Who dares to play the Russian roulette

Russian Roulette is a lethal game of chance in which participants place a single round in a revolver, spin the cylinder, place the muzzle against their head and pull the trigger. The game is usually associated with big prize money and the chances of winning are 5/6. However there are 1/6 chances of getting shot. Not many people come forward to play this game.

The Indian middle class growth story, the infrastructure investment, the industrial growth, and the vehicle penetration percentages tell us that there is a good chance of auto industry growing much larger than current level. But the OEMs are finding it difficult to convince all the suppliers to add adequate capacity. OEMs are dependent on suppliers for the most of the components. Unless capacity is added by every one of the component suppliers, there is no way the OEM can enhance their production.

Many suppliers are now seeking guarantees of capacity utilization for adding new capacity, which was not the case earlier. They don’t want to play the Russian Roulette as they have experienced, in 2008, the impact of the 1/6 chance of getting shot. Knowing well that severe dips in demand like what happened in the second half of 2008 can occur again, OEMs are reluctant to offer such guarantees. The industry seems to be on stalemate trying to answer the question “Who dares to play the Russian roulette?”

To understand the stalemate and evolve a Win-Win solution, we need to understand the crisis of 2008.

In the middle of 2008, OEMs, from the rising finished vehicles inventory in warehouses and dealers, were getting the signal that demand was slowing down. Yet under pressure to utilize capacity many of the OEMs kept on producing to full capacity, obviously based on a forecast, for about 2 months. When finally these OEMs took the decision to cut down their production, nearly 2-3 months of stock was piled up in the sales pipeline.

The same effect was seen with the Tier 1 suppliers, they continued to produce full blast even after the OEMs started to slow down, as they wanted to utilize their capacities. This led to piling up of their FG and WIP. It was the same scenario for the Tier2 and 3 suppliers.

When OEM dropped the production rate, the inventory of 30-45 days in the Tier 1 suddenly ballooned upto 60-90. The Tier 1 supplier started supplying from its current inventory and production was drastically curtailed. They now had raw material and parts for 60 days instead of 30 days. At the same time the inflow of payments dried out. Both due to OEMs money stuck in not selling finished vehicles and the low demand. Component vendors started finding it difficult to manage the expenses, leave alone buying fresh raw material. Hence they reduced drastically the pickup from Tier 2, leading to a huge drop in demand for tier 2.

The Tier 2 suppliers now had more than 90-120 days inventory, with a very low pickup rate. The income was far less than the requirement to cover fixed expenses. They were faced with the Hobson’s choice and inevitably had to lay off people in order to ensure survival.

The most devastating impact was that Tier 2 and Tier 3 starting using the working capital, meant for buying material, for daily expenses, interest and salaries. The rotation of their working capital was severely affected. Soon they did not have money to buy RM (for the reduced demand), further affecting their ability to generate money. A vicious cycle!

When the time came to ramp up, the workforce (laid off and now extremely disgruntled with the employers) and capital was not available and some of these suppliers took time of 2-4 months to gather workforce and capital. So even when significant demand was coming in, they could not service it fully. Thus lengthening the period of lower production rate.

Since the OEM depends on all component suppliers to ramp up together to get a net impact of increased production of vehicles, they suffered till the last supplier ramped up. A lose-lose for both parties.

Many suppliers made huge lose. With baggage of pain of 2008, it is not a surprise that component vendors are wary about adding capacities. Additional capacity means fixed higher costs, and their ability to survive another slowdown decreases. It is not difficult to appreciate why supplier don’t want to add capacities without any guarantees. The argument, that the suppliers are into independent businesses and hence should be prepared to take risks, does not hold good. No businessman will ever take risks, which has the potential to wipe out their business.

The only way out of such a dilemma is to diminish the risks significantly.

We need to understand the key lessons from crisis of 2008. While the OEMs saw a dip in 10-20% of their volumes for the year as a whole, many of the tier 2 and tier 3 suppliers made nearly 50% less than their yearly plan. While the dip lasted for 3-4 months for the OEMs, the production levels dipped below 40-50% for tier 1, for 4-6 months, while that for tier 2 and 3 was for nearly 6-9 months. The higher the capacity (of the total business) dedicated to OEM segment, bigger was the damage.

