Supply Chain Ripple Effects — Because they matter
Why Supply Chain Ripple Effects Matter
Competitive environments are made up of a collection of industries that produce different types of goods and services. Each of these industries has corresponding supply chains that source inputs which are turned into outputs — and value — for that industry and its associated businesses. Supply chains differ by industry, of course. Manufacturing companies, for example, are more dependent on refined raw materials than are financial services companies. Yet, manufacturing companies are also dependent on services (inputs) from, let’s say banks. And correspondingly, banks depend on a certain amount of outputs from manufacturing companies to deliver their services. Such outputs from manufacturing companies are “inputs” into the work the banks do — in the form of computers or other electrical equipment. In this way, industries are linked through a set of input-output relationships.
But why does this matter?
Because “events happen” — ranging from banal to disruptive, from a new marketing campaign to a trade dispute resulting in the introduction of a tariff which may lead to a counter-tariff or other regulatory change to more disruptive events. To take but one example, a particular tariff or regulatory change may not be targeted at your industry. However, it may be targeted at one of the industries that provide inputs to you, with a potential ripple or cascading effects of changes in prices, delays in delivery, or some more extreme impact.
Businesses are buffeted by millions of events that happen globally every day. Yet only a few of them matter. A key question becomes: how do you “amplify the faint signals” from the multitude of events that may impact you from every corner of the world? It’s hard enough to monitor events that directly impact your industry or supply chain. What about those that impact your partners or supply chains that are either sources of inputs or customers of outputs from you? The network of input-output relationships in which you are embedded is complex and given that complexity, not always seen or understood, until it’s too late not to.
So, here’s the blunt reality. A tariff, a regulatory change, or any of a number of business-impacting events may not be targeted at your industry. However, it could still have a material impact on you. The question becomes: how do you figure out if, how and how much such ripple effects could impact you, your business, and your customers? And this is where insights into the degree to which different industries and their corresponding supply chains are linked through input-output relationships become helpful. How? By building predictive “muscle” so that as different types of events occur, you can:
a. Predict what the potential impact may be,
b. Identify which specific inputs/outputs (we call them capabilities) and their corresponding KPIs (key performance indicators) are likely to be impacted
c. Strengthen traceability between events through “cascade lanes” of potential impact across industries and capabilities and consequently,
d. Mitigate specific risks from events before they happen.
Two more points before we explore ripple effects across different supply chains.
First — on partner networks and how insight into them is aided by input-output insights.
Partner networks have a simple objective: to provide capabilities you need either because you don’t have them, or you want to strengthen them. Many partners come from industries outside of your own. As is well known, insight into who your Tier 1 partner and what it is that they deliver to you is clear — and typically contractually aligned. However, insight into your Tier 2 and Tier 3 and so on seldom exists. Which is problematic since risk exposures on your expanded (Tier 2 and beyond) partner network can cascade to create both risk and financial exposures on you. Resilinc, a supply chain risk monitoring company, estimates that over 50% of most company’s risk exposures come from their Tier 2 and other partners. The problem is: there is little way to identify such exposures until they happen; in short, until it’s too late.
There are algorithmic methods that predict and quantify the risk exposure of your expanded partner network — a topic for another post. Insights into supply chain dependencies across industries can help anticipate what types of ripple effects are likely to occur and thus what parts of your partner network to monitor.
Second — so what can we really do if a shock is outside of our control?
Having foresight and traceability — from different types of events or shocks across differing supply chains is clearly helpful to re-allocate resources to mitigate risk. But what else can be done, really?
