Recession-Proof Your Supply Chain

Editor’s Note: Recently, Bruce C. Arntzen, the former executive director of the supply chain management program at MIT, sent me an article he had published in Supply Chain Management Review back in 2009. The article predated my tenure as editorial director. Reading it, I thought Arntzen’s advice then was pertinent to the challenges supply chain managers are coping with today. I hope you find Arntzen’s framework as you navigate through the slowdown; make plans for the eventual ramp up and consider how to manage your supply chains in the future. Bob Trebilcock, editorial director.

There is something about the good times that makes people forget about the bad times. Yet the bad times are by no means rare. Senior managers in their fifties have already lived through six stock market crashes and are experiencing their eighth major economic downturn.

If we were talking about floods or earthquakes, most business leaders would be very prepared. Not so with economic slumps. During better times, companies still take on staggering debt, carry huge fixed costs and create inflexible supply chains. Then, when the downturn arrives, it finds all the cracks in the supply chain. Recessions like this one pry those cracks wide open. And Murphy's Law dictates that recessions always strike at the worst time.

The US automakers provide a good example. Despite aggressively streamlining its operations, adopting best practices and cutting costs in 2005 and 2006, General Motors Corp. could not keep up with the decline in revenues, ending 2007 with a negative net profit margin loss of 21.5 percent. Further cost-cutting through 2008 failed to outpace the fall-off in demand, and the year ended with net margins from continuing operations more than 20 percent under water. Shareholder equity, worth $14.7 billion in 2005, had plummeted to a negative $86.2 billion, and a share of stock had dropped from $30 to $2.

While the headlines have highlighted GM's request for $30 billion and Chrysler's request for $9 billion in federal bailout money, behind the scenes the recession is taking its toll on the auto industry's Tier One, Tier Two and Tier Three suppliers. Some are in danger of being pushed out of business altogether.

Could auto-industry companies have done more to recession-proof themselves and their supply chains? We believe they could. Indeed, we maintain that businesses in many manufacturing industries can more actively anticipate and prepare for severe downturns—and then respond in more disciplined ways once the downturn is upon them. This article will describe an approach that can enable more effective preparation and response.

Impact of Recessions on Supply Chains

Recessions and stock market crashes should not be a surprise to anyone. True, we don't know when they will happen. But we do know that they will happen at some point. Recessions, as defined by the National Bureau of Economic Research, are a fairly common occurrence. There have been eight official recessions (including the one that began in December 2007) in the last 50 years. The time between recessions averages about six years, with each lasting just less than one year.

There have been at least six sharp sell-offs in the last half-century. They occur between five and 10 years apart, show drops in value of as much as 40 percent and take up to two years to make up their losses. The most recent crash—October 2008's seven-day free fall with drops averaging 340 points a day—is not unprecedented either. On Monday October 19, 1987, the Dow Jones index lost an astonishing 508 points—more than 22 percent of its value—in one day. The combined loss for two weeks at that time was over one-third of the value of America's publically traded companies.

Downturns have drastic effects up and down the supply chain, slowing flows of cash as well as the flows of materials and products. Most customers react quickly: They stop buying, cancel orders, delay accepting deliveries, and stretch out purchase orders and payments. After the stock market crashed in October 2008, a major US building products company sought to benchmark its DPO (days payables outstanding) against its competitors worldwide to see how far it could stretch payables and still stay within industry norms. The company will now exploit regional and industry sector differences in order to extend payments. Even companies that are faring relatively well begin looking for discounts from their suppliers.

For their part, anxious suppliers worry about customers' ability to pay—or at least to pay on time—so they push for early payment, and sometimes even put customers on a cash-on-delivery basis.

They can be right to worry: During a 2006 downturn in the semiconductor industry, a manufacturer of test equipment attempted to refuse delivery and payment for long lead-time raw materials it had ordered but no longer wanted. The contract manufacturer caught in the middle went to court and, after a long legal fight, forced the equipment maker to settle before the case went to trial.

