The Social Costs of Supply Chain Disruptions

I will never forget that speech. In April 2020 David Beasley (Executive Director UN World Food Program) gave a passionate plea for help to the UN Security Council. He warned the world was on the brink of a hunger pandemic, which would dwarf the health pandemic

Covid-19 pushed an additional 130m people to the brink of starvation. This is excluding the 135m that were already marching towards the brink of starvation, and the 821m people who already go to bed hungry every day. Collectively, we are looking at over 1bn people either experiencing acute hunger or at high risk.

To simplify, the causes of the hunger pandemic can be categorised into demand and supply challenges. Demand relates to the macroeconomic slump causing an affordability problem. Supply relates to disruptions in the flow of food across global supply chains.

Solving the global macroeconomic slump is beyond the capacity of any single organisation. However, minimising the impact of supply chain disruptions is not. This was one side of the equation which had a potential win on the horizon. It was ambitious but our team went after it.

How we did it:
We built a solution to help enterprises predict, monitor and simulate supply chain disruptions before they occur and simulate optimal resiliency decisions to minimise the financial and consumer impact. McKinsey & Company found companies can expect to lose 42% of 1 years profit every decade due to supply chain disruptions. We had a strong commercial case which would directly improve the bottom line and competitiveness of clients.

But, by also helping enterprises who controlled the supply chains for our essential goods (food, medicine, clothing etc) our efforts had a social impact multiplier effect. Resilient supply chains mean millions of consumers would not experiences shortages, improved livelihoods and financial security. There was a private benefit for the enterprise but importantly there was a social benefit to society. Vice versa, disruptions exhibit a private cost to the enterprise and a catastrophic social cost. Our work has shown supply chain disruptions and resiliency exhibit symptoms of market failure which need urgent correction.

The social cost of disruption are mirrored by the social benefit of resiliency

Summary: Key points

• The Market Failure Problem: Supply chain disruptions and resiliency have negative and positive externalities which are not captured in the market price. Policy makers, ESG investors/asset managers and NGO’s should see this as an opportunity to mobilise resources and create shared social value while improving the competitiveness of their companies
• Private Cost of Disruption: Disruptions have two types of private costs for enterprises; financial and strategic. Both have a detrimental impact on competitiveness. Financial refers to the impact on the bottom line and shareholder value, while strategic focuses on market share
• Social Cost of Disruption: Disruptions have a catastrophic social cost which can be measured using impact metrics and new accounting methods. Amongst others, these include measurements in food waste, malnutrition, starvation and economic livelihood.
• Social Benefits of Resiliency: Resiliency has financial and strategic private benefits for enterprises, but also exhibits social benefits. However, due to market failure resiliency solutions are consumed at a socially suboptimal level

The Problem: Market Failure in Concentrated Markets

As a result of consumer demand for cheap products, market consolidation, and globalisation a relatively small number of enterprises are responsible for providing billions of consumer with their essentials. Efficient private sector markets have formed supply chains which have enabled high quality of living, access to affordable essentials and quality products.

Market Concentration: We Rely on Corporations

Most competitive markets are characterised by 3 or 4 leaders who own the majority of the market share with the rest as distant followers. In 60% of cases the most important source of market power is relative cost leadership where unit economics and relative scale is the defining force in determining relative competitiveness. Cost leadership is a winning strategy. This drives consolidation, the search for economies of scale, exploiting different country’s comparative advantages, globalised supply chain which eventual leads to high entry barriers. All of which means access to our essential goods for sustenance is in the hands of a small number of companies

In Defence of Big Business

Competitive markets maximise consumer welfare. More consumers can access better and cheaper products. The same forces which have allowed us to access the cheapest food in human history, the most advanced healthcare on record, beautiful and cheap garments… these same forces mean a handful of companies are responsible for feeding us, healing us, clothing us and more. Concentrated markets are a function of our quality of life

Reliance on a relatively small number of enterprises for our essential goods is not the problem. Competitive forces drive down prices, force innovation and maximise consumer welfare. Market forces ensure consumers have consistently accessed their essential goods. If there was a social tradeoff between consumer welfare and the cost of dependence, we would tip the scale to maximising consumer welfare, every single time.

The problem lies when these enterprises experience disruption. The cost of disruptions are socially catastrophic therefore their resiliency is a social impact issue. One which should catalyse support from across society. The UK governments FeedUK initiative recognised this. Many more organisation should follow.

Market Failure:

Our theory of change focuses on addressing the market failure inherent in supply chain disruptions and resiliency. By providing enterprises with agile resiliency capabilities to manage supply chain disruptions shocks, we help them mitigate the consumer impact, minimise unfulfilled customer demand and prevent shortages. As we will see, disruptions have a social cost, but resiliency also has a social benefit. Dealing with these issues is compounded two other microeconomic failures and tradeoffs.

