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Knowledge at Wharton


Coronavirus and Supply Chain Disruption: What Firms Can Learn

Businesses dependent on global sourcing are facing tough choices in crisis management

Published: Wednesday, May 13, 2020 - 12:02

Long stretches of empty supermarket shelves and shortages of essential supplies are only the visible impacts to consumers of the global supply-chain disruption caused by the Covid-19 pandemic. Unseen are the production stoppages in locations across China and other countries and the shortages of raw materials, subassemblies, and finished goods that make up the backstory of the impact.

The Coronavirus Disease 2019 (Covid-19) outbreak is unprecedented in its scale and severity for humans and supply chains, not to mention medical professionals and governments scrambling to contain it.

Businesses dependent on global sourcing are facing hard choices in crisis management amid the supply chain disruptions. But in planning to mitigate the risks of similar disruptions in future, they confront other questions that have no easy answers: Should they broaden their supplier choices, or do more local or near-shore sourcing? How much inventory of raw materials, subassemblies, and finished products should they stock to tide over the crisis?

The impact of the coronavirus pandemic on global supply chains is “a major disruption, along the lines of having an earthquake or a tsunami,” says Morris Cohen, Wharton professor of operations, information, and decisions. “This is an unprecedented type of disruption. I don’t think we’ve ever seen anything quite like this.” Cohen is also co-director of the Fishman-Davidson Center for Service and Operations Management at the school.

The uncertainties ahead swing between extremes. As the shortages worsen before they get resolved, prices of many products could go up for consumers even if laws exist against price-gouging, says Cohen. At the same time, constrained supplies could cause declines in demand, which in turn may end up weakening prices. “All those things will happen and have already happened. There’s no magic answer here.”

Medical supplies are the priority

The choking of supply chains is “a second-order problem,” and the foremost priority is to ensure the availability of medical supplies, Senthil Veeraraghavan, Wharton professor of operations, information, and decisions, said in an interview with the Wharton Business Daily radio show on SiriusXM. “The first-order problems have to do with medical devices, medical products, protective equipment, masks, screeners, disinfectants [and so on], which are critically necessary for providing care for people we are going to see getting infected over the next few months,” he said.

Veeraraghavan noted that the United States alone needs a “supply chain ramped up for about 100 million people to get tested and taken care of,” based on predictions for the number of infections. With social distancing, the peak demand in the United States for testing kits is an estimated 5 million or 6 million, he added.

Getting those testing kits to the right locations across the country is the next big challenge. “This is why a lot of epidemiologists and supply chain [professionals] are suddenly talking about what we call flattening the curve, to help with production smoothing,” said Veeraraghavan. (Production smoothing, or production leveling, refers to removing unevenness in the supply of intermediate goods in manufacturing processes.)

Parallels from the past

The 2011 earthquake and the tsunami it unleashed on Japan is probably the closest comparison to the coronavirus outbreak in terms of the extent of disruption to supply chains, says Cohen. “It was also unprecedented, had a global impact, and it had multiple dimensions. Coronavirus is also a natural disaster. This is not something caused by the actions of governments or policies or economic actors.” Marshall Fisher, Wharton professor of operations, information, and decisions, also pointed to the 2011 tsunami as a watershed period for supply chains, and included the 9/11 terrorist attacks, the 2008 Great Recession, and the health scares around the Ebola virus in 2013–2016 and SARS in 2002–2003, among key disruptive events.

Although the 2011 earthquake and tsunami were short-lived, “we’re living with the consequences to this day,” Cohen continues. The tsunami caused a cooling failure and a meltdown at the Fukushima Daiichi Nuclear Power Plant, triggering the release of radioactive waste that still continues, he notes. “Many factories in that part of the country were closed, and they were suppliers of key parts to supply chains all over the world. It took weeks and weeks for companies to recover.”

The northeastern region of Japan that the earthquake hit was home to many factories manufacturing semiconductors, auto parts, and other components for export, and crippled manufacturing in China, for instance, according to a Knowledge@Wharton report at the time.

Honing risk mitigation strategies

Businesses have sharpened their risk mitigation tools after each successive disruption to supply chains. For example, after the 2011 tsunami, “companies like Cisco and Boeing have invested substantially in supply-chain risk management policies, strategies, and infrastructure so that they can be aware of [such] an event and understand its consequences,” Cohen says. “Now, there’s a fairly well-understood methodology, and most major companies have some kind of supply-chain risk management process in place.”

