“What we have learned is that most small companies don’t have good risk management plans and can’t afford them,” says Dr. Heinrich Steins, Director, Enterprise Supply Management Operations at heavy equipment manufacturer Deere and Company.  “So if you want to protect your small manufacturer supply base, which we do because there is a lot of knowledge in that base which is hard to replace, you need to raise their awareness so they know the kinds of risks they are exposed to and how to off-set them.”

As if to underscore Dr. Steins’ prescience, on the day we spoke Intel’s stock fell 5% on warnings that fourth quarter results would fall short of predictions due to hard disk drive supply shortages caused by the torrential flooding in Thailand.

To help Deere suppliers become more resilient, Dr. Steins and his colleagues offer them what he calls a kind of ‘risk management system-lite’ modeled on the resources and tools developed by the multi-national company. “It’s like a cook book, which you hand to your supplier and they use for free.”  It encourages them to think about questions like ‘how big a risk am I exposed to? where’s my biggest exposure? do I have to develop contingency planning?’

Material availability, observes Dr. Steins, “is a big deal for them, it’s at risk when markets turn up and capacity is limited.” One risk-mitigating approach: “hook up with other companies to combine the volume of their purchasing.”  Another often unacknowledged risk category is the implications of lay-offs.  “Companies tend to over-react by firing too many people. They regard the work forces as a ‘commodity’ instead of a ‘knowledge base’.  They need to determine the minimum amount of knowledge necessary to keep on the plant floor.”  Similarly, obtaining enough qualified workers can pose a risk when the supplier has to get back up to speed quickly: “in a down-turn, it’s useful to keep a data base of trained former employees so you can hire back critical people fast.”

Keeping supply chain partners who deliver critical product in good financial and operational shape is integral to Deere’s own risk management. Dr. Steins sketches a worst-case hypothetical: “We have a safety part on a combine, for example. Quality requirements mean you have to do testing in the field, and you only can do that in certain seasons.  If your supplier falls out in December, you have to wait for corn harvest time in North America to test a new supplier’s part, which would mean you couldn’t build machines for almost a year.”

One way Deere mitigates risk for its suppliers is by helping them reduce exposure to fluctuations in raw material cost and supply by allowing them selective access to Deere’s long-term contracts.  “We don’t let the supply base carry all the raw material risk.” Over the last several years, “we have more than doubled the amount of steel we buy for our metal fabrication suppliers.”  There is a risk-sharing agreement for rubber used for tires (“we have a six month agreement formula where commodity prices are going and then we do adjustments on the price”).

With Deere’s Tier One and Tier Two suppliers well on their way to contingency resilience, the company now has become increasingly concerned with Tiers Three and Four.“The Japanese earthquake raised problems with Tier Three and Four exposure in electronic suppliers that we weren’t aware of.”  The solution?  “We’re now in some serious discussion with Japanese manufacturers on how we can balance manufacturing in Japan and outside of Japan.”

While China’s prominence as ‘the world’s factory’ is likely not in jeopardy for the moment, savvy observers are increasingly spotting gathering storm clouds on the horizon that may start posing serious up-stream risks to supply chains. 
 
The factors that drove companies to low-wage countries over the past several decades is a litany of cheap labor, accessible raw materials, improved logistics, and technologically innovative IT. Many of these benefits which drove China’s explosive expansion and effectively outweighed the risks of long-distance management are, however, beginning to look problematic. “Rapid economic development and a smaller supply of young migrant workers are pushing up labor costs,” reported the Wall Street Journal in mid-December. “Tack on rising raw-materials prices, driven largely by Chinese demand, and a strengthening currency, and China-made goods aren't the bargains they used to be.”
 
Inflation, which had soared over the past few years eroding the ability of workers to afford basics like food, energy and housing, remains a threat.  David Pierson in the Los Angeles Times reports,  “…[M] any economists believe China's economy, which grew by 10.3% last year, has been pumped up by unsustainable lending. Between 2009 and 2010, the nation's money supply grew by 50% to blunt the effects of the global recession.”
 
Added to the problems of economic strain are prospects of social stress.  "Indicators showed that export industries and some other areas of the economy were cooling more sharply in the quarter ending in September.  According to the reporting of Elaine Kurtenbach and Joe McDonald (“Chinese Manufacturing Slowdown Sparks Growth Fever”), the slowdown is raising fears of job losses and possible unrest.
 
