Supply Chain Insurance

As of this writing, 47 people have been killed and many more injured by the earthquakes that have struck the Japanese island of Kyushu since April 14. These tragic events have had economic ramifications as well, offering a reminder that business risks can be hard for outsiders to evaluate.

The complicated industrial supply chains that are routine today began to develop in the 1970s, in good part because the spread of container shipping drove down the cost of transporting parts and components from one place to another. As I discuss in The Box, low transport costs made it practical for big manufacturers to decentralize: instead of running vast factories that churned out all sorts of inputs and assembled them into finished goods, they could farm out much of the work to specialized factories far away. Large retailers have done much the same. These long supply chains were seen as having two main advantages. Companies were able to draw on low-wage labor in developing countries, and they could gain economies of scale because a supplier might make just one or two components in enormous volume instead of lots of different things in small quantities. The result was lower costs—or so it seemed.

Invariably, though, the beancounters who made these calculations were afflicted with a dangerous myopia. Supply chains can lower costs, but they can also create risks that aren’t always visible. Some of these risks are reputational: if a supplier is accused of being a bad actor by polluting the water or by running an unsafe workplace, consumers may blame the better-known company that contracted out the work. There may be legal risks if the supplier’s shoddy work results in unsafe goods. And then there is the risk of supply-chain interruption. Interruptions aren’t high-frequency events: in a well-organized supply chain, most goods get where they’re supposed to be almost all the time. But when goods aren’t delivered due to weather, labor unrest, electricity cutoffs, or earthquakes, the cost can suddenly become extremely high.

The Kyushu earthquakes have halted plants that supply critical parts for many other consumer goods. But from what is known so far, the costs of this interruption may be less than might have been expected. The reason is that, with little publicity, companies like Toyota, Sony, and Honda seem to have reduced their potential losses by making sure that Kyushu is not their only source of critical inputs. While some of their plants will be shuttered, in some cases for several weeks, many of the key components produced in the earthquake-hit region are also made elsewhere. Those supply chain links will continue to function normally.

After the Fukushima earthquake and tsunami in 2011, factories around the world shut down for lack of components made only in the devastated region. Major industrial companies appear to have drawn lessons from that experience. Some of them have protected themselves against earthquake-related disruptions by developing redundant supply chains, so that an event such as the Kyushu earthquake won’t cripple their operations. This undoubtedly reduces efficiency and raises the firms’ normal operating costs. But supply-chain redundancy is not a frivolous expense. Like most insurance, it seems wasteful only until you need it.

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