Navigational aids for an uncertain world

Managing and coping with risk and uncertainty has long been a fact of life for supply chain professionals. But in the current environment, it has become a greater—and growing—concern. It is an understatement to say that volatility and uncertainty have eroded traditional supply chain management models, resulting in costly disruptions. We also face new and significant challenges in light of recent shifts in the political landscape, both in the United States and abroad. For those reasons, it is likely a good time for a fresh look at some of the sources of supply chain risk and uncertainty, and to identify tools that supply chain managers can use to better cope with them.

Supply chain risk comes from many sources: demand fluctuations, quality and safety challenges, supply disruptions, regulatory and environmental compliance, natural disasters, security concerns, and fluctuations in currency exchange rates.¹ Such risk creates headaches, undermines supply chain planning, and stifles innovation. When managers are not confident in their projections about variables, such as demand in key global markets, access to suppliers across borders, costs of raw materials, and logistics scheduling, the risk of negative outcomes increases. These risks, moreover, often lead to reluctance to invest in new facilities, to hire new employees, and/or to invest in and test new ideas and technologies.

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A quick look at the evolution of supply chains over the past two decades shows two clear patterns that have kept supply chain risk and performance in a rough equilibrium. One is the explosion of innovative technologies designed to help manufacturers, distributors, retailers/e-tailers, and logistics service providers deal more effectively with supply chain uncertainty. The other is an increase in globalization that, along with increasingly demanding customers, has pushed supply chain managers to meet ever-higher performance expectations. However, the current global political landscape tips this relative equilibrium and puts us in perilous waters. We find ourselves in the midst of a collision between interdependent global supply chains and waves of anti-globalization sentiment in both the United States and abroad.² Unease among supply chain managers is growing due to renegotiated or scrapped trade agreements, the possibility of new "border adjustment" taxes and import tariffs, and potential conflicts with major trading partners. Sailing in these choppy waters, supply chain professionals are struggling to determine whether to retreat, change strategy, or stay the course.³

To navigate this new world, supply chain managers are well advised to increase their awareness of both the economic policy environment and the decision-making biases shaping managerial actions. Toward that end, we offer four "guideposts" that managers should monitor in order to better assess their decision-making environment. We then discuss specific strategies that can help them address the heightened uncertainty surrounding international economic policy and, in fact, discover potential sources of competitive advantage.

GUIDEPOST # 1: Pay close attention to changes in economic institutions.
Supply chain managers working at a global scale are keenly aware of the disruption that poor public policy-making can generate. We see it in emerging economies with inconsistent rule of law, corruption, and rapid changes in regulation, legislation, and national priorities. However, it is not always easy to define what constitutes good public policy. Usually the best we can do is to ensure that high-quality institutions with clear and transparent processes, adequate resources, and a competent, accountable staff are in place. (A few examples of such institutions include courts of law, the U.S. Federal Reserve, and the World Trade Organization.) But this immediately raises the question: What sorts of institutions are conducive to a nation's long-term economic success? How can we recognize where these quality institutions exist and, more importantly, when they are starting to fade?

The prominent economists Daron Acemoglu and James Robinson address this question in their book Why Nations Fail: The Origins of Power, Prosperity and Poverty. Based on their studies of the relationship between institutions and economic prosperity, they argue that prosperous nations are characterized by inclusive institutions—those that recognize and embrace a plurality of views and interests that exist in the society. Inclusive institutions enforce the rule of law in an efficient, transparent, and balanced manner. They are equitable in the distribution of opportunities to benefit from the achieved economic prosperity (for example, through access to education) and in the distribution of costs to sustain the public sector (such as through taxes). They enable the development of new ideas (new products and technologies, for example), and they are designed to respond to the disruptive and often destructive nature of innovation and entrepreneurialism in a consistent and predictable manner, Acemoglu and Robinson write.

Acemoglu and Robinson argue that while inclusive institutions lead to sustainable, inclusive, and stable economic progress, the economic success of a nation reinforces the quality of institutions when it is widely shared by its members. This creates a virtuous cycle. In contrast, extractive institutions, which are those that are designed by and for the benefit of special-interest groups, fail to secure basic individual rights and economic opportunities for most members of the society. In fact, extractive institutions hinder the process of "creative destruction"—the evolutionary destruction of existing structures, alliances, organizations, and technologies—through excessive regulation or shortsighted policy reforms. Indeed, these tend to be both the cause and the consequence of poverty, inequality, and economic instability.⁴

GUIDEPOST #2: Beware of populist rhetoric.
The recognition that good governance is essential for economic progress is important because it refines the discussion of what constitutes good economic policy. For instance, we may ask: Will the recent move toward greater protectionism (for example, the United Kingdom's withdrawal from the European Union, the United States' withdrawal from the Trans-Pacific Partnership, renegotiation of the North American Free Trade Agreement, and talks about imposing high tariffs on Chinese goods) lead to greater prosperity? Does it align with the attributes of inclusive institutions mentioned above?

Let's tackle the basics first. Most economists believe that imposing barriers to international trade is, in general, a bad idea. They have long recognized that by trading with other countries each nation can specialize and use its resources in a more efficient manner. As a result, all trading partners can enjoy increased economic activity, higher national income, lower prices, and greater variety of goods and services.