The impact of customers' and suppliers' actions can be harsh. If a manufacturer's customers stop buying and taking delivery and suppliers keep shipping parts or materials, the producer will experience the “inventory bulge,” also known as the “working capital bulge.” Just when you need cash the most you are surrounded by it—except that it is trapped in the wrong form: inventory. A parallel phenomenon happens on the financial side: If customers stop buying and delay paying, and you continue paying your suppliers in full and on time, the net effect is the “profit squeeze.” Almost always, customers can reduce your revenues faster than you can reduce your costs.

Electronics parts maker KEMET Corp. fell afoul of those phenomena earlier this decade. The producer of tantalum capacitors saw demand soaring—sparked largely by surging mobile phone sales—with some electronics equipment manufacturers paying a premium to keep their production lines moving. In late 2000, the company locked in a three-year contract to buy 80,000 pounds of tantalum material from Cabot Corp. at a high price to guarantee availability of this scarce resource. When the dotcom crash hit the high-tech sector, capacitor shipments fell by 64 percent and the market price of tantalum came back to earth. KEMET lost $27 million in 2002 as the profit squeeze took hold. And the company was hit with the working capital bulge: Unable to quit its contract, KEMET had to keep receiving shipments of unneeded tantalum. In 2003, KEMET wrote off $16.4 million in on-hand tantalum inventory and took a $24 million-plus charge in recognition of estimated future losses from its commitment to buy tantalum at above-market prices.

So if crashes and recessions are so common, why don't we plan ahead? Despite the growing use of practices such as collaborative planning, forecasting and replenishment (CPFR) and sales and operations planning (S&OP) and the proliferation of tools to enable such practices, recession-proof planning is anything but second nature. It's surprising how many companies are still missing the basics, even though the last recession occurred only seven years ago. And many of the companies that do better at demand forecasting and planning are not consistent enough in their efforts.

A Framework for Recession Preparations and Reponses
Part of the problem is that operations leaders often lack the clear, systematic approaches needed to be able to plan more effectively. What's needed is a hierarchy of best practices that will help protect your supply chain against a recession and overcome the associated challenges.

For each of the six challenges identified, we can determine what should be done ahead of time to be prepared, and what companies can do now that recession is upon them. Granted, not all of the responses we describe apply to all companies, and probably no company can excel at all of them. But recessions do find all weaknesses, so the more of these practices you can embrace, the safer you will be. The key is to determine where you are most at risk and focus on those weaknesses first.

Challenge 1: Customers Cancel Orders and Finished Goods Inventory Builds Up

What to do ahead of time:

Build a robust CPFR program. A healthy, ongoing CPFR program will encourage your customers to discuss their plans with you, collaborate on risk-taking and work with you rather than against you during the hard times. CPFR attracted extensive coverage a decade ago, so it is easy to assume that everyone is using it by now. CPFR's landmark case studies involving such high-profile companies as Nabisco, Wal-Mart, Sara Lee, Procter & Gamble, and HP demonstrated the concept of forecast risk sharing upstream in the supply chain. Since the publication of the VICS CPFR guidelines in 1998, many top-tier companies have indeed implemented some form of CPFR, especially between major retailers and their suppliers. But CPFR is still a long way from being universal. It takes a long-term focused effort by both parties to establish trust, and trust is the main ingredient in CPFR. Adoption of CPFR in other relationships, such as between manufacturers and their raw material suppliers, is happening much more slowly.

Forge risk-aware contracts with customers. Too often in expansionary times, managers don't imagine how contentious material supply contracts can become if the end customer stops buying. All contracts with your customers should spell out very clearly what will happen to the material flow and the cash flow if their forecasts turn out to be significantly in error. What commitment does the customer have to the forecast that they provide? When long lead-time items are involved, the contract should specify time fences for the transfer of ownership of the goods.

