Chinese factories grind to a halt

In early February 2020, restrictions linked to the new coronavirus kept many Chinese factories closed beyond the Lunar New Year holiday, which normally means a short and predictable stoppage. This time the stoppage was lengthening and its duration was uncertain. For companies that rely on those production centres, every week of delay means orders that do not ship and customers who are kept waiting.

Companies around the world began to notice delays in components and goods. What had seemed a distant problem became a day-to-day management matter for manufacturers, distributors and shops that depended, directly or indirectly, on what those factories produced, and it showed how closely economies are connected.

A chain with many links

A finished product is rarely made in one place: its parts travel between factories in several countries before reaching the customer. This organisation, known as the supply chain, makes it possible to produce more cheaply and with more specialisation, but it also multiplies the points on which one depends. When one link stops, the delay spreads forwards and backwards. It is the familiar domino effect: the problem does not stay where it begins.

The effect reaches companies that do not even know they depend on that link. A manufacturer may buy from a European supplier that in turn receives a component from Asia, and only learn of the problem when the order fails to arrive. That is why the impact of an industrial shutdown is rarely confined to the country where it happens. Whoever buys from a local supplier is not necessarily safe, because that supplier may in turn depend on inputs that come from far away.

Efficiency versus resilience

For years, companies optimised costs with minimal inventories and single suppliers, because that was the most efficient approach. That efficiency has a price: when something fails, there is no room to manoeuvre. Working without stock is cheap while everything flows normally and very expensive on the day it does not. The temptation, when all is going well, is to save on that cushion; the moment to value it is when the chain is interrupted.

A little safety stock or a second supplier costs money every year, and pays off above all when things go wrong. It is the logic of any insurance: a small, steady premium is paid so as not to face a large, sudden loss. Each company must decide how much resilience it is willing to buy, and where. There is no single answer: it depends on the product, the margin and the delay the customer will tolerate.

Knowing your suppliers’ suppliers

For a small or medium-sized business, the useful exercise is simple: identify the critical components or services, find out where they really come from and assess what would happen if they were missing for two or three weeks. Asking direct suppliers where they source their materials is usually enough to uncover dependencies that appeared in no document. The question is hardly intrusive and tells a lot.

With that information it is possible to decide where alternatives are worth having and where watching is enough. It is also useful to review supply contracts: delivery times, penalties, force majeure clauses and the possibility of changing origin. And the result is worth discussing with the adviser and the insurer, to know which part of the risk is covered and which is not. An annual review of critical suppliers, with a short and up-to-date list, is usually enough to keep the map current.

It was the first warning of something the following years would confirm: knowing who each link depends on is part of managing risk.

This article is general information. It is not legal, tax or investment advice, and it does not take anyone’s particular circumstances into account.