Executive Briefings

Bracing for Supply Chain Sticker Shock

For most of the past three decades, private equity firms and other investors have relied on two simple questions to assess the supply chains of the companies in which they've invested: Are our companies leveraging low-cost country supply sources and are they keeping supply chain costs in check? Deeper inquiries have always seemed unnecessary, so private equity firms and investors have focused on other aspects of the businesses they own to drive value.

Bracing for Supply Chain Sticker Shock

Many of those investors will be surprised to learn that their seemingly consistent supply chain costs, supported by low-cost country sources, are going to increase in the next few years. It's a challenge likely to spread across a broad range of industries, and those who are unprepared are at risk of seeing their profits shrink.

What's fueling the coming changes to supply chains in traditionally low-cost countries? The short answer is that the conditions that have made developing markets so attractive - and profitable - over the past 30 years are swiftly changing. Once you understand how the suppliers' operating conditions have changed and what has happened to their costs in the last five to 10 years, you can see why investors may need a new supply chain strategy going forward. An updated strategy that encourages investors and their companies to move proactively to buffer their supply chains against future sudden price shocks could help protect their profitability

Most companies already analyze their supply chain costs using total landed cost calculations, which take into account transportation, duties, inventory carrying costs, and increased selling, general and administrative expenses, such as quality control and unit costs from suppliers. But performing total landed cost calculations is usually done only at specific points in time and is limited because it focuses on the customer's perspective, not their suppliers'. 

The suppliers' operating conditions - and therefore their costs - are always changing, and those changes impact a customer's prices. As a result, even more fine-grained analysis, with additional math, is possible - indeed, necessary–to truly understand what suppliers are facing and how it will affect the customer.

Supplier's Profitability

Knowing a supplier's cost structure and how it has been trending can help investors and their companies understand its future profitability. They can predict when the inflection point may arrive and prices may surge, or when quality and service may be compromised. To ensure a complete understanding of a supplier’s profitability, one has to consider many factors.

To illustrate, one investor's operating partner and its company recently reviewed their pending risk and identified alternative source regions, countries and suppliers throughout the world by assessing these criteria:

Manufacturing strength for the required capabilities and products

• Workforce costs, quality, availability and stability

• Infrastructure assessed on the basis of its energy, transportation and communications from quality, availability and stability perspectives

• Macroeconomic factors, defined as the country's fiscal health, monetary policies and political stability, and the government's influences on suppliers for items such as incentives, taxes, duties and tariffs

• Importing and exporting trends of key raw materials and the end products to understand where suppliers are getting raw materials from and whether the competition has a head start

• Lead times and other factors that might influence working capital and the ability to serve their customers

• Profitability scenarios, to understand how their suppliers' bottom lines react as operating conditions change

What the investor and its company learned about its suppliers' profitability was a surprise.

Suppliers' Labor Costs

The investor knew its suppliers' labor rates had been increasing, but until it made a concerted effort to do the math, it didn't fully understand the extent of the problem. Its suppliers' labor costs were increasing 8 percent to 15 percent annually and having a dramatic effect on their profitability.  Specifically, the suppliers whose margins would have exceeded 40 percent five years ago would be unprofitable within three years if their underlying labor costs continued to rise at the current rate.  Clearly this was an unsustainable position for the suppliers and represented a significant risk to the investor and its company, jeopardizing its entire investment thesis.

Direct labor costs weren't the only pressure the suppliers were facing. They were also facing lower labor productivity, more stringent labor and environmental regulations, unfavorable currency exchange rates, and decreasing tax or incentive rates. All of these factors were increasingly squeezing the suppliers' profitability, and at some point in the near future could force them to raise prices, reduce quality and service, or go out of business. 

With the information available today, investors and their companies can and should be proactive in understanding what their suppliers are experiencing. By taking a detailed inventory of the factors, conditions and events that affect suppliers' costs, investors and their companies can look below the surface of their suppliers' prices and identify the components that are experiencing upward pricing pressure. Investors and their companies can then move to buffer their supply chains against those sudden price shocks, rather than react after they arrive. In fact, this risk mitigation analysis and planning is best completed, during diligence, as the investment thesis is being developed.

In light of how quickly markets in traditional low-cost countries are changing, this should be a board-level concern today. It's crucial for investors and their companies to understand how much time they have before a contingency plan needs to be in place. Cost pressures in countries that were once thought of as "low-cost" are building up, and diligent investors and their companies - including, perhaps, your competition - are acting now to find alternatives.

