How to Recession-Proof Your Supply Chain

By Bruce Arntzen -- Supply Chain Management Review, 4/1/2009

There is something about the good times that makes people forget about the bad times. Yet the bad times are by no means rare. Senior managers who are in their fifties will already have lived through six stock market crashes and be experiencing their eighth major economic downturn.

If we were talking about floods or earthquakes, most business leaders would be very prepared. Not so with economic slumps. During better times, companies still take on staggering debt, carry huge fixed costs and create inflexible supply chains. Then, when the downturn arrives, it finds all the cracks in the supply chain. Recessions like this one pry those cracks wide open. And Murphy's Law dictates that recessions always strike at the worst time.

Can businesses do more to recession-proof themselves and their supply chains? We believe they can. Indeed, we maintain that businesses in many manufacturing industries can more actively anticipate and prepare for severe downturns—and then respond in more disciplined ways once the downturn is upon them. (For a look at how one company has met the challenge, see the accompanying sidebar on Philips Healthcare.)

Impact of Recessions on Supply Chains

Recessions and stock market crashes should not be a surprise to anyone. True, we don't know when they will happen. But we do know that they will happen at some point. Recessions, as defined by the National Bureau of Economic Research, are a fairly common occurrence.¹ There have been eight official recessions (including the one that began in December 2007) in the last 50 years. The time between recessions averages about six years, with each lasting just less than one year.

A history of stock-market crashes shows that they are a fact of economic life too. (See Exhibit 1.)

There have been at least six sharp sell-offs in the last half-century. They occur between five and 10 years apart, show drops in value of as much as 40 percent and take up to two years to make up their losses. The most recent crash—the seven-day free fall in October 2008 that saw drops averaging 340 points a day—is not unprecedented either. On Monday October 19, 1987, the Dow Jones index lost an astonishing 508 points—more than 22 percent of its value—in one day.²

Downturns have drastic effects up and down the supply chain, slowing flows of cash as well as flows of materials and products. Most customers react quickly: They stop buying, cancel orders, delay accepting deliveries, and stretch out purchase orders and payments. For their part, suppliers worry about customers' ability to pay—or pay on time—so they push for early payment, sometimes requiring cash on delivery. They can be right to worry: During a 2006 downturn in the semiconductor industry, a manufacturer of test equipment tried to refuse delivery and payment for long lead-time raw materials it had ordered but no longer wanted. The contract manufacturer caught in the middle went to court and, after a long legal fight, forced the equipment maker to settle before the case went to trial.

The impact of customers' and suppliers' actions can be harsh. If a manufacturer's customers stop buying and taking delivery and suppliers keep shipping parts or materials, the producer will experience the “inventory bulge,” also known as the “working capital bulge.” Just when you need cash the most, you are surrounded by it. Problem is, it's trapped in the wrong form: inventory. A parallel phenomenon happens on the financial side: If customers stop buying and delay paying, and you continue paying suppliers in full and on time, you soon feel the “profit squeeze.”

Electronics parts maker KEMET Corp. fell afoul of those phenomena earlier this decade.³ The producer of tantalum capacitors saw demand soaring—helped by surging mobile phone sales—with some equipment manufacturers paying premiums to keep production moving. In late 2000, KEMET locked in a three-year contract to buy 80,000 pounds of tantalum material at a high price to ensure availability of this scarce resource. When the dotcom crash hit the high-tech sector, capacitor shipments fell by 64 percent and the market price of tantalum came back to earth. KEMET lost $27 million in 2002 as the profit squeeze took hold. The company also felt the working capital bulge: Unable to quit its contract, KEMET had to keep receiving shipments of unneeded tantalum. In 2003, KEMET wrote off $16.4 million in tantalum inventory and took a $24 million-plus charge in recognition of estimated future losses from its commitment to buy tantalum at above-market prices.

So if crashes and recessions are so common, why don't we plan ahead? Despite the growing use of practices such as collaborative planning, forecasting and replenishment (CPFR) and sales and operations planning (S&OP) and the proliferation of tools to enable such practices, recession-proof planning is anything but second nature. It's surprising how many companies are still missing the basics, even though the last recession occurred only seven years ago. And many of the companies that do better at demand forecasting and planning are not consistent enough in their efforts.

Preparations and Reponses

Part of the problem is that operations leaders often lack the clear, systematic approaches needed to be able to plan more effectively. What's needed is a hierarchy of best practices that will help protect your supply chain against a recession. A simple graphic depicts the impacts of a downturn, allowing the behaviors of customers and suppliers as well as those of your company to be broken down and analyzed one at a time. (See Exhibit 2.)

