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Risk, resilience, and rebalancing in global value chainsIn recent decades, value chains have grown in length and complexity ascompanies expanded around the world in pursuit of margin improvements. Since2000, the value of intermediate goods traded globally has tripled to more than$10 trillion annually. Businesses that successfully implemented a lean, globalmodel of manufacturing achieved improvements in indicators such as inventorylevels, on-time-in-full deliveries, and shorter lead times.However, these operating model choices sometimes led to unintendedconsequences if they were not calibrated to risk exposure. Intricateproduction networks were designed for efficiency, cost, and proximity tomarkets but not necessarily for transparency or resilience. Now they areoperating in a world where disruptions are regular occurrences. Averagingacross industries, companies can now expect supply chain disruptions lasting amonth or longer to occur every 3.7 years, and the most severe events take amajor financial toll.VideoMaking supply chains more resilient in the post-COVID worldSupply chain disruptions lasting a month or longer now happen every 3.7 yearson average.The risk facing any particular industry value chain reflects its level ofexposure to different types of shocks, plus the underlying vulnerabilities ofa particular company or in the value chain as a whole. New research from theMcKinsey Global Institute explores the rebalancing act facing many companiesin goods-producing value chains as they seek to get a handle on risk—notongoing business challenges but more profound shocks such as financial crises,terrorism, extreme weather, and, yes, pandemics.Today technology is challenging old assumptions that resilience can bepurchased only at the cost of efficiency. The latest advances offer newsolutions for running scenarios, monitoring many layers of supplier networks,accelerating response times, and even changing the economics of production.Some manufacturing companies will no doubt use these tools and devise otherstrategies to come out on the other side of the pandemic as more agile andinnovative organizations.The COVID pandemic has delivered the biggest and broadest value chain shock inrecent memory. But it is only the latest in a series of disruptions. In 2011,a major earthquake and tsunami in Japan shut down factories that produceelectronic components for cars, halting assembly lines worldwide. The disasteralso knocked out the world’s top producer of advanced silicon wafers, on whichsemiconductor companies rely. Just a few months later, flooding swampedfactories in Thailand that produced roughly a quarter of the world’s harddrives, leaving the makers of personal computers scrambling. In 2017,Hurricane Harvey, a Category 4 storm, smashed into Texas and Louisiana. Itdisrupted some of the largest US oil refineries and petrochemical plants,creating shortages of key plastics and resins for a range of industries.This is more than just a run of bad luck. Changes in the environment and inthe global economy are increasing the frequency and magnitude of shocks. Fortyweather disasters in 2019 caused damages exceeding $1 billion each—and inrecent years, the economic toll caused by the most extreme events has beenescalating. As a new multipolar world takes shape, we are seeing more tradedisputes, higher tariffs, and broader geopolitical uncertainty. The share ofglobal trade conducted with countries ranked in the bottom half of the worldfor political stability, as assessed by the World Bank, rose from 16 percentin 2000 to 29 percent in 2018. Just as telling, almost 80 percent of tradeinvolves nations with declining political stability scores. Increasedreliance on digital systems increases exposure to a wide variety ofcyberattacks; the number of new ransomware variations alone doubled from 2018to 2019. Interconnected supply chains and global flows of data, finance, andpeople offer more “surface area” for risk to penetrate, and ripple effects cantravel across these network structures rapidly.Exhibit 1 classifies different types of shocks based on their impact, leadtime, and frequency of occurrence. In a few cases, we also show hypotheticalshocks like a global military conflict or a systemic cyberattack that woulddwarf the most severe shocks experienced to date. While these may be onlyremote possibilities, these scenarios are in fact studied and planned for bygovernments and security experts. The impact of a shock can be influenced byhow long it lasts, the ripple effects it has across geographies andindustries, and whether a shock hits the supply side alone or also hitsdemand.Exhibit 1We strive to provide individuals with disabilities equal access to ourwebsite. If you would like information about this content we will be happy towork with you. Please email us at:[email protected] analysis reveals four broad categories of shocks. Catastrophes arehistorically