Thai floods

The global supply chain: So very fragile

December 12, 2011: 11:21 AM ET

Manufacturers have spent years building low-cost global supply chains. Natural disasters are showing them just how delicate those networks really are.

By Bill Powell, editor-at-large

Cars outside a Honda factory in Thailand, submerged by severe flooding.

Cars outside a Honda factory in Thailand, submerged by severe flooding.

FORTUNE -- The image to the right is almost surreal: It shows part of a Honda auto factory in central Thailand, one of the largest in Southeast Asia, swamped under 15 feet of water, brand-new cars floating in the currents. The devastating November flooding in Thailand, which killed more than 600 people, also knocked out some of Honda's key suppliers, including electronics component maker Rohm & Co., forcing production delays in plants as far away as Ohio.

The Thailand floods alone would test any company's operational prowess; now consider that much of the auto industry and many technology companies are still recovering from the earthquake and tsunami that tore through north-central Japan in March, shutting down dozens of contractors and subcontractors that supply everything from glass to test parts.

The twin tragedies in Asia have shone a spotlight on the often anonymous but incredibly important niche companies whose products and parts go into every MacBook or Prius. Invented by Toyota Motor Corp., (TM) and perfected in the era of globalization, the lean supply chain completely decentralized manufacturing: Big manufacturers developed a multinational network of specialists to supply them with parts and to make sure those components arrived at assembly plants at the moment they were needed. When things go as planned, the system benefits everyone in the chain: The assembly plant is more efficient (no pesky inventories to manage), suppliers keep the cost of parts down by locating in regions with cheap labor, and consumers enjoy lower prices.

But natural disasters such as the earthquake and tsunami reveal just how fragile this carefully crafted ecosystem can be. As Bob Ferrari, a leading supply-chain consultant, puts it: "You never want to hear about the guys who run the supply chains for multinational companies. When you do, usually it means something really bad has happened."

Insurers and companies are still calculating the direct costs of the devastation. Munich Re, the big insurer, pegs the economic cost of the earthquake and tsunami in Japan at $210 billion for the first nine months of 2011 alone. Thailand's insurance commissioner estimates some $30 billion in losses from flooding in his country to date.

Scattered shipping containers in Sendai Shiogama Port in Japan on March 13

Scattered shipping containers in Sendai Shiogama Port in Japan on March 13

Because of the interconnected nature of supply chains, the economic impact of these disasters will be felt well beyond Asia -- and for many months to come. Computer hard-drive maker Seagate (STX), which operates two factories in Thailand, predicts disruptions to its customers (Seagate supplies hard drives to makers of PCs and servers) through 2012, and CEO Stephen J. Luczo says the industry won't "be back to normal" until 2013. iSuppli, a market research firm, says the computer industry is in need of 175 million hard drives but suppliers can deliver only 125 million units -- a shortfall of 29%. Apple (AAPL), Hewlett-Packard, (HPQ) and most recently Intel (INTC) are among the companies that have told investors that the flooding will have an impact on future earnings.

The effects of Mother Nature's wrath still are being felt in the U.S. Auto assembly workers in Ohio saw their hours cut in November because Honda (HMC) couldn't get parts from Thailand. (In late November, Honda returned those plants to normal production levels.) On the other hand, a factory in Decherd, Tenn., that normally makes engines for Nissan cars sold only in the U.S. suddenly had to ramp up production after the Japan earthquake; Nissan had the American plant ship engines to Asia for use in cars sold both in Japan and in Southeast Asia.

Not surprisingly, the events of 2011 have forced many manufacturers to rethink their global infrastructures. "These recent 'Black Swan' or unprecedented natural disaster events have obviously exposed vulnerabilities among industry supply chains," says Ferrari, the supply-chain expert. "The question now is, has the quest for lowest-cost production and hyper-lean supply chains overridden and exposed vulnerability to significant business risk?''

It is a big, knotty issue for CEOs: Are bottom-line-oriented executives prepared to pull back from a system of low-cost suppliers and "just in time" manufacturing in favor of a more old-fashioned model that has plants squirreling away components for a rainy day, or, more dramatically, investing in backup facilities?

For some companies the answer is a resounding yes. Seagate CEO Luczo says sophisticated companies have started asking his company for longer contracts on supply arrangements.

Analysts say Nissan has bounced back better than other Japanese automakers because it was able to ramp up production at its other plants, including the Decherd facility. (One stroke of bad luck: Nissan also bolstered production at one of its operations in Thailand, which has been slowed by flooding.) FM Global, an insurance company based in Johnston, R.I., surveyed 600 chief financial officers in early 2011 and asked what they feared could derail their companies' revenue drivers. The most frequently cited answer? Supply-chain disruptions. And that survey was taken before the Japan earthquake.

Carlos Ghosn, the CEO of Nissan, is philosophical. "There's going to be another crisis," he told an audience in New York in late November. "We don't know what kind of crisis, where it is going to hit us, and when it is going to hit us, but every time there is a crisis we are going to learn from it." If he's right, and crisis mode is the new normal, then the real cost advantage may not go to the manufacturer with the nimblest supply chain but the company with the most robust one.

This article is from the December 26, 2011 issue of Fortune.

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