For each of the six challenges identified, we can determine what should be done ahead of time to be prepared, and what companies can do now that recession is upon them. Granted, not all of the responses we describe apply to all companies, and probably no company can excel at all of them. But recessions do find all weaknesses, so the more of these practices you can embrace, the safer you will be. The key is to determine where you are most at risk and focus on those weaknesses first.

Challenge 1: Customers Cancel Orders and Finished Goods Inventory Builds Up

What to do ahead of time:

Build a robust CPFR program. A healthy, ongoing CPFR program will encourage customers to discuss their plans with you, collaborate on risk-taking and work with you rather than against you during the hard times. CPFR attracted extensive coverage a decade ago, so it is easy to assume that everyone is using it by now. Since the publication of the VICS CPFR guidelines in 1998, many top-tier companies have indeed implemented some form of CPFR, especially between major retailers and their suppliers. But CPFR is still a long way from being universal.

Forge risk-aware contracts with customers. Too often in expansionary times, managers don't imagine how contentious material supply contracts can become if the customer stops buying. All contracts with customers should spell out very clearly what will happen to the material flow and cash flow if their forecasts turn out to be significantly in error. What commitment does the customer have to the forecast that they provide? When long lead-time items are involved, the contract should specify time fences for the transfer of ownership of the goods.

Diversify into services. Purchases of services are often harder to avoid during recessions than product purchases. A company may delay buying a new telecommunications hub but it will not cancel the monthly service contract. IBM exemplifies successful diversification into services: In 1992, 70 percent of the company's revenue still came from hardware and software sales. Today that slice is just 40 percent, with the balance from IBM's Global Services unit, which comprises everything from maintenance to consulting and financing. In the fourth quarter of 2008, IBM earned net margins of more than 16 percent.⁴

Use demand-driven, lean manufacturing. By using build-to-order and “pull” manufacturing techniques with small lot sizes and just-in-time (JIT) replenishment, it is much easier to prevent supply from overshooting demand.

Run a healthy S&OP process. Since demand during recessions is usually so volatile, commitment to and regular participation in S&OP activities provide the best chance of matching supply to demand.

What to do during the downturn:

Talk to customers promptly. It's human nature to go quiet when there's bad news to discuss. But business is at risk: Your customer may be planning to cut costs by sidelining your purchase order. By communicating fully, you pressure customers to look elsewhere for their cost reductions. You also have the chance to remind them of existing orders and contract terms—and to get early warnings of their intentions.

Have a sale; offer discounts. As the economy slows, move your finished goods while you still can. A nice 20 percent discount may lure customers. But if you wait until six months into the recession, it may take a 60 percent discount to move the same product.

Act quickly to re-forecast. Most companies will try to revise their forecasts to reflect the reduced customer demand. But even those with strong processes and tight schedules for forecasting, demand planning, S&OP, and plan execution need to sharpen their forecasting capabilities. The stock market crashed inside three days in 1987. Imagine what can happen if a company does not react for another three weeks until its next regularly scheduled S&OP meeting.

Slow down production. Although it may be tempting to maintain production rates to uphold “manufacturing efficiency”—especially in sectors with costly plant and equipment assets—it is not the thing to do during steep downturns. One large U.S. cement maker sizes its own production to satisfy 85 percent of peak summer demand, using imports from Eastern Europe to meet the remaining requirements. The imports are the first to be dropped when a slowdown hits.

Challenge 2: Customers Slow Down Bill Payment, Stretch out Payables

What to do ahead of time:

Don't give away terms blithely. Control the sales teams' ability to give away terms. A key reason: Whatever terms you do give will likely be stretched out during a recession. Focusing management on the cash-to-cash cycle time is a great way to call attention to the terms issue without dictating to the sales force directly. After all, a dollar of accounts receivable counts as much toward working capital as a dollar of inventory.

Enforce contractual terms and conditions. It is crucial to indicate before any crash that you are entirely serious about enforcing terms and conditions. That may involve active discussions specifically on that topic rather than passive assumptions that the other party has read the fine print. Companies that allow customers to ignore their payment terms during good times will find their terms are not respected when money gets tight.

Provide payment options through financing. It's smart to persuade customers to agree to attractive flexible financing and payment options during good times so a formal financing mechanism is in place when recession hits. The financing arms of organizations such as GMAC and GE Capital offer an array of payment options. The customer can choose the number of months to pay off the purchase and must agree to the interest rate. Later, if money is tight, they cannot unilaterally stretch payments, as they could during a “conventional” sale transaction.

Monitor customers' financial health. The more warning you have that a customer may not be able to pay its bills, the better for the health of your supply chain. Include a report on each customer's financial health as a quarterly exercise.