All with PwC, Michael Deering is a partner, Steven Tess is a director, and Michael Edwards is a senior consulting associate.

© 2015 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity.

Source: PwC

Many of those investors will be surprised to learn that their seemingly consistent supply chain costs, supported by low-cost country sources, are going to increase in the next few years. It's a challenge likely to spread across a broad range of industries, and those who are unprepared are at risk of seeing their profits shrink.

What's fueling the coming changes to supply chains in traditionally low-cost countries? The short answer is that the conditions that have made developing markets so attractive - and profitable - over the past 30 years are swiftly changing. Once you understand how the suppliers' operating conditions have changed and what has happened to their costs in the last five to 10 years, you can see why investors may need a new supply chain strategy going forward. An updated strategy that encourages investors and their companies to move proactively to buffer their supply chains against future sudden price shocks could help protect their profitability

Most companies already analyze their supply chain costs using total landed cost calculations, which take into account transportation, duties, inventory carrying costs, and increased selling, general and administrative expenses, such as quality control and unit costs from suppliers. But performing total landed cost calculations is usually done only at specific points in time and is limited because it focuses on the customer's perspective, not their suppliers'. 

The suppliers' operating conditions - and therefore their costs - are always changing, and those changes impact a customer's prices. As a result, even more fine-grained analysis, with additional math, is possible - indeed, necessary–to truly understand what suppliers are facing and how it will affect the customer.

Supplier's Profitability

Knowing a supplier's cost structure and how it has been trending can help investors and their companies understand its future profitability. They can predict when the inflection point may arrive and prices may surge, or when quality and service may be compromised. To ensure a complete understanding of a supplier’s profitability, one has to consider many factors.

To illustrate, one investor's operating partner and its company recently reviewed their pending risk and identified alternative source regions, countries and suppliers throughout the world by assessing these criteria:

Manufacturing strength for the required capabilities and products

• Workforce costs, quality, availability and stability

• Infrastructure assessed on the basis of its energy, transportation and communications from quality, availability and stability perspectives

• Macroeconomic factors, defined as the country's fiscal health, monetary policies and political stability, and the government's influences on suppliers for items such as incentives, taxes, duties and tariffs

• Importing and exporting trends of key raw materials and the end products to understand where suppliers are getting raw materials from and whether the competition has a head start

• Lead times and other factors that might influence working capital and the ability to serve their customers

• Profitability scenarios, to understand how their suppliers' bottom lines react as operating conditions change

What the investor and its company learned about its suppliers' profitability was a surprise.

Suppliers' Labor Costs

The investor knew its suppliers' labor rates had been increasing, but until it made a concerted effort to do the math, it didn't fully understand the extent of the problem. Its suppliers' labor costs were increasing 8 percent to 15 percent annually and having a dramatic effect on their profitability.  Specifically, the suppliers whose margins would have exceeded 40 percent five years ago would be unprofitable within three years if their underlying labor costs continued to rise at the current rate.  Clearly this was an unsustainable position for the suppliers and represented a significant risk to the investor and its company, jeopardizing its entire investment thesis.

Direct labor costs weren't the only pressure the suppliers were facing. They were also facing lower labor productivity, more stringent labor and environmental regulations, unfavorable currency exchange rates, and decreasing tax or incentive rates. All of these factors were increasingly squeezing the suppliers' profitability, and at some point in the near future could force them to raise prices, reduce quality and service, or go out of business. 

With the information available today, investors and their companies can and should be proactive in understanding what their suppliers are experiencing. By taking a detailed inventory of the factors, conditions and events that affect suppliers' costs, investors and their companies can look below the surface of their suppliers' prices and identify the components that are experiencing upward pricing pressure. Investors and their companies can then move to buffer their supply chains against those sudden price shocks, rather than react after they arrive. In fact, this risk mitigation analysis and planning is best completed, during diligence, as the investment thesis is being developed.

In light of how quickly markets in traditional low-cost countries are changing, this should be a board-level concern today. It's crucial for investors and their companies to understand how much time they have before a contingency plan needs to be in place. Cost pressures in countries that were once thought of as "low-cost" are building up, and diligent investors and their companies - including, perhaps, your competition - are acting now to find alternatives.

All with PwC, Michael Deering is a partner, Steven Tess is a director, and Michael Edwards is a senior consulting associate.

© 2015 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity.

Source: PwC

Bracing for Supply Chain Sticker Shock