Macroeconomic Market Failure:

Supply chain disruptions have a social cost which is the private cost experienced by the enterprise (MPB=MPC) + the negative externality experienced by society (welfare loss)

Microeconomic Failure 1: Resiliency vs Efficiency

Compounding to the macro market failure challenge is the inherent trade-off in supply chain management between resiliency and efficiency. Over the past 20 years, competitive pressures have forced the adoption of lean manufacturing, just in time, global sourcing etc.

The disruptions caused by covid-19 unearthed the hidden vulnerabilities which exist in these operating models. Shocks upstream such as a temporary closure of a port due to a covid outbreak, snowballed into significant consumer shortages. However, these competitive pressures will not disappear post covid. Resiliency will be top of the agenda, but competitive pressures are forcing the hand of companies. Calls for new operating models fail to appreciate this. There is no one size fits all strategy and firms will have to prioritise their trade offs while satisfying consumer needs and financial markets.

Microeconomic Failure 2: Perception Bias

Covid exposed how unprepared firms were to handle exogenous shocks. Speaking with countless companies, the same patterns emerged.

• Risk management culture is non-existent
• Discovered and reacted to the disruption too late
• Asymmetric information failures & siloed working
• Decision making crisis between c-suite and front line
• No playbook or scenario planning

The Disruption Risk Paradox

Most risk studies show a perception bias between what companies prepare for and what impacts them. 85% of all the negative financial impact of supply chain disruptions are caused by events firms can not control for; earthquakes, hurricanes, a pandemic. Paradoxically, most firms spend less than 10% of their risk management preparation on these shocks. Firms over focus on operational and compliance risks which make up less than 10% of the financial impact of disruptions.

The Private Costs of Disruptions:

There are two main private costs associated with supply chain disruptions; financial and strategic. The larger the company, the greater its exposure.

Financial Cost:

The most comprehensive analysis on the financial impact of supply chain disruption was conducted by Hendricks & Singhal in 2003. They analysed 800 instances of supply chain disruptions from publicly traded firms. Due to increased globalisation and complexity in supply chain networks since 2003, we anticipate these figures to be greater in todays environment

Supply chain disruptions negatively impact profitability, shareholder value and share price volatility for up to 2 years

McKinsey & Company synthesised the impact of supply chain disruptions into a single inevitable cost. They found companies can expect to lose 42% of 1 years profit every 10 years due to disruptions.

Strategic Cost:

Little research has explored the changes in relative market share due to supply chain disruptions. As data from Q4 2020 and Q1 2021 emerges, we will see how Covid-19 disruptions reshaped market boundaries, taking from the larger disrupted firms and giving to their more resilient direct competitors and smaller responsive firms.

Case Study: Phillips Electronics — Ericsson vs Nokia

In 2000 a ten minute fire at Phillips Electronics plant in New Mexico ‘touched off a corporate crisis that shifted the balance of power between two of Europes biggest electronics companies’ (Wall Street Journal). The small fire led to a complete outage of the plant. Both Nokia and Ericsson sourced microchips from Phillips. Nokia was able to shift production to other Phillips plants and source from other global suppliers, while Ericsson was trapped by its sole source dependence on this particular plant.

Ericssons market share of global handsets fell 3%, stock price reduced 12% and its mobile phone division reported a $2.34bn loss.

Disruptions reshape market boundaries as firms are unable to fulfil consumer demand. In some markets, there is a greater concern that lost customers will never return. Firms spend huge resources making incremental gains in relative market share under normal circumstances. Times of chaos and crisis can wipe out years of progress. Unstable environments also provide the greatest opportunity to increase relative market share

The Social Costs of Disruptions

Supply chain disruptions also exhibit negative externalities whereby the social cost of disruption is greater than the private cost to the enterprise. When there is a breakdown in the flow of goods; consumers, workers, businesses and governments all pay a price. There is no standard metric for measuring the social cost of disruptions, much is dependent on the specific product supply chain. However, disruptions in food supply chains can be partially assessed using impact metrics and new accounting methods.

Covid-19 & Food Supply Chain

The collapse of food supply chains due to Covid-19 has been well documented. Primarily there were two major issues

1. Collapse of food services industry: Not all food reaches consumers through supermarket channels. E.g 50% of US dairy and 40% of US onions are destined for food services (restaurant chains, schools, hotels etc). These supply chains have specialised packaging and distribution to drive efficiency. As demand in food services collapsed due to lockdown measures, these products could not be redirected to other channels where there was unfulfilled demand. Supermarkets could not absorb the stock. All of which led to mountains of food waste and excess supply.
2. Covid Outbreaks: As a labour intensive industry, Covid-19 outbreaks impacted the labour force at various parts of the supply chain which led to reduced capacity and outages. Harvest, transportation and processing were all impacted leading to further food waste and unfulfilled customer demand.

