A New Basis for Manufacturer-Retailer Cooperation

The relationship between manufacturers and retailers is often thought of as adversarial. They are, after all, competing for their share of the same pie, retailers often launch private label brands that compete with manufacturers’ brands, and both parties are trying to influence the same consumers albeit in different ways.

Yet the untold story of the relationship between manufacturers and retailers over the past several decades is that of the remarkable success of their cooperation. They have integrated their ERP systems, linked up logistics, coordinated advertising, and pooled their understanding of the consumer. As a result, they have built supply chains that are far more efficient than they were even at the turn of the century.

One of the consequences of this tight cooperation is that both retailers and manufacturers today need to carry far less inventory than they used to. Manufacturers can monitor sales at the retail checkout and replenish stock as and when it is needed on the shelf. In the fast moving consumer goods industry, for example, Danone replenishes yogurt on Carrefour’s shelves several times a day. As a result, working capital is not stuck in inventory that sits around in warehouses, and both retailers and manufacturers can pare down short term capital.

But efficient supply chains are not necessarily resilient supply chains. They are logistical machines that hum along until hit by an external shock. A trade war, a pandemic, a geopolitical decoupling, sanctions, a shooting war, bottlenecks at ports, or disruptions in the Suez or Panama canals, can shock global trade. In the past few years, the exquisitely lean chains have been hit by all of these shocks. The consequences are potentially very large, and not entirely understood or tractable.

The Consequences

A first order consequence of disrupted supply chains is stock outs or excess unsellable inventory. Stockouts are expensive: both manufacturers and retailers spend a lot of money driving consumers to the store to purchase. That money is wasted if consumers do not find the product in the store. Add that to the lost margin on the product not sold. Excess inventory has similarly high costs, with product disposed of below cost.

But there are several less obvious costs in supply chains that are out of sync. One is that risk is everywhere: just in time models that minimized inventory and working capital and logistics costs are suddenly much too risky. The normal reaction to the risk of stockouts is to increase inventory.

But firms are finding that the costs of risk mitigation increase exponentially with increasing risk. You can mitigate Suez Canal risk by shipping around the Cape of Good Hope, but that adds 25% more time to the journey: which increases the inventory in the channel and working capital requirements. Which, in a high-interest rate environment, is very costly.

And it is not just a Working Capital problem. For example, if you’re shipping around Africa rather than through the canal, you need 25% more ships. Where are those going to come from? In the short term this means big spikes in the cost of shipping. You also will want to stock more, in case of disruption, so you need bigger or more warehouses. In the short term, in the absence of warehousing capacity, warehousing costs spike.

In the long term, this means: holding more inventory, larger warehouses, multiple supply chains and supply routes, investments in shorter supply chains. In the extreme, it could even lead to more vertical integration, as companies buy their upstream suppliers or their downstream customers to reduce risk by locking in assured supply or demand.

The Enemy within

One of the biggest risks that manufacturers and retailers face as they move from a secure just-in-time environment to one replete with risk is the bullwhip effect in which demand estimation errors are magnified through each step of the value chain. The retailer orders 20% more, just to be sure they don’t run out of stock. The manufacturer adds 20% to that, just to be sure. The supplier in China looks at the huge increase in orders and the increasingly risky environment, and adds another 20% to their upstream orders. The component and materials suppliers each add another 20%, and so on. Pretty soon, the origin of the chain is ordering and producing 100% or more than is needed at the retail level. The entire supply chain is feverishly building manufacturing, warehousing, and transport capacity that will not be needed; logistics chains are overstuffed and clogged; working capital costs are going through the roof. It looks like an economic boom. But a bust is just a matter of time because the entire chain is catering to phantom demand.

Miscalibrations that lead to bullwhip effects are more likely the longer and more opaque the value chain. As many companies have added intermediate steps in Southeast Asia or Mexico to their value chains in order to look like they’re decoupling from China, the risks of supply chain turbulence have grown.  

These types of shocks to the supply chain can cause it to go out of balance for years, alternating between excess supply and not enough supply. And when this happens to a large number of supply chains simultaneously, the economy can bounce between deflation and inflation for a while.

The lesson is that just as manufacturers and retailers cooperated to build their supply chains to be efficient, they now need to cooperate to make sure they are resilient. Resilient to both exogenous shocks and to miscalibration in internal decision making.

Photo credit: Somruthai Keawjan, Unsplash.