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Small Scale Supply Chain: Why is it so Hard?
The NY Times had an interesting article featuring a story of a ski equipment firm that was traditionally sourcing wood for its skis from China. The article highlights many of the issues that small firms face when dealing with the recent supply chain disruptions.
First, they don't have the capital or cash flow to make bold and expensive moves:
“Unlike giants such as Walmart, they lack the means to charter their own cargo ships — or to design their own semiconductors, as Ford Motor said it would do this month. Instead, they are revisiting some of the practices — lean inventories, just-in-time deliveries, and reliance on components from China and other faraway suppliers — that were part of the established factory playbook.”
Second, these small retailers and brands don't have the power to change prices without losing customers.
But I don't think the article taps into the fundamental issues that small firms have to deal with when running their supply chains.
To better understand these issues, we need to first understand what drives firms to choose the “right” supply chain for them.
In general, there are two types of supply chains: efficient and responsive.
In order to better determine which supply chain is more suitable for a firm, we must understand the implied uncertainty the supply chain experiences.
“Implied uncertainty” has two aspects:
The inherent uncertainty of demand itself, and the additional uncertainty placed on the supply chain, based on the decisions the firm makes:
Varying purchasing quantities: Not only is demand volatile, but the firm has to prepare for the possibility that each customer may buy either a single item, or clear out the entire shelf.
Offering a high service level: When firms provide higher levels of service, they amplify the already existing uncertainty since the supply chain now has to respond within a limited amount of time.
Offering a wide variety: Wider variety means the firm has a hard time forecasting demand, given that it’s more fragmented and disaggregated. The firm also needs to make stocking decisions for additional products, increasing the likelihood of significant mistakes on any product.
Selling on many channels: Similar to offering more products, more channels mean forecasts are more disaggregated, and decisions are more complex, inflicting even more uncertainty on the system.
Short product life cycle: The shorter the life cycle, the faster the firm has to respond to demand, and the more the firm has to guess when making stocking decisions since there is little time to absorb mistakes. Overstocking means most likely having to write off inventory, and understocking means possibly not having enough time to manufacture things in time for the current product cycle.
In the case of DPS, the ski equipment firm from the NY Times article, there are two things going in opposite directions.
On the one hand, customers need to place their orders in the spring, which reduces the implied uncertainty on the supply chain.
But at the same time, the founder is quoted saying:
“The window is really short. Skiers get excited when they know snow is coming.”
Given that the season is very short, the inability to deliver on time can be extremely costly both for the firm’s cash flow and reputation.
This increases the implied uncertainty.
The “Right” Supply Chain
Given the implied uncertainty, the firm now needs to make sure it has the right (i.e., most suitable) supply chain.
When there is high implied uncertainty, the firm needs a responsive supply chain, whereas when there is low implied uncertainty, an efficient supply chain seems to be a better choice.
A responsive supply chain focuses on speed and aims to build excess capacity and inventory to achieve this responsiveness. A responsive supply chain will carry inventory close to customers, meaning it will manufacture close to home or use faster modes of transportation. This makes it more attractive for customers, but the costs the firm incurs are much higher.
Efficient supply chains tend to be vertically integrated to respond quickly to demand, but will focus on the cost and thus tend to offshore and/or outsource.
So there is an inherent tradeoff between these two types of supply chains.
Matching Supply and Demand: Why is it Hard?
As firms grow, they can stop making these choices. They can be both efficient and responsive; see Amazon and Walmart.
One can take many angles here, but it is essential to understand the value of scale beyond bargaining power and sheer capital.
For that, let’s go back to the basics: The goal of every supply chain is to match supply and demand: The right product at the right time at the right location.
Why is it hard? Because it's simply impossible to forecast demand.
I know the focus recently is on the supply side of the “supply chain” and its disruptions, but if demand was not uncertain, the impact of these supply chain issues would have been minimal.
What makes forecasting demand hard?
It may sound trivial, but there are many factors. From the state of the economy to the weather conditions and the competition or demand for other products (substitutes and complementary). These are all truly uncertain, but as time progresses and the timing improves, they become less uncertain; weather forecasts become more accurate, and the state of the economy in 2022, for example, becomes clearer as we approach the new year.
So the best way to match supply and demand is to reduce the time between ordering or manufacturing decisions and selling the products.
This has nothing to do with Just-In-Time. It’s just pure first principle logic.
How can firms reduce that time? They can manufacture closer to home, choose a faster mode of transportation…or carry less inventory.
While the first two are simple to understand, the final one might be less so. The idea is this: the less inventory you carry, the less time it spends in your warehouse, which means that when you decide to order one more component, you only need to forecast up until the time it will be sold, which hopefully will be soon.
But here is the main tradeoff: if you want to offer a certain level of service, you need safety stock. If you want to reduce logistics and transportation costs, you need scale, which means you must order more than what you truly need.
And this is precisely what happened to the women’s apparel company, Two-One-Two:
“‘Even Two-One-Two New York, a strictly domestic manufacturer of apparel with a plant on Long Island, is being forced to do things differently,’ said Marisa Fumei-South, the company’s owner and president. The company has accumulated larger stocks of yarn and other raw materials in response to rising prices and higher shipping costs. ‘We’re sitting with a lot of inventory,’ Ms. Fumei-South said. ‘We’re waiting to see how this evolves.’”
The Impact of Scale
So why is this tradeoff not valid for large-scale firms?
Larger firms have a better ability to deal with uncertainty and scale economies.
Uncertainty: As firms pool their demand from more locations and across products, their uncertainty decreases; they need less inventory to provide the same service level. Think about it as a portfolio effect.
Economies of Scale: Since bigger firms already order large amounts, they don't need to optimize and tradeoff full truckloads vs. the amount they truly need. As supply chains scale, their fixed costs are spread over more units.
The implication is that larger firms have high inventory turnover.
Vishal Gaur and Saravanan Kesavan write in this Book Chapter: “On average, in our data set, a 1 % increase in firm size is associated with a 0.035 % increase in inventory turnover.”
So for big firms, everything seems to be on their side: more bargaining power, less inventory, and shorter time to forecast.
Larger firms don’t have to choose between being responsive or efficient.
What About Small Firms?
Smaller firms, however, do.
DPS, the ski firm, is suffering from the fact that it is expected to be responsive and have the right inventory ready for the winter, but at the same time, lacks the pricing power to reflect it.
The article focuses on reshoring and the decisions small firms have to make.
But I think it's less about reshoring and more about understanding that in a volatile world, the only way to compete with big retailers is by doing things differently.
Finding other dimensions to differentiate, which do not inflict too much volatility on your supply chain.
Being transparent is one example, which is what Everlane does well.
Building a community is another. On shoes did it well for many years before building scale.
It’s about being a niche. A different niche. One that does not inflict more uncertainty on your supply chain.
So the main question is not (just) about outsourcing vs. reshoring. It's about why small retailers should avoid the efficiency-responsive tradeoff altogether.
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