Diversify into services. Purchases of services are often harder to avoid during recessions than product purchases. A company may delay buying a new telecommunications hub but it will not cancel the monthly service contract. IBM exemplifies successful diversification into services: From its start in 1911, IBM focused mainly on hardware along with some software and hardware maintenance. In 1992, 70 percent of IBM's revenue came from hardware and software sales. Today that slice is just 40 percent, with the balance coming from IBM's Global Services unit, comprising everything from maintenance to consulting and financing. In the fourth quarter of 2008, IBM earned net margins of more than 16 percent.

Use demand-driven, lean manufacturing. By using build-to-order and “pull” manufacturing techniques with small lot sizes and just-in-time (JIT) replenishment, it is much easier to prevent supply from overshooting demand.

Run a healthy S&OP process. Since demand during recessions is usually so volatile, commitment to and regular participation in S&OP activities provide the best chance of matching supply to demand.

What to do during the downturn:

Talk to customers promptly. It's human nature to “go quiet” when there's bad news to discuss. But business is at risk: Your customer may be planning to cut costs by sidelining your purchase order. By over-communicating, you put pressure on the customers to look elsewhere for their cost reductions. As the downturn deepens, there is no substitute for over-communicating with customers to get an early warning of their intentions and to remind them of existing orders and contract terms. Part of the discussion can be about how to share the risks of unwanted inventory.

Have a sale; offer discounts. As the economy slows, move your finished goods while you still can. Nobody likes to sell at a loss, but the price of distressed items always goes down over time. When the market first crashes, nobody knows how long it will stay down. A nice 20 percent discount may still lure customers. But if you wait six months until the recession has really taken hold, it may take a 60 percent discount to find a buyer.

Act quickly to re-forecast. Most companies will try to revise their forecasts to reflect the reduced customer demand. But even those with strong processes and tight schedules for forecasting, demand planning, S&OP, and plan execution need to sharpen their forecasting capabilities. The stock market crashed inside three days in 1987. Imagine what can happen if a company does not react for another three weeks until its next regularly scheduled process cycle comes around.

Slow down production. Although it may be tempting to maintain production rates in order to uphold “manufacturing efficiency”—particularly so in process industries with costly plant and equipment assets—it is not the thing to do during steep downturns. One large US cement maker sizes its own production to satisfy 85 percent of its peak summer demand, using imports from Eastern Europe to meet the remaining requirements. The imports are the first to be dropped when slowdowns hit.

Challenge 2: Customers Slow Down Bill Payment, Stretch out Payables

What to do ahead of time:

Don't give away terms blithely. Control the sales teams' ability to give away terms. A key reason: Whatever terms you do give will likely be stretched out during a recession. Focusing management on the cash-to-cash cycle time is a great way to call attention to the terms issue without attacking the sales force directly. After all, a dollar of accounts receivable counts as much toward working capital as a dollar of inventory.

Enforce contractual terms and conditions. It is crucial to indicate before any crash that you are entirely serious about enforcing terms and conditions. That may involve active discussions specifically on that topic rather than a passive assumption that the other party has read the fine print. Companies that allow their customers to ignore their payment terms during good times will find their terms are not respected when money gets tight.

Provide payment options through financing. It's a good idea to present your customers with attractive flexible financing and payment options—and to encourage them to buy into this system during good times so when a recession hits there is already a formal financing mechanism in place. The financing arms of giant companies—organizations such as GMAC and GE Capital—offer customers an array of payment options. The customer can choose the number of months to pay off the purchase and will agree to the interest rate to be charged. Later if money is tight, they cannot unilaterally stretch out payments, say from 30 days to 60 days, as they could during a “conventional” sale. They must re- negotiate with the finance company.

Monitor customers' financial health. The more warning you can have that a customer may not be able to pay its bills, the better for the health of your supply chain. Include a report on each customer's financial health as a quarterly exercise.