However, those risk management processes are not robust enough to cope with the fallout of the coronavirus pandemic, Cohen says. “This is unprecedented in its scale and in the extent of it. We’ve never seen a disruption like this where... a large number of countries are telling their populations to stay home, to not work—there are lockdowns all over the world.”

Businesses will surely revisit their strategies on sourcing raw materials, subassemblies, or finished products. During the past two decades, the concept of supply diversification has focused on continually driving down costs, said Veeraraghavan. Companies such as General Motors, which have sizable demand for their products in both the United States and China, benefit from locating production capacities in both countries to be close to their customers, he noted. Consistent with that strategy, it would benefit U.S. businesses to have “some amount of supply capability” that they can ramp up to deal with the outcome of a pandemic like coronavirus, he added.

“It is a prudent idea for companies to invest in the resilience of their supply chains—and this has become more important than ever before,” Veeraraghavan continued. “Given that we are living in a global economy with a lot of people traveling all over the world, we’re going to have such public health crises—hopefully infrequently—for sure in the future.”

Companies could “stabilize their supply chains” in multiple ways, such as enlisting new suppliers, boosting inventories, or investing in omnichannel distribution that includes online sales, according to a McKinsey report on the implications of the pandemic for businesses.

The benefits of timely action

“All those are great ideas of ways to mitigate the risk, and they can be effective, but unfortunately, most of those are based on decisions that you have to make before the event occurs,” says Cohen. “It’s hard after the event occurs to go find alternative suppliers or redesign your product or your process or introduce new technologies. Those are all great things to do in the long run.”

“There’s always been pressure or incentives for companies to maximize efficiency and reduce costs, finding the lowest-cost supplier and the most efficient producer or distributor in the world and to go after that,” says Cohen. “On the other hand, if you end up with a single source, you’re vulnerable to risk. And that’s what is playing out now.”

There’s always a fundamental trade-off between costs or return, and risk, Cohen notes. “This will tip the balance more toward trying to mitigate risk, which means that going to the low-cost producer and giving them 100 percent of your demand may look very risky now. Companies may start to want to hedge their bets and have alternative suppliers more than they would have in the past.”

Another possibility is that businesses could be persuaded to source more of their needs locally. Cohen points out that the pharmaceutical industry is particularly challenged now, since “the vast majority of the active ingredients are manufactured in China.”

Mitigating risk by adding new suppliers is not an easy solution, though. “There will be more pressure [on businesses] to make those investments and perhaps absorb a higher cost of sourcing things so that they have a higher insurance against these disruptions,” says Cohen.  “It comes at a price. If you want to mitigate risk and absorb uncertainty, you have to make investments and pay a price.”

There are two schools of thought regarding how businesses could plan for those unforeseen risks, says Fisher. “One is you try to identify the risks that might happen.” However, “had anybody been making up a list of potential risks, I’m not sure this [Covid-19 pandemic] would have even been on the list. The other school of thought is to identify all the different things that might disrupt supply.”

But companies don’t need to go through that exercise, says Fisher. “Just take it as a given that something could disrupt your supply. The prevention is either keep a buffer stock in inventory or have multiple sources of supply, geographically separated. Or you could do both.”

However, the disruption in supply chains caused by Covid-19 is “the mother of all disruptions,” says Fisher. “How do you do geographic mitigation of supply when the whole world is involved?”

Be proactive and agile

Being proactive is critical, according to Cohen. “If you want to be prepared for the occurrence of a random risk, then you have to make investments and decisions upfront, before the event,” he says. “You have to buy that insurance by making those investments. But once the event has occurred, as in this case, many of those strategies take a long time to implement; they may not be feasible at this point. It’s hard for a company that has its main supply coming from China to go find an alternative supplier. Maybe there isn’t one. Maybe the alternative supplier is also disrupted. The problem is they’re not going to find enough capacity to replace what was lost in many cases. It’s just not feasible.”

For sure, there are exceptions that have demonstrated superior supply chain agility. Fisher recalls how a fire in 2000 at a Philips Electronics semiconductor plant in Albuquerque, New Mexico, disrupted the supply of chips for Nokia of Finland and Ericsson of Sweden, which needed them for the mobile phones they manufactured. Philips needed weeks to get the plant back up to capacity, as The Wall Street Journal reported, but Nokia deployed a crash plan to cope with the crisis.

Within two weeks of the fire disrupting chip supplies from Philips, Nokia “redesigned chips on the fly, sped up a project to boost production, and flexed the company’s muscle to squeeze more out of other suppliers in a hurry,” according to the Journal. Ericsson lost nearly $400 million in potential revenue that year, and eventually became part of Sony of Japan.  Like that episode, “there have been lots of events in the past that have been wake-up calls for companies that disruptions can be a big deal in your supply chain,” Fisher adds.