remarkable events that cause trillions of dollars in losses. Someare foreseeable and have relatively long lead times, while others areunanticipated. Larger patterns and probabilities can guide generalpreparedness; hurricanes strike in the Gulf of Mexico every year, for example.But the manifestation of a specific event can strike with little to nowarning. This includes some calamities that the world has avoided to date,such as a cyberattack on foundational global systems.Disruptions are serious and costly events, although on a smaller scale thancatastrophes. They, too, can be split into those that telegraph their arrivalin advance (such as the recent US–China trade disputes and the UnitedKingdom’s exit from the European Union) and unanticipated events such as databreaches, product recalls, logistics disruptions, and industrial accidents.Disruptions do not cause the same cumulative economic toll as catastrophes.Companies tend to focus much of their attention on managing the types ofshocks they encounter most often, which we classify as “unanticipateddisruptions.” Some other shocks such as trade disputes have made headlines inrecent years and, as a result, companies have started to factor them intotheir planning. But other types of shocks that occur less frequently couldinflict bigger losses and also need to be on companies’ radar. The COVIDpandemic is a reminder that outliers may be rare—but they are realpossibilities that companies need to consider in their decision making.All four types of shocks can disrupt operations and supply chains, often forprolonged periods. We surveyed dozens of experts in four industries(automotive, pharmaceuticals, aerospace, and computers and electronics) tounderstand how often they occur. Respondents report that their industries haveexperienced material disruptions lasting a month or longer every 3.7 years onaverage. Shorter disruptions happen even more frequently.We analyzed 23 industry value chains to assess their exposure to specifictypes of shocks. The resulting index (Exhibit 2) combines multiple factors,including how much of the industry’s current geographic footprint is found inareas prone to each type of event, the factors of production affected by thosedisruptions and their importance to that value chain, and other measures thatincrease or reduce susceptibility.Exposure to different types of shocks varies sharply by value chain. Aerospaceand semiconductors, for example, are susceptible to cyberattacks and tradedisputes, because of their high level of digitization, R&D, capital intensity,and exposure to digital data flows. However, both value chains have relativelylow exposure to the climate-related events we have assessed here (heat stressand flooding) because of the footprint of their production.Specific types of shocks are more likely to touch certain industries.Pandemics, for example, have a major impact on labor-intensive value chains.In addition, this is the one type of shock for which we assess the effects ondemand as well as supply. As we are seeing in the current crisis, demand hasplummeted for nonessential goods and travel, hitting companies in apparel,petroleum products, and aerospace. By contrast, while production has beenaffected in value chains like agriculture and food and beverage, they havecontinued to see strong demand because of the essential nature of theirproducts.In general, heat stress is more likely to strike labor-intensive value chains(and some resource-intensive value chains) because of their relatively highreliance on manual labor or outdoor work. Perhaps surprisingly, these samevalue chains are relatively less susceptible to trade disputes, which areincreasingly focused on value chains with a high degree of knowledge intensityand high-value industries.Overall, value chains that are heavily traded relative to their output aremore exposed than those with lower trade intensity. Some of these includevalue chains that are the most sought after by countries: communicationequipment, computers and electronics, and semiconductors and components. Thesevalue chains have the further distinction of being high value and relativelyconcentrated, underscoring potential risks for the global economy. Heavilytraded labor-intensive value chains, such as apparel, are highly exposed topandemic risk, heat stress (because of their reliance on labor), and floodrisk. In contrast, the value chains including glass and cement, food andbeverage, rubber and plastics, and fabricated metals have much lower exposureto shocks; these are among the least traded and most regionally oriented valuechains.All in all, the five value chains most exposed to our assessed set of sixshocks collectively represent $4.4 trillion in annual exports, or roughly aquarter of global goods trade (led by petroleum products, ranked thirdoverall, with $2.4 trillion in exports). The five least exposed value chainsaccount for $2.6 trillion in exports. Of the five most exposed value