Supply chain lessons from Japan

The devastating earthquake and tsunami in Japan have again raised the issue of supply chain robustness to disruption risk, and in particular, are they too fragile? FT.com (3/15/2011) asserts that  “Strategies that look rational for individual manufacturing companies… can create big macro-level vulnerabilities…”

The reality is that it is too costly to source every component from multiple locations throughout the world just to hedge natural disaster risks. But that doesn’t mean that companies should turn their back to the problem. The best companies follow a few intuitive steps to make their supply chains more robust. I’ll offer two.

First, map your supply chain. If you know your Tier 1, Tier 2 and Tier 3 suppliers, then you won’t have to spend one week figuring out whether you will run out of a part. Most companies know their Tier 1 supply chain, but do they know the other tiers? Do they keep track of changes to the supply chain? This information is crucial because the company that is first to work the phone to find alternative  supplies is most likely to be able to secure those supplies.  This information also gives you information that you can use to make downstream adjustments to your production. For example, should you eliminate an overtime shift or not? Should you redirect scare parts from one plant to another? Those are difficult decisions to make and are made much more complicated if you don’t even know if you have a problem – why shut down a plant for a potential part shortage that may not materialize?

Second, before disaster strikes, map out vulnerabilities. Some components can be sourced in many locations. Some components have several months of buffer inventory. You don’t need to worry about those. But if the amount of buffer inventory is limited and it is sourced in a few locations, especially a few locations that happen to be close to each other, then you need to consider finding alternative sources or alternative parts. Maybe the conclusion is that the company needs to bear the risk – there are no effective alternatives. But maybe the conclusion is that a substitution to a less risky part is actually feasible.  Finding this substitute is less costly before the disaster. There have been reports of companies that are scrambling to qualify additional suppliers, but that could have been done before disaster struck.

Finally, one risk that will hit many companies, even if they don’t have a shortage of parts, is the risk of exchange rate fluctuations – the Yen has just hit a post WWII high against the US dollar.

Why China – cheap capital?

In 2008 Evergreen Solar opened up a solar panel factory in Devens,  Massachusetts, but they just announced that they will layoff their 800 workers and move production to China (NY Times 1/14/11). Why? Well, of course, it is too expensive to manufacturer in the U.S. And low cost production is critical – the price of solar panels has fallen from $3.39 per watt in 2008 to $1.90 per watt now. Evergreen Solar has reduced its cost to $2.00 per watt, but Chinese manufacturers are producing at $1.00 per watt.

But labor is NOT the reason for the high cost of production in the U.S. – labor is a small portion of the cost to make solar panels. Nor does it seem a lack of technical skills. Instead, the issue is the cost of capital – a solar panel plant can cost $400 million and Chinese manufacturers have access to low cost bank loans.

It it is likely that there will be more movement to China for reasons other than the cost of labor.

Intel to invest in U.S. manufacturing

Intel announced today that it will invest $6-8 billion in the U.S. to build a new plant in Oregon and to improve existing  manufacturing facilities.  (See WSJ 10/19/10).  This investment will give them the capability to produce chips with 22 nanometer circuits, whereas the previous wave of investments gave it 32 nanometer capability. (A nanometer is one billionth of a meter – a couple of billion dollars to produce lines that are a billionth of a meter wide!)

The interesting part of this story is that Intel is sticking with U.S. production.  The potential allure of overseas production is not from the typical “cheap labor” issue, but rather because foreign governments are willing to hand out considerable subsidies for building a chip plant in their territory.  Intel estimates that the potential subsidies are equivalent to $1 billion, a considerable portion of the cost to build the plant.

So why is Intel sticking with the U.S.? Unlike apparel, they are not concerned about “made in America” – they will gain no premium in the market for made in America.  Unlike autos, their product is not expensive to move around the world, so local production to avoid higher transportation costs is not a concern. Nor is there a concern about tariffs or labor unions.

The issue is production yield – when you first start making chips, some of them, maybe even most of them, don’t work. The trick to make an investment in capacity pay off is to improve yields as fast as possible. And yields don’t improve because of better equipment, but rather because the equipment is used more effectively – engineers and line workers need to find out what particular recipe generates the best yield. Thus, improving yields requires intelligent experimentation, i.e., a skilled workforce.  It follows that Intel must believe that a U.S. workforce can improve yields faster than an overseas workforce, fast enough to  justify the additional $1 billion in cost.  It will be interesting to see how long that U.S. advantage can last.

