Buttonwood--The fragility of perfection(1/2)

 

When supply chains go wrong

ONLY connect. The words of the novelist E. M. Forster sum up globalisation. An international company may buy its software from California, send its data to India, purchase its electronic equipment from China and staff its canteen with workers from eastern Europe.

The theory dates back to the economist Adam Smith and ①(phrase) . The productivity of a pin factory can be improved if production is broken down into its component parts. Similarly, companies (and countries) should specialise in fields where they have a ②(phrase) . The revenues can be used to buy the other goods and services the company needs, at a cheaper cost than it could manage in-house.

But specialisation depends on one critical factor: the reliability of supply. A bicycle maker may turn out fantastic handlebars but if his supplier produces wonky wheels (or no wheels at all, because of a strike or other disruption), he will not sell a single bike.

David Bowers of Absolute Strategy Research, a consultancy, thinks this makes the global industrial system vulnerable. He draws an analogy with the boom in structured finance, which saw banks distribute risk to specialist vehicles like conduits. They worried less about the creditworthiness of borrowers as a consequence. But when the subprime crisis broke, the risks ended up back on the banks'  ③(phrase) after all. “Just as the banks mispriced credit risk, so companies have misjudged strategic risk,” he says.

④(sentence) That may end up undermining the cost advantages of outsourcing, as the prices of raw materials and labour rise.

In the long run, disruption to supply chains may be a huge strategic risk. Energy is one obvious area. Britain has just shown how a two-day strike at a Scottish refinery affected deliveries to petrol stations and, more seriously, disrupted oil output. “Just-in-time” inventory levels normally create savings—unless suppliers do not deliver just in time, when they extract a huge cost. American companies such as Mattel, a toy company, have also discovered that their brand names can be tainted if goods made by overseas suppliers (particularly from China) turn out to be bad for consumers' health.

The problem could be called the “fragility of perfection”. The greater the interdependence within the system, the wider the effects of disruption in one part of it. In finance the “⑤(phrase)” model of bank lending may have dispersed risk, but it also meant that a problem in the American housing market damaged banks all over the world. Similarly, a supply disruption in China, which might have been ignored ten years ago, could prove to be catastrophic in many countries today.