This is a contributed op-ed written by John Frechette, founder, and Dr. Ralph Sonenshine, head of research, of Sourced Economics. Opinions are the authors’ own.
In the same way economists claim that companies are often “price-takers” at the mercy of using prevailing market prices for their products, companies can also similarly be thought of as “cost-takers,” powerless to influence the cost of their supply chain.
The supply chain for a single coil of aluminum, for example, dropped off at the loading dock of a beverage manufacturer for packaging, demanded a volume of transactions so enormous that the manufacturer’s knowledge of the aluminum’s production is infinitesimal. Even companies that own a significant share of the market and have a better knowledge of their tier 1 and 2 suppliers are largely in the dark about what happens before supplies reach their door.
What can be inferred from this for supply chain management teams and how they manage their budgets? A lot.
Supply chain managers should be first focused on resiliency
The role of supply chain management is not necessarily to minimize costs. It is also not necessarily to get its arms around as many vendors as possible, and monitor and influence how those vendors are doing business. Therefore, the typical definition of supply chain visibility, which to many refers to explicitly mapping out as many transactions upstream as possible, is impractical and costly.
Instead, the primary role of supply chain management is to continuously push for the optimization of its supply base, in order to increase the company’s resilience against unanticipated macroeconomic, geopolitical and industry-specific shocks. In practice, this means selecting geographies and supplier markets that will best ensure supply.
And when it comes to driving operational resilience, their objective is predominantly to maximize supply elasticities across critical raw materials markets.
The typical definition of supply chain visibility ... is impractical and costly.
John Frechette and Dr. Ralph Sonenshine
When facing a disruption to supply, the goal is to source from markets where new suppliers can quickly rush in to clean up the mess. Otherwise, costs will increase, companies will be forced to pay more to existing suppliers and they’ll often have to foot the bill to keep end product prices constant to retain market share in the interim.
Said differently, the price elasticity of demand for a company’s own products will, if its network is not structured correctly, significantly outstrip the price elasticity of the supplies for those products. Customers are often more price sensitive than suppliers.
The result is an “elasticity mismatch,” of which supply chain management is just one, but likely the most important, component of the equation. In crafting strategy then, supply chain managers should be extremely well-versed in the characteristics of the company’s supplier markets first, and focused on procuring from the most competitive vendors within those markets second.
For better or worse, how to get a handle on the supplier market is both an art and a science. Where strong data exists, we can use regression models to calculate and map elasticities across key markets. Where strong data does not exist, we can examine qualitative trends, general country market structures and relative changes in adjacent markets to build logical inferences.
Wrapped up in a single “supply elasticity” measure is a great deal of information on the supplier markets within a supply chain network, including their various regulatory environments, trade barriers, infrastructures, geographic positions and more.
Arguably most importantly, these measures reflect the characteristics of all upstream markets, not just tier 1 and 2 suppliers. Each level of supplier is implicitly weighted for the magnitudes of its direct contributions to the materials that need to be sourced.
Elasticity mismatches extend beyond prices
Companies make decisions about products to buy and sell based on a huge stock of variables, of which price is just one. Increasingly, social impact considerations, corporate reputation and even political considerations impact these decisions. Here, similar techniques can be useful in determining, for example, how fast a country or industry’s suppliers will be incentivized to respond to environmental concerns – what we’d call its “environment, social, and governance (ESG) elasticity of supply.”
By analyzing elasticities – and most immediately, price elasticities of supply – companies can better understand their levels of resilience to external shocks. If supply elasticity is significantly lower than demand elasticity, relative to an industry average, for many key products, supply chain and finance teams may want to reorganize supply chains or diversify their portfolios to improve these ratios.
The target outcomes? One is to simply shine a light on major potential weaknesses in a supply chain network; another is to inform a reallocation of sourcing activities. In a more advanced application, these measures can be used to support sensitivity analyses, organized around different categories of supply chain disruptions. Beyond these uses, the opportunities are seemingly endless.
For large multinational companies, the best supply chain network wins. Hence, in our view, the supply chain management team that knows its markets best wins. Learn first. Save the negotiating and arm-twisting for later.