After all, industries that receive shocks pass those shocks onto other industries that need their products as inputs into their supply chain. What can you do, for example, as an industrial manufacturing company if such shocks are part of an overall industrial shock in a different industry from yours — e.g., a steep tariff on rare minerals that impacts the price of electronic componentry? The answer is, it depends. On a) the expected duration of the shock, b) extent of the price shock and whether or not it could easily be passed on to your customers, and critically, c) the ease/cost of substitution of the particular inputs impacted. Industry shocks may be more important due to the inability to easily substitute across inputs. Perhaps. But, here’s our point. This is *precisely* the topic executives should be focusing on: re-assessing the strategic implications of their sourcing strategies, the design of their partner networks, and the degree to which they can shift sourcing in support of specific/granular capabilities under different conditions. Of course, having and executing on tactical plans to respond quickly to supply shocks are important. But, predictive insights in support of such strategic considerations will strengthen tactical plans and make them more effective and arguably, less costly.
Supply Chain Ripple Effects
Supply chain dependencies can be assessed, and visualized, through input-output linkages. Such linkages vary across time given changes in products, technologies, and what is needed *as* inputs. Pragmatically, this means that insight into what makes up these changes provides foresight into how ripple effects will occur within your business and the specific capabilities and KPIs likely impacted as a result. We’ll cover how to derive such foresight algorithmically in another post. For now, the point is simple: supply chain dependencies highlight potential ripple effects and consequently potential risk exposures to different types of events, or shocks. The extent of these dependencies change over time. Such changes can be monitored to predict the changing competitive structure of your particular industry through amplifying the faint signals of change in those of your partners from other industries. But first things first.
The table (fig.1)below depicts dependencies across 16 different industry supply chains. The table depicts the degree to which the output of any particular industry (the rows) is consumed by other industries (the columns).
For example, 7% of the metals industry is purchased/consumed by the Petroleum Industry, and 31% by Food and Agriculture industry. Implication? Shocks on the metals industry would primarily impact the Food & Agriculture sector, followed by Petroleum.
The input-output relationships can be visualized differently to highlight what is known as the “centrality” of individual industries. Centrality highlights the extent to which a particular industry is connected to others — e.g., how “central” it is. Measuring network density can shed light on the extent to which shocks are likely to propagate throughout the economy through input-output linkages. The same technique is used to identify and consequently predict the ripple effect of different types of risk exposures on one’s partner network.
So what and why does this matter?
Shocks happen. They have ripple or cascade effects across capabilities that make up a supply chain as well as differing supply chains and partner networks. Ripple effects consequently create exposures with potential implications on both financial and operational metrics. Surprises in supply chains are never a good thing. Any insight to lower the likelihood of surprises can save time, costs and revenue. Being able to respond quickly to events once they happen is a necessary “organizational muscle” to have. Being able to predict what is likely to occur and consequently adjusting appropriately is a differentiating muscle to build. Amplifying the faint signals of shocks and predicting their specific pathways of potential impacts — on capabilities, through partner networks, through supply chains, and onto specific KPIs — is one way to begin strengthening this muscle.
The adjacent figure depicts the degree of trade dependencies across countries. Both the x-axis and y-axis are made up of countries — the darker the color, the greater the dependency between them. (Source: Global Supply Chains in the Pandemic paper by Barthelemy, Huo, Levchenko and Pandalai-Nayar; IFM Conference on Extreme Events on Global Economies, November 6, 2020.)
In a similar vein, the following depicts the mutual interdependencies of a set of industries — either as sources of inputs or as customers of its outputs/products (with the darker again indicating the greater the dependency.) (Source: UNCTAD and World Bank Input-Output Table, ClearPrism Data Science Analysis).
For both, the point is clear — ripple effects exist across partners, industries and geographies. The degree to which they may occur, however, depends on three considerations:
1. The extent of the dependency — e.g., from a company, industry and/or supply chain perspective, or based on the degree to which suppliers and/or customers are “from” other companies, industries and/or locations;
2. The second degree of impact — i.e., a particular company may source from only a few other industries, but those industries, in turn, may source from multiple others, which creates an exposure on the company in focus if a shock impacts its Tier 2 partners (how you identify both this extended network and your risk exposure to it is the topic of a subsequent post); and
3. The degree to which any particular shock may trigger ripple effects — e.g., a heavy rainstorm may knock out the power in a particular location or say, the data center, of one of your partners, but the likelihood of that event having significant impact on your supply chain or revenue is low and (typically) easily contained. In contrast, more drastic events such as the COVID pandemic (as an extreme case) is systemic causing significant ripple or spill-over effects all over.