chains,apparel accounts for the largest share of employment, with at least 25 millionjobs globally, according to the International Labor Organization.Even value chains with limited exposure to all types of shocks we assessed arenot immune to them. Despite recent headlines, we find that pharmaceuticals arerelatively less exposed than most other industries. But the industry has beendisrupted by a hurricane that struck Puerto Rico, and cyberattacks are agrowing concern. In the future, the industry may be subject to greater tradetensions as well as regulatory and policy shifts if governments take actionwith the intent of safeguarding public health. The food and beverage industryand agriculture similarly have relatively low exposure overall, as they areglobally dispersed. Yet these value chains are subject to climate-relatedstresses that are likely to grow over time. In addition to disrupting thelives and livelihoods of millions, this could cause the industries to becomemore dependent on trade or force them to undertake expensive adaptations.Shocks inevitably seem to exploit the weak spots within broader value chainsand specific companies. An organization’s supply chain operations can be asource of vulnerability or resilience, depending on its effectiveness inmonitoring risk, implementing mitigation strategies, and establishing businesscontinuity plans.Some of these vulnerabilities are inherent to a given industry; theperishability of food and agricultural products, for example, means that theassociated value chains are highly vulnerable to delivery delays and spoilage.Industries with unpredictable, seasonal, and cyclical demand also faceparticular challenges. Makers of electronics must adapt to relatively shortproduct life cycles, and they cannot afford to miss spikes in consumerspending during limited holiday windows.Other vulnerabilities are the consequence of intentional decisions, such ashow much inventory a company chooses to carry, the complexity of its productportfolio, the number of unique SKUs in its supply chain, and the amount ofdebt or insurance it carries. Changing these decisions can reduce—orincrease—vulnerability to shocks.Weaknesses often stem from the structure of supplier networks in a given valuechain. Complexity itself is not necessarily a weakness to the extent that itprovides companies with redundancies and flexibility. But sometimes thebalance can tip. Complex networks may become opaque, obscuring vulnerabilitiesand interdependencies. A large multinational company can have hundreds oftier-one suppliers from which it directly purchases components. Each of thosetier-one suppliers in turn can rely on hundreds of tier-two suppliers. Theentire supplier ecosystem associated with a large company can encompass tensof thousands of companies around the world when the deepest tiers areincluded.Exhibit 3 applies network analytics to illustrate the complexity of the first-and second-tier supply ecosystems for two Fortune 500 companies in thecomputer and electronics industry. This is based on publicly available dataand may therefore not be exhaustive. These multitiered, multinationalnetworks span thousands of companies and extend to deeper tiers that are notshown here. This illustration also underscores the fact that even within thesame industry, companies may make materially different decisions about how tostructure their supply ecosystems, with implications for risk.Companies’ supplier networks vary in ways that can shape their vulnerability.Spending concentrated among just a few suppliers may make it easier to managethem, but it also heightens vulnerability should anything happen to them.Suppliers frequently supply each other; one form of structural vulnerabilityis a subtier supplier that accounts for relatively little in spending but iscollectively important to all participants. The number of tiers ofparticipating suppliers can hinder visibility and make it difficult to spotemergent risks. Suppliers that are dependent on a single customer can causeissues when demand shocks cascade through a value chain. The absence ofsubstitute suppliers is another structural vulnerability.In some cases, suppliers may be concentrated in a single geography due to thatcountry’s specialization and economies of scale. A natural disaster orlocalized conflict in that part of the world can cause critical shortages thatsnarl the entire network. Some industries, such as mobile phones andcommunication equipment, have become more concentrated in recent years, whileothers, including medical devices and aerospace, have become less so (Exhibit4). The aerospace value chain, for example, has diversified in part due tosecure market access.Exhibit 4We strive to provide individuals with disabilities equal access to ourwebsite. If you would like information about this content we will be happy towork with you. Please email us at:[email protected] in value chains that are generally more geographically