Supply Chain Under Strain

By Russ Banham

Risk Management

The COVID-19 pandemic has affected businesses in every sector around the world, with expectations by the Organization for Economic Cooperation and Development that it will cut the global economic growth outlook in half. Many industries have been hit hard, including travel, hospitality and transportation, but the impact on manufacturing supply chains has been difficult to ascertain.

Although sluggish demand remains worrisome, large original equipment manufacturers (OEMs) with sophisticated supply chain risk management practices and backup supplier contracts have so far been able to ride out the impact of COVID-19 from a supply standpoint. “It’s the small cap companies without big risk management departments or the resources of an Apple or a General Motors that are most susceptible to disruptions in supply,” said Josh Nelson, supply chain principal in The Hackett Group’s strategy and business transformation practice.

According to the firm’s analysis, industries at the greatest risk of business disruption due to the coronavirus include electronics and appliances, tools and hardware, building products, diversified chemicals, and industrial specialties. “Although large industrial conglomerates, telecom, automobile and computer peripherals have less inventory in their supply chains, companies in these industries typically have the scale and resources to reduce their supply chain risks,” Nelson said.

Delays in product shipments are another concern. Large manufacturers with extremely tight production schedules and inventories have the resources to shift product shipments from one port to another in a different region. They also have relationships in place to source supply from the new region. “Smaller companies generally don’t have such networks in place,” said Gary Lynch, founder and CEO of research and consulting firm The Risk Project and former head of the global supply chain practice at insurance broker Marsh. “The longer the coronavirus goes on, the greater the risk of not being able to source needed supply. You end up competing to get what you need. It’s a bidding war not every company will win.” 

Nevertheless, some experts believe the global supply chain is holding up well. “Are there some manufacturers incurring disruptions to their supply chains? Yes, but many of them previously lined up other sources of supply outside China to fill in when needed,” said Beth Pride, president of supply chain compliance consulting firm BPE Global.

Threats from All Angles

COVID-19 is the latest blow to manufacturing supply chains, which have endured recent disruptions from natural disasters, devastating cyberattacks and the two-year trade dispute between the United States and China.

“From an operational standpoint, a company’s supply chain already is a highly complex ecosystem subject to fast-changing risks, from logistical logjams to currency fluctuations,” said Sanjiv Mahajan, an associate principal at The Hackett Group. “Add the coronavirus and complicated trade and tariff issues and it becomes even more mind-boggling.”

Although the United States and China signed a Phase 1 accord relaxing some of the tariffs President Trump imposed last year, the trade war is far from over. In March, the U.S. Department of Commerce proposed regulations to further restrict U.S. sales to Chinese companies deemed to pose espionage and technology theft risks, and the Wall Street Journal reported that Trump administration officials were “pushing for additional trade restrictions by invoking further national security concerns.”

For many manufacturers, the trade dispute was already forcing them to decide between maintaining long-standing manufacturing and supplier partnerships in China or moving these operations and relationships elsewhere. Typically, this involves examining other countries’ “landed costs”—the total of trade-related tariffs, duties, customs, insurance and value-added taxes. The unprecedented impact of the coronavirus has complicated these deliberations, as governments have essentially shut down entire economies to stop the spread of the disease. In early March, Forbes even predicted this pandemic could end China’s three-decade-long position as the world’s leading manufacturer.

Tariff Uncertainty

Although COVID-19 has understandably pushed the trade war between the United States and China to the back burner, many companies remain stymied by the uncertain tariff environment. “I have a U.S. client that manufactures steel wheels for low-mileage vehicles like dump trucks, with operations in North America, South America, Europe, India and China,” said Mike Varney, a consulting partner at international public accounting, consulting and technology firm Crowe LLP. “They’re having trouble deciding if it’s worth it to them to continue to manufacture in China or relocate it.” Complicating the company’s plans is a possible repeat of the back-and-forth tariff threats that occurred prior to the Phase 1 accord.

Other companies are equally uncertain. “Prior to the current administration, tariffs were just another line-level expense,” Pride said. “Then President Trump launched the trade war. For the first time, many companies had to understand how the products they imported were classified.”

This classification is determined by the Harmonized Tariff Schedule (HTS), a database used by the U.S. government to calculate specific tariffs on imported goods, based on a particular product’s description and related duties. “Fifty percent of our clients called us and asked, ‘What is HTS and why am I getting hit with all these penalties?’” Pride said. “The reason is they had been incorrectly classifying their products. It was a huge wake-up call.”

Roused by the financial impact of the penalties, many companies hunkered down to assess alternate supply sources or relocate production out of China. “We’re seeing large automotive, semiconductor and heavy machinery companies moving parts of their supply chains to places like Vietnam, Cambodia and Mexico,” said Pete Mento, managing director of global customs and duties at Crowe. “Mexico, in particular, offers the opportunity to substantially shorten the supply chain, increasing delivery timeframes and expense savings.”

