Supply Chain Under Strain

This post first appeared on Risk Management Magazine. Read the original article.

The COVID-19 pandemic has affected businesses in every
sector around the world. Indeed, in early March, the Organization for Economic
Cooperation and Development warned that the pandemic could cut global economic
growth outlook in half. Many industries have been hit hard thus far, 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.”

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