diversified,production of certain key products may be disproportionately concentrated.Many low-value or basic ingredients in pharmaceuticals are predominantlyproduced in China and India, for instance. In total, we find 180 productsacross value chains for which one country accounts for 70 percent or more ofexports, creating the potential for bottlenecks. The chemicals value chain hasa particularly large number of such highly concentrated products, but examplesexist in multiple industries. Other products may be produced across diversegeographies but have severe capacity constraints, which can create bottlenecksif production is halted. Geographic diversification is not inherentlypositive, particularly if production and sourcing expands into areas that aremore exposed to shocks.When companies understand the magnitude of the losses they could face fromsupply chain disruptions, they can weigh how much to invest in mitigation. Webuilt representative income statements and balance sheets for hypotheticalcompanies in 13 different industries, using actual data from the 25 largestpublic companies in each. This enables us to see how they fare financiallywhen under duress.We explore two scenarios involving severe and prolonged shocks: * Scenario 1. A complete manufacturing shutdown lasting 100 days that affects raw material delivery and key inputs but not distribution channels and logistics. In this scenario, companies can still deliver goods to market. But once their safety stock is depleted, their revenue is hit. * Scenario 2. The same as above, but in this case, distribution channels are also affected, meaning that companies cannot sell their products even if they have inventory available.Our choice to model a 100-day disruption is based on an extensive review ofhistorical events. In 2018 alone, the five most disruptive supply chain eventsaffected more than 2,000 sites worldwide, and factories took 22 to 29 weeks torecover.Our scenarios show that a single prolonged production-only shock would wipeout between 30 and 50 percent of one year’s EBITDA for companies in mostindustries. An event that disrupts distribution channels as well would pushthe losses sharply higher for some.Industries in which companies typically hold larger inventories and have lowerfixed costs tend to experience relatively smaller financial losses fromshocks. If a natural disaster hits a supplier but distribution channels remainopen, inventory levels become a key buffer. However, the downstream companywill still face a cash drain after the fact when it is time to replenish itsdrawn-down safety stock. When a disruption outlasts the available safetystock, lower fixed costs become important to withstanding a decline in EBITDA.Having calculated the damage associated with one particularly severe andprolonged disruption, we then estimated the bottom-line impact that companiescan expect over the course of a decade, based on probabilities. We combinedthe expected frequency of value chain disruptions of different lengths withthe financial impact experienced by companies in different industries. Onaverage, companies can expect losses equal to almost 45 percent of one year’sprofits over the course of a decade (Exhibit 5). This is equal to sevenpercentage points of decline on average. We make no assessment of the extentto which the cost of these disruptions has already been priced intovaluations.Exhibit 5We strive to provide individuals with disabilities equal access to ourwebsite. If you would like information about this content we will be happy towork with you. Please email us at:[email protected] are not distant future risks; they are current, ongoing patterns. On topof those losses, there is an additional risk of permanently losing marketshare to competitors that are able to sustain operations or recover faster,not to mention the cost of rebuilding damaged physical assets. However, theseexpected losses should be weighed in the context of the additional profitsthat companies are able to achieve with highly efficient and far-reachingsupply chains.Today much of the discussion about resilience in advanced economies revolvesaround the idea of increasing domestic production. But the highlyinterconnected nature of value chains limits the economic case for makinglarge-scale changes in their physical location. Value chains often spanthousands of interconnected companies, and their configurations reflectspecialization, access to consumer markets around the world, long-standingrelationships, and economies of scale.We set out to estimate what share of global exports could move to differentcountries based on the business case and how much might move due to policyinterventions. To determine whether industry economics alone support a futuregeographic shift, we considered a number of factors. One is whether somemovement is already under way. Between 2015 and 2018, for instance, the shareof trade produced by the three leading export countries in apparel