Supply chain 'rethink' required as risk and regulatory burdens grow

The Covid-19 pandemic has revealed how vulnerable global supply chains can be to disruption and how seriously such disruptions can affect businesses and, by extension, entire economies. The war in Ukraine has highlighted this once again. However, many companies still appear unwilling to make structural changes to their supply chains.

Over decades, a system of global division of labour has been established in the manufacturing industry, based on the fact that certain raw materials, preliminary and end products are prepared and produced in certain regions of the world. This system has so far been driven in particular by the desire for maximum cost efficiency. However, the past two and a half years have shown that the most cost effective way is not always the most reliable. As a result, many businesses are now faced with a decision in which they have to weigh price stability against security of supply. However, many businesses continue to weigh costs in their decision higher than the question of supply chain reliability. Accordingly, it is no surprise that many supply chains are still fragile.

In addition, a shift in the structure of global supply chains is emerging in some industries, such as the automotive industry - for example, when it comes to the supply of intelligent systems such as electronics and sensors. Previously, ‘tier 1’ producers such as system and module suppliers had control over the supply chain and also received the largest margins. In the wake of the crises, however, many original equipment manufacturers (OEMs) in the automotive sector are becoming increasingly aware that the most value is not created by the tier 1 producers themselves, but at the lower levels: the tier 2 and tier 3 manufacturers. Consequently, OEMs are now increasingly breaking up traditional supply chains by contracting directly with tier 2 and tier 3 producers such as electronics manufacturers. This could lead to significant losses for tier 1 producers in the future. It remains to be seen whether this development will spread to other industries.

Identifying risks in the supply chain

There are various risk factors behind disruptions and failures in the supply chain: for example, upstream suppliers may be located in crisis or war zones. In such cases, it is often difficult to relocate production to other, safer regions at short notice. Natural disasters, border closures and other unforeseeable events can also cause logistical problems, so that goods can still be produced but can no longer be delivered - or transport has to be switched to another means of transport, which increases time and costs. This is particularly difficult in cases of ‘just-in-time’ production, as there is no time buffer and the ordered goods are needed immediately on site. In addition, natural disasters or government intervention can also lead to production stoppages, which means that certain input products are no longer available in sufficient quantities. This in turn can result in massive price increases.

Another disruption scenario is currently occurring particularly frequently due to rising energy prices: upstream suppliers get into economic difficulties and can no longer provide security of supply. Customers in the supply chain should prepare for such scenarios to be able to take immediate action in the event of economic difficulties.

Identifying risks in one's own supply chain requires a thorough analysis of both one's own business and its operations and the businesses in the supply chain, including logistics partners on both sides.

Stabilising supply chains

As diverse as the reasons for supply chain disruptions are, so can be the solutions that make supply chains more resilient. One measure many companies have taken in the wake of the pandemic is to diversify their supply chains: instead of relying on a single supplier for a particular product, they now source it from multiple manufacturers. In particular, they are making sure that supplies no longer come exclusively from certain regions - China, for example. While this increases costs, it creates security should a single manufacturer fail or logistics chains be interrupted for a longer period of time.

Another way of making supply chains more resilient is through digitalisation: supply chains become more plannable, controllable and thus more secure when it is recorded down to the second where in the world an ordered product is currently located or in which production stage it is currently at. In this way, it is also possible to react to any problems at an earlier stage. Digitising the supply chain requires replacing partly manual and paper-based processes with digital and autonomous mechanisms, including the digitisation of data flows and the introduction of technologies that create more flexibility and agility in the supply chain. However, it is important that supply chain management is fully digitised, since hybrid supply chains, which include a mix of digital and paper-based mechanisms, are often inefficient and prone to errors.

‘Near shoring’, where companies look for suppliers in the area where their production or sales market is located, can also prevent logistical problems. The same applies to better inventory management and a departure from just-in-time production. Ideally, warehouses with intermediate products should be located close to the production site and their stocks carefully planned and closely monitored.

Another important measure is to contractually agree with suppliers what should happen in the event of production stoppages and delivery difficulties, especially in so-called allocation scenarios in which several of the supplier's customers compete for the supply of limited quantities of products. However, still too few businesses incorporate the lessons learned from the supply chain disruptions of the last few years due to events such as the pandemic, accidents, fire disasters, sanctions and war, into their contract design.

ESG compliance in the supply chain

Supply chains do not only face commercial risks. Compliance issues are also increasingly becoming a challenge, as businesses are confronted with growing regulatory requirements.

A company's supply chain poses numerous compliance risks in areas such as corruption, fraud, export controls and sanctions, as well as increasing environmental, social and governance (ESG) requirements. Companies are increasingly confronted with changes and a multitude of new requirements, particularly in relation to sanctions and ESG, which mean that they have to monitor their supply chains and the way suppliers operate within them more strictly.

In the future, ESG factors should be given much more weight in the choice of suppliers than they have been in the past, because companies or parts of groups of companies may be obliged to take specific measures with regard to their global supply chain due to ESG-related laws in various countries. Such laws include the Modern Slavery Act in the UK and similar legislation in countries such as Singapore, Australia and Hong Kong; the "conflict minerals" provisions in Chapter 15 of the Dodd-Frank Act in the US and the corresponding EU regulation; the Transparency in the Supply Chain Act in California; the French Duty of Vigilance Act; or the Dutch Child Labour Act. Mandated measures may include specific due diligence on human resources or labour rights standards within the supply chain, annual public statements or other reporting requirements, and informing customers of supply chain transparency measures.

In Germany, the Supply Chain Due Diligence Act will also come into force in 2023. It obliges large German businesses as well as foreign companies with a branch office in Germany to take defined compliance measures to ensure that both they themselves and their suppliers from Germany and abroad comply with certain environmental and social standards. In addition, the companies must report annually on their compliance with the law. The new law will apply to companies with at least 3,000 domestic employees from January 1, 2023. From 2024, it will also cover smaller businesses with 1,000 or more domestic employees.

Similar, even more far-reaching regulations are planned at EU level. The European Commission presented a proposal for a sustainability directive in February 2022, which was fundamentally endorsed with changes in a joint position of the member states in November 2022. This directive could oblige even more businesses to monitor their supply chains for human and environmental rights risks, and also includes obligations on climate protection. This was followed in September 2022 by a proposal for a regulation banning products made with forced labour from the EU market. All products in the EU would be affected by the ban, regardless of whether they are produced for domestic consumption or export or imported from third countries.

Businesses should closely follow regulatory changes in this area and establish a compliance management system (CMS) for their supply chains that is tailored to the company's specific risks. This requires in particular a thorough risk analysis of the supply chain, including the company's own business operations (with group companies at home and abroad) as well as at least the immediate tier 1 suppliers worldwide.