Apple’s amazing run

Apple just announced some impressive profit numbers: it’s first quarter with $20 billion in revenue and profits that exceed those of  IBM, HP and Intel.  Only Microsoft had higher profit, but not a higher market capitalization.  The following graphic comes from the WSJ 10/19/2010:

The focus in the popular press on Apple’s success has been on how the consumer market loves their products and technology.   For example, the WSJ article discusses how Apple’s bet on the consumer market has paid off relative to IBM’s focus on the business market. I agree that Apple has been remarkable at design. But to me, they don’ t get enough credit for how well they execute.

Consider the iPad. It went on sale April of 2010. We have sales numbers from the first two quarters – by the end of Q2 (Jun 26) they sold 3.3 million and in Q3 (ended Sep 26) they sold 4.2 million.  That is 7.5 million units in the first 6 months of selling a product.  The fact that they sold that many units means that they were able to produce that many units, which is the amazing untold story.

How many iPads might they be able to sell in Q4 of this year. Let’s look at the sales history of the iPod.  Notice that they sold about 2.5 times as many iPods in Q4s as they did in the previous Q3. That means that Apple is on track to be able to sell about 10-11 million iPads in Q4.  How can they ramp up the necessary capacity to make all of them? They don’t talk about their capacity management strategy, but I suspect the following are the keys to their strategy. First, they must be tracking sales weekly if not daily and making updated forecasts and comparing them to previous sales trajectories, like those of the iPod.  Second, they have outsourced production to a flexible firm who can switch labor from other products to the iPad if necessary. Third, either they are securing component supplies or their supplier (Foxconn) is securing component supplies – you cannot assemble a product if you don’t have the components. Fourth, the iPad must be made with components that are either standard (hence there is lots of available capacity in the market) or easy to make (in the sense that the yields are high and stable already). On the last point, if the iPad were made with a component that is unusual or hard to make, Apple simply would not be able to ramp up production as quickly as they seem to be able to do.

Apple executes so well that they make it look simple. But it is a mistake to assume it so simple. To relate this to baseball, Mariano Rivera (the closer for the Yankees, i.e., the pitcher that comes in very late in the game with the job of defending a small lead)  has two pitches that he throws with deceptive ease. It might be tempting to conclude that there should be many pitchers that could throw Mariano’s two pitch combo. Many can, but none have thrown them as successfully as Mariano. Quality execution is often underrated. 

 

 

Blockbuster – doomed by its own medicine

Blockbuster filed for bankruptcy protection this week, which was expected for quite some time (NY Times, 9/23/10).  Blockbuster surely had a good run, but ultimately was doomed by its own medicine.

Blockbuster grew to dominate the video tape/DVD rental business by providing convenience to its customers – many well-located stores and many copies of the movies/shows customers wanted to see. If you took the time to go to a Blockbuster, you knew you would find something worth watching.  This convenience was provided in large part by negotiating revenue sharing contracts with the movie studies, thereby allowing Blockbuster to stock a large inventory even when at item was first released.

Fast forward to today. I live two blocks/200 yards from a Blockbuster but I was surprised to discover a couple of weeks ago that it was gone.  My 15-year old son explained it to me – “why would I walk to Blockbuster to pay $5 for a movie when I can download the same movie to my PS3?” I had no idea that a PS3 could do that (isn’t it a game machine?) – clear evidence that the generation gap I swore I would avoid is right there in front of me. But I digress. The point is that Blockbuster is no longer as convenient as the alternatives – RedBox, Netflix, etc. It is no longer as important to have many copies of new releases in a store because customers don’t feel the need to leave their home. It is true that Blockbuster makes content available sooner to customers, but that doesn’t seem to have the value that it use to have – my kids troll around for movies of all ages and don’t  rush to see the latest thing.

It is unlikely that Blockbuster will ever regain the dominance it once had. Surely, it will not do it via its 3000 stores, a number that will have to decline. The fall of movie rentals has been predicted for at least a decade – the technology has finally advanced to the point to make it happen.

Do we need a Manufacturing Czar?

President Obama has named Ron Bloom as a special advisor to tackle the problem of declining manufacturing in the United States (see NY Times 9/10/10):

The President said “We’ve got to get back to making things.” Do we?

Here are the arguments why the decline in manufacturing is a problem:

• Without manufacturing we won’t be able to take advantage of emerging markets in green technology “I don’t want to see new solar panels or electric cars or advanced batteries manufactured in Europe or in Asia. I want to see them made right here in the U.S. of A. by American workers” says President Obama.
• Without manufacturing there will not be research and development in the U.S. (which are presumably higher paying).  The argument is that R&D and manufacturing have to be co-located.
• If R&D declines because of a lack of manufacturing, then innovation will decline and innovation is the engine of productivity growth.

