Rethinking supply chains

According to the GEODIS Supply Chain Worldwide Survey, 62 per cent of companies have limited visibility of how they source and/or deliver product, which is perplexing when you consider that transportation and logistics account for 12 per cent of global gross domestic product. For corporations large and small, an understanding of this area of their businesses will become ever more critical due to changes in consumption patterns and ongoing digital transformation.

The Covid-19 outbreak has laid bare how dependent we have become on transnational supply chains in the globalised age, but the pandemic will merely serve to accelerate trends already in evidence, be they linked to technological change, human rights considerations, environmental regulation, or interventionist trade policies.

Supply chain dependence exposed through drug shortages

The flipside of our dependence on lower-cost, geographically distant supply chains is vulnerability, both in political and economic terms. Nowhere is this better illustrated, or has received wider media coverage, than in the global supply of active pharmaceutical ingredients (APIs), the chemical building blocks that give drugs their therapeutic value. 

Since 1992, the western pharmaceutical industry has been steadily outsourcing the production of off-patent APIs to China and India. This has been positive in terms of driving profitability; supply chain expenses are the main contributors to the cost of manufactured goods.

But this transfer has resulted in periodic shortages of key antibiotics, such as amoxicillin, and even commonly used painkillers such as aspirin and paracetamol – a point that came home to western consumers as the pandemic took hold. The impact of the Covid-19 outbreak is just the latest in a long line of production outages and quality issues, but it may have galvanised policymakers into action.

At the height of the crisis, the European Union’s (EU) Commissioner for Health and Food Safety, Stella Kyriakides, told MEPs that the production of medicines and APIs needs to be gradually repatriated to Europe to avoid any future recurrence of shortages experienced during the pandemic.

Her call echoes the sentiment expressed by Simon Marsh, communications director at the Chemical Industries Association, who told us that “making sure that essential components of the pharmaceutical supply chain can be produced in Europe is a necessary step to ensure the European Union can face any surge in demand or be ready in case of a global event”.

It may take some doing. The European Fine Chemicals Group estimates that around 80 per cent of chemical inputs used to make drugs sold in Europe now originate from China and India. That equates to significant political leverage at a time when diplomatic relations with The People’s Republic are deteriorating.

Political pressure and an entrenched system

The sentiments expressed by Ms Kyriakides have been repeated across the Atlantic by US Secretary of State Mike Pompeo. It pays to remember that we were coming off the back of a major trade dispute – one that has yet to be satisfactorily resolved – between the US and China.

There is bound to be further fallout as attitudes toward China have been hardening since a report from the Department for Homeland Security suggested that the country had deliberately concealed the potential severity of the virus to the World Health Organization, while simultaneously ramping up imports of personal protective equipment (PPE) and decreasing exports of key medical supplies. These actions were somewhat at odds with what you might expect from a country which once enjoyed ‘most-favoured-nation’ trading status.

But dismantling an entrenched system with the world economy at such a low ebb would be far from straightforward. Companies across the globe have become totally dependent on production and supplies in China, and other low-cost jurisdictions. The country’s share of the world’s manufactured goods (bound for export) has more than doubled since the turn of the millennium and now stands at roughly a fifth of the global total.

Companies would also be aghast at the prospect of losing access to China’s burgeoning consumer market if the trade war reignites in the wake of the pandemic, although Washington is also prioritising the elimination of enforced tech-transfer and IP theft, an unwanted side-effect of globalisation, again, deemed a potential national security risk.

The fact is that decisions to offshore many areas of manufacturing have been undertaken for sound commercial reasons, at least in terms of cost efficiencies. It is essentially the search for comparative advantage – an economy's ability to produce goods at a lower opportunity cost than that of other trading partners.

So, if the EU, or US state officials, are serious about repatriating API production, it is probable that they will need to introduce major fiscal incentives, non-refundable grants, and other measures designed to bridge the gap between domestic and foreign manufacturing costs.

Any such measures could contravene state aid guidelines from the World Trade Organization and other transnational regulatory bodies, although any criticism of government intervention in the private sector is probably moot given present circumstances.

A legislative approach emerges

There is a blunter approach, of course. Some US politicians are looking to legislate their way around the problem. Earlier this year, two Wisconsin congressmen introduced the Medical Supply Chain Security Act, which could give the US Food and Drug Administration (FDA) the right to identify sourcing locations for medical supplies, while a separate bill, the Pharmaceutical Independent Long-Term Readiness Reform Act, would require the US Department of Defense to purchase only US medicines, as the military’s indirect reliance on Chinese supply could well constitute a national security risk.

Other US lawmakers believe that moving bulk production of APIs away from China in favour of US territories and/or more reliable regional locales – such as Puerto Rico and Mexico – should be the preferred method of guaranteeing supply.

Low labour costs and lax regulatory regimes

This last point highlights two of the main themes that are likely to transform the way in which companies develop their supply chains in the future: to ensure reliability of supply, and an onus on localism/regionalism.

The draw of relatively low labour costs and lax foreign regulatory regimes has proved irresistible to western manufacturers over the past 30 years, but some of the inherent cost benefits of emerging market economies are under threat due to their success in expanding their wealth base.

The rapid growth of China’s middle-class and the nation’s pivot towards the domestic consumer market provides a case in point. It is the reason why advanced economies are inevitably forced up the value chain (increased value-add production) if they want to compete – they certainly have not been able to on price.