What to do during the downturn:

Talk to customers frequently. Never sit tight and wait to see whether the customer will pay your invoices on time (or at all); get every early indication you can of the customer's intentions and financial viability. Proactively discuss invoices with customers before they are due so you get early warning of any difficulties they may have with paying. At precision plastics molding leader Nypro Inc., global and local account managers call on the company's suppliers every week to review quality, costs, inventory and delivery, service levels, and technology. Nypro has enjoyed 22 consecutive years of profitable sales growth despite several recessions.

Enforce contract terms relentlessly. Be clear with customers that you are enforcing the terms and conditions they agreed to. Confrontational though it may be at times, be sure to regularly exercise the penalties when customers fall short of the terms in order to motivate them to pay their bills.

Exercise your financing options. In some cases, it makes sense to help valued customers that need to extend their payments to participate in a financing arrangement so they can get the relief they need without hurting you.

Leverage services businesses to collect payments. No on-time payment on a product sale? Then no service. Customers will re-prioritize their bills in order to keep important service contracts in effect. In the jet engine business, for example, it is not uncommon for a manufacturer to offer a 95 percent discount on a new engine if the customer signs up for the service contract. Communications companies are also good at bundling new hardware and services on the same invoice.

Challenge 3: Raw Inventory Builds Up as Material Keeps Arriving

What to do ahead of time:

Use common, industry standard parts. By working closely with your product design engineers, you can more easily avoid using custom parts. Such parts have long lead times and provide suppliers with few options to dispose of them if your demand falls off. When a small electronics company performed a “where-used” analysis on it products in a bid to minimize its materials inventory risk and reduce component costs, it found that 24 percent of the components were used only on one end product and another 15 percent were used in just two end products. When the company's engineering vice president learned about the attendant supply risks, he instituted a policy of tracking new and non-standard parts and required designers to justify their use.

Rely on VOI or VMI. The best situation, if you can do it, is to set up nearby stocking with vendor-owed or vendor-managed inventory programs that provide JIT delivery to your site.

Place cancellable orders. It is well worth negotiating supplier contracts that provide a way to cancel orders and share the risk. All contracts need to have a reasonable “way out” yet many do not. Too frequently, small companies, often in a hurry, end up using the “standard contract” provided by a larger trading partner. Any attempt to change the language is stonewalled usually with the line: “That will require the lawyers to get involved and it will delay the deal by months.” Such standard contracts are almost always heavily biased in favor of the large company and provide no risk-sharing and no reasonable exit for the smaller partner.

Establish CPFR systems with your suppliers. Giving suppliers as much forewarning as possible helps them react faster to your need to stem the inbound flow of raw materials.

Set up risk management contracts with suppliers. Anticipate downturns in your supplier contracts. Define time fences for transfer of material ownership in the contract. And provide a contractual way to stop the inbound flow of materials. Explains Rashid Shaikh, Nypro's senior director of global sourcing and supply chain operations: “We set up back-to-back agreements with customers and suppliers so no-one bears all the risk of a demand stoppage. For example, we will ask a supplier to keep X days of raw inventory on hand as consignment stock at a Nypro factory. The supplier agrees to this because we use this assured supply to get an X+10 day commitment from the customer to their forecast. The customer gets a guaranteed availability when plastics supplies are tight and the supplier gets a solid commitment from us to buy the consigned inventory within a reasonable time period. NYPRO bears little risk since their customer commitment is longer than the consigned raw material days of supply.” Such practices have helped Nypro's revenues grow from $198 million in 1994 to $1.16 billion in 2008.

Apply lean purchasing practices. Lean techniques can be applied to procurement too, in concert with lean production practices. The more you can utilize demand-driven build-to-order or “pull” manufacturing techniques with small frequent deliveries, the better you can regulate replenishment and prevent raw material build-up.

