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5. The Financial Crisis and the Money Supply Chain

Published onApr 08, 2020
5. The Financial Crisis and the Money Supply Chain

Recall the discussion of supply chains in chapter 1 and, specifically, the three types of flows underlying supply chain management: material, information, and money. Most disruptions (e.g., a tsunami, a labor strike, or theft) affect material flows from suppliers to their customers. Material flow disruptions are often coupled with disruptions in the information flow (see chapter 4). In contrast, a financial crisis disrupts the flow of money and credit, which affects the ability of consumers to purchase goods from retailers and of manufacturers to purchase parts and products from suppliers. Thus, whereas many disruptions affect supply, a financial crisis affects demand as well.

A Disruption of the Money Supply Chain

If a tsunami of water takes minutes or hours to wreak its devastation, then a tsunami of debt takes months or years to inflict its ravages. And just as a massive earthquake arises from centuries of accumulated seismic strain, the 2008 financial crisis began much earlier, in the 1990s. Low interest rates after the 2001 recession made housing much more affordable to borrowers and created rising demand for housing at ever higher prices. And those same low rates pushed lenders and investors to seek innovative new investments with higher rates of return, as well as creating new financial instruments that transferred and hid the risks of default.

The Buildup to a Breakdown

Between 2002 and 2006, housing prices doubled in the United States1 and also surged in other countries, including Spain, Ireland, and the United Kingdom.2 The more housing prices appreciated, the more attractive housing became to housing buyers, real estate speculators, and the investors funding the mortgages. Financial innovations such as securitization—the bundling and redividing of collections of debts—enabled global investors to share in the profits of the housing boom. If housing prices could only go up, then even people with bad credit and no down-payment looked like safe investments. The percentage of subprime mortgage originations almost tripled to 20 percent of all mortgages.3

Between 2002 and 2006, some $14 trillion (!) in mortgage-backed securities (MBS) were issued in the United States alone.4 Not only did these trillions finance a surge in construction and related durable goods purchases (e.g., home appliances), but cash-out financing and home-equity loans let home owners convert their home’s rapidly rising equity into cash for other purchases (cars, recreational vehicles, flat-panel TVs, etc.). Between 2002 and 2008, US homeowners converted roughly $4.5 trillion of home equity into cash and took on increasing personal debts.5 Flows in global supply chains grew significantly on the abundant money supply. Between 2002 and 2008, US exports6 and US imports7 doubled.

In June 2004, the US Federal Reserve began raising short-term interest rates to reduce monetary stimulus, but the initial hikes had no effect. In fact, long-term rates, such as mortgage rates, paradoxically dropped. This prompted then-chairman of the Federal Reserve, Alan Greenspan, to remark, “For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum.”8 Housing, GDP, exports, imports, and the stock market marched exuberantly upward even as the Fed continued to raise rates.

The Crest of the Breaking Wave

But the debt-fueled housing-bubble economy could not grow forever, and a succession of peaks portended the coming declines. First, sales of new houses peaked (July 2005). Next, housing starts peaked (January 2006). Then housing prices reached their zenith in April 2006.9 As real estate activity slumped, banks tightened lending standards on commercial real estate (Q4 2006), and residential mortgages (Q1 2007).10

The rising interest rates hit many mortgage borrowers with higher monthly payments. Tighter lending standards and declining housing prices locked them out of further refinancing. Real estate speculators—who relied on flipping real estate quickly—got stuck with houses they could not sell. Delinquencies and foreclosures began to rise in 2006, which began to erode banks’ finances. At the end of 2007, banks further tightened lending terms for commercial and industrial loans and hiked interest rates on those loans.11,12

When it became clear that securitized subprime mortgages would not deliver their promised profits, the edifice of debt began crumbling. Both banks and borrowers found themselves overextended, which pushed the US economy into recession in January 2008.13 By August 2008, unemployment had risen, durable goods sales had dropped 5 percent, and car sales had dropped 20 percent. The retreating economy revealed the rocks of risk lurking below the financial froth. Or, as Warren Buffett is credited with saying, “You only find out who is swimming naked when the tide goes out.”14

The downturn entered a more dangerous phase shortly after midnight on Monday, September 15, 2008, when Lehman Brothers, the fourth largest investment bank in the United States, declared bankruptcy, citing debts totaling $768 billion and assets worth only $639 billion as a result of large losses on subprime mortgages.15 The stock market lost 4 percent of its value that day. American International Group (AIG), an insurance company with $1 trillion in debts, including credit default swaps that backed $60 billion in subprime mortgages held by other financial institutions,16 appeared to be the next company on the brink of collapse. The global financial system was unraveling quickly with a very real risk that the liquidation of one firm’s holdings could drive down asset prices to the point that it forced the liquidation of other firms. To halt the domino effect, the Federal Reserve Board arranged an $85 billion bailout on September 16.17 As part of the bailout, the United States became the owner of 79.9 percent of AIG’s equity.18

From Breakdown to Bullwhip

The Lehman bankruptcy sent a shock throughout the financial system and the broader economy, affecting the demand for almost every good; US consumer spending fell 8 percent.19 Hardest hit were capital goods industries, as a result of constriction in the supply of capital. New home sales fell by 80 percent.20 New car sales dropped 30 percent,21 and new orders for durable goods sales slumped 40 percent.22 Chrysler filed for bankruptcy in April 2009, General Motors in June 2009. Demand for services fell, too, with declines in restaurant sales and airline passenger volumes. Europe also suffered as a result of a combination of the global recession, European bank exposure to US mortgages, Eastern European debt, unfunded state largess, and housing bubbles in Ireland and Spain. Exports from Europe fell and the economies of the peripheral countries of the EU nosedived.

