B. Trade increases from reducing supply chain barriers can be achieved only if specific tipping points are reached
B. Trade increases from reducing supply chain barriers can be achieved only if specific tipping points are reached
1. The effects of reducing barriers are not gradual; changes occur when tipping points are reached
Macroeconomic models typically assume a continuous function showing the impact of supply chain barrier reductions on trade volume and investment. However, the case studies in this report indicate that countries make progress in discrete steps: small incremental changes may have minimal effects until a tipping point is reached. So while macroeconomic models provide useful information on average effects, the consequences of any given set of changes will vary based on the specific country, industry and shipping lane.
The chief reason for this is that company decisions on where to locate production and which markets to serve are often binary. One location is either the best place to site production, or else some other location is a better choice. It is either profitable to serve a particular market or it is unprofitable.
Perhaps the best illustration of the importance of tipping points is in companies’ decisions about investments. When Global Co. faces the choice of manufacturing in the United States or in Mexico, it needs to analyse a host of factors to determine what makes financial sense. There are obvious advantages to producing in Mexico, such as lower labour costs. But there are also mitigating supply chain considerations; for example, until 2011, goods sent to the US required different trucks and drivers on each side of the border, a situation which is only partially solved today. Also, less automation and lower labour productivity in Mexico would necessitate a larger labour force. Ultimately, Global Co. would need to perform a discounted cash flow analysis to determine which country would make the most profitable production centre.
There is a similarly complex decision process in investments made by Semiconductors Co. In fact, in deciding where to locate production, Semiconductors Co. creates a model that assigns a dollar value to all the relevant factors, including the types of supply chain barriers discussed in this report. As with Global Co., the decision is binary: whether to produce in that country or not. Moreover, by monetizing the factors, Semiconductors Co. can compare each one directly. Thus there is no single combination of factors that leads to success.
Multi-factor analyses also help companies decide where to hold inventory and sell products. For instance, in deciding where to operate in Africa, CPG Co. considers a host of factors, including the political environment, security, corruption and currency risk. Depending on the perceived riskiness of a country, the company establishes hurdles that must be met in order to justify investment. Until recently, for instance, CPG Co. did not even consider a southern African country for major trade or inventory. It was only after a period of relative stability that the company began to consider the business case for investment there.
Merchants working with eBay further illustrate the importance of tipping points. They can either chose to sell internationally or not. Based on estimates derived with preliminary pilot results, through different enabling initiatives, cross-border sales could increase by 60%-80%. This effect underscores the fact that if barriers can be reduced to a tipping point, the result is a flood of increased trade activity, particularly from small businesses.
As these case studies demonstrate, incremental improvements will have little impact on trade and investment until a country reaches a tipping point that fundamentally alters the equation. Apparel Co., an apparel manufacturer in Madagascar, offers perhaps the clearest illustration of this reality. Apparel production occurs in a specially designated free zone instituted by Madagascar to facilitate trade. Exports from this zone are subject to fast-track export procedures. In addition, Madagascar has adopted electronic export and import declarations. And yet, notwithstanding its low labour costs and these reductions to supply chain barriers, Apparel Co. continues to suffer relative to competitors in Asia because of poor local infrastructure (see figure 8). Moreover, although the border administration process is electronic, the government has not made sufficient investments in facilities, resulting in long queues and waiting times. A similar phenomenon occurred in Brazil, where the government adopted an electronic freight invoice system. Because of insufficient investment in the supporting infrastructure, servers failed regularly. Agriculture Co. estimates that the unreliability of Brazil’s information and communication technology (ICT) systems and processes cut the annual operating efficiencies of its truck fleet by some 4%. In both cases, incremental investments were not sufficient to reach a tipping point that fundamentally altered the environment for trade.
The cases also show that countries are in constant competition with one another. In addition to using its monetization model to make investment decisions, Semiconductors Co. uses the output to negotiate incentives from governments by pricing the difference in attractiveness between two locations.
Handset Distribution Co. is another company that constantly re-evaluates its supply chain decisions based on changing conditions. For example, in the past the company has produced phones in Mexico for export to Colombia. However, if Colombia joins the Mercosur common market, the tariffs on imports from Brazil will likely fall to zero (compared with a 5% tariff on Mexican imports), and Handset Distribution Co. will most likely start sourcing from Brazil. This intensity of competition, combined with the importance of tipping points, requires governments to carefully analyse their unique situations. To realize substantive results, policy-makers must understand where the tipping points lie for particular industries and lanes and pull the appropriate levers. As is so often the case, the devil is the details.
