Formula is just the latest supply chain crisis – we should ask why

The baby formula shortage is the latest high-profile supply chain crisis and, as we’ve seen, it’s causing dangerous shortages for many new parents. Much has already been reported about the Food and Drug Administration (FDA) closing the Abbott Nutrition plant in Sturgis, Michigan, halting formula production, so I won’t dwell on that. But we are also seeing critical shortages in many other commodities like essential medicines, and in the years to come we are likely to see more setbacks. What we should ask is why. Most often, the answer lies in a simple question: who is going to pay (more)? Let’s look at this from first principles.

There is not enough spare capacity

The infant formula crisis has many unfortunate circumstances, including the closure of a factory that used to make up a large part of the national supply. This took a significant part of the country’s capacity offline. But it also reflects a lack of unused capacity in the system. There were no other factories that had a lot of spare capacity to intervene quickly. Why that ? Well, you usually want to run a plant at a high utilization rate because then you can spread your fixed operating costs over as many production units as possible. If your company wanted to sell products from low utilization factories in order to have more margin, you will have to charge more. But consumers don’t see the value built into a higher price on the store shelf, so they would likely buy a similar product that doesn’t have that “resilience” in the price. In other words, consumers don’t want to pay.

Insufficient inventories to cover emergencies

The next question we might ask ourselves is, why don’t companies stockpile more inventory in case of an emergency like this? The answer is again that it costs money, sometimes a lot. Inventory costs money – you have money tied up because it costs you something to make the product, and until you sell it you don’t get the money back (more likely a profit ). And those freight charges have to be recouped, which again means you have to charge more. As a consumer comparing products on a store shelf, you don’t really care if a business has spent more money on inventory, you look at the selling price. And generally, you don’t want to pay more if the manufacturer has more inventory to protect you in case something goes wrong.

Many investors look askance at companies that also have a lot of cash tied up in their inventory. “Why do you have so much money tied up in inventory?” they might ask. “How often do you shoot it? Lower inventory, less tied up cash – these things make investors happy.

For infant formula and “dated” products – those with a limited shelf life (and expiration date), you really don’t want to have a lot of inventory. Consumers will choose products with the longest expiration date, and if you have too much stuff lying around, you might end up throwing away what you can’t sell before it expires. This drives up your costs, which means you have to charge more. But again, no one wants to pay more just because you’ve decided to have more inventory.

There are exceptions, of course. A few years ago I had the opportunity to visit the Novo Nordisk factory in Kalundborg, Denmark. At the time, this factory produced half of the world’s insulin supply, which in itself was very impressive. But the folks at Novo also saw it as their responsibility never to run out since lives depended on insulin, so they had a five-year supply in the freezer. Now Novo is an amazing company, and I imagine there are others doing similar things, but that tends to be the exception rather than the rule.

Supply concentration

For many products, we have observed that industries have been reduced to fewer suppliers. Early in the pandemic, we saw meat shortages when COVID-19 tore through packing plants, shutting them down. Decades ago, there were many small packing houses spread across the country, rather than a few giant factories. As you can imagine, having lots of small factories is more resilient than a few large ones, because if a large one goes offline, you take a bigger chunk of the overall capacity. But large factories enjoy economies of scale, which means they are more efficient. Their fixed costs and overheads can be spread over higher product volumes, so they can sell at more competitive prices. In January 2020, I took a class to visit a factory that made 45% of all microwave ovens in the world. You name the brand, and they probably made models there. It was a sight to behold. But this company was by far the low-cost producer. Economies of scale often mean that smaller players are pushed out because they are not cost competitive. Will consumers pay more because the product comes from smaller, less efficient factories? Probably not, unless it’s a handmade product or something with a lot of uniqueness. More generally, this is why we have fewer factories supplying the market. Because consumers won’t pay more.

A race to the bottom in prices

We live in a very price-conscious society, especially when we feel the pressure of inflation, as we are now. But the “daily low prices” and the Sunday circulars that lead to the price reinforce this behavior. We also see it in the behavior of group purchasing organizations, whose mission is to drive down the prices of products such as prescription drugs (generics in particular). But that means big producers with economies of scale win, high-cost domestic (but local) producers are driven out of the market, and much of the production goes to foreign producers in low-cost countries. This leads to long supply chains that are subject to all the congestion-related delays and disruptions we’ve seen, as consumers don’t want to pay more.

Logistics bottlenecks make everything worse

On top of all these problems, the logistical bottlenecks of the past two years are making the situation worse. There are not enough truck drivers, warehouse workers, people to work in grocery stores. It’s like when you have an accident that causes a clogged freeway, and the traffic jam causes more accidents that make the traffic jam even worse. This is what supply chains look like. Training effects coupled with training effects. If you’re in the logistics industry trying to meet consumer demand, you’re not having a happy time.

Pantry inventory

You could say that’s why many consumers buy toilet paper, or when they hear of an impending shortage, they go out and stock up on whatever comes next. In effect, consumers hold inventory if they are worried about shortages, and the cost to them of transporting it is out of sight, out of mind. When I was in the consumer products business, we often called this “pantry inventory.”

For the sake of all those parents with infants, let’s hope the formula shortage gets better soon. In the meantime, we can consider the consequences if no one is willing to pay for supply chain resilience. One thing is certain, this will not be the last setback.

Willy C.Shih is the Robert and Jane Cizik Professor of Management Practices at Harvard Business School. His research focuses on global manufacturing and supply chains. Follow him on Twitter: @WillyShih_atHBS

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