The swift contraction in demand sparked an amplified reaction in upstream supply chain activities that grew more and more extreme as the disruption in demand propagated up the chain of suppliers—a phenomenon known as “the bullwhip effect.”23 In a hypothetical illustration of the bullwhip effect, if a retailer sees an X percent drop in sales, it might reason that future sales will be low, too, because most forecasts are based on past experience. In addition, it might realize that its current inventories are too high if future sales continue to be low. Consequently, the retailer might cut orders to the wholesaler by, say, 2X percent (reflecting both lower future sales and desire to decrease the high current inventory). The wholesaler, seeing the 2X percent drop in orders from the retailer, might prepare for future lower sales and too much inventory by cutting orders to the wholesaler by 4X percent. At each tier of the supply chain, the decline in demand sparks a bigger decline in orders from suppliers—each company reasoning that it needs to quickly cut production (to adjust to declining sales) and work off its bloated inventory.

The exaggerated decline in orders can be especially damaging to upstream suppliers who have high fixed costs tied to production assets. Ford CEO Alan Mulally tried to mitigate the impending bullwhip during the financial crisis by imploring the US Senate banking committee to save his competitors. He argued that otherwise the automotive Tier 1 suppliers would fail and then their suppliers would fail, and so on, affecting the entire US automobile industry.

When demand revives, the bullwhip pattern reverses as each echelon boosts ordering both to cover expected higher sales and to quickly replenish depleted inventories. Again, the effect amplifies up the chain with larger and larger order size increases upstream in the supply chain. However, because of cuts in capacity during a downturn, upstream companies take time to respond to orders. As orders flood in, lead times grow, suppliers start allocating partial shipments to customers, and customers respond by boosting orders even more in an effort to garner a greater percentage of the allocation. All of this causes significant swings in inventory and orders, such that the amplitude of the swings is larger the further upstream (and further from the consumer orders) a company is in its supply chain.

In the context of a normal economy with modest demand volatility, the bullwhip effect causes volatility to vary across the tiers of a supply chain—wholesale volumes will be more volatile than retail volumes, manufacturing volumes will be more volatile than wholesale volumes, and supplier volumes will be more volatile still. This phenomenon has been documented in consumer-packaged goods industries,24 food,25,26 semiconductor manufacturing,27 and others.

Macroeconomic data during the 2008 financial crisis show the bullwhip effect operating on a much broader scale. For example, US retail sales (representing consumer demand) declined by 12 percent; yet US manufacturers pulled down inventories by 15 percent and manufacturing sales declined almost 30 percent, while imports plunged over 30 percent.28 The financial crisis created a broad bullwhip across the globe. More than 90 percent of OECD countries exhibited simultaneous declines in exports and imports of more than 10 percent.29 A survey of 125 Dutch companies found that those in Tier 1 and Tier 2 relative to end-consumers saw a 25 percent drop in revenues, while those in Tiers 3 and 4 saw a 39 to 43 percent drop.30 The bullwhip showed in the financial data of individual companies, such as the life sciences and materials company Koninklijke DSM N.V.; Dutch multinational Akzo Nobel N.V.; German conglomerate ThyssenKrupp AG; and in Koninklijke Philips N.V., the Dutch diversified technology company commonly known as Philips.31 Evidence of the bullwhip effect during the financial crisis was also found in studies of French import/export transaction data.32 The bullwhip effect explains, in part, how a global financial earthquake can shift the tectonic plates underpinning the economy and create a global tsunami of economic disruption.

Disrupting the Supply of Trade Finance

The disruption of the banking system also had a direct impact on global trade.33,34 Banks and other financial institutions act as financial intermediaries in foreign trade by issuing letters of credit that guarantee payments across international borders. These financial instruments require trust between banks, and trust was in short supply after Lehman failed. The TED-spread,35 which represents the willingness of the largest banks in the world to lend to each other in short-term routine transactions, spiked from pre-crisis levels of 0.3 percent in April 2007 to over 4.5 percent by mid-October 2008.36 Banks simply didn’t know who was exposed to toxic debt—in some cases, the banks themselves weren’t aware of risks lurking within their own portfolios. Analogous credit spreads in exporting countries were even higher than the TED-spread.37

Between 2008 and 2009, letter-of-credit messages in the SWIFT38 network declined at a rate faster than the decline in merchandise trade.39 Most banks tightened trade-related lending guidelines and increased the costs of lending to exporters.40 The problem affected seaborne international trade more so than air or land-based international trade as a result of the much longer durations needed to cover slower modes.41 In short, the supply of money for international trade dried up.

