Over the past few months, more companies have struggled with delivery delays on products sourced from China. Highly variable lead times combined with volatile customer demand must be addressed or customer service goals will suffer.  

The limitations of traditional inventory management tools in dealing with the current uncertainties are becoming well known. The common practices of planning for inventory at an aggregate level rather than at an SKU level, and making adjustments after shortages are encountered will result in missed deliveries to customers, higher costs, and higher working capital requirements. To minimize inventory requirements while still meeting customer service goals companies need to account for the variability across their supply chain and plan for inventory at an SKU level.

China delivery issues
Delivery delays on China products are now a fact of life for companies big and small. As economies around the world contracted in 2009, many governments implemented protectionist trade policies.

As a result of these policies, a 3% to 4% reduction in world GDP resulted in a whopping 10% reduction in world trade volumes. Container liners were slow to respond and many teetered on the edge of bankruptcy. Factories in China shut down and laid off millions of workers. With world trade recovering in early 2010, shipping and manufacturing capacity have struggled to keep pace with demand, slowing deliveries.

Labor issues

In a curious twist, labor shortages have emerged in China. The China labor situation can be characterized by the following.

• Some economists believe China has arrived at its Lewis turning point, a turning point in the development of economies when the supply of surplus labor from rural areas tapers off and as a result labor shortages start to appear and wages start to increase more rapidly for unskilled workers.
• Several million factory workers (~20 million) were laid-off in China in 2009. Most of these workers were from the inner rural areas of China.
• These workers returned to their villages to take up well paying jobs closer to home that were created as a result of the Chinese government’s $1trillion stimulus program.
• They are now unwilling to return to the cities and return to their old factory jobs. One of our clients witnessed a 30% evaporation of its workforce after the Chinese New Year.
• A recent government survey showed a 35% increase in vacancies posted by employers in the first quarter of 2010, but only an 8% increase in the number of applicants for those vacancies.
• Wages for Chinese workers increased by 16% in 2009 in spite of the global financial crisis.
• Two recent cases underscore the issue of rising wages for factory workers in China. Honda Motor Company gave a 24 % pay raise to striking workers at a car parts factory in southern China. In a different part of southern China, Foxconn, a leading manufacturer of contract electronic products, announced a 100% increase in wages for its assembly line workers and a 66% increase for all its other employees.

Shipping issues

As the recession deepened in 2009, container liners in an effort to cut costs and protect revenues responded by discontinuing services, implementing slow steaming, cancelling or delaying delivery of liner orders, laying up ships in storage, and stepping up demolition activity. The shipping situation has played out as follows in 2009 and early 2010.

• Worldwide idle container ship fleet reached its peak of 1.5 million Twenty-Foot Equivalent Units (TEU) or approximately 11.6% capacity in December 2009.
• Spot prices for container shipments reached lows of $871 per Forty-Foot Equivalent Units (FEU) in July 2009 (currently at $2189) on the Drewry benchmark for Hong Kong-LA shipments.
• In the first quarter of 2010, as transpacific eastbound trade increased by approximately 12%, the shipping industry responded cautiously by delaying return of ships from lay-up and expanding the practice of slow steaming.
• Slow steaming, in which ships operate at speeds of 17-20 knots instead of the normal 24-26 knots, now accounts for close to 50% of the services connecting Asia and North America.  Slow steaming helps carriers absorb capacity while reducing operating costs by 5-7%.
• In response to a more than anticipated robust growth in demand, container liners have returned approximately 1M TEU of capacity from layup. Currently, approximately 0.5M TEU or 4% of capacity is in layup, and utilization of active capacity is close to 100%.
• By implementing emergency and peak-season surcharges and general price increases liners have also managed to bring back shipping rates close to pre-crisis level.

Impact on businesses sourcing from China:

The container supply situation is expected to ease a bit through the second half of the year as demand tapers off after the peak shipping season and carriers take possession of their delayed order deliveries from ship builders. However, in an attempt to recoup losses suffered during the recession, carriers are expected to actively manage both supply and prices in the future. The labor shortage situation is expected to continue through the foreseeable future. All these portend longer lead times, unpredictable deliveries, and higher costs for companies sourcing from China.

In the absence of a swift adjustment, lost sales and delivery delays to customers can be expected to increase. Longer lead times could mean higher average inventory levels and thereby higher working capital requirements. In addition, an increase in direct costs from higher labor and shipping rates, as well as an increase in hidden costs from expedited shipments and customer fines, will increase total product costs. Product quality might also suffer as Chinese factories struggle with recruiting sufficient levels of skilled labor.

Under this scenario, the prevalent assumption of automatic cost advantages when sourcing from China would have to be revisited. While comparing multiple sourcing options, a more thorough analysis that includes all manufacturing costs, supply chain costs, disruption costs, and state subsidies of raw materials, would be warranted in most cases to make the right decision.

How can companies respond?

Companies can adopt various measures to adapt to this new business environment. In the short term:

• Companies must improve visibility across their supply chain by more readily sharing information with their customers and suppliers about demand, inventory levels, and capacity.
• By regularly monitoring demand patterns, companies can work with their suppliers frequently to prioritize order deliveries.
• By scheduling smaller but more frequent order deliveries, companies can more effectively manage the limited supply of raw materials while minimizing the impact of supply chain disruptions.
• Companies can analyze their past data to study variability in demand and lead times. Inventory levels can be set to account for variability, in addition to sales volumes. Higher variability levels necessitate larger inventory buffers and vice versa. A Plan for Every Part (PFEP) that incorporates these principles would help companies optimize their inventory levels.

In the longer term:

• Companies need to completely reassess their sourcing strategies.
• Many companies are already exploring the option of sourcing from suppliers in multiple countries. We have noticed an increasing trend among companies in moving manufacturing operations from China to Mexico. We have seen numerous situations where the landed cost of a Chinese product was only negligibly higher than a Mexican product. However, the Mexico option offered 30% to 40% lower lead times, and greater flexibility in ordering policy and responding to demand changes. This reduces the levels of inventory dramatically.
• Developing secondary manufacturing options in the U.S. could also be an attractive option for some companies.
• A thorough cost-benefit review that models for the variability in the various supply chain parameters and identifies all the supply chain costs can help companies make the right decisions.
• Companies would have to train their employees to take a more holistic approach to managing their supply chains in the face of volatile business conditions.

For more information about Caledonia Group’s inventory planning, click here.