Many people are highly skeptical of free trade. In some cases, their skepticism can be traced back to basic misunderstandings. For example, most people are not familiar with the scientific evidence for the economic effects of trade liberalization and form their opinions based on casual observations or on the opinion of other equally uninformed individuals. Many are similarly unaware of economic principles related to trade. For example, they incorrectly believe that international trade is a zero-sum game. That is, if one country gains from trade, then the other must be losing. The epitome of this sort of misunderstanding is the frequently heard statement that the U.S. is "losing" to China and to Mexico because we buy more from them than they buy from us. This is an argument that is as absurd as saying that a company "loses" to its suppliers with every purchase it makes.

Many people also recognize the benefits from freer trade, but they correctly point out that trading with other countries involves the loss of many jobs to competing foreign firms. Some of those who are displaced adapt by acquiring the necessary skills to succeed in the new environment and end up benefiting from the change. Others, however, take lower-paying jobs or remain unemployed for long periods of time and never see the gains from trade materialize.

Economists like to respond to this by pointing out that the disruptive nature of globalization is no different than that of technological progress (and that the two probably complement each other), and yet only the development of productivity-enhancing technologies is widely accepted and encouraged. Moreover, just like technological progress, freer trade has the potential to increase the size of the economic pie, so in theory it is possible to fully compensate the individuals who are made worse off by the reform. But the fact of the matter is that although opening to trade generally reduces consumer prices, which is something that benefits everyone, those that work in industries that compete with imports tend to be harmed by freer trade if their skills cannot be easily moved to the industries that gain from trade, or if their skills become obsolete. As a result, the movement toward freer trade has contributed (again, jointly with technological progress) to the increasing levels of income inequality in the United States.

Economists are good at describing the trade-offs brought by globalization, but only the political process can resolve them, and it is in the resolution of these trade-offs that the quality of institutions plays a critical role. Unfortunately, in contrast to the above-mentioned aspects of good governance, recent policy reform surrounding international trade in the U.S. and UK, among other countries, has typically occurred under changing norms about transparency and consistency. Around the world, special-interest groups, misinformation, and demagoguery all are playing a significant role in debates and subsequent policy reforms. In effect, the way that international trade policies are being discussed and implemented in Washington, London, and other world capitals has shifted toward the populist rhetoric that is so common in some Latin American countries and their extractive institutions.

GUIDEPOST #3: Closely monitor economic policy uncertainty.
There are many ways an inconsistent and unpredictable policy environment can hamper long-term economic progress. For example, greater uncertainty tends to depress the consumption of durable goods as well as investments in capital goods. It leads firms to postpone hiring decisions, and it distorts the efficient allocation of a nation's scarce resources by, for example, delaying entry into and exit from markets and reducing the efficiency of financial markets. In addition, as indicated earlier, greater policy uncertainty results in higher system variation and supply chain risks, leading to an intensified "bullwhip effect" that is characterized by increasing variability in perceived demand as one moves up the supply chain, away from the end customers. This can result in significant inefficiencies, including excessive inventory, poor customer service, lost revenues, misguided capacity plans, and/or missed production schedules.

How can supply chain managers monitor and recognize increased levels of policy uncertainty in the U.S. and around the world—and then use this information to adapt their strategies to changing conditions? While different alternatives exist, a particularly useful tool is the monthly index of Global Economic Policy Uncertainty (see Figure 1), recently developed by Baker, et al.⁵ The index is based on worldwide newspaper coverage of economic policy uncertainty, and it captures the importance that the media gives to the topic at a given point in time. The index clearly shows that in the last decade, managers have been confronted with an upward tick in the level and the volatility of economic policy uncertainty. Not surprisingly, the index increased significantly during the global financial crisis, and then jumped again in June 2016 with the UK Brexit referendum, and in November 2016 coincident with Donald Trump's election.

Regular monitoring of this index should provide supply chain managers with information about medium-term changes in economic conditions that are based on policy changes. As perceived uncertainty increases, supply chain managers should take active steps, such as: developing multiple sourcing arrangements in alternate locations; investing in futures or options for important commodities; accumulating country- or region-specific intelligence, either developed in-house or purchased through consultants or other experts; and increasing safety stocks. When perceived uncertainty decreases, managers should consider moves in the alternative direction in terms of sourcing, futures/options, and safety stocks. This information can also be helpful in timing capital investments in facilities and equipment.

GUIDEPOST #4: Beware of your cognitive biases.
We know that managers have cognitive biases—flaws in human perception and understanding that lead to errors of judgment—that often hinder them from making accurate and timely decisions.⁶ Specific cognitive biases include availability bias (overestimating the validity of data they already have versus data they have access to); the ostrich effect (ignoring critical information); omission bias (tendency to prefer no action to any action); irrational escalation (making irrational decisions based on past rational decisions); and herding (following the crowd in a risky direction).

