In This Issue
Spring Bridge on Postpandemic Engineering
March 14, 2021 Volume 51 Issue 1

Designing the Global Supply Chain in the New Normal

Wednesday, March 31, 2021

Author: Hau L. Lee

Considerations for designing manufacturing supply chains to be resilient in the face of likely future disruptions.

The year 2020 was one of turbulence and unprecedented challenges. Global companies had already been redesigning their supply chains in response to escalating trade frictions, threats of higher tariffs, and increasing protectionism from governments in many countries, but the covid-19 pandemic presented even more complex issues  as disruptions resulted in major shifts in both demand and supply.

The need for shifts will persist as the new normal is likely to involve increasingly frequent disruptions—other pandemics, earthquakes, floods, hurricanes, trade disputes, perhaps even human-made disasters. In addition, globalization is expected to yield highly unpredictable opportunities that will require prompt action to meet customer needs and demands. This article focuses on the design of the supply chain in this new environment.

Supply Chain Weaknesses Exposed by the Pandemic

When the pandemic hit different parts of the world, there were soon shortages of products because of offshored production, primarily to China (“the world’s factory”). The pandemic exposed the risk of having a single source: when that source was disrupted, the company’s supply chain quickly broke.

The massive breakdown in supply chains has also been attributed to excessively lean processes in practice: “just-in-time” operational processes hold very little buffer inventory to protect against unexpected disturbances. Cost considerations also reduced capacity levels to the minimum.

A number of remedies have been suggested. In the United States the most common is to address the risk of overreliance on China as the manufacturing base. Companies have been advised to diversify their supply bases, either instead of or in addition to China (the latter is referred to as the “China Plus One” strategy).

Coupled with the diversification strategy is the push for more domestic or regional supply chains to safeguard against future shocks, as managing a disruption at a faraway site is much more difficult than at a nearby one.

Because being too lean in the supply chain is risky, some redundancies in the form of buffer inventory or capacity are appropriate. Of course, greater lead time and flexibility in production processes through automation and labor upskilling are always helpful.

Implementation of these recommendations could lead to increased investments in digital technologies, reshoring, dual sourcing, more inventory stockpiling, and extra idle capacity. Shih (2020) provides an excellent overview of the risks and potential ways forward.

Factors to Consider in Supply Chain Design

Protecting supply chains against disruptions by adding redundancies such as increased buffer inventory and additional capacity can be costly. The inefficiencies introduced could lead to the loss of competitiveness. Companies that once maintained ample inventory and extra capacity were pressured to reduce the buffers for cost efficiency when no major disruption occurred and they were left with excess inventory. Such oscillation creates nervousness in the system and hurts the long-term health of the supply chain.

For security reasons, a certain level of domestic supply chain with redundancy for essential products is desirable. But it may not be feasible or it may be too costly to develop a complete, domestic, vertical supply chain for some products, even in resource-rich countries. And a disaster in the home country may completely disrupt the domestic supply chain. So a diversified global supply chain is likely to be more resilient than a totally domestic one.

A survey of executives of global companies found that supply chain design requires more than simply follow-ing one best practice principle (Cohen et al. 2018). It is a balancing act among multiple objectives and risks and requires careful consideration of the follow-ing questions:

  • What is the role of total (landed) and other costs in changing a supply chain design?
  • To what extent are trade agreements and customs duties a determining factor in the design of a supply chain?
  • What are the factors to consider in reshoring production or pursuing a combination strategy, with both off- and reshoring? And how should diversified supply bases be used differently?
  • What is the best way to balance the trade-off between cost efficiency and redundancy to ensure flexibility in the face of supply chain disruptions?

Assessment of Total Landed Costs

One of the pitfalls in redesigning the supply chain either by moving a factory to a new location—domestic or offshored—or diversifying to multiple locations is an incomplete landed-cost analysis.