2. Barrier’s consequences vary by industry
How much a company is hurt by a barrier depends largely on its cost structure and on industry characteristics such as time sensitivity and value
Different cost factors determine the impact of supply chain barriers on an industry. In general, the higher the logistics costs, the more the industry is likely to be affected. Lower value products typically have higher relative logistics costs and so are hit hardest by barriers. Also, different industries have different inventory needs, which in turn determine inventory costs. All logistics costs depend on the value of the product, on time sensitivity, and on the sophistication of the supply chain. A highly sophisticated supply chain, for example, magnifies barriers: primary inputs themselves face the barriers and then are used in secondary or tertiary inputs, which face the barriers again. These factors also determine the necessary speed of the supply chain, and thereby affect how much a company might be willing to invest.
The implications of barrier-related delays vary by industry
The most common response to the problem of delays across a supply chain is to increase inventory. For example, Rubber Products Co. mentions a lead time of up to 5 months to obtain rubber gloves for its European distribution centre. Shipping requires only two weeks of this time; the rest is attributable to barriers. The delay means that the company must maintain an average of 120 days of inventory, a level that could be reduced to only 30 days if the supply chain were more reliable and faster. Several other companies take the same approach, with the increased inventory adding to their warehousing costs, working capital requirements, and even demurrage costs. Chemical Co., a chemical manufacturer, deals in bulk shipments. These shipments face severe demurrage costs, amounting to some US$ 60,000 per day, as a result of delays in loading and unloading at ports. Every hidden cost resulting from delays negatively affects returns and makes investments less attractive.
Even though most companies and industries have to build stock to address barriers, the specific effects depend on industry characteristics. Durable, time-sensitive goods may face rapid depreciation. Fashionable apparel items depreciate quickly if they are not supplied within specific timelines and the item then goes out of style. On average, apparel manufacturers lose ~9% of revenues due to cancellations or returns of late shipments. Non-durable, time-sensitive goods face spoilage if stored for long periods of time. This is particularly problematic for the pharmaceutical industry: large stocks delayed at borders with minimal infrastructure and high temperatures may spoil the products. Pharmaceuticals, for example, must conduct further testing to ensure product integrity, and must dispose of any spoiled medications. High-value products such as high-tech items pose a risk of theft. Handset Distribution Co. sometimes faces issues at its warehouses. In countries such as Brazil and Mexico, where truck raids are frequent, Handset Distribution Co. assigns an escort for shipments worth more than US$ 1 million. Theft may also occur in government warehouses at the border. Semiconductors Co., for instance, must deal regularly with theft of chips at Indian warehouses monitored by customs. Such differences shape the costs faced by different industries and affect each industry’s stance toward barriers.
A slow and inefficient supply chain has other indirect implications as well. A company that runs out of stock faces significant opportunity costs. CPG Co., for instance, struggles constantly to find the right balance between over- and under-stocking in Africa. If a given product is popular, the company may run out of stock, losing significant revenue. If the product does not sell, it might be left with worthless inventory. Then, too, delays may interrupt production. With the advent of just-in-time manufacturing in the high-tech industry, Semiconductors Co. customers try to minimize inventories. But an unexpected delay may then stop production completely. In general, delays and unreliability generate uncertainty in forecasting, leading to poor planning. This might unintentionally lead to grey markets, in which companies sell unsold stock (particularly high-tech products) in other markets. Delays may also lead to lawsuits, and they may generate financial risk from changing foreign exchange rates. All such effects have an impact on industries, though they are sometimes ignored.
At a still broader level, delays may restrict the development of time-sensitive industries or restrict innovation in business models that rely on supply chain speed. For example, the “fast fashion” industry can exist only with reliable, fast supply chains. Zara launches a new fashion line approximately every month by tracking in real time what sells and what does not and then telling manufacturers what to produce. The company must get designs into production quickly, and must receive shipments in three days rather than three weeks. Countries that are unable to meet such expectations will miss out on an entire industry. Apparel Co., an apparel manufacturer, enjoys labour cost and tariff advantages, but the lack of shipping services in Madagascar can generate delays of about a week, which is unacceptable by fast-fashion industry standards.
