Breaking The (Supply) Chains

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by Tyler Durden
Tuesday, Oct 05, 2021 - 06:30 AM

By Nick Colas of DataTrek research

“Supply chain disruptions” has become a catch-all phrase to explain product shortages and inflation. But how exactly does that work, and why is this problem taking so long to fix? For Story Time this week, Nick uses his 30 years of experience analyzing the US auto industry to explain what’s going on. It all comes down to “lean manufacturing”, which started in Japan after World War II and caught on worldwide in the 1980s/1990s. The pandemic has created systematic challenges to “lean”, enough that structural inflation is a threat.

Here is a story about how supply chains work and why they are so snarled just now. Yes, a grimy topic compared to some of our others, but important and my personal history as a long-time (30 years) auto industry analyst gives me a unique perspective on the issue.

To understand how global supply chains operate the way they do today, you really need to go back to Japan just after World War II.

The country, defeated and impoverished, desperately needed to restart its industrial base. It did so by producing what it could with a minimum of capital. That meant, for example, no capital-intensive vertical integration; there were parts suppliers, and then there were final assembly companies. It also meant keeping the supply chain tightly integrated to maximize throughput.

This spawned a new production model, now commonly known as lean manufacturing, and Japan’s auto companies led the way in its adoption.

Parts like exterior metal stampings and interior trim like seats and dashboards all arrived at automotive final assembly plants from suppliers within a few hours of when they were installed in a vehicle moving down an assembly line. Also, vehicle designers thought not just about how a vehicle looked or drove, but how it would be assembled. They designed for ease and cost of manufacturability and long-run quality as well as for consumer tastes.

For decades, this process was mostly unique to Japanese manufacturing.

American car companies like Ford and GM remained vertically integrated after World War II. And, because there was no shortage of capital in the US, there was no need to limit work-in-process inventory. In fact, plant managers preferred having spare inventory because they were not as tightly integrated with their suppliers (even internal ones) and they needed that buffer stock to assure smooth day-to-day operations.

Then, in 1991 a group of MIT researchers published a book titled “The Machine that Changed the World”, essentially a benchmarking study of auto manufacturers in the US, Europe, and Japan.

No prizes for guessing what they found. US and European companies were much less efficient than Japanese manufacturers. The root cause of that difference was lean manufacturing, and even Mercedes – long considered the “best” car company in the world – was woefully behind.

The anecdote from the book that got the most attention: it took more than 50 hours of assembly time to produce an S-Class and several of those came at the end of the process when trained engineers manually fixed all the problems each car had. Toyota was producing higher quality vehicles (lower defect rates) in less than 20 hours.

The publication of “Machine” in 1991 is as good as any single event if you want to assign a date to the West’s transition to lean manufacturing, especially its focus on tightly integrated supply chains.

By the end of the decade, GM had spun off its supply network (Delphi Automotive), as had Ford (Visteon). Vertical integration, made famous by places like Ford’s River Rouge facility where raw iron went in one end and finished cars went out the other, gave way to a focus on efficient final assembly and managing complex third-party supply chains.

The Japanese manufacturing approach also spread to China, as that country industrialized in the 1990s. In 1992 I was part of a team that took the first Chinese company public on the New York Stock Exchange.

China Brilliance, as it was known then, had two products. One was a locally designed/produced minivan, made in plant that looked like it was out of a Dickens novel. The other was also a minivan but produced under license from Toyota. The goal here was to work with Toyota to recreate its lean manufacturing system in China by having local suppliers produce copies of the components needed to eventually make the minivan in-country.

While I’ve focused on the automotive side of this story so far, it’s certainly not just car companies that learned the value of “lean manufacturing” from 1990 onwards.

Apple, the world’s most valuable company by market cap, has its name on hundreds of millions of physical devices but operates no factories. It designs, it innovates, it develops software, and it markets. When it buys machinery (and it does, to the tune of billions of dollars a year), that still goes in one of their suppliers’ plants. Apple is essentially the leanest manufacturing company in the history of global commerce.

Now, lean manufacturing only works well when 1) final demand is predictable and 2) the supply network is operating reliably. Both are equally important. To illustrate, consider the very prosaic example of the seats in a passenger vehicle:

  • No car company we know of makes its own seats anymore. They are produced by firms that specialize in this product and other interior trim items like floor coverings and headliners. Most car companies use only 1 seat supplier for any given vehicle.

  • Car companies schedule their assembly plants 3-6 months in advance, deciding exactly what vehicle with what options will run down the assembly line at exactly what time.

  • It then orders seats for those exact vehicles from the supplier. They, in turn, order everything from foam to leather/cloth, metal frames to motors and switches, from their suppliers. These are also supposed to deliver their products “just in time” to the seat manufacturer so they don’t bear the burden of excess working capital.

  • Any disruption to this supply chain, whether it be from sudden shifts in orders from the car company due to recession/sudden demand to a shortage of any individual part, essentially crashes the entire production process. Lean it may be, but flexible it is not.

The point to today’s Story Time is, therefore, that decades of global corporate focus on lean manufacturing has put the world’s manufacturers in a very difficult spot because of the operating challenges thrown up by the pandemic.

Semiconductors have been the system’s Achilles Heel, because on top of the complexities we’ve described today there is now also a global chip shortage. But that is really only part of the story, as we’ve tried to describe.

Stepping back for a moment, I can’t help but wonder if the pandemic’s disruptive effect on global supply chains is in some ways similar to the 1973 oil shock. When oil prices spiked in 1973/1974 due to the Saudi oil embargo, US inflation rose quickly because the American economy was set up for structurally low energy prices. When gasoline prices tripled in a year, for example, the supply chain for everything from food to apparel to durable goods had to pass along those costs.

You know how that story ended: another oil shock in 1979 forced Paul Volcker’s Fed to raise interest rates to dampen demand and bring inflation back under control. Let’s hope history does not repeat itself in 2022.