Dr. Charles Wolf Jr., Distinguished Chair in International Economics at the Pardee Graduate School at RAND and author of China's Expanding Role in Global Mergers and Acquisitions Marketsand China and India, 2025: A Comparative Assessment,recently discussed with SCRLC’s Nancy Moore what the current China situation might mean for supply chain risk.
 
Dr. Wolf cites other factors likely to create head winds.  There is extreme and worsening economic inequality within the country (per capita GDP differentials between the richest and poorest provinces is as high as 16:1, by way of comparison the differential between California and Mississippi is a scant 3:1).  Access to education, legal process and land holdings is inequitable, with the Communist Party’s 75 million members enjoying privileges unavailable to others.  China also ranks high in corruption.  The military looms dominant, rates of its spending is growing at a rate twice that of the country’s GDP as per Dr. Wolf’s estimates.

When asked about China’s future growth, Dr. Wolf predicts China will have a“soft but bumpy” landing due to “pot holes in the runway” (a metaphor for corruption) and “defective landing gear” (a metaphor for flaws, imperfections, and weaknesses in China’s economic model).  He predicts that China’s average rate of growth will be slower than it has been, although still good in the range of 4% to 6%. 

All these factors serve to diminish the luster China once possessed as an uncontested superior site for sourcing. When it comes to additional supply chain investment, Dr. Wolf suggests looking beyond China, urging portfolio diversification to diversify risk.  One factor he cites in support of that recommendation is the shift in the U.S. to two tiered wage scales (e.g. General Motors), which makes American products more competitive and should prompt re-consideration of on shoring.Recent data from the U.S. Bureau of Labor Statistics lends further credibility to that position, showing that U.S. labor costs per unit of output are 13% below the level a decade ago and that energy costs are cheaper (attributable to the shale-oil boom).

How big a concern are severe weather incidents to Rob Gilbert, Supply Chain Risk Manager for GE Energy?
 
“Incredibly important,” he says.  He sees an increasing number of supply chain disruptions attributable to weather (“2011 was more active than 2010”). It’s not just headline events like the Japanese tsunami or the Thailand floods that cause problems but also lesser incidents (“in the U.S. there were hundreds”).
 
Electrical power is particularly vulnerable to the impact of severe weather. “Collapse of the grid because of weather is a compelling risk,” observes Gilbert.  “Our grids are antiquated and badly in need of up-dating.”
 
In the United States, for example, power plants are no longer built close to customers (as was originally true).  Instead, most users are supplied by way of the power grid, some 160,000 miles of connected transmission lines, which enable utilities to supply electricity to large areas with fewer power plants.  The good news is that this makes it easier to balance supply and demand; the bad news is that it entails expensive infrastructure susceptible to damage in extreme weather events.
 
According to a report issued in 2011, More Extreme Weather and the U.S. Energy Infrastructure Power, outages and disturbance are estimated to cost the American economy between $25 and $180 billion each year. During the mid 1990s, the country averaged 5 to 20 major outages annually. In the last five years, those numbers have risen dramatically, with around 50 to 100 major outages now occurring each year.

Hotter summers are also posing increased weather strains on power.  The Electric Reliability Council of Texas, for example, recently warned that recurring power crises like last year’s rolling blackouts would face the state should it continue to incur “extreme weather conditions and worst-case generation outages.” According to the Council, the state’s reserve generating capacity will “likely fall below the minimum target beginning next summer (2012).”

For Rob Gilbert, charged with assessing and facilitating the business continuity capability of “mission critical”  suppliers (some 4% of GE Energy’s total of 100,000), power reliability is an increasingly important concern. “We will ask ‘how do you prepare yourself for a deadlock in electricity?’ “

Although GE Energy does not currently require business continuity plans from mission critical vendors (at present he estimates about 25% have one in place), part of Gilbert’s mandate is to strongly encourage them to consider developing and implementing one, including back-up generator capability where it is relevant.

“I’ll ask them ‘do you have another means to get things done if you can’t produce because of power outage?’ I tell them to try to prepare for this situation instead of thinking, as many do, that since this has never happened before they don’t have to worry about it.”