Companies react very differently to the risk and unreliability associated with barriers
In general, barriers generate risk. Companies can handle this risk either by incurring it themselves or by insuring against it. A company can insure itself by spreading the risk among suppliers and by manufacturing in different centres worldwide. This might be less efficient than a single manufacturing plant, but it mitigates risks. However, companies will closely evaluate risks before taking either path. They will expect higher returns to justify the risk, and may forgo some projects entirely. In countries with high risk profiles, for instance, CPG Co. factors risk into its expected cash flow. This negatively affects the business case for investments, and may lead to investments in other markets instead. In other instances, Global Co. and Handset Distribution Co. consider risk in other financial parameters, such as weighted average cost of capital, return on investment, or internal rate of return, all of which may affect investment decisions.
3. Barriers are harder to overcome for smaller businesses
The supply chain barriers discussed in this report are particularly debilitating for small- and medium-sized enterprises (SMEs). Case studies and data analyses conducted across multiple regions have found that SMEs everywhere face similar supply chain hurdles when exporting. In its 2012 Annual Report to Ministers, the Asia-Pacific Economic Cooperation’s Committee on Trade and Investment (APEC-CTI) listed delays in customs clearance and problems related to differing legal, regulatory and technical requirements as two important barriers to exporting by SMEs.21 An analysis by the OECD concluded that SMEs are particularly vulnerable to the impact of customs procedures and domestic regulations.22 And surveys conducted by the US International Trade Commission (USITC) found that representatives of SMEs cited both the administrative burdens of compliance and a lack of standardized regulations from one country to the next as particular problems for small businesses.
Supply chain barriers particularly hinder the trade of smaller firms because dealing with the barriers requires significant upfront investments. Few SMEs operate on a scale that would make such investments economical.23 For example, one barrier is simply the time and personnel required to understand the idiosyncrasies of a given country’s policies and procedures. Testimony to the USITC indicated that small firms cannot easily absorb the cost of hiring personnel dedicated to navigating the market and regulatory requirements of export markets, whereas larger firms can do so.24 The eBay case study also indicates that these barriers are relevant to a small firm’s decision not to export. Those merchants that do choose to sell internationally typically limit sales to countries where the regulations are easiest to navigate.
If such barriers could be sufficiently mitigated, the potential for international trade by SMEs would be immense. In twelve countries identified as target markets by the EU, including China, Japan, Russia, India and Brazil, more than 50% of the € 261.6 billion (US$ 347.7 billion) in European exports come from SME-dominated sectors. Yet only 13% of EU small businesses are internationally active outside of the EU.25 In the United States as of 2010, 59% of SMEs that currently export recorded sales in only one foreign market. In contrast, 55% of large US exporters recorded sales in five or more countries.26 While SMEs account for half of economic activity in the US, they account for only 31% of total export value.27
Removing the barriers would likely boost trade substantially, as preliminary results from various short-term, highly targeted eBay pilot programmes show. Under these pilot programmes, eBay worked with some of its pre-selected small business users to make the small business listings visible to a global customer base (whereas the listings had previously been visible only to a domestic audience). It then undertook to eliminate the barriers for international buyers and sellers by providing transparency on fully landed costs and delivery dates, facilitating communication between people who might speak different languages, and handling shipping. Estimates here show that that addressing barriers such as these can result in expanded cross-border activity by small business sellers by 60% to 80%. As this result shows, the Internet can be a powerful tool to unlock SME export potential. The finding is further supported by a study in Europe showing that, after controlling for other effects, the possibility of selling online is positively correlated with activity in export or import markets. The study concluded that the Internet makes it easier for all sorts of SMEs to overcome barriers to international trade.28 For example, SMEs can far more easily identify potential markets and customers through the Internet than previously.
By definition, SMEs are a fragmented group of small players. Although they are an integral part of most countries’ economies and generate a significant share of overall employment, they may find it difficult to mount a united effort to enact the changes and reach the tipping points that enable significant expansion into international trade. If they could, however, the benefit to consumers would be substantial. The small merchants that do business through eBay, for instance, enable customers to enjoy niche products and experience the best of many cultures.
4. Clear regulations and better coordination among agencies are needed
Regulatory factors are a key barrier to efficient cross-border trading. At times, even policies specifically designed to reduce barriers either create new problems or fail to have an impact because of poor implementation.