A Disruption in Demand

Whereas physical disasters usually have an obvious geographic epicenter, the financial crisis created more widespread uncertainty. At first, companies didn’t know the impact on demand and supply. Would there be bank runs? How far would real estate prices fall? How far would the stock market drop? How high would unemployment climb? How would consumers, customers, retailers, suppliers, and governments react to the crisis? Which suppliers, logistics companies, and retailers would fail? No one knew. With the tightening of credit and so much financial uncertainty for consumers and businesses, consumer demand fell.

Given the disruption in the money supply and the fact that money to purchase goods and services enters the supply chain on the retail end, retailers had front row seats for the disruption. Many US retailers failed, including Circuit City, Linens ’n’ Things, Filene’s Basement, Eddie Bauer, Ritz Camera Centers, and many others. US retailers were responsible for 19 percent of the mass layoffs in 2009,42 although the retail industry represented only 6 percent of US gross domestic product.43

Consumers Shift to Frugality

The uncertainty created angst everywhere, manifesting itself in consumers’ anxieties over spending. Consumers embraced frugality and sought to stretch their constrained budgets.44 Although Shaw’s supermarket chain believed it was relatively recession-proof because people must eat, it noticed a strong shift in consumer buying habits away from higher-priced (and higher-margin) items toward less expensive store brands. While unit sales in food remained the same, both revenues and margins dropped as sales of low-cost staples such as pasta and Campbell’s Soup grew. For Chiquita, banana sales increased while premium salad sales decreased. Other retailers, such as Staples, similarly noted the trend toward frugality among consumers.

Although most companies were negatively affected, those serving the lower end of the price spectrum garnered increased demand. “Walmart sells what you need to have as opposed to what you want to have,” said Howard Davidowitz, chairman of a national retail investment-banking and consulting firm.45 Similarly, when people ate out, they went to low-priced venues such as McDonald’s.46 To address the shift, some companies responded by creating “value-for-money” products to attract the growing numbers of price-conscious consumers. For example, the downturn forced Starbucks to offer $1 cups of coffee and new instant coffee to offset declining sales of its premium coffee drinks.47

Paradoxically, the downturn actually created supply shortages in some industries, for two reasons. First, the increase in order cancellation rates caused suppliers to delay production. Suppliers didn’t want to purchase raw materials for orders that might be canceled. They cut inventories and waited for firm orders, building a sales backlog as a “cushion.” This reluctance of suppliers to commence production without firm orders (and upfront payments) caused supply shortages.48 Second, changing demand patterns brought shortages of (now higher-volume) lower-priced goods and private-label brands.49 Both Shaw’s and Staples found that the shift from brand-name to private-label products strained the contract manufacturers making these generic products.50

Frugality Disrupts Forecasting

The changes in consumer’s purchasing behavior upended years of historical data used by companies for forecasting. Before the crisis, grocery chain Shaw’s “knew what you would have for dinner next week.”51 The retailer, with 169 stores, used 10 years’ worth of data to forecast exactly what consumers would buy and even how they would react to promotions. During the crisis, however, demand shifted so much that a survey of 342 global companies between late 2009 and early 2010 found that the top two challenges for supply chain performance were “demand volatility and/or poor forecast accuracy” (74 percent of respondents) and “lack of visibility to current market demand” (33 percent).52

Along those lines, office supplies retailer Staples said that its forecasts were no longer as accurate as they once were. Other companies experienced abrupt customer events that changed demand patterns. For makers of computers and other electronic products, such as HP (the biggest creditor of Circuit City53), that meant a sudden shift of the business to other retail channels with different patterns of demand.54 History stopped being a good a predictor for demand patterns.

Reacting to Forecast Inaccuracy

The downturn and disruption of forecast reliability forced companies to resort to reactive tactics rather than to planned strategy. Shaw’s Supermarkets had neither sufficient historical data nor applicable forecasting models to estimate the new pattern of demand for the private-label products that consumers were suddenly seeking. As a result, the company had to become more nimble and short-term focused, using ad hoc communications as well as manual ordering from its suppliers. Rather than Shaw’s promotions driving sales and marketing activities, consumer behavior was driving marketing—a complete reversal from the past; consequently, the company became focused on the next week, not on the next quarter.

Companies Shift to Survival Mode

“Hunkering down” for survival was the prevailing behavior of customers, suppliers, and companies in many industries. Responding to falling orders from their customers, companies cut orders to their suppliers even further, thus contributing to the bullwhip. Interviews with 20 companies, conducted at the MIT Center for Transportation and Logistics, documented that cost-cutting was the prevailing response to the crisis.55 Many companies slashed budgets, cut staff, and eliminated non-essential expenses. In 2009, another survey found that companies reduced supply chain costs by negotiating supplier cost reductions (75% of respondents), reducing inventory levels (60%), moving to lower-cost suppliers (44%) and reducing the number of suppliers (40%).56

Even recession-proof industries such as healthcare and education were affected. Medical device makers saw customers such as hospitals having financial problems. Well-funded universities such as MIT and Harvard University saw their endowments decline in value by 25 to 30 percent. This caused the universities to curtail operating budgets and halt many capital projects.