What to do during the downturn:

Talk to customers frequently. Never wait to see whether the customer will pay on time (or at all); proactively discuss invoices with them before they are due so you get early warning of any difficulties they may have with paying. At precision plastics molding leader Nypro Inc., global and local account managers call on the company's suppliers every week to review quality, costs, inventory and delivery, service levels, and technology. Nypro has enjoyed 22 consecutive years of profitable sales growth despite several recessions.

Enforce contract terms relentlessly. As noted earlier, customers have to know you are enforcing the terms and conditions they agreed to. Confrontational though it may be, you must motivate customers to pay by regularly exercising the contract penalties.

Exercise your financing options. In some cases, it makes sense to help valued customers that need to extend their payments to participate in financing arrangements.

Leverage services businesses to collect payments. No on-time payment on a product sale? Then no service. Customers will re-prioritize their bills in order to keep important service contracts in effect. In the jet engine business, it's not uncommon for a manufacturer to offer a 95 percent discount on a new engine if the customer signs up for the service contract.

Challenge 3: Raw Inventory Builds Up as Material Keeps Arriving

What to do ahead of time:

Use common, industry-standard parts. By working closely with your product design engineers, you can more easily avoid using custom parts. When a small electronics company performed a “where-used” analysis on its products in a bid to lower its materials inventory risk and cut component costs, it found that 24 percent of the parts were used only on one end product and another 15 percent were used in just two end products. When the company's engineering vice president learned about the attendant supply risks, he instituted a policy of tracking new and non-standard parts and required designers to justify their use.

Rely on VOI or VMI. The best situation, if you can do it, is to set up nearby stocking with vendor-owed (VOI) or vendor-managed (VMI) inventory programs that provide JIT delivery to your site.

Place cancellable orders. Negotiate supplier contracts that provide a way to cancel orders and share the risk. All contracts need to have a reasonable “way out,” yet many do not. Too frequently, small companies, often in a hurry, end up using the “standard contract” provided by a larger trading partner. Any attempt to change the language is stonewalled with responses like: “That will require the lawyers to get involved and it will delay the deal by months.” Such standard contracts are almost always heavily biased in favor of the large company and provide no risk-sharing and no reasonable exit for the smaller partner.

Establish CPFR systems with your suppliers. Giving suppliers as much forewarning as possible helps them react faster to your need to stem the inbound flow of raw materials.

Set up risk management contracts with suppliers. Plastics molding leader Nypro exemplifies this practice. Explains Rashid Shaikh, senior director of global sourcing and supply chain operations: “We set up back-to-back agreements with customers and suppliers so no one bears all the risk of a demand stoppage. For example, we will ask a supplier to keep X days of raw inventory on hand as consignment stock at a Nypro factory. The supplier agrees because we use this assured supply to get an X+10-day commitment from the customer to their forecast. The customer gets guaranteed availability when plastics supplies are tight and the supplier gets a solid commitment from us to buy the consigned inventory within a reasonable time period. NYPRO bears little risk since our customer commitment is longer than the consigned raw material days of supply.” Such practices have helped Nypro's revenues grow from $198 million in 1994 to $1.16 billion in 2008.

Apply lean purchasing practices. Lean techniques can be applied to procurement too, in concert with lean production practices. The more you can utilize demand-driven build-to-order or “pull” manufacturing techniques with small frequent deliveries, the better you can regulate replenishment and prevent raw material build-up.

What to do during the downturn:

Just as with your customer-facing issues, you have to act quickly to work your supplier-facing issues, re-forecasting swiftly and ensuring that your buyer-planners quickly adjust their orders to fit the new forecast. It's also vital to talk to suppliers promptly to put the brakes on your orders and to share the risks of unwanted inventory. And in cases where a key supplier holds inventory of parts that the customer no longer wants, that customer can often help find other buyers. Other actions that you should pursue include:

Switch purchases when need be. You may be able to switch your order from parts that you no longer need to parts that you definitely need—or know you will need soon. Not only can this help to deflate the working capital bulge, but it will likely cushion the impact on the supplier.

Steer sales and production toward consuming excess raw inventory. An effective S&OP process can help guide the sales force toward selling products whose production will consume excess materials.

Challenge 4: Parts Shortages Become Critical When a Supplier Collapses

What to do ahead of time:

A detailed review of the supplier's financial health should be part of the quarterly business analysis discussed with each supplier. You can further reduce the risk of supply-chain disruption by using more industry-standard parts, thereby making it easier to find alternate sources. Other techniques include:

Have a second source of supply. This approach helped a network router maker avoid forfeiting its sizeable investments in product design. Its new router design called for three custom semiconductor chips to be built and for the work to be outsourced. With each chip costing $1 million-plus to develop, the OEM decided to duplicate the contracts, assigning the work to two chip design companies. Of the six prototypes received, one did not work. Without the second source, a whole generation of product would have been at risk.