One barrier facing exporting companies is the lack of standardization in regulatory requirements across countries. Standardizing the requirements would reduce the costs of operating in multiple markets. The case studies in this report illustrate a number of areas where differences in regulatory practices add to the direct and indirect costs of exporting products to multiple regions. In Europe, for instance, chemicals regulations require lab tests at certified European laboratories before chemical products can be registered. This policy forces foreign companies like Mexican Chemical Co. to incur the additional costs of rerunning trials and creates delays in introducing products into the European market. In Mexico, certain chemicals are restricted from import because of concerns that they may be used to produce drugs. However, many of these products have legitimate uses and are allowed in other major markets. Mexico’s unilateral bans create conflicts for products designed and synthesized in a global supply chain. Such problems are not limited to the chemical industry. PC Co. faces rules of origin and local content restrictions that vary from market to market, creating a costly administrative burden as the company tries to understand and comply with a diverse set of rules and documentation requirements.
Companies must deal at times with multiple regulatory regimes within a single country. Such conflicts are particularly likely when several agencies have jurisdiction over imports and fail to communicate or coordinate with one another. When exporting into the US, Chemical Co. may have to comply with regulations issued by the Food and Drug Administration (FDA), the Drug Enforcement Agency (DEA), the Office of Homeland Security, and others – five different agencies on average. Unfortunately, these agencies coordinate ineffectively, causing extensive delays and increased costs. For example, the company’s shipments of acetyl products, approval of which requires coordination by the DEA and Customs and Border Protection, are delayed a staggering 30% of the time.
Even when there is a single set of regulations, the rules and procedures may be vague, with little guidance provided by the regulatory body. Under these circumstances, companies must devise their own interpretations of the rules, with no guarantee that the government will ultimately agree. Semiconductors Co., for instance, is required by Chinese regulations to ensure that bonded assets remain under customs control; however, the government offers no guidance on how these items should be tracked or exactly which items are covered by the rule. Uncertainty about how to interpret and implement the regulatory requirements requires Semiconductors Co. to create its own guidelines, which may or may not be consistent with the government’s intent. Yet Semiconductors Co. cannot get an answer as to whether its interpretations are correct.
The example of bonded zones in China, discussed elsewhere, also provides an example of how government policies intended to encourage trade can sometimes introduce a new set of even costlier barriers. China introduced bonded zones to provide tax benefits and other incentives to increase trade. The case study of Semiconductors Co. indicates that, as more of its finished products produced in China are ultimately sold domestically rather than exported to other markets, the bonded zones have become a burden. The reason is that customs compliance requirements when moving products between bonded zones are particularly onerous. In fact, it is often faster to first export a product to Hong Kong and then import it back into China than to transfer the good from one bonded zone to another.
Some government policies designed to reduce supply chain barriers to trade, while theoretically beneficial, are poorly implemented. One example of such a programme is the Customs-Trade Partnership Against Terrorism (C-TPAT). The principle behind C-TPAT is to give companies that implement certain security measures access to a faster customs process when importing into the US. In practice, however, companies such as Chemical Co. stated that the requirements are quite costly, while the purported benefits of faster customs times are minimally realized.
Other government programmes to reduce barriers have been successful. Canada was able to institute a trusted trader programme that is widely viewed as a success. Canada’s programme is based on account-based clearances, which require customs authorities to assess and inspect only a small portion of the total shipments a company imports.
Meanwhile, efforts to make regulations more sensible often founder because there are few effective communication channels between industry and government. Indeed, many companies the authors spoke to believe some governments actively discourage feedback or criticism. Many companies discussed in this report would not agree to be named for fear of government reprisals. However, as discussed extensively in this report, governments should be striving to minimize regulatory barriers to trade. Effective improvement will come only with clear and honest communication between stakeholders, especially government agencies and companies.
Figure 8: Madagascar has labour-cost and free-trade advantages but supply chain barriers erode competitiveness
Source: Euromonitor 2011 data for labour costs; Bain analysis; company interview.
Source: Establish, Inc., 2009. Logistics Cost and Service 2009, page 14. CompuStat 2006; Bain analysis.
Note: Latest year is 2004.
Figure 10: Based on pilots, this analysis estimates 60-80% increase in cross-border sales by reducing barriers
Note: Assumes same average revenue per listing in domestic and international markets; author calculations based on US eBay pilot studies preliminary results.
Source: Company data; interviews; based on preliminary, targeted US pilot results; authors’ calculations.
Source: Company interview