly, Toyota spokeswoman Shiori Hashimoto says.
These lines of communication alerted the company early on that it needed to stockpile chips. “The process of making semiconductors is complex, and the facilities used to create them are specialized,” Hashimoto says. “With that in mind we’ve needed to make sure there’s enough stock to cover a period of potential supply disruption.”
So, what did they do? Rather than applying a just-in-time approach blindly, they actually increased their inventory of parts they estimated were high-risk.
“The Tohoku earthquake’s aftermath pushed Toyota to increase flexibility, and the value of inventory Toyota carries has almost doubled since 2011. Speaking at a briefing in February, Toyota Chief Financial Officer Kenta Kon said as part of the company’s business continuity plans, it keeps as many as four months of stock for some crucial components such as chips. Toyota didn’t expect the semiconductor shortage to disrupt production in the near term, he said.”
That’s particularly striking, as semiconductors lose value fast. Most companies focus on keeping as little inventory as possible when it comes to electronic components in general.
Toyota made the calculation that being unable to sell hundreds of thousands of cars when a once-in-a-decade incident comes up is more costly. A pretty good call, it seems.
Ideally, long supply chains and Just-In-Time inventory orders would still be an option, but they’re increasingly problematic.
Toyota pinpointed components that were particularly likely to be a problem if unavailable such as semiconductors and kept a stock of them due to lessons they learned thanks to the earthquake. Many Western automakers hadn’t gone through similar issues, though, and so were caught cold when the pandemic started.
As a result, Toyota was less affected by the shortage of semiconductors, and they looked pretty good for a while. It ended up catching up with them, though, as the current situation is particularly bad. Dan Harris mentions on China Law Blog:
Last August, Toyota slashed its production forecast for September due to the scarcity of semiconductors, and in December it again announced factory shutdowns due to parts shortages. Most other major auto manufacturers have also reduced production schedules because they have been unable to secure enough semiconductors.
How does your business increase inventory?
As I mentioned here, you have 3 options:
- Have your current supplier buy those components now – you benefit in 2 ways, locking in today’s prices which may keep rising and insulating yourself against shortages, however, can you trust they’ll be stored correctly and not tampered with?
- Purchase those components yourself and keep them in a safe warehouse – as above, but you keep control over the components.
- See if alternative components can be used – this is a workaround. Would it be easier and cheaper to use different components that are less risky, such as off-the-shelf components instead of custom ones made solely for you? This may not be possible for certain electronic parts, but for more common parts it should be.
Have your say…
What have you done to reduce supply chain risks? Do you follow any of the three supply chain risk reduction strategies mentioned here? How have they been a success or a challenge? Let me know by commenting or contacting me, please.
You can read my blog post series on supply chain risk reduction here, and you may like this episode of our podcast on the topic, too.