In the current situation, in order to overcome capacity shortages, more capital is needed for production planning and equipment delivery, Veeraraghavan said. The transportation industry, for instance, will need that additional capital as it faces both supply and demand constraints, he pointed out. “I’m not sure every company that’s facing a crisis right now has enough capital to last them for the next few months. I do see governments having to play a role [here] at some point, for sure.”

In addition to governments, multiple other actors would have to come aboard to address shortages of various products, almost like “a war effort,” said Veeraraghavan. He noted, for instance, that LVMH, the French maker of Dior and Givenchy perfumes and cosmetics, has decided to repurpose its production lines to make hand sanitizers to cope with shortages in that country.

The fallout of the coronavirus pandemic on supply chains will also likely strengthen the hands of critics of globalization. “Absolutely; it’s going to have an impact on that whole debate,” says Cohen. A March 2019 paper Cohen co-authored with Stanford University professor Hau L. Lee examines the impact of changing government policies on designing supply chain networks. Those changing government policies have taken the form of trade wars, such as those between the United States and China; protectionism; and efforts to bring back American manufacturing jobs lost to China and Mexico.

“Are people going to hit the pause button on globalization?” Fisher asks. “That was already happening for a number of reasons, including the tariffs and trade wars with China and other regions, and Brexit. Trade disruptions are already causing companies to have to rethink how they approach globalization and basically do less of it.”

Long road to recovery

The pandemic’s disruption to global supply chains will have a long tail. “Supply chains are a problem so sticky that they take time to resolve,” said Veeraraghavan. Even if production “comes back to 100-percent levels, let’s say as about six months back,” there will be delays of up to a few months in getting products to consumers, and that situation will continue until fall 2020, he added. It is precisely because these disruptions take a long time to wear off that it is important for companies “to have [sufficient] capital to last this period of lull,” he said. Meanwhile, China seems to be on the rebound, according to Veeraraghavan. “[We are] seeing some life for production and consumption coming back in China,” he said. Apple, for instance, reopened all its 42 stores in China in early March, he noted.

Businesses that have already invested in supply chain risk mitigation will be able to bounce back faster than others. “The reason that companies maintain these networks of locations around the world and have multiple factories and multiple suppliers is precisely to respond as events occur by shifting production and shifting sourcing,” says Cohen. Redundancy is built into that diversified supplier base, which enables a quicker rebound, he adds. “This is like buying a real financial option, and you either exercise that option or not.”

According to Cohen, “the capability of global supply chains to recover [from the Covid-19 fallout] is fairly strong.” Many businesses have already invested in redundancies to absorb the risks of supply chain shocks, he says. “I think they’ll respond quickly. I’m going to be an optimist here.”

Signs of optimism are visible also in the progress in select regions in containing the pandemic. Fisher points to data on the global spread of Covid-19 as tracked by the Center for Systems Science and Engineering at Johns Hopkins University, which shows a sharp drop in the number of new cases after reaching a peak in China’s Hubei province and its capital, Wuhan, where the outbreak first began.

Fisher nots that the number of new cases in Hubei peaked on February 13 at 14,840 cases, but by March 13, that number had fallen to five, according to the Johns Hopkins data. That extent of containment shows how effective social distancing, self-quarantine, and testing could be, he adds.

So, is the end of the coronavirus pandemic within sight? “If everybody enacts identification of who has [the infection] and isolates them, and [with] all the aggressive [measures that are] going on now, it has the potential to be over in a month or two,” says Fisher. However, if people just go back to life as normal, and don’t change the way they live or practice hygiene, it could blow up all over again.”

The repercussions of Covid-19 could extend far beyond supply chains. “This is almost an issue that we all face as individuals, thinking about how this will change our lives,” says Fisher. “Maybe the world will become less materialistic, or consumers will be less materialistic. Many of us have multiples more of material goods than we actually need to lead a happy life.”

First published March 17, 2020, on Knowledge@Wharton.


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Knowledge at Wharton

Knowledge@Wharton is the web-based research and business analysis journal of the Wharton School of the University of Pennsylvania. Launched in May 1999, its goal is to disseminate business knowledge and insights to readers around the world. The Knowledge@Wharton Network offers free access to analysis of current business trends; interviews with industry leaders and Wharton faculty; articles based on the most recent business research; conference overviews, book reviews, and links to relevant content; and a searchable database of more than 1,500 articles and research abstracts.