The rise of the emerging economies, fluctuating prices in commodities, the lingering effects of the global financial crisis and an unprecedented series of natural disasters are forcing major transformations in the global supply chain. Last year’s tsunami in Japan and floods in Thailand, which produces a fourth of the world’s computer disk drives, managed to shut down or delay production lines around the world, illustrating both how interconnected the world’s manufacturing has become and how vulnerable manufacturing has become to unforeseen events in places that on the surface might seem distant and unrelated. After the Japanese tsunami, Apple faced a sudden shortage of lithium ion batteries for its iPod because the factory it had subcontracted to in Japan couldn’t receive the chemicals it needed to create an essential polymer. The factory in Japan was not damaged, but the port that was needed to transport the battery was. Camera stores in New York and Switzerland were unable to meet the market demand for Nikon’s new D7000 camera, because although Nikon is a Japanese company, critical parts for the camera were being made in factories and Thailand that were damaged by the floods, which the World Bank described as the fourth most costly natural disaster in history. Even without a major natural disaster, the growing threat of protectionism and increasingly volatile fluctuations in the prices of commodities ranging from oil to minerals, copper and even steel, mean that global supply chain managers need to be constantly alert and prepared for the unexpected.
For most companies, the advantages in global outsourcing remain compelling, and focusing on the supply side of the business model tends to be a more effective way of increasing profits than concentrating on expanding sales and market share alone. Our research indicates that lowering supply chain costs by 10% produces a 60% increase in profits, while increasing market share by 10% is only likely to produce a 40% increase (see table 1)
Because of duality of globalization and protectionism, the rise of emerging economies and recent financial crises, we contend that the business model for approaching the global market place is now fundamentally different than it was in the past. We see five major transformations taking place:
- The current model is moving from market-driven to customer and supply chain-driven
- A growing number of businesses are moving from internal innovation to “open” innovation
- The most recent trend is from “made in China” to “designed in China” and “made in China for China.”
- Smart companies are moving from arm’s length financing to joint financing.
- Leading corporations are broadening risk assessment to a global level with a particular focus on complex risks in which one event may trigger another that ultimately breaks the chain.
From market driven to customer and supply driven
The economic slowdown combined with the increasing commoditization of goods and services means that it is increasingly difficult to compete on price alone, and more to the point, it is no longer possible to rely on the market by itself when it comes to defining a business strategy. The key to increasing profits in the current environment is to focus on exactly what it is that the customer really needs, and to take a radically innovative look at how to take advantage of the supply chain side of the equation.
Ryanair, the Irish airline, illustrates this approach. The company earned hundreds of millions of euros in profits while most other airlines were either losing money or fighting to hold onto business during a brutal economic climate.
Instead of scrambling to attract customers in a shrinking market, Ryanair’s CEO, Michael O’Leary, decided to make the economic downturn work in his favor. First, O’Leary realized that in a recession, cash-strapped customers were more likely to make decisions based on cost than anything else. Second, he reasoned that, in order to shore up their bottom line, the more established airlines confronted with falling passenger demand would sell off the planes they no longer needed at a fraction of the price they had originally paid for them.
O’Leary went on a buying spree, acquiring planes at a steep discount and building Ryanair’s fleet at a fraction of the price paid by competitors. As airlines jettisoned less profitable routes, O’Leary snapped them up, taking advantage of subsidies offered by isolated localities, desperate to pay a premium for access to a commercial carrier. When the French port of Marseilles objected to Ryanair staff working on Irish labor contracts instead of more restrictive French ones, O’Leary simply re-routed his planes just across the border to Spain. Ryanair’s customers, he reasoned, wouldn’t mind the inconvenience if it meant being able to travel at an affordable price.
To make the plan work, O’Leary took advantage of a wide range of incentives and tax advantages that other airline executives tended to overlook. Ryanair makes a profit of around €300 million a year, but recoups anywhere from €600 million to €700 million a year in tax rebates, government subsidies and reduced landing charges. The key to O’Leary’s success is the expansion of his business strategy to include “sourcing” as well as pricing and customer needs. The mistake that O’Leary’s competitors had made was a failure to see the sourcing side of the game.
The savings that O’Leary was able to leverage by emphasizing careful purchasing and negotiating his costs amount to more than double the company’s profits. Had O’Leary only paid attention to customer demands, he would have secured landing rights in Marseilles instead of exploring an alternative in Spain. The company would have been far less profitable.
In a stagnant or shrinking market, much more effort is required to attract new customers while the returns are likely to be smaller. We argue that it is possible to extract greater profit for the bottom line by increasing supply chain efficiency and taking advantage of the potential for innovation of the supply network. Of course, no one wants to neglect customers. The trick is to include the supply chain in the calculations and to find the best combination of all these elements.
