Why Were We Unprepared for Japan?

As demonstrated by Japan's recent disaster trifecta—an earthquake and tsunami quickly followed by a nuclear crisis—corporations too often find themselves unprepared when low-probability events shock their supply chains.

They're caught without a Plan B because of two fallacies: 1) the belief that because no one can predict the future, they should operate under the assumption that things will more or less stay the same; and 2) the notion that a supply chain represents a cost rather than an investment. Moreover, in the case of this particular crisis, many companies likely figured they didn't need a contingency plan since they buy so little from Japan. They forgot that the Chinese suppliers with whom they do business depend on goods and services from Japan.

The larger supply-chain problem stems from companies' focus on minimizing short-term costs rather than maximizing flexibility to meet future needs. This leads them to build static supply chains rather than dynamic ones. Such supply chains may save money today, but they carry hidden costs that can rise precipitously in the face of unforeseen events.

The crisis in Japan should force the global business community to see that traditional, static supply chains are a relic of the past. Companies should ready themselves to identify problems and react swiftly when a high-odds crisis occurs.

Multiple Sources of Supply

How? They can start by diversifying their supply bases. This means more than having multiple suppliers separated by distance; it's about finding (and perhaps even creating) independent suppliers. For example, many companies depend on China as a supply base. What happens to their production outside China if the yuan exchange rate moves from 6.5 to 4.5 to the dollar? What if wages in China increase at more than 20 percent per year? What if oil costs jump to $150 per barrel? Or what if China further reduces its rare earth exports? Companies need plans that address such issues.

Companies must identify risk points in their supply chains and create the capability to lock in alternate supply and quickly reroute materials. Immediately after the Japanese earthquake hit, some companies wisely placed large orders with different suppliers, securing their supply base. When shortages occur, it will hurt their competitors, not them.

When most of what we consumed was made domestically, using domestically produced parts and components, it didn't much matter what happened elsewhere. But those days are gone. Supply chains today span the globe.

Japan, for example, produces approximately 40 percent of all electronic components used by the world's manufacturers, including parts and materials for semiconductors, computers, automobiles, and telephones. Nearly 19 percent of all Japanese exports last year went to China. If Chinese assembly plants don't get the components they need, they can't fill orders, shelves around the world go unstocked, and companies' profits fall.

Leveraging Local Suppliers

Companies can start making their supply chains more stable via localization. One of the world's largest consumer products companies, for example, thought it would gain cost advantage by scaling up from local manufacturing to regional. The company soon discovered, however, that it benefited little from the unit cost savings achieved by consolidation when the actual delivered price, including transportation costs, was much higher. It was then that the company's executives realized they got tremendous value from local manufacturing, which enabled them to tailor certain products to the local market and shift production from one facility to another as conditions changed—or when commodity prices differed. In this way, global companies can better tailor to local needs and spread operational risk simultaneously by leveraging local suppliers.

Another company rethought its capital investment strategy. For products with short life cycles, it came up with the idea of "disposable plants"—inexpensive temporary facilities it could abandon or more easily convert to other uses after a few years, rather than highly engineered facilities with a 20- or 30-year lifespan.

Others are focusing on "variabilizing" costs—that is, lowering fixed costs and increasing the percentage that fluctuates with the market. Such a strategy requires management's constant attention and significantly affects suppliers as well. They, too, will need to become more flexible. The advantage is that it gives management more control over immediate costs and more maneuvering room—to buy, sell or cancel orders—as needs and costs change. The disadvantage is that the company will have to pay market price for fuel, raw materials, and components.

Could anyone have anticipated the 9.0 earthquake, tsunami, and nuclear-power crisis that destroyed property and human lives, threatened the power supply, crippled businesses, and endangered the long-term welfare of those who survived?

The question is actually irrelevant, because you don't have to anticipate events; you only have to prepare for them. Risk management makes for smart business. The best preparation in today's volatile global economy, the best preparation for unforeseen, disruptive events, comes in the form of a dynamic supply network.

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