Insurance companies, particularly reinsurance companies, model such ripple effects pretty routinely as they underwrite risks they’re being asked to insure against. Often, they make a distinction between an initial “destructive cost” (of an event) and the “loss of economic output” as the result of ongoing performance impacts. In economic terms, the difference between a destructive cost and loss of economic output is one of “stock” versus “flow.” The full impact of any particular (especially severe) event is the combined total of stock and flow losses, with the latter typically being the most difficult to model and consequently plan for and mitigate. (Source: https://axaxl.com/-/media/axaxl/files/optimizing-disaster-recovery.pdf)
And, here it gets interesting.
Risks to one’s supply chain always exist, but a key question is which ones actually “matter” in terms of the likelihood of impacting you directly… and indirectly through ripple effects sourced elsewhere — from locations, partner networks, and even other industries. Another is: what are the specific impacts of the ones that “matter” on your organization’s SPECIFIC capabilities and KPIs?
For now, the point is pragmatically simple: Being able to answer both of these questions is a critical (new?) capability to strengthen your organizational and supply chain resilience. Resilience is often characterized as the capability to respond quickly ONCE a “bad thing” has happened. That’s a fine start but is hardly enough.
It is critical to have the foresight (i.e., predictive insight) into the potential sets of risk exposures and their implications on specific capabilities, partners, locations and KPIs. The combination of “responding quickly” and having “foresight into” is what creates dynamic resilience — and need to become part of the quiver of the demand planning and sourcing toolkit.
1. You have both less and more control of your path forward at the same time — a.k.a., the “whack-a-mole” lesson
COVID requires responses, clearly. Yet, as we have all learned, decisions made and actions taken also trigger responses from others, and those responses, in turn, can lead to subsequent ripple effects. The degree to which you have “agency” depends on a variety of factors, including your degree of “connectedness” that creates exposure to ripple effects from others.
Which helps to explain why a number of organizations — and countries — are rethinking their sourcing strategies. Should we pull back from our dependence on China? Should we pull back from globally dispersed locations? Should we restructure our partner network depending on their locations? And, as some policymakers are thinking aloud, should we go so far as to nationalize critical supply chains to reduce our exposure to both the existing COVID pandemic and yet unknown, but certainly expected future shocks?
Aside from the “being late to the game” or the “shutting the barn door after the cow has fled” adage, discussions of nationalization and sourcing “pull-back” are understandable… but blunt (in the sense of too broad) and, as such, could use some refinement.
Let’s start with the nationalization of the supply chain discussion, and then consider its implication from a global sourcing perspective — because the logic is similar.
Clearly, GDP has contracted significantly due to COVID globally. The graph below summarizes country-specific GDP retraction as of November 2020. (Source: Bonadino, Huo, Levchenko and Pandalai-Nayar, IMF Conference November 2020)
Now, take a look at the following projection of GDP contraction if countries nationalize their critical supply chains. (Source: Bonadino, Huo, Levchenko and Pandalai-Nayar, IMF Conference November 2020).
There is one key point and one key implication to highlight based on the above.
The point? There is no hiding from “ripple effects.” Ripple effects do and always will exist across industries, workforces and locations.
The issue is: What are the sources and extent of potential exposures and ripple effects? If you nationalize, you move the sources of potential ripple effects from trading partners (other locations) and how well they are mitigating risks to how well you are.
You can change your hand position and grip on a balloon in an effort to control and contain it, but parts of the balloon will still, stubbornly pop out somewhere. Or to use a different analogy, it’s like whack-a-mole. You respond to a mole popping up in one part of your garden and it pops up in another.
The same applies to tariffs on a particular industry or location. And it equally applies to your sourcing strategy — and changing that strategy with respect to the types of partners you engage with, the products you need from them, and the locations from which they and your other materials are sourced.