What to do during the downturn:

Just as with your Customer-Facing issues, you have to act quickly to work your Supplier-Facing issues as well. Act quickly to re-forecast and have buyer-planners quickly adjust their orders to fit the new forecast. Talk to suppliers promptly to put the brakes on your orders and to share the risk of unwanted inventory. Other actions that you should pursue include:

Switch purchases when need be. You may be able to switch your order from parts that you no longer need to parts that you definitely need—or know you will need soon. Not only can this help to fend off the working capital bulge, but it will likely cushion the impact on the supplier.

Help supplier find markets. A large company can often help a supplier find a buyer for parts that the customer no longer wants. The new buyer may be another division or a customer or supplier that uses similar parts.

Steer sales and production toward using up excess raw inventory. An effective S&OP process can help guide the sales force toward selling products whose production will consume the excess raw materials. The supply chain managers at a producer of real-time on-board television programming units for commercial aircraft routinely tell the sales force what models to promote as a means of consuming available work in progress and raw materials inventory.

Challenge 4: Parts Shortages Become Critical When a Supplier Collapses

What to do ahead of time:

Closely track the financial health of your suppliers. Include a detailed review of your suppliers' financial health in your quarterly business analysis with each supplier. The loss of a major supplier, a sole-source supplier, or one that provides custom-made parts will cause a serious disruption in your material supply. A frequent risk assessment of these particular suppliers is especially important to your own survival.

Use industry standard parts. Another big advantage of using common industry parts is that you are much more likely to find an alternate source of supply if your primary supplier cannot deliver. Using industry standard parts is one of the simplest and yet most powerful things a company can do to lower cost, increase flexibility, and recession-proof their supply chain.

Have a second source of supply. For critical parts, it is crucial to maintain a second source of supply whenever possible. Further, it helps to split your purchases between the two suppliers to keep each one viable. This approach helped a network router maker avoid forfeiting its considerable investments in product design. Its new router design called for three custom semiconductor chips to be built and for the work to be outsourced. With each chip costing over $1 million to develop, the OEM decided to duplicate the contracts, assigning the work to two chip design companies. Of the six prototypes received, one did not work. Without the second source, a whole generation of product offering would have been at risk.

Keep extra inventory on hand. In our push to create Lean supply chains we have minimized raw inventories and now depend on rapid resupply from suppliers. But recessions make even dependable suppliers undependable. And parts that you take for granted in good times may become critical-path if supplies are interrupted. Understanding where your critical path is and keeping some extra inventory of critical parts is a smart insurance policy against supply interruptions.

What to do during the downturn:

Talk to suppliers promptly. If the failure of a shipment to show up is your first indication that your supplier has gone under then you have squandered valuable time in the race to find another supplier. Your own production lines may be idled needlessly. No one erects a billboard to advertise their weak condition but you need as much early warning as possible. In hard times, you need to talk to your suppliers frequently and get candid information about their real situation.

Consider helping the supplier survive. It may be easier to help your current supplier get through the recession than to find, qualify, and ramp up a new supplier. Currently, the Tier 1 auto-industry suppliers in North America are trying to keep the Tier 2 and 3 suppliers alive until the economy recovers.

Switch to a backup supplier. One of the leaders in the communications equipment sector deliberately uses the shipping services of both Fedex and UPS at its central parts warehouse, with each provider able to handle 100 percent of the load if needed. Having both systems up and running allows the company to switch instantly from one to the other in case of a failure. The strategy has paid off: The communications company has experienced three failure episodes in the past two years that caused them to switch to the alternate shipping system.

Help another supplier ramp up quickly. It may be in your best interest to help another supplier to ramp up quickly to provide the critical parts you need. Prior to the 2001-2002 recession, a mid-tier networking equipment company worked with its Canadian contract manufacturer to perfect rapid line changeover and build-to-order processes. But when the recession hit, the contract manufacturer was forced to close when its other customers stopped buying. The networking company quickly found a new contract manufacturer and dispatched a team to teach that manufacturer how to master build-to-order techniques.