The only way out to reduce such risks is to ensure that when demand drops, the suppliers should not experience large period of drastic dip in production, but a smaller dip spread in a shorter period. It is clear from the experience of 2008, that higher the inventory, between the supply nodes, more is the extent and period of correction.

While most auto companies swear by lean production system, the dark underbelly of auto supply chain is seen at the dealers, the transportation godowns and plants of the vendors. Months of inventory is piled up between 2 entities that are just few hours /couple of days away from each other.

The reason for high inventory is the wide fluctuation of the average daily requirement of the month. The wide fluctuation in demand is triggered when one supplier does not deliver a component in required quantity. The OEMs have the pressure to utilize their capacity fully, so with many items in various states of availability, they have no option but to load the lines with anticipated arrivals, resulting in some vehicles being loaded much more than the daily rate conveyed to the suppliers. The spikes could be as high as 5-10 times the average demand.

Tier 1 suppliers know that their fortunes are dependent on the OEMs. If they are repeatedly unreliable, the OEM will decrease his volumes or develop other suppliers. This risk for the supplier is very high as the capacity built by him is for specifically engineered items, and he cannot find new markets immediately. (A peculiarity of auto industry)

So suppliers try to overcome the problem with very safe (high) finished goods and raw material stocking to cater to any spikes /increases. The same logic applies to Tier 2 suppliers, but they have to keep even higher level of inventory as the Tier 1 is producing in large batches. Which means that if the OEM is carrying 2-3 days of parts, the Tier 1 suppliers will carry 15- 30 days of finished goods and about 30 days of parts and raw material inventory. The Tier 2 suppliers carry about a month of FG+WIP (due to high batches of production) and about 30-45 days of raw material stock.

Since the excess inventory is causing the problem, the way out is a perfect pull system in the entire supply chain right from the dealers to OEM production to the supplier’s production.

A perfect pull system in entire supply chain will prevent 2 major problems

• The lag in reaction by OEMs to demand signals
• The huge inventory carried by most suppliers.

The lag in OEMs reaction to market slowdown is because OEMs’ production is based on forecast. If the production is based on the actual sales from the dealers, there will be minimal lag in reaction time of the OEM. Since the plant is an aggregation point for all sales variations across the dealers in the country, the load on the plant for any SKU will be fairly uniform on a daily basis. This has two dramatic impacts.

• The ability to react to slowdown in 3-7 days and
• The uniform load on suppliers reduces the tier 1 FG inventory by almost 1/4th of current levels.

At the same time, if pull system of customer drawing daily requirement from a designed buffer of the supplier node, is also implemented between Tier 1 and Tier 2, then RM inventories of Tier 1 and the finished goods and raw material in Tier 2 (and 3) will also reduce by about half of current levels. This will not only reduce the bullwhip dramatically, but also reduce the period of large dip in demand for Tier 2 and 3.

Suppliers do understand that dips will exist, they don’t want huge dips for longer periods.
The auto Industry swears by the Lean Management. Most of them will agree that the way out of this is to implement Kanban system of flow management right from dealers to all the way down to suppliers’ supplier. But most of them have not been able to do so because of environment of widely fluctuating demand across time horizons, not just at vehicle level but also at the component level. The other problem with the Kanban/ JIT system is that it takes a long time, years, to implement across the supply chain. With everyday firefighting, it is very difficult to sustain the effort for a very long time. The Production System and the Replenishment System of the Theory of Constraints (described very briefly above) enhances the solution of Kanban in such environment. Not only does it help in implementing a supply based on consumption it also helps in dynamically adjusting the inventory norms (equivalent of no of Kanban cards). It can also be implemented for a link in less than 6 months.

A powerful system which enables the whole supply-chain to work at much lower inventory and can correct the inventory on a daily basis, is the way to assist suppliers in reducing their risk in adding capacities i.e. mitigate the 1/6 chance of being shot dead.

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