The total landed cost is the end-to-end cost from sourcing point to product delivery, covering transport of the raw materials for production through multiple intermediate points to reach the demand destination. The cost should also account for the riskiness of disruptions and other vulnerabilities throughout the process.

Every supply chain redesign involves potential changes in sourcing costs, processing costs, and logistics costs.

Every supply chain redesign involves potential -changes in the sourcing costs of the raw materials, processing costs at the site, and logistics costs to get products to the destination points. The logistics costs include customs duties and freight. These are the obvious components of the total landed costs, but there are many other components (e.g., inventory, border delays, quality, and risks of regulatory or code of conduct violations) that require consideration. Careful evaluation may reveal that a new supply source is not as attractive as it first appeared.

Operations research models have been developed for such evaluation. For example, one analysis of network design based on landed-cost components considered taxes, local government incentives, customs duties, local content requirements, and transfer prices (shown in the mathematical programming model described in Cohen and Lee 1989).

Less obvious, but critically important, are the costs associated with crossing borders—what the World Bank calls “cross-border logistics frictions” (Hausman et al. 2005, p. 1). In addition to customs duties, these are the costs and time involved in getting products through borders, such as loading and unloading from shipping vessels, documentation requirements, waiting for inspections, and delays incurred at port facilities. One item singled out by the World Bank as a significant source of delay is the number of signatures—ranging from a few to 48—required by the receiving government. Such logistics frictions can be a major impediment to the attractiveness of trade between countries (Hausman et al. 2014) and are part of the total landed cost.

The costs of noncompliance and breaches—
and of monitoring to reduce or prevent them—
are part of the total landed cost.

When setting up supply sources in emerging and developing economies—for example, for Central America to serve the North American markets, North Africa or Eastern Europe to serve the European Union, or Southeast Asia to be part of a diversified strategy to reduce reliance on China—it is important to account for the risk of problems or violations in sustainability in new supply sources. The costs of noncompliance and breaches—and of monitoring to reduce or prevent them—are part of the total landed cost.

Finally, another component often missed is the cost of exit. A new production site may turn out not to be a permanent one. Changes in market demands, technologies, economic or geopolitical conditions, or trade relationships may result in the need to redesign the network and to close a site or abandon the supply source. The cost of such a closure or discontinuation of a relationship should be factored into the total landed cost. One may have to think twice if that cost is prohibitive.

Customs Duties, Trade Agreements, and “Product DNA”

The calculation of customs duties as part of the total landed cost may not be simple. It depends on the bill of material for the product (i.e., the components and subassembly of the product) and the location of the manufacture of the components, subassemblies, and final assembly, all of which are often governed by various bilateral and regional trade agreements. Whether a final product can be labeled as made in a particular country depends on its content, or “DNA”—its structure and the origins of its components. All of these -factors determine the customs rate for products entering a country.

There has been a proliferation of trade agreements in the past few decades—from three in 1970 to more than 300 in 2020[1]—that specify rules, including customs duty rates, for trade in specific products between two or more countries. The rules may allow duty-free treatment or reduced duties if certain requirements are met. The agreements may have expiration dates, with options to renew or modify rates and terms.

For these reasons trade agreements may affect supply chain design decisions. For example, the US shoe company Crocs retained its manufacturing plant in Canada to make products for export to Israel, taking advantage of the zero duty rate stipulated in the trade agreement between Canada and Israel (Hoyt 2007).

The Logan car made by Renault also illustrates the impact of trade agreements on supply chain decisions (Lee and Silverman 2008). Intended primarily for markets in Eastern Europe, the Middle East, and North Africa, the Logan was originally built entirely in Romania. But the country quickly ran out of capacity when the car became unexpectedly popular in Western Europe. After Romania’s EU accession in 2007, parts produced there qualified as European parts, so, to get duty-free shipping, Renault took advantage of the complex set of trade agreements between Romania and Morocco and between Morocco and the European Union. Instead of investing in the facility and manufacturing processes for the whole car in Morocco, Renault arranged to ship the core kit of parts from Romania to Morocco and used the factory in Morocco for the final assembly of the vehicle. With enough of the value of the parts imported, the Logan assembled in Morocco could satisfy the rules of origin to achieve a duty-free rate for the finished vehicle shipped to Europe, saving 10 percent duty.