These types of biases are frequently observed in business situations, including in the supply chain management environment. For instance, we often make false attributions of cause and effect, or worse, ignore impending bad news altogether. Another example: When confronted with uncertainty, many supply chain managers tend to fall back on ideas and beliefs that they know from the past. Yet because unique or novel situations (new trade barriers placed on former trade partners, for example) tend to require new solutions, relying on familiar decision patterns is often the least effective path to follow.

The simple act of being aware of one's own cognitive bias is one way to reduce the impacts of those biases. In fact, research shows that awareness of our own biases, together with the use of such practices as working with peers to look at decisions from multiple perspectives and employing trusted outside observers to put "fresh eyes" on a decision before it is implemented, can help reduce decision errors. When these and other approaches are used regularly as part of a structured decision-making process, response times can actually decrease.

How to take advantage of uncertainty
When uncertainty crests, it is important to have a strong base knowledge and current data about economic conditions, effective tools for analysis, and good contingency plans. These three capabilities result in a keen ability to "peek around corners" to see what is coming and respond faster and more accurately than competitors. Thus, for those organizations that have made the necessary investments in knowledge, data, tools, and plans, increasing uncertainty can become a competitive weapon to be deployed, rather than a condition to be feared. By responding to change more successfully than competitors, effective organizations can grow market share, enhance revenues, decrease costs, and enjoy increased margins.

We believe supply chain managers should prepare for increased economic policy uncertainty in six ways:
1. Employ "what-if" scenario planning by utilizing advanced quantitative techniques, such as operations research and simulation modeling, to investigate the impact of various sources of uncertainty and conduct sensitivity analyses.
2. Utilize financial risk mitigation by purchasing insurance or by utilizing forward and future contracts to reduce the severity of disruptions.
3. Vary products, policies, and market positioning to boost revenues and market share by tailoring to suit local needs and tastes. To avoid increases in costs and complexity, we recommend designing common platforms that local variants can be built upon through a postponement strategy or delayed differentiation.
4. Design a more flexible supply chain configuration and infrastructure. This can be accomplished at the input stage (having a variety of suppliers for volume/delivery flexibility); process stage (labor and machine flexibility); and output stage (customer flexibility, identifying customers that are less sensitive to delivery dates or products). This should be high on the priority list, as supply chain flexibility has emerged as a critical management strategy for achieving competitive advantage in an unpredictable environment.
5. Redesign the supply base by examining the availability of potential suppliers and their willingness to help manage sources of uncertainty. Multiple suppliers may enable an organization to cope with changing production plans and exploit differences in labor costs, tax rates, tariff rates, and so forth.
6. Make strategic acquisitions, partnerships, or alliances to overcome emerging tariffs or barriers to trade. For example, Europe's Airbus SE and the Canadian manufacturer Bombardier Aerospace have partnered on the marketing, sale, and production of C-Series aircraft in Airbus' existing plant in Alabama as a response to new U.S. tariffs on Bombardier C-Series aircraft sold to U.S. airlines.⁷

Our point: A few simple strategies and tools can help supply chain managers navigate changing global economic policy with more confidence. By looking at short, medium, and long decision horizons, supply chain managers can greatly increase their preparation for uncertain times, increase available strategic options, and reduce the threats inherent in today's political and economic environment. Figure 2 classifies the above six strategies into different time horizons for managing uncertainty that stems from international economic policy. We conclude that it is critically important for managers to understand the underlying causes of economic progress; to beware of populist rhetoric that threatens the quality of current institutions by inducing less consistent and less predictable policies; to continuously monitor shifts in economic policy volatility; and to avoid cognitive biases that are likely to arise in periods of heightened policy volatility. There is no reason to fear policy changes, only motivation to be prepared to deal with these changes and develop a resilient supply chain. In fact, in the case of global economic policy and supply chain management, uncertainty can be viewed as an opportunity to gain competitive advantage.

Notes:
1. Eliot Simangunsong, Linda C. Hendry, and Mark Stevenson, "Supply-chain uncertainty: A review and theoretical foundation for future research," International Journal of Production Research 50, no. 16 (2012): 4493-4523.
2. Chris G. Christopher Jr., "Globalization at a Crossroad?" CSCMP's Supply Chain Quarterly, Q4/2016; Toby Gooley, "Time for some scenario planning?" Q1/2017; Toby Gooley and Mark Solomon, "U.S.-Mexico trade relations to survive Trump's anti-trade rhetoric, Mexican official says," April 21, 2017.
3. Pankaj Ghemawat, "Globalization in the Age of Trump,"Harvard Business Review, July-August 2017, 112-123.
4. Daron Acemoglu and James Robinson, Why Nations Fail: The Origins of Power, Prosperity and Poverty (New York: Crown, 2012).
5. Scott R. Baker, Nicholas Bloom, and Steven J. Davis, "Measuring economic policy uncertainty," NBER working paper 21633 (2015).
6. Amos Tversky and Daniel Kahneman, "Judgment under Uncertainty: Heuristics and Biases,"Science 185, no. 4157 (September 1974): 1124-1131.
7. Frederic Tomesco, Joshua Wingrove, and Richard Clough, "Airbus snaps up Bombardier jet in new challenge to Boeing," Bloomberg News, October 17, 2017.