Manufacturers might think twice about offshoring production if they believed labour cost benefits would dissipate over time. Indeed, China has already moved much of its low value-added manufacturing to neighbouring countries, such as Vietnam and Thailand.

Over the years, western companies have attenuated supply chains in a bid to drive down costs, while optimising working capital and reducing inventories – or locked-in capital – but the pandemic has forced a rethink on priorities, with cost efficiencies losing ground to security of supply.

Resilience the new buzz word

A recent report published by McKinsey – Resetting supply chains for the next normal – included results of a second-quarter survey of senior supply-chain executives from across industries and geographies, and showed that 93 per cent of the respondents said they were planning to increase the level of resilience across their supply chains.

Technology will play a key role in realigning supply chains. Knut Alicke, McKinsey Partner and co-author of the report, believes that “digitization is likely to accelerate and as a result supply chains will become more agile, transparent, integrated, which will help lead to risk resilient supply chains”. Supply channels could even move a little closer to their end markets, as Mr Alicke revealed that “many heads of supply chain are looking into regionalisation as one response to increase resilience”.

The industrial disruption brought about by the pandemic may convince some manufacturers of the desirability of having two or more sources of supply for raw materials or industrial inputs.

They could even opt for the failsafe option of expanding inventories to cover any potential production outage, or one-offs crises such as Covid-19. Such a move would result in reduced inventory turnover, and increased inventory-to-sales ratios, developments that would seem out-of-step with prevailing wisdom on the optimisation of capital allocations. Not that long ago, these measures would also have been anathema to purchasing managers, but ‘resilience’ is fast becoming the key consideration in the formation of many supply chains.

Realigning supply chains in response to ESG mandates

Businesses will always attempt to drive down their costs, but with today’s key target demographic more keenly attuned to the wider impact that business has on society and the environment, they would be foolish to ignore the growing threat posed by reputational risk in the social media age.

Stakeholder expectations for risk screening and due diligence are increasing due to the focus on socially responsible investments, with ever greater attention paid to environmental, ethical, and human rights risk monitoring. Naturally, the risk is heightened for publicly listed companies, which always struggle to avoid the limelight.

A slew of environmental pledges from auto manufacturers, oil companies, et al, is forcing a rethink on supply chain management. Research from McKinsey suggests that up to 60 per cent of a manufacturing company’s carbon footprint is linked to the supply chain.

But reducing the environmental impact of supply chains has often proved problematic, as it has been difficult to accurately assess which links within the chain are readily addressable in terms of carbon emission reductions. But there are other considerations which are bound up with environmental, social and governance (ESG) investment objectives. 

Supply chains generally fall outside of a company's central operations, so management’s influence over the way that goods are assembled and/or sourced is often limited, particularly if production is carried out on the other side of the world. That said, the recent experience of boohoo (BOO) suggests that problems linked to employee welfare are not the preserve of foreign locales.

The danger exists that business practices undertaken within remote supply chains can be difficult to monitor, potentially obscuring the types of risks that run counter to their ESG policies. However, that is becoming less of an issue now, due to the spread of digitalisation within the logistics industry, and the application of technologies such as blockchain, machine learning, and augmented reality.

Digitalisation and automated production processes 

It does not stop there. Beyond any political posturing, beyond the rhetoric over reshoring and increased protectionism, another reason we will witness a trend towards truncated supply chains will be the continued roll-out of automated production processes.

So, while industrial production could conceivably return to post-industrial economies such as the UK, many of the jobs it used to support may not, certainly within specialised corners of industry.

Fused deposition modelling (FDM), a variant on 3D printing, provides a case in point. It is already being utilised for prototyping within the aerospace industry, and for the widespread production of customised fixtures and parts for the medical device industry, including those used in prosthesis. Research from Deloitte points to the growth of 3D printing for use in metal-parts fabrication – a huge addressable market. Advanced in-house production technologies may be in their infancy, but there are clear incentives for manufacturers to go down that road.

A company such as Amazon (US:AMZN), which has been at the forefront of utilising emerging technologies through automated and robotic solutions for order despatch and inventory control, would be only too willing to embrace increased in-house production if circumstances allow. It has already increased the proportion of its own lower-cost (higher-margin) products for sale on the platform, in addition to white-labelling products from other sellers. Where Jeff Bezos goes, others will follow.

In response to increased household demand during the global pandemic, retailers and e-commerce companies have been optimising their warehousing capacity, while distribution centres have been turning to technological solutions, including a significant step-up in the use of cloud computing, to assess inventory levels, predict likely shifts in demand, and determine appropriate capital allocations in response.

Warehousing has gone resolutely high tech. The value of a company such as Ocado (OCDO), which has had its share of detractors, is now totally bound-up with its proprietary technology. It essentially offers an integrated service for its retail clients, including supply and inventory controls, customer software for websites and mobile apps, and even software designed to optimise delivery routes and the operation of contact centres. From September 2020, retail analysts will be paying close attention to how the logistics operator fares in its new commercial relationship with Marks and Spencer (MKS).

Supply chains are evolving, and the ability to adapt to new industry catalysts and wider social change will set apart quality businesses from the also-rans. We have identified a pair of industrial titans, whose success has been largely predicated on their ability to seamlessly intertwine their procurement, production, and logistical capabilities, to achieve leading market positions in their respective industries.