From internal innovation to “open” innovation
In a period when products and services are reduced to commodities that all seem alike, and competition drives prices down, innovation is an essential means of differentiating one product from another. Every company makes an effort at being innovative in producing its own products, but in the current environment it can be even more productive to look for innovative ideas from the suppliers, who can prove to be closer to and more knowledgeable about the products that they are actually producing.
In 2002, the Dutch firm Royal Numico, a leading producer of baby food, tackled a highly competitive, shrinking market by turning to one of its suppliers, Babynov, a former yogurt company, headed by Roger Beguinot, a French entrepreneur. Beguinot had developed an ingenious plastic packaging concept that let mothers save time by preparing easy-to-serve baby food at ambient room temperature. Beguinot realized that mothers, pressed by hectic schedules, were likely to feel guilty at spending less time with their infants, and would consequently be ready to pay extra for a premium brand as compensation. The product innovation enabled Numico to increase its profits dramatically, despite a declining birthrate that threatened to shrink the customer base. Numico’s emphasis on innovation led French competitor Danone to buy the company in 2007 for €12.3 billion—roughly 22 times Numico’s earnings.
Procter & Gamble, one of America’s longest surviving corporations, literally redefined itself from a manufacturing company to a corporation focused on “creating and building brands.” By 2003, P&G, which had previously manufactured detergents, beauty aids and a variety of products with its own proprietary equipment, had moved towards becoming an aggregator of products made by a wide range of suppliers, and it was outsourcing a growing percentage of its manufacturing.
As part of P&G’s changing corporate identity, CEO A.G.Lafley adopted a “connect and develop” strategy which called for acquiring more than 50% of its innovation from outside the company. Lafley had realized that efforts to rely on in-house research and development (R&D) was stretching the resources too thin, distracting from core operations. Innovation, P&G concluded, was the key to providing sufficient value to offset the higher prices of P&G’s premium products.
Unilever, one of P&G’s main competitors, arrived at a similar conclusion. After finding that it was spending €891 million on R&D and €26 billion on suppliers, Unilever reasoned that if suppliers were spending 6% of their revenues on R&D, then Unilever was effectively investing €1.5 billion in the R&D of each of its suppliers. If the company failed to take advantage of that research, it was simply handing it to competitors.
Apple, a corporate leader in innovation and a company that is notorious for insisting on its own proprietary hardware, also found that some of its best ideas by paying attention to outside suppliers. In 2001, its senior vice president for hardware engineering at the time, Jon Rubinstein, made a routine tour of Toshiba’s computer hard disk manufacturing facility. Toshiba had just developed a tiny 1.8” hard drive. Toshiba’s engineers complained that they didn’t really know what to do with their creation. As it turned out, Apple did. The drive was the missing component needed to make the iPod possible. It changed the music business forever and the company along with it.
From “made in China” to “designed in China” and “made in China for China.”
Manufacturers originally went to China looking for cheap labor. The expectation was that the design and technology would come from the west, and that workers in China would assemble the pieces without doing anything more than they were told. China’s emphasis on education and especially on engineering is changing that early formula. China is not only matching the West when it comes to developing university-trained talent. It has made a commitment to go considerably beyond. In 1998, Chinese universities and colleges produced 830,000 graduates a year. In May, 2010, that number was more than six million.1
With a large pool of qualified and creative talent willing to work for wages that are considerably lower than in the west, China is fast developing as an important source for innovation and new ideas. Significant resources and manpower are being employed in a growing number of highly sophisticated R&D centers.
The result has been a steadily increasing emphasis on designing and developing goods in China itself. The better salaries and higher living standards are now leading major western companies to begin researching tastes and preferences in China. In one example, PepsiCo, maker of Pepsi, Lay’s potato chips and Quaker Oats, is building a massive R&D center in Shanghai that will include pilot plants for each product area so food scientists can quickly test new offerings created for Asia, including regional varieties, and get them to market within months.
The Swiss pharmaceutical giant, Novartis, is spending $1 billion on a six-building campus in Shanghai that will become a third global R&D center. This is not for outsourcing or a cheaper place to run drug trials. It will be a primary research site.
Major brands from Louis Vuitton to Apple and even Coca Cola now see China as having the potential to develop into their single biggest market.
From arm’s length financing to joint financing: Re-thinking the supply chain
Traditionally companies tried to squeeze the lowest price possible out of suppliers. That approach inevitably created an adversarial relationship that was far less productive than a partnership in which both worked together to make the most effective use of their combined assets. More can be gained by encouraging the supplier to move towards innovation than by imposing cost-cutting on materials and labor. A more enlightened approach is to leverage R&D through the supplier. The supplier with the best technology is in a better position to help the corporation compete effectively, and the potential for increased profit outweighs the risk that a competitor will gain access to a corporation’s technology through the supplier. Developing a collaborative relationship is the fastest approach to improving the bottom line. This is a dramatic change of thinking from business in the past and it requires input at the highest level from the corporation’s management team.