Keep extra inventory on hand. In our push to create lean supply chains, we now depend on rapid re-supply from suppliers. But recessions make even dependable suppliers undependable, and parts we take for granted in good times may become critical-path if supplies are interrupted. Identifying your critical supply chain path and keeping some extra inventory of critical parts is a smart insurance policy.

What to do during the downturn:

Talk to suppliers promptly. If a shipment's failure to show up is your first indication that your supplier has gone under, you have squandered valuable time needed to find another supplier. In hard times, you have to talk to your suppliers frequently to get candid information about their financial situations.

Consider helping the supplier survive. It may be easier to help your current supplier get through the recession than to find, qualify, and ramp up a new source. Currently, the Tier 1 auto-industry suppliers in North America are trying to keep their suppliers alive until the economy recovers.

Switch to a backup supplier. A communications equipment leader uses the shipping services of Fedex and UPS at its central parts warehouse, with each provider able to handle 100 percent of the load if needed. The equipment maker can switch instantly from one to the other in case of a failure. The strategy has paid off: The company has had only three failure incidents in the past two years that called for a switch to the alternate shipper.

Help another supplier ramp up quickly. Prior to the 2001-2002 recession, a networking equipment company worked with its contract manufacturer to perfect rapid line changeover and build-to-order processes. But when the recession hit, the manufacturer was forced to close when its other customers stopped buying. The equipment company quickly found a new source and dispatched a team to teach that contract manufacturer how to master build-to-order techniques.

Use substitute parts. Substitution may require some engineering changes, retooling, or new testing. In some industries, such as electronics, large component distributors routinely have conversations about substitute parts with their manufacturing customers.

Challenge 5:Direct Labor Spending Stays High

What to do ahead of time:

Move to a variable cost structure. Outsource operations based on a cost per piece. This approach could be used, for example, with contract manufacturing, common carriers, third-party logistics providers, and contract repair centers. Many of these providers are much more practiced at ramping up and down and shifting resources around than are typical large OEMs.

Deploy a more flexible workforce. Rethink your labor resources so they can more easily scale up and down based on need. Arrange this flexibility with workers during good times when the issue is less contentious so it will be in place when you need it.

What to do during the downturn:

Scale back on variable costs. Outsourced activities should be scaled back automatically as demand decreases. At one high-tech company, spare parts distribution and repair, once internal, have been outsourced. Now, when parts demand drops by X percent, the costs of supplying or repairing them drops by much the same percentage.

Reduce the workforce. The basics are familiar: implement a hiring freeze, promote early retirement, reduce hours, enforce vacation usage, and implement plant furloughs. There are more palatable ways to manage these issues. For example, when a small U.S. maker of wiring harnesses gathered its employees to discuss the downturn, employees voted overwhelmingly to have everyone work a four-day week instead of laying off some employees.

Challenge 6: Overhead Spending Stays High

What to do ahead of time:

Implement a variable cost structure. Use the good times to set up a variable cost structure. Employees with flexible hours will enjoy overtime during good years and provide cost relief during lean years. In addition, call centers and a host of back-office functions can be outsourced as variable costs.

Install firm purchasing controls. Central control of spending is needed to enforce policies consistently to modulate spending in hard times; otherwise, departments always point to the “other guys” for spending cuts. Employees must be required to get spending approved by someone accountable for the budget.

Consolidate approved suppliers of indirect materials and supplies. The fewer approved suppliers you have, the easier it will be to control spending—even with a reluctant or undisciplined employee base.

What to do during the downturn:

Many of the principles applied to reducing overhead spending apply here too. Scale back variable costs by outsourcing; reduce fixed costs with selective layoffs, offers of early retirement, and offers of part-time work as alternatives to layoffs. Delay discretionary spending in areas such as equipment investments, system upgrades and travel. And find ways to minimize the costs of perks such as company cars and airline club memberships, perhaps by reducing employer subsidies.

The stock market crash that started on Oct. 28, 1929 finally hit bottom three years later, after falling by nearly 90 percent. It took a quarter of a century for the market to recover. In the 80 years since, the world has changed in almost every way, yet we are still taken by surprise by steep and sudden economic downturns. Far too many senior managers still make decisions that assume the good times will last forever—which leads to many companies getting caught with working capital trapped in unmoving inventory or accounts receivable.

There are many simple actions that companies can take to better position themselves to withstand a downturn. By far the most effective are those actions taken when the economy is buoyant and demand is strong. Once a recession is underway, remedial options are limited—and much less effective.

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