Smaller Shipments, Slower Modes

Cost cutting affected demand patterns for logistics in two ways. First, C.H. Robinson, a third-party logistics provider, noticed that customers wanted smaller shipments. Companies switched from using full truckload (TL) to less-than-truckload (LTL) carriers and from LTL to parcel carriers. Even though the smaller shipments cost more per unit shipped, shippers chose smaller order sizes because they were more concerned about high inventory levels and customer nonpayment risks.57

Second, the financial crisis also coincided with high oil prices and growing concerns of greenhouse gas emissions, which reduced demand for faster modes. UPS and FedEx saw their customers shift from premium air service to less expensive ground delivery modes. Between 2008 and 2009, FedEx Express (air) shipments dropped nearly 5 percent but FedEx Ground shipments rose 1 percent.58 The total volume of international airfreight fell 25 percent.59 Mission-critical parts service providers noticed a decline in requested service levels: two-hour service became four-hour, and four-hour service requests became eight-hour, for example.60 High oil prices also motivated ocean carriers to adopt “slow steaming” (see also chapter 10) to save fuel.61,62 Slow steaming delayed delivery of goods, increasing inventories in transit. The longer transit times also increased exposure to a multitude of transoceanic trade risks such as customer bankruptcies, port disruptions, and tariff increases.

The interplay of shipment size, speed, cost, and inventory create complex tradeoffs, which many companies addressed through a segmentation of their supply chains. For example, Shaw’s considered lower-cost transportation modes, such as rail instead of truck. Rail was cheaper, but it took 21 days to move rail containers across the country, which increased the inventory costs. Not all products were shifted to rail; strawberries were too perishable, but hardier fruits such as Washington apples could make the rail journey. Astute companies performed frequent reassessments of transportation costs because fuel prices fell during the latter part of the recession, making trucking, at times, attractive again for more products.

Looking at the Bigger Picture before Making Bigger Cuts

With the downturn in demand, BASF (the largest chemical company in the world) faced tough choices in operating its expensive, massive chemical plants. As a result of diminished demand, some plants were operating below economically productive volumes, and their managers wanted to shut them down in order to limit the losses. Yet BASF has many vertically integrated parts in its internal network, a strategy it calls verbund (which is German for “linked” or “integrated”).63 This integrated structure means that some of the most important suppliers and customers of BASF plants are other BASF plants.

Rather than analyze each plant in isolation (i.e., whether a given plant has enough direct customer demand to justify its continued operation), BASF looked at the bigger picture of its internal supply chain. Although a certain facility might have been economically unproductive on an individual basis, BASF kept the plant running if the plant made intermediate products that were used by other still-profitable parts of BASF. This was analogous to the value-at-risk calculations described in the last part of chapter 3, in the sense that BASF was calculating the total impact of disrupting production of an intermediate chemical on all the downstream products that use that chemical, and thus on the entire company’s financial performance. The company could rely on this holistic strategy because it had control over all the company’s divisions for purposes of cost sharing. This is not the case for most other companies, who rely on external suppliers, some of whom may go out of business, creating shortages.

The Upside of a Downturn

“A crisis is a terrible thing to waste,” said economist Paul Romer, noting the opportunity for making changes that would be difficult at other times.64 During downtimes, there is significantly less resistance to change, and companies also may have underutilized workers who can take on the restructuring tasks. With this in mind, some companies used the financial crisis to their advantage. Office supply giant, Staples, made major changes to its IT systems by merging two IT networks to improve its operations. Home Depot implemented a new distribution strategy, consolidating cross-docking flow centers to improve delivery efficiency.

While some companies reacted to the downturn by squeezing their suppliers for price reductions, others did the opposite by seeking reliable and stable suppliers. Thus, Trevor Schick, vice president of global supply chain management and chief procurement officer at EMC Corporation (an IT storage hardware solutions manufacturer) saw a “flight to quality” phenomenon among some customers. Schick also noticed that the biggest companies gained market share in a recession while the weaker ones lost. In an industry like storage devices, which had five large companies and 80 startups, fears about the survival of the startups pushed customers toward sourcing from the larger suppliers.

Other companies took advantage of the downturn by beginning expansion initiatives. Barrett Distribution Centers exploited distressed real estate prices to buy warehousing in new markets for geographic expansion. Other companies used the downturn to lure key people away from competitors. Robert W. Baird & Co., a 2,400-employee Milwaukee-based investment bank, hired 70 executives during 2009, many from rivals, and “significantly more” than in 2008, said Managing Director Robert Venable.65 Nearly half (49 percent) of companies surveyed said that poaching was a concern, even in a down economy.66 And 62 percent of companies were concerned about losing key talent as a result of the cutbacks made during the recession.67

Training employees was another low-cost, high-impact strategy for using the downtime labor surplus to create more opportunities during the recovery. For example, Toyota launched training and quality-enhancement projects rather than laying people off. “We used the downtime for environmental, OSHA, and diversity training as well as improving problem-solving skills and standardized work,” said Wil James, senior vice president for manufacturing and quality.68 Some countries, such as Germany and Singapore, provided government support for employers to retain and retrain employees—covering some of their salaries—rather than be passive as companies lay them off.69,70 The programs benefited companies, workers, and the government: the company retained the worker at a reduced pay-rate, the workers kept their jobs and gained training, and the cost to the government was less than the cost of full unemployment benefits and social discord.