Assessing risk in a more complex globalized world
The eruption of an Icelandic volcano in 2010, and the tsunami in Japan and floods in Thailand last year underscore the importance of calculating risk in any global supply chain. In the past, responsibility of dealing with suppliers was often entrusted to a single, mid-level executive, who was responsible both for finding suppliers and for vouching for their reliability. That was largely enough when companies were vertically integrated, but it is not enough in a world in which more and more production is globally outsourced. When the corporation is assembling a finished product composed of parts from hundreds if not thousands of suppliers, the key decisions and oversight need to be made at a senior management level. This is even truer when it comes to assessing risk and working out a plan to deal with possible ruptures. What distinguished the Japanese tsunami, the floods in Thailand and the volcano in Iceland is that all three of these disasters were unimaginable before they actually took place. The fact that no one could have predicted them in advance did not lessen the impact on companies that were unprepared for a disruption in their supply chain.
A recent study by the World Economic Forum recommends that instead of trying to predict future disasters, companies need to have backup plans in place and alternative solutions for any disruption in the supply chain. A survey for the World Economic Forum of a large number of leading companies found that 90% did have emergency plans, but that these plans tended to focus on internal company operations or on the local area around the company. It is clear that a risk strategy increasingly needs to look at the company’s operations from a global rather than a local perspective. As one analyst put it, events have local effects but global implications. The risk factor is further complicated by the fact that the real danger to the supply network may come from an event that has been triggered by another event. After the tsunami in Japan, for instance, Apple was cut off from its supply of lithium ion batteries for its iPods. The company in Japan that produced the batteries had not been affected directly by either the tsunami or the earthquake that triggered it, but the sea ports that the company depended on for shipments of chemicals needed to manufacture a special polymer used in the batteries were closed, so the company had to stop production and Apple’s supply of batteries from that factory were effectively halted for several weeks.
Calculating risk is not an easy task, and it is in fact becoming a major subject for research, especially when it comes to the complexity created by multiple risks coming together. The potential dangers that need to be taken into account include:
- natural disasters and weather (successive and unusually intense cyclones, etc)
- political disruptions, terrorism and piracy
- import/export restrictions and embargoes
- financial crises and currency and commodity price volatility
- brand and public perceptions of labor conditions
- medical pandemics (bird flu, swine flue, etc)
- unexpected disruptions of transport routes (e.g. a naval blockade of Straits of Hormuz)
The bottom line:
Although the global supply chain concept is turning out to be more complex and a great deal riskier than many companies understood at first, it still remains the most effective approach to cutting costs and having a positive impact on a company’s bottom line. In most cases, an effective global supply chain can produce savings of anywhere from 40% to 80%. Even more significant, it offers a diversified source of talent and expertise at prices that cannot be beat anywhere else. The cross-fertilization of ideas and an expanded access to R&D and innovation that result are difficult to match. The greater demands that the transformed global supply chain places on senior management are undeniable. At the very least, senior management needs to evaluate each situation on its own merits and to search for the right balance. It is a new world that requires skills and a broader, far subtler vision of the global operating environment than was ever required in the past.
About the authors
Winter Nie is Professor of Operations and Service management at IMD. Dr. Nie’s areas of research interest are service management, low cost competition, and extended supply chain. She has written several books: In the Shadow of the Dragon: The Global Expansion of Chinese Companies-and How It Will Change Business Forever (2012); Made in China-Secrets of China’s Dynamic Entrepreneurs (2009); and Managing global operations: Cultural and technical factors (1996). She is the author of many articles, case studies, and book chapters. Her research has appeared in both academic and practitioners’ journals. Professor Nie has provided training programs for and consulted with companies in pharmaceutical, telecommunications, automotive, food and beverage, machinery, clothing and fashion, and electronics industries as well as financial and professional services.
Professor Carlos Cordón’s areas of interest are supply and demand chain management, manufacturing management, process management, and outsourcing. He is currently developing research in the following areas: leading customer supplier relations, supply chain configurations for speed, and types of supply chain structures per industry (pharmaceutical, electronics, fashion, food, and transportation). He is the author of numerous articles and case studies in these fields, and over the past few years has won many prizes for his cases and articles.Professor Cordón is also a consultant to multinational companies and holds a PhD in Management from INSEAD.
1.International Herald Tribune, Nov 25, 2010