From supply chain to "supply web"

By Gregory Daco and Chris G. Christopher, Jr. | From the Quarter 4 2010 issue

Global supply patterns have changed dramatically since the beginning of the 20th century— not just once but several times—and they will continue to change over time.

Global supply patterns have changed dramatically since the beginning of the 20th century— not just once but several times—and they will continue to change over time. Whenever shifts in production and consumption occur, new winners and losers emerge. This dynamic has a direct effect not only at a country or regional level but also at the supply chain and individual company level. Supply chain managers, therefore, can benefit from a basic understanding of some of these shifts and their consequences.

Changing production patterns
In the past, less developed countries with low production costs produced the raw input materials, while capital-intensive countries would design, produce, and consume the finished goods. During the course of the 20th century, however, a new paradigm for goods production emerged. Trade patterns reflected the comparative advantages that arose from supply chains that extended to less developed countries. They also came to feature multilateral exchanges of finished consumer goods among advanced economies. For example, Germany both exported and imported beer. This is partly related to the fact that consumers in modern capitalist societies developed a preference for variety; satisfying that demand required more intragroup trade in parallel with the outsourcing of production to markets with lower production costs.

Article Figures

[Figure 1] The "smiley curve"Enlarge this image

The international trade picture, then, could be characterized as raw materials from less developed countries flowing to industrial countries in a traditional, linear supply chain, with a considerable volume of similar finished and capital goods trading between industrial countries. Despite this paradigm shift, the ability to add value at lower production costs (i.e., comparative advantage) remained an essential determinant of international trade flows.

Eventually, manufacturers came to realize that by locating production or assembly plants within the consuming countries, they could reduce distribution costs and offer lower prices to end consumers. For example, a U.S.-owned soft drink plant in a Latin American country would produce soft drinks for local consumption, thereby substantially reducing logistics and transportation costs. This shift is not limited to low-cost countries. In the United States, for instance, a Toyota plant in Mississippi or a Mercedes plant in Alabama imports some parts from Japan or Germany but assembles the automobiles themselves in close proximity to the consuming market.

After the end of the Cold War, trade flows and the integration of global markets have increased at a rapid pace, while transportation costs have fallen. More countries have opened their borders to free trade or have liberalized trade in some way. Landmark developments include China's entry into the World Trade Organization (WTO) and a swing by India and many other developing countries away from anti-trade and anti-market policies. These developments caused the economic paradigm for goods production to change once again.

Now many North American and European companies locate production and assembly facilities in countries like China, where input costs are lower. The finished goods are subsequently imported by the North American or European company, so that the final sales proceeds stay with the parent company, in the home country, or both. Economic activities in this new supply chain paradigm mean that the value added to a product, the productivity level, and the costs for many products are lowest at the production level and highest at the design and distribution levels. A visual depiction of this phenomenon shows a "smiley curve" (see Figure 1).

Weaving a supply web
During the last two decades, there has been a consistent flow of low-skill and low-value-added jobs from developed economies to emerging economies that have a comparative advantage in less capital-intensive industries. This phenomenon has had an important, transformational impact on global supply chain dynamics: the metaphor of a linear supply chain, with product moving chronologically through the stages of supply, production, and distribution, may be heading toward obsolescence. Instead, today's global supply chain is increasingly looking and acting like a global supply web. The concept of a series of interconnecting links, from the input link (supplier) to the output link (distribution) has given way to a network pattern involving myriad suppliers, producers, and distributors cascading across international boundaries.

With companies scattering production around the globe and conducting economic activities in multiple countries, tracing the flows and interconnections of the global supply web has become an almost impossible task. It's not uncommon to see a pattern like this: Low-cost Country A imports raw materials or components from Country B, which has higher production costs. Country A assembles the parts or processes the product. The assembled or processed product is then exported to Country C. Further processing or assembly may then be done in Country C before the finished product is exported back to Country A or to another country altogether.

As that scenario suggests, companies are taking increasing advantage of their ability to fragment the production process by locating design and engineering in one place, parts in another place, and assembly in still another place. China offers a prime example of this new phenomenon. A large volume of raw materials and parts are shipped to China for manufacture or assembly. Once incorporated into a finished product, they are exported to the country of origin or to another country. This strategy has become very common in recent years. Since 2000, the value of Chinese merchandise exports of finished or semi-finished goods processed with imported materials has multiplied by a factor of six. According to manufacturing trade data, it is estimated that more than half of China's total merchandise exports now include imported materials. The total value of those exports in 2010 represents an estimated US $600 billion (on an annual basis).

Another element of Chinese trade patterns worth mentioning is that the gap between the value of merchandise imports and merchandise exports has grown from 15 percent in 1994 to 50 percent in 2010. This is most likely a consequence of increased productivity and a higher value added to Chinese exports since 1994. Increased productivity has allowed Chinese companies to produce more output (and therefore exports) with a given amount of inputs (or imports). At the same time, the improvement in Chinese processing and assembly processes since then is likely to have boosted the value added to the finished products.

Interestingly, production fragmentation is no longer limited to manufactured goods and has also made its way into the information services sector. Many companies now locate call centers, data processing facilities, and research centers in countries where the production costs for those functions are lower.

Shared prosperity
For the time being, advanced economies will continue to focus on the parts of the supply web for which they have a comparative advantage, while low-productioncost countries will concentrate on other segments. But the shape and complexity of the supply web could change over time. As populations in many of the key emerging economies age or attain higher levels of education, the geographical concentration of those nations having comparative advantages will shift, creating new and interesting patterns of international trade.

Regardless of how the lineup of developed and emerging economies changes in the future, the global supply web will connect them in a strong ensemble that is capable of reaping the greatest benefits from free trade. As Nariman Behravesh, IHS's chief economist, writes in his book Spin-Free Economics.

"In war, one country wins and another loses. In globalization, both countries prosper. Power can be gained at someone else's expense, but prosperity can be shared."