The start of the downturn didn’t imply an end to innovation or new product introductions. Patent applications increased during the downturn, a pattern seen in other downturns including the Great Depression.71 Apple released its 3G iPhone during the recession and saw a 240 percent increase in sales.72 The first iPhone competitor based on Google’s Android system, the HTC Dream, launched about a month after the Lehman failure, and yet it sold a million units during the worst two quarters of the recession.73 A. G. Lafley, then chief executive of Procter & Gamble, said, “I think it’s more essential to innovate through a recession … to continue to bring disruptive new brands and products for our consumers.”74

Bankruptcies in the Supply Chain

The disruption in the money supply, and the fall-off in demand, reverberated across global supply chains to create risks of bankruptcies everywhere. Flextronics summarized these risks in its 2009 annual report. The report stated that the company faced risks from “the effects that current credit and market conditions could have on the liquidity and financial condition of our customers and suppliers, including any impact on their ability to meet their contractual obligations.”75 During a 2009 MIT Center for Transportation Logistics conference, corporate participants agreed that they were all struggling with both suppliers’ and customers’ problems.

Demand Disruption Becomes Supply Disruption

In February 2009, Edscha, a maker of automobile roof modules for convertibles, declared bankruptcy. When car sales plummeted 30 percent, supplier revenues dropped further, straining them financially.76 Not only did automotive suppliers suffer greater sales declines owing to the bullwhip effect, but many suppliers are capital-intensive businesses because of large investments in tooling and equipment. Thus, many suppliers carried high debt loads and were especially impacted by the disruption in the credit markets. Edscha had suffered a loss of almost 50 percent of sales, which pushed the €1.1 billion company over the edge.77 In North America, nearly 60 suppliers’ plants closed in the three years after 2008, with the loss of about 100,000 jobs.78 Bankruptcies in the automotive industry more than tripled between 2007 and 2009.79

A Business Continuity Institute survey in the summer of 2009 found that 28 percent of companies had suffered a disruption caused by a financial failure of a supplier in the preceding 12 months, and 52 percent said such failures would be a major threat in the following 12 months.80 Manufacturing companies were especially hard hit by this type of disruption, with 58 percent of them reporting supplier financial failures.81 In another survey, 40 percent of respondents ranked “suppliers going out of business” among the risks are most likely to affect their own supply chains.82

Managing the Risks of Supplier Bankruptcy

During the depths of the downturn, one company said, “Supplier disruptions are now corporate risk number one. Risk management in the financial crisis is all about being very fast in reacting, since we lose millions of euros if a strategic supplier goes out of business. The faster we know that the supplier defaults, the less money we will lose.”83 Such efforts are discussed in greater depth in chapter 8.

Spending on supplier risk assessment and the frequency of reassessment increased dramatically during the crisis. For example, one automotive company went from a six-month assessment cycle to a weekly assessment for all first-tier and also some second-tier suppliers.84 Companies such as EMC, Boston Scientific Corporation, and Shaw’s Supermarkets had mounting concerns about supplier quality during the downturn. They saw suppliers’ capacity and staff cutbacks as a potential threat to quality; fewer people meant more knowledge gaps, more sporadic production runs, and fewer people to do quality-critical tasks like maintenance and inspections.

Financial Support of Suppliers

The precarious state of supplier finances forced some companies to offer direct support to their ailing suppliers. Edscha’s bankruptcy was a shock for BMW, which needed the supplier’s roof modules for its new Z4 convertible and other models. BMW said, “We had to help Edscha and try and stabilize it. We had no choice to go to another supplier, as that would have taken six months and we don’t have that.”85 Surveys found that between 9 and 12 percent of companies were providing financial assistance to suppliers.86,87

Most companies explicitly eschewed direct investment in suppliers because of the risks and the company’s own needs to conserve capital. Instead, companies helped financially struggling suppliers in a number of other ways. For example, BASF, HP, and others helped some suppliers by accelerating payments or by buying raw materials on their behalf. Other companies prepaid for tooling or other capital-intensive supplier needs if suppliers couldn’t get their own credit.88 According to Dr. Hermann Krog, then executive director of logistics at Audi, the automotive OEM helped suppliers by agreeing to be the guarantor on some bank loans.

Jackie Sturm, vice president and general manager of Global Sourcing and Procurement at Intel, said that the company assisted suppliers in creating financial plans as well as in finding other customers or investors.89 In some cases, however, Intel went a step further. It provided liquidity, by lending working capital against future production. Intel Capital even took equity stakes in a few suppliers and—as it turned out—profited from those investments when the economy recovered.