Quantifying the Social Cost:

Food Waste: Social & Environmental Costs

Hidden social costs of food waste extends far. Food that is produced, but never consumed, causes environmental impacts to the atmosphere, water, land and bio diversity without delivering the returns (consumption). These environmental and social costs must be paid for by society and future generations.

The FAO estimates the annual economic cost of food waste to be $1tn. However the environmental costs could reach around $700bn per year, and the social costs around $900bn per year.

Below is a breakdown of the biggest environmental and social costs of food waste per year by the FAO using full cost accounting.

Human cost of Supply Chain Disruptions-Price rises

Supply chain disruptions increase the price of food which excludes the most vulnerable market segments from consumption. Changes in global food prices have a greater effect on food consumption in lower income countries and in poorer households within countries.

In a study of food price elasticity in low and high income (Green et al: 2013), found a 1% increase in the price of cereals results in reductions in consumption of 0.61% in low income countries and 0.43% in high income countries. While a 1% increase in the price of meat results in reductions of consumption by 0.78% in poor countries.

That may not sound like a big change in consumption, but once you extrapolate across an entire country of region, price rises push millions into starvation. In 2008 an additional 40m people were pushed into hunger due to the prices rises of cereal according to the FAO.

Economic Cost

The causes of the supply chain disruptions have enormous cumulative costs to economies. Disruptions follow the 80/20 Pareto Rule. 80% of disruptions will be relatively small scale but the rare 20% will generate the majority of the impact. These costs have consequences for government spending, future taxation, consumer welfare and industry competitiveness. Minimising the cumulative economic cost depends on our ability to minimise the frequency and severity or maximise our ability to withstand shocks. Below the cumulative economic cost of the top 10 natural disasters.

Other Social Costs

Using impact metrics from the global impact investment network (GIIN), we looked at metrics of social impact which could be negative affected due to supply chain disruptions. Below is rough idea of impacted metrics using a broad definition of supply chain disruptions.

The Social Benefits of Resiliency

Enterprise supply chain resiliency has benefits which extends beyond the private benefit experienced by the firm. Enterprises consumes resiliency solutions at the Marginal Private Benefit level which is socially sub optimal. Policy makers, NGO’s, ESG investors and asset managers have an opportunity to unlock social value by stimulating the adoption of resilient supply chains.

Resilient supply chains have 2 major benefits

• Economic Resiliency: Supply chain resiliency is central to economic resiliency. The ability to deal with our grande challenges such as climate adaptation requires strong macro financial resiliency and capacity. Supply chain resiliency strengthens this capacity.
• Maximising Consumption: Resilient supply chains maximise fulfilled demand to maximise the number of consumers who can fulfil their essential needs for sustenance. Consumption is also an economic multiplier

Economic Resiliency:

Vanuatu is a South Pacific country with roughly 80 islands. Every year it loses 6% of its GDP due to natural disasters. The economic impact of climate change makes it harder for Vanuatu to invest in climate adaptation. This is a virtuous cycle many countries experience. SwissRe also found if current trends continue, the countries they studied will experience 1–12% reduction in GDP as a result of existing climate patterns.

Climate change mitigation and adaptation requires strong public and private balance sheets — World Bank

Supply chain resiliency strengthens the macro financial capacity to deal with existential threats. Business continuity is critical for financing, minimising uncertainty and stimulating investments.

Conclusions:

There is a strong case for making supply chain resiliency a corporate social responsibility issue. Concentrated markets of our essential goods mean billions of consumers are reliant on a relatively small number of enterprises. When these enterprises experience disruptions, the social costs are catastrophic. There are clear symptoms of market failure. Disruptions have a social cost, and resiliency has social a benefit. However, competitive pressures force decision making. Enterprises must stay in business before they can fulfil their social responsibility. Competitiveness and social responsibility are not mutually exclusive, but you can’t have the latter without the former.

There is an opportunity to minimise the social costs of supply chain disruptions and unlock the social benefits of resiliency. If left to market forces, adoption of resiliency solutions will remain at a socially sub optimal level. Cross sector support from venture investors, policy makers, asset managers, research institutions, NGO’s can stimulate adoption to ensure consumption of resiliency is at a socially optimal level.

About Kavida.ai

Launched in October 2020, Kavida.ai provides enterprises with disruption decision tools to prevent and mitigate supply chain disruptions in real time or before they occur.

The platform creates digital twins of supply chain replicas within the following sectors: FMCG, food processing and retail, pharmaceuticals and medical devices; textile and apparel.

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