Explaining “structural changes” in the value chain

Today, economists frequently use the phrase “structural changes” to explain major aspects of the multifaceted impact of globalization. It is an umbrella term that captures the macroeconomic view but seldom gets into the details of the structure itself, i.e., the micro view. (And in defense of economists, their focus is the “forest” as opposed to the “trees” of the inner workings of the global supply network with its extreme complexity and processes intertwined among hundreds of businesses spread across multiple economic entities.)

To understand the structure of the network and how it evolved over time, we need to view the world through the “value chain” lens, and wind the clock back to the days of Henry Ford.

The virtuous circle of Henry Ford’s value chain

In 1927, Henry Ford’s Rouge River facility contained the entire manufacturing process within the world’s largest industrial complex at that time. The process began with iron ore, coke and limestone transported by barge boats being fed into the blast furnaces at one end of the operation, and four days later, a car rolled off the assembly line at the other end of the operation. Henry Ford’s network was a closed system in terms of both the enterprise as well as the larger economy. As an enterprise, its value chain represented one of the earliest vertically-integrated, just-in-time operations. As an economic ecosystem, this value chain was largely contained within the borders of the United States, enabling a “tightly coupled” virtuous circle of value creation between the business and society.

When we fast forward almost a century ahead from the days of Henry Ford, we see a very different supply chain structure. In contrast, the modern day automotive supply chain is a globally distributed operation that gives every global brand (including Ford) the flexibility to “design anywhere, build anywhere, and sell anywhere”, while giving customers more models, more options, more convenience, etc.

The increasing complexity of the modern global supply chain

So how did we get from there to here? The changes to the supply network structure since the days of Henry Ford reflect the shift in the balance of power from suppliers to customers that occurred over the last 100 years. (Note: Trade liberalization following World War II has many important historical events leading up to the current state of globalization — that is NOT the focus of the timeline shown below. Rather, it is to underscore the point that the root cause is ultimately the consumer and their demand for variety, quality, etc., as the primary driver of the structural changes. )

Major (customer-driven) forces that shaped the supply network structure

  • Cost (the baseline): We start the timeline in 1927 because Henry Ford’s mass-production model was designed for cost efficiency. Ford was obsessed with cost (to a point where his efforts to achieve cost reductions through methodical efficiency studies made life difficult for workers.) And of course, that singular focus on cost led him to declare that “the customer can have any color they want so long as it is black!” This famous remark epitomized the height of supplier power during the early days of industrialization. With limited to no competition, the balance of power heavily favored suppliers over customers. In the absence of competition, customers had limited choices, received their order when suppliers were ready to deliver, and accepted whatever quantity that was available.
    But supplier power has its limits. In the face of growing competition, the need for business to differentiate itself slowly but surely began to shift the balance of power towards customers, and the supply network had to evolve and adapt accordingly to remain competitive.
  • Variety: Next stop: the 1950s. The post-war prosperity boom and the advent of color television combine to create what some call the golden age of advertising. The race for the consumer was on, and companies became serious about branding and market share. Since then, we have seen an explosion of product variety to entice and capture greater share of the consumer’s wallet.
  • Quality: The emergence of Japan in the 1980s as a manufacturing powerhouse that could build higher quality products in the world of automotive and electronics jump-started the Total Quality Management movement and prompted US manufacturing in these sectors to think/become global. The trade deficit during this decade hovered around $100 billion– until the mid-90s when outsourcing went into high-gear as manufacturers decisively shifted their supply network structures to take advantage of low-cost labor in the emerging economies.
  • Time: As quality matured and became a cost of entry, product availability and response times now became the new differentiators. An example that captures the customer desire for quick response was the introduction of the “one-hour photo” processing service that began in 1980. Since then, customer expectations for response times have only continued to increase and today we have the digital camera that lets us not only capture instantly but also share immediately by uploading to Facebook, etc.
    Unlike the digital world, the physical world presents limits on time compression. Instant gratification requires that we maintain large buffers of finished goods inventory which is an expensive option. Typically, there is a logical “push-pull” point in the network that balances the trade-offs between customer service levels and inventory costs. For example, Henry Ford’s vertically-integrated, just-in-time supply chain only took 4 days, whereas  today’s automotive supply chain with its far more complex network takes about 45-60 days to build a car from start to finish. Somewhere in between exists an optimal push-pull point that determines what inventory to hold (SKUs), how much quantity to hold (specified as days of inventory), and where to hold (locations or nodes in the network) that balances cost vs. customer responsiveness.
  • Risk (Volatility):On the demand side, more product variety made it harder to forecast accurately at the end-item (SKU) level. For example, today’s customer can find over 500 varieties of shampoo at Wal-Mart, over 200 different types of pens at Office Depot, and 52 versions of a single brand of toothpaste at the local drug store . With so many choices, it is hard to predict what customers are going to buy – forecasting too little meant risk of lost sales, and forecasting too much meant risk of inventory obsolescence.
    On the supply side, greater product variety meant managing more suppliers (more supply nodes in the network) to ensure product quality and timeliness; more frequent replenishment cycles (that sometimes used different transportation modes, different inventory policies, etc.); outsourcing meant less direct control of an increasingly fragmented supply chain that was more vulnerable to outside disruptions; and higher complexity of coordination in implementing postponement strategies.
  • Risk (Security): In the increasingly virtual supply chain, the security of nodes outside the “four walls of the enterprise” has to be considered. For example, product pedigree issues have resulted in consumer deaths in the case of counterfeit or tainted substances in pharmaceutical and food supply chains. Or in the case of a popular shoe manufacturer, theft and piracy forced them to separately ship the right and left shoes from the factory in Mexico and have them assembled prior to retail distribution in the US.
  • Green: Eco-friendly is the most recent consumer megatrend that impacts the supply network structure. For example, cheap oil made it cost-effective to ship iron ore from Brazil to Chinese steel mills that produced raw materials for air-conditioners and washing machines that were shipped back to the American continent. But rising oil prices are now driving the economic case to reduce carbon emissions in the transportation network, and rising consumer expectations for products with green footprints continue to shape the structure of the network.

For almost a century since the days of Henry Ford, market forces like those identified above have shaped the structure of the business model – and the table below contrasts the differences between then and now:

How much business models (and structures) have changed

Key takeaway

It is easy to blame globalization for today’s economic challenges when in reality, the current state of the global supply network is actually more the effect and less the cause than most people think. At its heart, the business system is a relatively simplistic system designed to respond to the joint forces of shareholders and customers. Part of the problem for the US economy is that for large multinationals, globalization has decoupled the shareholder from the customer, and thus, weakening the virtuous circle. But the very fact that the system is responsive holds the key to making the next set of structural changes that will align the interests of the enterprise with the interest of the larger economy and society. But as the timeline shows, it isn’t a quick fix. It takes foresight, planning, perseverance, and commitment from all the stakeholders to work towards realigning the virtuous circle of value.

Advertisements