Solutions for Customer Insolvency

Supplier bankruptcies weren’t the only risks faced by companies; customers failed, too. For example, in 2009 alone, Flextronics “incurred $262.7 million of charges relating to Nortel and other customers that filed for bankruptcy or restructuring protection or otherwise experienced significant financial and liquidity difficulties,” according to Flextronics’s 2011 annual report.90 A customer bankruptcy might mean an indefinite delay in getting paid, if one got paid at all. A spring 2009 survey found that 7 percent of companies were providing financial assistance to customers.91

Nypro, a $1.2 billion global plastic parts manufacturer, reviewed all of its “customers-at-risk,” sometimes on a daily basis during the crisis. For some customer accounts, the company was able to insure the receivables. On accounts for which it couldn’t get insurance, such as on automotive customers, the company offered early payment discounts to customers to mitigate financial default risks, thus reducing Nypro’s exposure to those risky customers. Some customers paid in as few as 15 days under this program. A survey by World Trade magazine found that 43 percent of companies offered pricing concessions to customers for early payment in an effort to conserve working capital.92

Compared to prior recessions, the rise of outsourcing and contract manufacturing created new customer-side risks during the 2008 financial crisis. For example, Nypro might make parts on behalf of a large low-risk firm, such as bottle caps for P&G or cell phone bodies for Nokia. But as a result of outsourcing by the OEM, Nypro’s parts might actually be sent to a small regional copacker or a Chinese contract manufacturer before being shipped to the OEM. This intermediary contract manufacturer was then responsible for paying Nypro. This arrangement exposed Nypro to the credit risk of the contract manufacturer, rather than the OEM. Worse, when Nypro negotiated an agreement with a big OEM like P&G or Nokia, Nypro might not even know who these contract manufacturers would be. Consequently, Nypro sought guarantees from the OEM, or enlisted its help in performing due diligence on copackers and contract manufacturers.

Recovery: Phase 2 of the Bullwhip

During the downturn, US unemployment had more than doubled—reaching 10 percent in December 2009.93 The rate of business failures increased 30 percent from the prerecession value to 235,000 failures per quarter in March 2009.94 Although the world may have been staring into a financial abyss after Lehman’s failure in the fall of 2008, global resilience absorbed the shock. Trillions of dollars in monetary stimulus stabilized the financial markets, and fiscal stimulus helped limit the depths of the downturn. Governments took over ailing financial institutions or agreed to take toxic assets off of banks’ balance sheets. These concerted efforts by central bankers and governments prevented a deeper deflationary cycle, runs on banks, and other types of value-destruction processes that contributed to the 1930s Great Depression. Retail sales began to recover after March 2009, and by June 2009, the recession was officially over in the United States.

Risks in the Rebound

Managing during the downturn had been difficult, yet managing during the rebound wasn’t easy, either. In the following 12 months, retail sales rebounded by a modest 7 percent, but imports surged 27 percent as distributors and retailers started to build inventory in anticipation of increased sales. The bullwhip was now again in effect.

“Sometimes it’s easier to manage on the way down in a recession than on the way up,” said Brian Hancock, vice president of supply chain at Whirlpool Corp. “It takes quite a bit of effort to bring capacity back on line, and everybody is hesitant to increase capacity in case they don’t see the economy returning to 2006 and 2007 levels.”95 In Q3 2009, a survey by technology research firm AMR found that nearly one-quarter of respondents worried that the downturn would continue.96

To manage the recovery, USG Corp., a US-based maker of construction materials with 2009 sales of $3.2 billion, used advanced planning software. When the housing bubble burst, the company cut production capacity strategically and reduced costs. As construction slowly rebounded, the company planned for careful growth and determined the optimal use of manufacturing plants for specific products and markets.97

“Now, we are looking at long-term forecasts and running models five to 10 years into the future to help us determine when and what [capacity] we will need to bring back online first,” said Timothy McVittie, senior director of logistics for USG Building Systems. “Finding the right balance is a big hairy beast,” McVittie explained, “due the challenge of staying lean but still meeting customer expectations.” He then added, “Considering that industry demand is as low as it is, the marketplace has little patience for manufacturers who cut too deep and can no longer effectively service their customers.”98 Corroborating this view, a supply chain risk survey by AMR Research in the third quarter of 2009 found that 44 percent of respondents believed the recovery cycle would pose the greatest risk in 2010.

Overextended Suppliers in a Fragile Economy

Companies worried about suppliers’ abilities to handle a rebound; a company couldn’t be poised for growth if its suppliers weren’t poised for growth. EMC noted that the 2000–2001 tech industry recession had been a painful one because suppliers cut capacity too slowly. In contrast, during 2008–2009, EMC was surprised by how quickly technology suppliers reacted. DRAM memory chip capacity, for example, fell rapidly. But overly aggressive cutbacks could be just as damaging as overly cautious ones, so EMC prepared for the recovery by using contracts that required suppliers to maintain 20 percent upside capacity available. When EMC visited a supplier, it made sure that the supplier was devoting resources to EMC and that if the supplier cut capacity, it did not cut capacity devoted to EMC.

The automotive industry experienced similar effects. As automakers and other vehicle manufacturers increased their production volumes beginning in 2010, the growth strained their suppliers. Some of these suppliers grew too fast and without adequate capital. Small suppliers, especially, still didn’t have access to capital, and other suppliers were too uncertain about the economy to make needed capital investments. Part of companies’ concerns about these supply risks were driven by ongoing economic uncertainties such as the United States’s “fiscal cliff,” debt ceiling, budget sequestration battles, European sovereign debt crisis, government austerity moves, and mixed data about the robustness of the recovery.