In the United States in 2019, as import tariffs on bicycles made in China increased and threatened to go up even higher, some bicycle companies were able to switch to make bike frames in Cambodia while continuing to buy about half the components from producers in China (Singh 2019). The finished bicycles from Cambodia could enter the US tariff-free, designated as made in Cambodia as long as 35 percent of the costs were derived from that country.

Optimizing Mixed Sourcing for Cost Efficiency and Flexibility

When companies use a dual or multisourcing strategy, they need to take into account the characteristics, strengths, and weaknesses of each site.

Broadly speaking, sites can be classified as “cost-efficient” or “flexible” (this is a crude classification but is used here to illustrate the idea). Cost-efficient sites provide a low cost for production or procurement, but may be less flexible and require longer lead times. Flexible sites tend to have better engineering support and capabilities to enable quick responses, but higher costs. Offshored manufacturing sites in very low cost countries may be viewed as cost-efficient sites, and onshore (domestic) or nearshore (regional) sites as flexible sites. A combination of these types may be effective.

As an example of mixed sourcing, Hewlett-Packard used a cost-efficient site to produce at a fixed volume and a flexible site to produce variable volume in response to fluctuating and uncertain market demands (Olavson et al. 2010). The company thus enjoyed the benefits of both.

There are other ways to use multiple sites based on the characteristics of the sites and the products. Within a company, the needs of multiple products at various stages of the lifecycle and the manufacturing processes involved are different. The different product needs and manufacturing processes must be matched with the sites that have the right characteristics. This is the basis of supply chain strategy alignment (Lee 2002). Different strategies are shown in table 1.

  • A volume-based mixed strategy addresses the need to accommodate both fixed and variable volume.
  • A product-based strategy depends on the nature of demand for the product: stable demand (e.g., for basic apparel or standard consumer electronics, or noncritical products); or risky, uncertain demand (e.g., for fashion apparel or advanced electronics, or essential products such as those critical for national security).
  • With a time-based strategy the cost-efficient source is used for products at their mature phase, when demand tends to be more stable and predictable; the flexible source is used in the ramp-up or end-of-life phase, when demand is more volatile.
  • Finally, a process-based strategy recognizes that the initial stage of the production process tends to be more standardized, for building generic core engines, for example; later, in the customization or post-ponement stage, products are customized or differentiated into options or distinct products. The earlier standardization stage has more stable, predictable demand, while the customization stage involves greater demand uncertainties. Hence, the cost--efficient source is better suited for the initial stage, and the flexible source better for the customization or postponement stage.

Lee table1.gif

Balancing Cost Efficiency and Redundancy: Capacity Building and Agility

Besides a resilient supply chain design, best practice calls for reexamining the need for buffer inventory and buffer capacity. With the increasing uncertainties of the new normal, two additional capabilities are needed: quick capacity building and agile configuration of the supply network.

When the pandemic hit in early 2020, Taiwan was able to respond quickly to make personal protective equipment (PPE) not because it had domestic vertical supply chains of PPE or a large buffer inventory of the products. Instead, Taiwan has the know-how of the machining industry, which was leveraged to make PPE production equipment (Fang and Li 2020). This highlights the importance of having the knowledge and capability to build capacity when needed, instead of maintaining costly extra capacity or inventory just in case.

Companies must strengthen their ability to create new capacities as needed. The know-how involved in manufacturing process technologies is critical and should not be outsourced or offshored. When companies diversify their manufacturing footprint, they should locate some sites in a region with a capacity-building ecosystem. This was the machine-building ecosystem that Taiwan used.