Nevertheless, shifting supplies at the eleventh hour is “not an easy decision to make,” Pride said, especially given the complexities of certain sectors. “It takes a minimum of six months to move a supply chain for most companies. For a pharmaceutical company, add another two years.”

Driving Better Decisions

Risk management professionals use lessons learned from past disasters to better manage the next one. But supply chains keep getting leaner, with only the right amount of inventory on hand to address just-in-time production demands. At the same time, supply chains have become more complex.

“It’s the Wild West, with all these primary, secondary and tertiary suppliers all over the place,” said Dan Kinsella, partner and U.S. and Americas extended enterprise and third-party assurance leader at Deloitte & Touche LLP. “Figuring out if they’re performing well is increasingly impossible, with no one and everyone in charge. If ever there was a reason for enterprise risk management, this is it.”

Companies like ON Semiconductor have adopted an enterprise risk management strategy and developed plans well in advance to identify diverse threats before they materialize. When the coronavirus struck in China, the company was ready. Three of its 30 factories are located in the country. As of mid-March, the facilities were performing up to speed. “Supply chain resiliency is something we have worked on for a long time here,” said Michael Zuraw, the firm’s senior director of global enterprise risk management.

ON Semiconductor’s ERM program has long focused on potential risks that may occur decades into the future. The Fortune 500 company has experienced a range of events that could have had an impact on its supply chain, such as the 2011 Fukushima earthquake and tsunami in Japan and the Thailand floods, as well as prior epidemics like SARS in 2003 and swine flu in 2009.

“These experiences guide us in what to do and what not to do to maintain business continuity,” Zuraw said. “We’ve embedded these principles into a series of tabletop exercises we practice to be ready when a crisis event occurs.”

Zuraw’s ERM group contemplates different supply chain risk scenarios, “and then we roll things back from there,” he said. “If this event happens in the future, we try to identify the intermediate points that have to happen first.”

These points are the leading indicators of the event happening. “They’re proxies for us to know we’re getting closer to the inflection point of the scenario occurring,” he said. “By tracking them, we can create plans today of what we’ll do if the event happens.”

Since pandemics and epidemics were among the types of supply chain events on their radar screen, the company was prepared with specific action steps. All of its factories are managed to respond to demand signals that can change quickly. “If there is an event, we make the decision on where we can allocate the capacity from one factory to another,” he explained. “With the coronavirus, we were lucky in a sense that it was around the Chinese New Year, a period when businesses shut down anyway to celebrate. We had already been planning for the holiday shutdown, so it wasn’t a huge change for us when the virus extended the duration.”

The slowdown in global semiconductor demand has actually provided ON Semiconductor and other component manufacturers some relief, in terms of its available supply, to absorb production delays. This was not the case during the Fukushima crisis or the Thai floods in 2011, when OEMs with overheated demand cycles could not find adequate supply sources fast enough.

Also helping ON Semiconductor effectively address the impact of the coronavirus is the company’s use of supply chain software that is configured to assess the impact of different supply and demand scenarios on a factory-by-factory basis. This helps guide the scheduling of each plant’s manufacturing agenda, Zuraw said.

Considering a wide range of supply chain threat scenarios is important in analyzing the overall risk to make informed decisions. “We’ve seen situations where a company shifts its manufacturing to save on the landed costs but fails to appreciate the risk of a train derailing in the new location,” said Charles McCammon, team leader of marine risk consulting at Willis Towers Watson. “If the train is carrying a critical piece of the manufactured product for a company in a just-in-time production environment, everything stops at once and chaos ensues.”

Using risk scenario and risk modeling exercises, manufacturers can integrate flexibility and resiliency into their supply chains, limiting the need to make a major decision, such as pulling all production and supplies from China. Mahajan cited the wisdom of a client that made speakers entirely in China, but is now temporarily making some speaker components in Mexico. “That’s allowed them to maintain the relationship with the supplier in China, giving them leeway to make the entire product there again in future,” he said. 

Preparing for the Next Crisis

With COVID-19 continuing to infect people at alarming rates, the companies most prepared for the risks of a pandemic are best positioned to mitigate the impact on the supply chain. At the same time, companies are learning new lessons from the coronavirus.

“The longevity of this event is unlike any other I’ve come across in my career,” Lynch said. “Fukushima and even the earlier epidemics were quick hits that were somewhat isolated. What seems clear is that supply chain risk managers need to think more like an economist thinks, focusing not just on the flow of goods but also looking at the impact on accounts receivable, cash flow, debt and people assets. If you lose a worker with a critical skill set, do you have someone with that expertise who can fill in instantly?”

Risk professionals must take a broad look at the current and potential risk landscape to plan for the future. “I would advise companies to start scoring each region based on a composite of risks, such as geopolitical issues, social unrest, natural disasters, pandemics, currency fluctuations, economic volatility, and so on,” Nelson said. “Do this on a regular basis so you can react quickly to changes, modifying sources of supply or adding inventory here and there as a buffer to reduce aggregate risks.”

Russ Banham is a Pulitzer-nominated financial journalist and frequent contributor to Risk Management magazine.

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