And what are the causes of the problem:

• Unfair trade practices by China and others.
• Private equity only invest in firms that manufacturer in China because the U.S. is not “where you make things”.
• Large U.S. companies don’t want to promote domestic production because they now produce everywhere.

So what do they plan to do about the decline? Here the specifics are thin. They have ruled out subsidies. They will focus on trade diplomacy and improved export-import financing.

Unfortunately, for Mr. Bloom, I strongly suspect he will not be able to reverse the trend, nor do we want him too. But if he wanted to reverse the trend, he is not pulling the right lever.

To fix a problem requires identifying the cause. There are two reasons why manufacturing has declined in the U.S. First, although not mentioned in the article, transportation costs have declined.  If it costs a lot to move parts and finished good around, you need to do things locally. When you can start shipping and training and trucking things for cheap, your options as to where to manufacture expand. Second, things are much more modular than they use to be. Henry Ford’s designers had to be very close to the manufacturing process because I suspect design was an iterative process – design something, try to make it, redesign it, try to make that, etc. Now, computers, telecommunications and precision machinery means that for many things the design and the production can be decoupled – an Apple engineer can dream up the next Iphone in her office and send the specs over to China without fear that what she created will be costly to make.

So if the causes are cheaper transportation and let’s call it decoupled R&D, then what could be done to reverse the trend? We wouldn’t want to ban computers to prevent the former. But maybe we should make transportation more expensive. At least that would have an environmental benefit. But if it is expensive to move stuff from China to the U.S., then it is expensive to move it from the U.S. to Europe, i.e., it cuts both ways. Which brings me back to an earlier point – should we care? Our decline in manufacturing has also occurred during a period of increased productivity and standard of living. Where is the evidence that we have been hurt by the decline in domestic manufacturing?

And let’s consider the geo-politics of trying to break manufacturing ties with other countries. If we purchase nothing from China and China purchases nothing from us, will they be more or less inclined to use their military? (For that matter, how about the U.S.’ inclination to use its military.) The answer seems clear – as long as countries are linked together via trade, the world will be a safer place.

America should promote innovation and we should make things in America that make sense to make here (like cars). But we have better things to worry about than manufacturing’s declining percentage of the economy.

Will Intel keep rolling?

Intel is on a roll. They just reported 2009 Q4 revenue of $10.6 billion with net income of $2.3 billion – not bad indeed! (See NY Times, 1/14/20).  The success is attributed to their recent investment in new plants ($7 billion), a resurgence in PC demand,  and their move to make chips for netbook and smartphones (their Atom chip targeted to those markets brought in $1.4 billion in revenue). Kudos to Intel, but will the fun last? How long can Intel succeed with its strategy to heavily invest in new manufacturing technology so that it can stay ahead of rivals?

There are reasons to believe that this strategy will work for at least another 5 years. This is based on the premise that the need for new, smaller, more energy efficient chips will continue. And in particular, the premise that the latest investment is necessary to make improvements in performance that generate real value for which people are willing to pay for.  As we continue to push towards the “Dick Tracy” era (everything can be done on something the size of a wristwatch), there is reason to believe that this will be the case.

The economics of chip manufacturing is well known. Invest a huge sum of money to build a clean plant with very advanced equipment. Then you start to make chips and most don’t work, so continuous refinements of the production process are necessary to increase the yield of good chips.  The faster the yield curve increases, the better the return on investment.  The more sophisticated the chip, the lower you start on the yield curve and the hard it is to increase your yield. 

There are plenty of companies that can make chips in the world. But these chips are not as complex as the ones Intel makes. Hence, they are satisfied to let Intel take the lead. Intel bears the risks and earns the reward. And it is important to recognize that the risk is significant. At some point Intel will follow this strategy and it will fall flat – the new chips they will make won’t be sufficiently better than existing, simpler chips, meaning that they won’t be able to charge a premium price and recover their investment.

It is interesting to compare Intel’s situation to two other companies, Microsoft and Dell.  Microsoft earned a huge amount because it had its hands around everybody’s neck (the operating system), not because they were particularly good at making software. (Or, maybe they were particularly efficient at writing code, but the technology has changed and they no longer appear to have that advantage. Plus, the fixed cost to write code is much lower than the cost to build a chip plant.) Dell’s advantage came from declining component prices. As long as they were dropping really fast (40% a year), Dell had a commanding lead over its rivals becuase it carried less inventory. Once the cost of components stopped declining at a torrid pace, Dell lost is advantage – having very little inventory buys you little if prices are not dropping.  Plus, its product design was not sufficient to command a premium price.

