The drawbacks of globalized supply chains have become painfully apparent. A rethink is required – it’s time to apply the laws of physics.
Over the last three years, many organizations have experienced significant disruptions and shortages across their supply chains. Pundits have blamed just-in-time, globalization and geopolitics – but the reality is that these problems are driven by multiple events. The result has been a vivid demonstration of the fragility of today’s global supply chains. They have proved vulnerable to sudden disruptive forces ranging from severe climate changes to labor shortages, lack of capital investment, material shortages, port and railway congestion, shortages of truck drivers and workers, and a host of other risks. These problems require a fundamental rethinking of supply chain design, based on a renewed appreciation of the fundamental laws of physics.
The value of free cash flow
As organizations begin to reassess their supply chains, the starting point is to understand the value of free cash flow (FCF), which is of the most important metrics relating to supply chain performance. FCF represents the cash that a company generates after accounting for cash outflows to support operations and maintain its capital assets. High levels of FCF are seen in companies that have inventory moving rapidly through their supply chain, while low levels are seen in companies with obsolete material that is tied up in long supply chains and sitting in warehouses. Inventory that is sitting still is not accruing value. To increase FCF, inventory has to move rapidly from suppliers to customers, thereby generating cash more quickly.
Today, organizations are becoming more cognizant of the importance of cash flow as an indicator of their company’s financial health, of customer satisfaction, and of the likelihood of repeat business. It makes FCF the essential new metric for assessing how business speed and financial performance are linked. It is extremely important to multiple business stakeholders, not only in supply chain roles but in finance, IT, human resources and innovation management.
The relationship of free cash flow to physics
But how to generate high levels of FCF? To gain insights on this question we turn to the concepts of physics, to learn how matter flows in nature. In our new book, Flow: How the Best Supply Chains Thrive, we explore how principles found in physics can be linked to the idea of increasing the speed of material flows in supply chains. We discovered the role of new technologies in creating faster supply chain flows, including artificial intelligence, cognitive computing, augmented reality, blockchain and other new technologies.
Several concepts in physics have parallel concepts in supply chains. For example, velocity in physics can be compared to speed of material and speed of information flows in supply chains. Speed of inventory movement is self-evident – faster movement increases inventory turns and increases cash flow. Physical compression can be linked to the trend towards near-shoring, which reduces distances between suppliers and customers, which in turn reduces the time to move material from point A to point B. The laws of physical flows found in thermodynamics can be tied to the flows of working capital enabled by technologies that create greater material visibility in supply chains.
Thermodynamics dictate that all entities in a supply chain evolve into a balanced multi-scale structure designed to improve flow of an entire system. Executives who ignore the physical laws of supply chains do so at their peril.
How executives disregarded physical laws
The laws of physics are important – and their parallels in supply chains are essential to comprehend. Unfortunately, however, executives have ignored how these laws shape supply chains, much to their detriment. Over the last 30 years, executives in multiple industries, starting with GE’s Jack Welch, began moving their manufacturing operations offshore, to China, India, Eastern Europe and other off-shore countries with low-cost labor. This evolved into labor arbitrage, where the goal was to push costs lower and drive margins by moving to the lowest cost countries.
In effect, it became a race to the bottom. As a result, supply chains became increasingly extended, with longer lead times, more inventory and delays, less communication and the loss of intellectual property. Many companies’ balance sheets went haywire: their working capital and pipeline inventory became bloated, supply lead times went from weeks to months, and the volume of damaged goods and excess or obsolete inventory escalated. Eventually, as overhead costs rose, customer satisfaction suffered, costs began to rise, and the lower labor cost of outsourced products became less of an advantage. This understanding really hit home during the Covid-19 pandemic when personal protective equipment (PPE) and hospital supplies could not be received from China due to export restrictions.
The drive to reduce costs and satisfy the demand for increased operating income has become less appealing in the post-globalization era of supply chain shortages. Applying the principles of supply chain physics increasingly reveals that organizations have sacrificed distance, time and speed in pursuit of low costs. In essence, the laws of physics that determine outcomes – speed, compression, and physical flow evolution – will become the key elements to drive flow in supply chains. Flow, in this sense, refers to the increase in movement velocity, compression of sourcing networks, and evolution to the lowest total cost in supply chains. Just as a river’s water flows over time to the lowest possible level, supply chains are flowing to the lowest total cost of ownership in global networks.
How physical laws apply to supply chain principles
Physics is integral to what happens around us every day. The parallel between physical and supply chain flows is eloquently depicted by a famous Duke University physicist, Dr Adrian Bejan, who describes the physics of flow in his book, The Physics of Life: “The way to see the law of physics of living systems is to see them as flow systems in motion, driven by power, with finite-size constraints and, above all, with freedom to change and time direction for the evolution of design changes.”