A disruption like covid-19 could lead to an instant need for products that did not even exist before. Social media and fast-changing fashion trends can also rapidly create opportunities for new products. Companies need to have the capability to configure a new supply network on the fly. Such a network is not just about suppliers of materials and final assembly, but about quickly connecting designers, intellectual property (IP) owners, prototype builders, market testers, and new sales and logistics channels.

A digitally connected platform is effective for agile configuration. Haier, which owns GE Appliances, has achieved such agility with a digital platform, COSMOplat (Xie and Li 2020), that connects the entities involved in design, market test, and production of industrial appliances for new product generation and launch. This is how the company was able to create a mobile isolation ward for hospitals in China during the worst of the pandemic. The country was in lockdown at the time of the Chinese New Year, and there was a need for mobile isolation wards that could be moved from hospital to hospital as patient loads shifted. This was not an existing product, and so the supply network did not exist. Haier’s digital platform made it possible to design and build the product in 2 weeks.

Lee figure 1.gif

An agile configuration platform requires a network of multiple modules (figure 1). The technology exchange module allows designers and IP holders to collaborate on new product design, do rapid prototyping, perform feasibility tests, and design for manufacturability. With the user-interaction design module, potential users test the product, provide feedback, and give an early indication of market acceptance. The sourcing and configuration module facilitates identification of the component, subassembly, and final assembly partners in the supply network for building the product, and the logistics management module engages the right players for channel development, order fulfillment, and after-sales service and repair.

Conclusion

Global supply chain design in the new, postpandemic normal requires a full understanding of total landed costs, integration of product design, alignment of the characteristics of production sites with product DNA and trade restrictions, and, finally, the ability to build capacity and reconfigure supply networks quickly.

References

Cohen MA, Lee HL. 1989. Resource deployment analysis of global manufacturing and distribution networks. Journal of Manufacturing and Operations Management 2(2):81–104.

Cohen MA, Cui S, Ernst E, Huchzermeier A, Kouvelis P, Lee H, Matsuo H, Steuber M, Tsay A. 2018. OM Forum—Benchmarking global production sourcing decisions: Where and why firms offshore and reshore. Manufacturing and Service Operations Management 20(3):389–402.

Fang TF, Li L. 2020. Taiwan’s “hidden champions” help corona-virus fightback. Nikkei Asian Review, Apr 24.

Hausman W, Lee HL, Subramanian U. 2005. Global -Logistics Indicators, Supply Chain Metrics, and Bilateral Trade Patterns. Policy Research Working Paper 3773. Washington: World Bank.

Hausman W, Lee HL, Subramanian U. 2014. The impact of logistics performance on trade. Production and Operations Management 22(2):236–56.

Hoyt D. 2007. Crocs: Revolutionizing an industry supply chain model for competitive advantage. Stanford Graduate School of Business Case GS57.

Lee H. 2002. Aligning supply chain strategies with product uncertainties. California Management Review 44(3):105–19.

Lee H, Silverman A. 2008. Renault’s Logan car: Managing customs duties for a global product. Stanford Graduate School of Business Case GS62.

Olavson T, Lee H, DeNyse G. 2010. A portfolio approach to supply chain design. Supply Chain Management Review 15(4):20–27.

Shih WC. 2020. Global supply chains in a post-pandemic world. Harvard Business Review 98(5):82–89.

Singh RK. 2019. How US bike companies are steering around Trump’s China tariffs. Reuters Business News, Feb 25.

Xie Y, Li Y. 2020. Research on Haier COSMOPlat promoting industry upstream and downstream collaboration and cross-border integration. IEEE 7th Internatl Conf on Industrial Engineering and Applications, Apr 16–21, Bangkok.

 


[1]  World Trade Organization, http://rtais.wto.org/UI/charts.aspx#

About the Author:Hau Lee (NAE) is the Thoma Professor of Operations, Information, and Technology in the Graduate School of Business at Stanford University.