In particular, Toyota watched for suppliers who respond to production launches with plans to work seven days a week. Although the financial results of these suppliers were impressive when judged according to traditional metrics, many were actually becoming more fragile and more risky as a result of deferred maintenance, lack of equipment renewal, and overworked employees. Around-the-clock production “immediately throws up a flag,” said Toyota’s North American purchasing chief Bob Young. “It means we have to visit them to understand their true condition.”99 As the recovery progressed and Toyota North America planned to boost production, the company doubled its supplier watch-list to 40 in April 2013 from 20 suppliers in 2012.

In thinking about long-term relationships and the stability of the entire supply base, companies were looking to aid selected suppliers as needed. They were again considering tooling buys, accelerated payables, buying materials for suppliers, loans, and so forth. In one case, a large company simply bought the small supplier when the supplier ran into trouble. Honda Motor Co.’s North American purchasing chief, Tom Lake, acknowledged that Honda can’t just say “more” and expect suppliers to jump. “Because so many automakers are increasing production, suppliers have to pick and choose where to make an investment.”100

Cash Becomes King: Reducing Working Capital

The financial crisis revealed the sharp distinction between profit and cash flow, making cash a much more important financial measure of company health.101 The disruption of the money supply and the resulting recession-induced bullwhip meant companies had to rely, at first, on retained earnings or preexisting cash reserves. A Grant Thornton/World Trade magazine survey found that 90 percent of respondents worked to reduce their working capital in 2009 (up from 78 percent in 2008).102 The financial crisis created urgency and an opportunity to both reduce operating costs and free up scarce capital locked in the supply chain. One of the results was increased collaboration between companies’ finance departments and supply chain organizations.

Even strong companies faced liquidity issues. Nypro, for example, had two cash-related challenges. First, it had high capital costs associated with the injection molding machines and molds it needed to make plastic products. Nypro needed about $300,000 to $600,000 in capital assets to support each additional $1 million in revenues. Second, employees owned the privately held Nypro. When employees retire, the company had to have the cash to buy the retirees’ shares in the company. Between 2010 and 2014, Nypro needed $200 million in cash to handle an upcoming rash of retirements. As described in the section titled “Terms of Endearment: Reducing Working Capital” below, Nypro was able to extract cash from its supply chain.

Some companies gained market share from failing competitors and as the economy recovered, they needed capital for growth. Church & Dwight (a manufacturer and marketer of personal care, household, and specialty products under the Arm & Hammer brand name and other trademarks) had grown by acquisitions. It had acquired 14 key brands in 2001–2007, and that strategy required cash and financial strength. The company also had substantial debts that needed to be serviced, causing a determined emphasis on finding free cash flow and debt reduction opportunities rather than simply reducing costs.103

Material Flow Begets Cash Flow

Although companies’ supply chain operations do not typically make financial headlines, they have three significant effects on cash flows and working capital requirements. First, DPO (days payables outstanding) are unpaid bills to suppliers and represent a de facto loan of cash from the supplier to the company. Second, DSO (days sales outstanding) are customers’ unpaid bills and represent a de facto loan of cash from the company to its customers. Third, DIO (days inventory on-hand) is cash tied up in inventory. Companies can reduce their working capital levels through paying suppliers later (increasing DPO), accelerating the collection of customer payments (reducing DSO), or reducing inventories (reducing DIO). A spring 2009 survey found that 55 percent of companies extended payment terms with suppliers (DSO), 25 percent worked to accelerate customer payment terms (DPO), and 44 percent worked on reducing supply chain wide inventory (DIO) as part of their efforts to manage working capital.104

Terms of Endearment: Reducing Working Capital

Prior to the financial crisis, many salespeople paid little attention to customers’ payment terms. That left their companies with high DSO and high working capital requirements. The recession made companies more aware of the costs of giving away working capital via generous terms. Many of them looked to reduce DSO by improving customers’ compliance with payment terms. Companies scrutinized actual payments relative to contractual payment terms, realizing that payment terms in reality were longer than specified in the contract—especially with customers strapped for cash who tried to delay payments. When Nypro compared its actual DSO to its contractual average, it found that its average contractual DSO was 52 days but the actual average payment was received 65 days after delivery. The company started focusing on chronically late customers in order to decrease this average.

Similarly, the financial crisis also led companies to scrutinize supplier payment terms. For example, in the past, Nypro let each of its plants negotiate and manage supplier payment terms, but that practice resulted in a wide range of 30- to 75-day terms. During the crisis, Nypro created global supply contracts with its top 50 suppliers and worked on lengthening its payment terms. Nypro had some success because its financial stability and reputation for consistent and timely payments made suppliers more willing to extend the terms.

Nypro’s program was part of a larger effort to create a cash-neutral supply chain, adding discipline to incremental activities that might consume cash or capital. For example, Nypro started performing a capital and cash-flow analysis of all new programs, including large sales quotes, so that the company didn’t take on projects or sales commitments that it couldn’t afford. This analysis included the capital, inventory, terms, and ROAE (return on average equity) implications of any new program or quote. By incorporating cash and capital analyses at that level, the program managers and salespeople became aligned with the company’s financial goals.

Cash neutrality also affected on-going supply chain activities. If the company faced a unilateral increase in DSO on the customer side, it passed that increase through to the DPO and the supply side. Keeping the terms matched on both sides avoided unexpected demands for cash to support supply chain operations. Nypro also rented equipment for flexible capacity rather than buying all the equipment needed for the upside estimates of demand. That way, if demand failed to materialize, Nypro didn’t have surplus capacity on its books. In total, Nypro freed up $100 million in cash from the beginning of the financial crisis to October 2009.