So Dell and Microsoft were victims of changing technology. At some point Intel will be too… just probably not in the immediate future.

4Q is time for what’s hot and unavailable

Every 4th quarter there are stories about what is hot and hard to find. This year, it is the e-reader category, specifically Sony’s Daily Edition Reader ($399) and Barnes & Noble’s Nook ($259). (See WSJ 11/18/09 – Sony Says Some E-Reader Orders May Miss Christmas).  Sony is telling customers that they are now shipping orders on Dec 18th – a little tight to ensure being included as a stocking stuffer.

My favorite quote from the article is:

“The possibility that Sony, a huge electronics manufacturer, would be caught off guard by supply-chain issues is surprising, said Mike Serbinis, president of Shortcovers”

The presumption is that an experienced and large manufacturer should not have any trouble matching supply with demand. This simply ignores the fact that size and experience are no match for the uncertainties of the market.

Next, it is interesting that Sony is capable of quoting shipping dates:

“In October, the company told its first wave of customers that the Nook would ship Nov. 30. A second wave of customers was told it would ship Dec. 7; shipping dates of Dec. 11 and Dec. 18 were later given.”

This does demonstrate a sophisticated level of supply chain management, assuming their quotes are reasonably accurate: to be able to do this requires a significant amount of real-time information sharing across the supply chain and the skill to process that information quickly.

Finally, I can’t help but speculate on whether they intentionally kept supplies short. Suppose you think you could sell 100,000 units. If you make 75,000, they you are likely to run short. If demand turns out to be 120,000, you are really short and you get lots of free press about how hot your product is. But to make that strategy work, loosing thousands in sales has to cost you less than the free advertising. Hard to say if it is worth it.  Then again, it is entirely possible that if your new techno gadget isn’t “hot”, then it becomes “stone cold”. For example, if “natural” demand is 100,000 but you make 75,000, then actual demand turns out to be 125,000.  If “natural” demand is 100,000 but you make 100,000, then actual demand turns out to be 60,000 because who wants to buy a product that isn’t popular.

It isn’t your father’s PC industry anymore

My first PC was an IBM PC with an Intel 8088 microprocessor, two floppy disk drives and a whopping 64K of RAM (not 64MB or 64G, the 64,000 variety) – and it cost about $4000 in 1985 (but my father worked for IBM so we got it for the employee discount price of something like $2700). HP is currently selling a laptop through WalMart for $298 (or $148.47 in 1985 dollars, http://data.bls.gov/cgi-bin/cpicalc.pl). 

The PC industry has gone through many stages in which one firm was on top. Apple started it, then IBM took over. IBM tripped in the early 90s and Dell took over. Dell started to stumble about 5 years ago and now HP is on top as we see in the following graph reported in WSJ (HP wields its clout to undercut rivals, 9/24/09):

So how is HP able to do this. First, they are working with small margins, razor thin 4.6% margins. Next, the article gives some other clues to their strategy.

 (1) “Simplifying the specifications of the product”

i.e., reduce product variety so that contract manufacturers can have higher volumes and thereby offer lower prices. This is a standard recommendation in an OPs class.

(2) “By getting orders in earlier, H-P could save on component and manufacturing costs, which are cheaper if they’re ordered far in advance.”

This line is intriguing. If component prices are falling, then ordering early is a disadvantage, not an advantage. This suggests several possibilities. First, component prices may not be falling rapidly and HP is better off giving suppliers a long lead time to get an advance purchase discount from them. Second, component prices are still falling but it is cheaper for HP to take on that risk than to let the suppliers take on that risk – i.e., if they take on that risk then they have to charge more, which is passed on to HP.

As I said, it isn’t your father’s PC industry anymore. What makes me think it could be entirely different in another 5 years?

Out of stock for Christmas

Believe it or not, there is actually a product out of stock this Holiday season – Amazon’s Kindle. Oprah announced that she loves her Kindle and sales have exceeded Amazon’s expectations. The forecast is that they will not be in stock until February.  The key question is how many unit sales will they lose because they are not available in the peak month of the year? Probably more than they want. Even if those sales are deferred to the next holiday season, it is a costly situation for the company.  Of course, there is no way to know if they are just the victim of bad luck (or too much good luck) or bad planning, but it does illustrate that challenges of meeting highly uncertain demand.

Wall Street Journal Dec 4, 2008 – Better Scratch That Kindle Off Your List