The Reason the Modern Supply Chain Is Snapping

Efficiency bites. Just-in-time inventory and outsourcing sound great when demand is normal and margins matter more than anything else.

But what's normal these days? The economy will learn from this, but that is of little use now or for the next few months. JL


Lizzie O'Leary reports in The Atlantic:

We’ve built a global supply chain that runs on outsourcing and thin margins, and the coronavirus has exposed just how delicate it is. "Vendors don’t have a lot of extra margin or slack to play with." So when demand spikes, everyone feels it. "There’s almost no industry sector—manufacturing and nonmanufacturing—that isn’t reliant on China in the United States.” Car parts, technology, fashion, medical gear, and drug components are particularly vulnerable to disruptions in Asian markets.

When president donald trump invoked the Defense Production Act, it was telling in two respects. First, it showed that the full force of the federal government will be brought to bear in the manufacturing of vital medical supplies. Second, it underlined what has already become clear: The way our modern supply chain is built is incredibly fragile.

For Doug Watkins, that was obvious several weeks ago, when he realized that his hospital didn’t have enough surgical gowns. Watkins, who oversees the supply chain at the Medical University of South Carolina health system, learned in February that one of the Chinese gown manufacturers that supplies his hospital had a contamination issue with its products.

The problem was unrelated to the novel coronavirus, and in any other time, it would have been a small hiccup on the way to finding replacement gowns. But then, as the virus surged, so did demand for gowns, both in and out of China, leaving Watkins and his colleagues scrambling. “This is probably as bad as I’ve seen it,” he said in a phone interview.

We’ve built a global supply chain that runs on outsourcing and thin margins, and the coronavirus has exposed just how delicate it is. “I guess we’ve done a good enough job within the health-care supply chain of getting pricing down to the point that the vendors don’t have a lot of extra margin or slack to play with,” Watkins said. So when demand spikes, everyone feels it.

In general, hospital supply chains work like this: A hospital (or nursing home or health agency) enters a group purchasing organization, or GPO, with several other providers. They pool together to order what they need, in bulk. When the system works, everyone saves money. But GPOs aren’t nimble; when there are problems, they’re felt across the system. And individual hospitals can’t immediately get what they need.

That means someone like Watkins ends up appealing to state and federal authorities for help. The World Health Organization is asking manufacturers to ramp up production of personal protective equipment for health-care workers. There is a strategic reserve of health-care supplies, which the White House has discussed tapping. And now it’s invoking the Defense Production Act.

But across other industries, the supply chain doesn’t have a similar cushion. And the strain is obvious. The Institute for Supply Management, which conducts monthly economic surveys, found that nearly 75 percent of the companies it contacted in late February and early March reported some kind of supply-chain disruption due to the coronavirus. And 44 percent of the companies didn’t have a plan to deal with this kind of disruption. “That is a little surprising in this day and age,” ISM’s CEO, Tom Derry, said in an interview.

“However,” he added, “you have to realize that there’s almost no industry sector—and when I say that, I mean manufacturing and nonmanufacturing—that isn’t reliant on China in the United States.”

Chinese materials and manufacturing are so pervasive that the average customer has no idea how many of their everyday products contain Chinese components, or how reliant on Chinese components most companies have become. “If you don’t have a first-tier supplier who’s sourcing from China,” Derry said, “then your supplier’s supplier is.”

To understand why the modern supply chain is uniquely vulnerable to a threat like the coronavirus, you have to realize how quickly it has changed. China joined the World Trade Organization in 2001, and surpassed the U.S. as an industrial powerhouse in 2010. During the SARS epidemic of 2002 and 2003, China represented 4.31 percent of worldwide GDP, wrote the MIT professor David Simchi-Levi, who studies supply chains. Now that’s 16 percent.

Western companies find it cheaper to manufacture goods in China, and elsewhere in Asia, than to do so closer to home. Car parts, technology, fashion, medical gear, and drug components are particularly vulnerable to disruptions in Asian markets. Derry noted that in 2012, after the Japanese tsunami, “you couldn’t buy a red Toyota for months, because the one factory that made red pigment for Toyota was offline.” Apple, Fiat Chrysler, and Hyundai have already warned investors of potential supply constraints due to the coronavirus pandemic.

In addition to offshoring, Simchi-Levi told me, companies have emphasized “just in time” delivery, keeping only 15 to 30 days of products on hand. That has made global companies more profitable but has also “significantly increase[d] supply-chain risk.”

He predicted that the worst of the supply-chain disruptions would begin now, in mid-March. Fewer Chinese ships are on the water, and major ports around the world, such as Rotterdam and Le Havre, are already feeling the effects. Those 15 to 30 days of inventory (even if a company stocked up prior to the Chinese Lunar New Year holiday) are likely running low now. “We are going to see a slowdown, disruption, less variety, less options to the customers,” Simchi-Levi said.

As the COVID-19 pandemic ripples throughout the world economy, it’s possible that it may begin to change the way global supply chains work. Simchi-Levi said companies will come under pressure to diversify where they make their products, which will prove easier for some than for others. While the blood thinner heparin may still be made in China, it’s not as difficult to move the infrastructure for, say, the kind of fashion sold at H&M and Zara to other Asian countries. “You can still emphasize low labor costs by moving into Vietnam, Malaysia, and Cambodia,” he said. More electronic and car-part production could shift to factories in Mexico and Brazil.

One thing not to worry about is the grocery supply chain. While some consumer products, such as toothpaste or shampoo, could be limited because of components sourced from China, that’s not the case for food.

Derry noted that the grocery supply chain is remarkably robust. Stores that run out of ingredients one day will be full a day or two later. As for nonperishable goods, such as toilet paper and cleaning supplies, now is a time to be prudent.

If you’re buying up all your local store’s inventory, he said, “I would argue that you’re doing your fellow citizens a disservice. Do we really need to have a gallon of Lysol at home? Probably not.”

For everyone to do their part, he said, it requires thinking like you work in the supply-chain industry: “It only exacerbates the problem if we all—as we call it—bring forward demand.”