Too Much Junk in the Trunk: Reducing Inventory

A January 2010 survey found that 60 percent of companies had reduced their inventory levels throughout 2009.105 Both Church & Dwight and Limited Brands worked to become more demand-driven with leaner inventories. In fact, Church & Dwight started measuring inventory in terms of dollars rather than weeks to emphasize the financial burden of inventory rather than inventory’s role as a buffer. The company reduced inventory through improved sales-and-operations-planning (S&OP) processes, tightened safety stock requirements, integrated raw materials planning, and consignment-at-vendor optimization. The company also paid special attention to slow-moving and remnant inventory, the size of which grew during the downturn, as a result of the drop in demand as well as the shifts in demand patterns. This emphasis helped improve other financial variables such as write-offs and capital tied up in warehouse space.106 Between 2006 and 2009, Church & Dwight reduced remnant inventory from 12 percent to between 4 and 5 percent.

Relative Credit Quality in the Supply Chain: Winning the Battle and Losing the War

Strategies to reduce working capital requirements can have unintended effects. Lengthening payment terms to suppliers meant that those suppliers’ financial situations worsened. Too-low inventories of material and parts reduced a company’s buffers to any supply hiccup. And low inventory of finished goods could reduce the company’s level of service, straining its relationships with customers. Even tightening payment terms and cutting down on the time until the company got paid (cutting down DSO) carried a risk, especially during the downturn, that customers would demand better prices or other extra services in return for cutting DSO or take their business to suppliers who offered longer payment terms.

Advance Auto Parts (AAP), a Fortune 500 automotive retailer of parts, accessories, and maintenance items, was careful about reworking terms with suppliers. An improved, longer DPO for AAP meant a worse DSO for its suppliers. AAP saw this as a zero-sum game or worse. A company could readily optimize itself into a worse position by being too aggressive with longer DPO terms. First, if AAP’s supplier had to borrow extra cash because of lengthening payments, those borrowing costs would appear in the supplier’s prices. And if the supplier had a worse credit rating than AAP, then the supplier would pay more for one day of the supplier’s DSO than AAP would pay for one day of its DPO. Second, longer payment terms to suppliers could increase the risk of a supplier bankruptcy. AAP devised an innovative supply chain financing program to address this issue.

AAP did very well during the crisis; although many consumers stopped buying new cars,107 most still had a car, and those cars needed maintenance. The maintenance needs of the aging fleet meant good times for car part retailers such as AAP.108 While Chrysler begged for a government bailout and slipped into bankruptcy, AAP had little trouble obtaining credit on favorable terms.

The company had many small suppliers that make automotive replacement parts, including ones that supplied the struggling OEMs. Given the small size of the suppliers and the turmoil in the automotive industry, the suppliers were hurting for cash but couldn’t borrow at affordable rates, if they could borrow at all.

AAP crafted a supplier financing program109 with some financial institutions in which the financial institution paid the supplier’s invoice at a discount on quick terms—as short as 20 days. But rather than use a discount factor based on the supplier’s credit rating, the program used AAP’s much better credit rating. This rate was about half the one the most suppliers could have gotten on their own. The result was that suppliers became willing to offer AAP significantly longer payment terms—as much as 240 days. At the end of this much-extended payment term, AAP paid the invoice amount to the financial institution.

AAP noted three key details that were needed to make the program work. First, AAP inspected incoming goods in a timely fashion to certify the invoice to the bank, making the supplier eligible for quick payment. The 20-day early payment terms reflected the minimum time that AAP needed to ensure the quality and correctness of the order. Second, careful documentation also ensured that AAP had the necessary audit trails and Sarbanes-Oxley compliance.110 Third, AAP worked with its outside auditor and rating agencies to ensure that the program would be counted as accounts payable and not ordinary debt on the company’s balance sheet. The reasoning worked, because the financing was directly tied to transactions between AAP and the suppliers. Moreover, the supplier (not AAP) controlled the duration of the “loan” because the supplier decided when to ask the bank for the money.

The three-way financial relationships in the program helped all three participants. AAP got longer payment terms, which let the company conserve cash without incurring more debt on its balance sheet. The program also reduced AAP’s supplier risks because it helped improve the financial strength of the suppliers. The supplier got paid quickly but also had flexibility to manage cash coming from outstanding receivables on favorable interest-rate terms. Suppliers were not forced to use the program or pay any fees for unused borrowing. The financial institution earned interest through the difference paid to the supplier and the amount paid by AAP. The mutual benefits of the program enabled AAP to attract several financial institutions to the program as well as a large number of its top suppliers.111

When Black Swans Drop In

Some types of very rare, high-impact disruptions lead to novel responses, such as a clever way to create a beneficial relationship between a company, its cash-strapped suppliers, and risk-averse bankers. Other types of disruptions, however, have less idiosyncratic causes and more frequently felt effects. For these kinds of disruptions, companies can prepare options prior to the disruption that accelerate recovery and mitigate impact. Many of these preparations also help when some unpredictable phenomenon hurtles the company, industry, or the economy toward a crisis.

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