Physical flows provide an underlying set of rules that explain why things around us happen the way they do. The universal nature of these physical principles makes them inherently appealing; engineers use them to design products, processes and systems, and rely on them to hold true in various situations. Physics governs the behavior of matter, time and space, making it critical in mechanics and industrial design as well as in the construction, electrical, chemical and nuclear power industries.
Physics depicts the evolutionary path of every natural entity in the way it evolves and follows its pathway in the natural world. Physics is especially suited to understanding the ways in which supply chains morph and develop over time, and can even be used to predict how supply chains will evolve. Using the laws of physics, we were able to derive a set of principles for supply chain flows that can be applied to what we see happening in global supply chains in our post-Covid world. These include the following:
- Velocity of inventory movement speeds up FCF. As organizations pay more attention to FCF, they will invest in technologies that allow them to visualize where their inventory is in real time – which allows managers to make adjustments to speed up its movement.
- Compression of supply chain networks speeds up velocity of inventory movement. As the distance between customers and suppliers is reduced through near-shoring, the time and distance between them is compressed, which means inventory spends less time traveling between its point of origin and its destination.
- The flow of supply chains will evolve to the lowest total cost, which is often driven by compression of supply chain networks. The lowest cost includes not just the price of the product, but all of the costs in transporting it from point A to point B, as well as the opportunity cost of holding higher levels of inventory.
Consider the following example. A container being shipped from Shanghai might take 60 days to reach the US; on a truck from Mexico, it would take one day. In an era of global trade shifts, distance is becoming an ever-more-important variable in supply chain planning. The importance of inventory velocity ensures that inventory is not tied up sitting in a container on a boat in the middle of the ocean when it could be put to good use within 24 hours.
Weight and volume are also critical. Increases in either one will naturally increase shipping cost: higher volumes, weight and distance take more time and cost more. This leads to interesting discussions about the cost of shipping quickly versus the cost of holding material for a longer time in transit. For instance, buying products in China may result in a lower price that improves the company’s operating margin. However, because of the long transit time, inventory sits on the balance sheet for longer and weighs down the company’s working capital.
Considering such trade-offs involves understanding the increased levels of working capital required to finance globalized supply chains – to measure the total cost of a product (not just the price). For instance, not all products will travel on a slow boat from China. If a product has very high value and low volume, such as an Apple iPhone, it makes sense to put it on a plane over a longer distance, and pay a higher freight cost. Apple will do this if it is running late on a product announcement, and will suck up a lot of airlift to get its phones to the market on time. But most organizations will put heavy, bulky or low-value products on a ship rather than on a plane. Of course, not every product can be produced in China – so some blend of off-shoring and near-shoring may be required in some instances.
The importance of culture in improving supply chain flows
This is not to say that physical laws are all that matters. Clearly culture – encompassing social communities, work ethic, educational institutions, infrastructure and governments – also enables every supply chain to adapt to the global ecosystem. In short, culture enables a country’s supply chain to flow. Cultures must also embrace change to survive. Singapore’s leaders, for example, recognized many years ago that their country’s geographic location meant it could play a role in the global logistics system. They set up as a logistics center, building ports and infrastructure, and pivoting the country’s economy to improve its supply chain efficiency for transportation and business. Similarly, when FedEx chose to build its headquarters in Memphis, the city’s entire culture shifted to embrace the opportunity, leading to the growth of distribution centers, factories and warehouses throughout the area.
These two examples are not anomalies. Throughout history, cities located along major trading routes have become major logistics hubs by embracing change to enable supply chain and economic success. In a sense, an enabling culture is the key lubricant that creates the flow, versus the friction, that enables physical laws to act. An adaptable culture enables flow, whereas a resistant culture, such as a community lobbying against Amazon’s plans to build a headquarters in New York City, can stop physical progress in its tracks.
Rethinking global supply chains
To overcome the complexity of today’s fragile global supply chains, it is essential to understand and embrace the natural flows of global supply chain commerce. This means overcoming resistance to change with force and influence – or, if resistance is too heavy to move, applying leverage to lift it.
Our book emphasizes the importance of solution design, which requires rethinking assumptions about data, flow and how people learn. There are no simple formulas for how to embrace flow. Every company will need to learn how to observe and understand what natural evolutionary flows mean in terms of their particular goals, corporate culture and philosophy, and executive team’s flexibility. It will require leaders to challenge long-held assumptions and take risks with innovative ways to align decision-making in an evolving supply chain.
Rob Handfield, PhD, is Bank of America University distinguished professor, North Carolina State University. Tom Linton is a senior advisor at McKinsey. They are co-authors of Flow: How the Best Supply Chains Thrive (University of Toronto Press, 2022).