The implication? You have agency, of course. You decide your course of action. But agency doesn’t mean control. Every decision made and action taken has implications on others. Similarly with others and the decisions they make and actions they take — with ripple effects on you.
There are “constraints” and “opportunities” within every event — or shock — of relevance to you. That’s what strategy is all about…figuring out where to play and how to do so under different conditions.
The old game of GO well characterizes how effective strategy — and execution — plays out. In GO, a player (you, the decision-maker) “plays” in different parts of the board at the same time. The objective remains the same: “Win the game.” How you play the game, however, depends on how effectively your moves are in different parts of the board.
Sounds like what we do in the business world every day, yes?
So, the implication becomes: you *can* play “one part of the board” — e.g., nationalize your part of the global supply chain, change where you source your materials, etc. — but only at the cost of being surprised by what’s going on in other parts of the board (or competitive landscape)
Pragmatically, what do you do? Obtain the ability to monitor events, the hundreds of thousands of activities that could impact you, globally. Doing so is vital to identify, predict and thereby more effectively design how to respond based on action and potential ripple effects from others.
1. Granularity matters
McKinsey estimates that 16 to 26 percent of exports, worth $2.9 trillion to $4.6 trillion in 2018, could shift over the next five years as a result of systemic supply chain risk — whether that involves reverting to domestic production, nearshoring, or new rounds of offshoring to new locations. (Source: https://www.mckinsey.com/business-functions/operations/our-insights/risk-resilience-and-rebalancing-in-global-value-chains)
Interesting perhaps, but useful?. To be truly valuable, we need to know more.
What we do know is that the consumer price index fell overall between February and April 2020. That it fell from 1% to a negative value reflects a significant demand shock: in aggregate, folks purchased less given the dramatic amount of uncertainty due to the pandemic.
We also know that consumer spending has changed dramatically, and again, in aggregate, has yet to recover. In the United States, as of late October 2020, total spending by all consumers decreased by nearly 4% compared with January 2020.
But these aggregate pictures masks significant differences by sector.
And here it gets interesting, again.
Prices rose in some areas, such as food and health, but fell significantly in others, including auto insurance and airline travel.
(Source: https://www.imf.org/external/mmedia/view.aspx?vid=6207826242001, paper on Global Supply Chain in the Pandemic, Comments by Lorenzo Caliendo, Yale University, November 6, 2020).
As much as COVID was and remains a systemic shock that impacts everyone, every business, everywhere, it does so differently. What specifically those differences are, and what drives them, really matters. To not get insight into them is competitively unwise. Granular insights into the extent to which your shocks are health, or supply, or demand-driven, or more likely, a differing combination of these, is important — assuming that “organizational resilience” and “competitive advantage” are more than just buzzwords.
So what and a call to action:
COVID has reminded us what we already know, but more so.
Events happen; risk exposures change; opportunities emerge — all of which require not just insights and capabilities to respond quickly to them, but also the foresight into what these shifts are — and what they mean to what we do, where we do them, the partners we engage to support us, and how we mitigate them as risks or exploit them as opportunities.
Such foresight, from an event monitoring perspective, into:
1. Identifying and amplifying faint signals of potentially high impact events of relevance to us;
2. Quantifying risk exposures and economic opportunities catalyzed as a result; and
3. Clarifying and thereby reallocating our capital and resources to move quickly…
… becomes something many have discussed, but lots fewer have implemented — until the wake-up call that has been and will continue to be COVID and other systemic shocks that follow.
One final point. The ability to:
· Amplify faint signals;
· Identify the ripple effects;
· Understand/model the different parts of your strategic execution plan and its implications on others; and
· Inform your high-level plans with highly granular insights…
… can be executed by any industry, at any size. It no longer requires the expense and time of high-priced consultants. Rather, the analysis can be set up, run and monitored, and enhanced, powered by algorithmic insights and hosted platforms… a topic for another post.
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