Use substitute parts. It may be possible to substitute another component for the critical part that you can no longer source. This may require some engineering changes, retooling or new testing. In some industries, such as the electronics sector, it is routine for large component distributors to have regular conversations about substitute parts with their original equipment manufacturer customers.

Challenge 5: Direct Labor Spending Stays High

What to do ahead of time:

Move to a variable cost structure. Outsource operations based on a cost per piece. Examples include using contract manufacturing, common carriers, third-party logistics providers, and contract repair centers. Many of these providers are much more practiced at ramping up and down and shifting resources around than are typical large OEMs.

Deploy a more flexible workforce. Rethink your labor resources so they can more easily ramp up and down based on need. Arrange this flexibility with workers during good times, when it is less contentious, so it will be in place when you need it. This can include adjusting employees days and hours per week.

What to do during the downturn:

Scale back on variable costs. Outsourced activities should be scaled back automatically as demand decreases. At one major high-tech company, spare parts distribution and repair, once an inflexible internal operation, has been outsourced. Now, when parts demand drops by X percent, the costs of supplying or repairing them drops by much the same percentage in a very short time.

Reduce the workforce. Implement a hiring freeze, promote early retirement, reduce hours, enforce vacation usage, and implement plant furloughs. Shift skilled labor to any available job to retain best workers (if labor laws allow). There are more palatable ways to manage these issues. When a small US maker of wiring harnesses gathered its employees to discuss the downturn in business, employees voted overwhelmingly to have everyone reduce to a four-day work week instead of having some employees be laid off completely.

Challenge 6: Overhead Spending Stays High

What to do ahead of time:

Implement a variable cost structure. People love a variable cost structure when they will get a higher wage. So use good times to set up a variable cost structure. Pay the sales force with a highly variable component and they will get a nice bonus during good times and the company will get cost relief during a recession. Workers with flexible hours will enjoy overtime during good years and provide cost relief during lean years. In addition, many call center, back office, and administrative functions can be outsourced as a variable cost.

Install firm purchasing controls. Central control of spending is needed to enforce
policies consistently to modulate spending in hard times. Allowing each department to order its own supplies is risky. People always understand how important it is for the “other guy” to cut back their spending. Employees must be required to get spending approved by someone accountable for the budget.

Consolidate approved suppliers of indirect materials and supplies. Many companies have more luck controlling suppliers than they do controlling their own people. Suppliers are told that they will not get paid unless they receive a Purchase Order in advance of the sale. The fewer approved suppliers you have, the easier it will be to control spending even with a reluctant or undisciplined employee base.

What to do during the downturn:

Similar to reducing Direct Labor Costs, many of the same principle apply to reducing Overhead Spending. Scale back on variable costs by outsourcing to third parties on a variable cost basis. Reduce workforce. Offer early retirement. Implement a hiring freeze and reduce hours of flex-time workers. Offer part time employment as an alternative to layoffs. Delay discretionary spending. Scale back on any discretionary spending including investments in plant and equipment, system upgrades, travel, and training. Finally, Charge for amenities and employee “freebies.” Scale back on perks (company cars, airline club memberships, travel upgrades, etc.) or reduce any company subsidies of these items.

The stock market crash that started on October 28, 1929 finally hit bottom three years later, after falling by nearly 90 percent. It took a quarter of a century for the market to recover. In the 80 years since, the world has changed in almost every way, yet we are still taken by surprise by steep and sudden economic downturns. Far too many senior managers still make decisions that assume the good times will last forever—which leads to many companies getting caught with working capital trapped in unmoving inventory or accounts receivable.

There are many simple actions that companies can take to better position themselves to withstand a downturn. By far the most effective of those actions are those taken when the economy is buoyant and demand is strong. Once a recession is underway, remedial options are limited—and much less effective.

Bruce C. Arntzen, Ph.D., was the co-founder and managing director of Avicon Partners, LLC when this article was written. In 2019, he retired as the executive director of the supply chain management program at MIT. He can be reached at [email protected].

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