dropped. Incontrast, the top three countries in semiconductors and mobile communicationsincreased their share of trade markedly.Other considerations include whether the value chain is highly capital- orknowledge-intensive, or tied to geology and natural resources. All of thesemake relocation less feasible. Highly capital-intensive value chains areharder to move for the simple reason that they represent hundreds of billionsof dollars in fixed investments. These industries have strong economies ofscale, making them more costly to shift. Value chains with high knowledgeintensity tend to have specialized ecosystems that have developed in specificlocations, with unique suppliers and specialized talent. Deciding to moveproduction outside of this ecosystem to a novel location is costly. Finally,value chains with comparatively high levels of extraregional trade have morescope to shorten than those that are already regionalized. We also consideroverall growth, the location of major (and rising) consumer markets, tradeintensity, and innovation dynamics.With respect to noneconomic factors, we consider governments’ desire tobolster national security, national competitiveness, and self-sufficiency.Some nations are focusing on safeguarding technologies with dual-use (civilianand military) implications, which could affect value chains such assemiconductors and communication equipment, particularly as 5G networks arebuilt out. In other cases, governments are pursuing industrial policiesintended to capture leading shares of emerging technologies ranging fromquantum computing and artificial intelligence to renewable energy and electricvehicles. This, too, has the potential to reroute value chains. Finally, self-sufficiency has always been a question surrounding energy. Now the COVIDpandemic has driven home the importance of self-sufficiency in food,pharmaceuticals, and certain medical equipment as well.We estimate that 16 to 26 percent of exports, worth $2.9 trillion to $4.6trillion in 2018, could be in play—whether that involves reverting to domesticproduction, nearshoring, or new rounds of offshoring to new locations. Itshould be noted that this is not a forecast: it is a rough estimate of howmuch global trade could relocate in the next five years, not an assertion thatit will actually move.The value chains with the largest share of total exports potentially in playare pharmaceuticals, apparel, and communication equipment. In dollar terms,the value chains with the largest potential to move production to newgeographies are petroleum, apparel, and pharmaceuticals. In all of thesecases, more than half of their global exports could potentially move. With fewexceptions, the economic and noneconomic feasibility of geographic shifts donot overlap. Thus, countries would have to be prepared to expend considerablesums to induce shifts from what are otherwise economically optimal productionfootprints.In general, the economic case to move is most viable for labor-intensive valuechains such as furniture, textiles, and apparel. These value chains werealready experiencing shifts away from their current top producers, where thecost of labor has risen. The continuation of this trend could represent a realopportunity for some developing economies. By contrast, resource-intensivevalue chains, such as mining, agriculture, and energy, are generallyconstrained by the location of natural resources that provide crucial inputs.But policy considerations may encourage new exploration and development thatcan shift value chains at the margins.The value chains in the global innovations category (semiconductors,automotive, aerospace, machinery, communication, and pharmaceuticals) aresubject to the most scrutiny and possible intervention from governments, basedon their high value, cutting-edge technologies as well as their perceivedimportance for national competitiveness. But the feasibility of moving thesevalue chains based on the economics alone is low.Production networks have begun to regionalize in recent years, and this trendmay persist as growth in Asia continues to outpace global growth. Butmultinationals with production facilities in countries such as China, India,and other major emerging economies are typically there to serve local consumermarkets, whether or not they also export from those places. As prosperityrises in these countries, they are key sources of global growth that companieswill continue to pursue.In a McKinsey survey of supply chain executives conducted in May 2020, anoverwhelming 93 percent reported that they plan to take steps to make theirsupply chains more resilient, including building in redundancy acrosssuppliers, nearshoring, reducing the number of unique parts, and regionalizingtheir supply chains.## Strengthen supply chain risk management and improve end-to-end transparencyGlobal manufacturing has only just begun to adopt a range of technologies suchas analytics and artificial intelligence, the Internet of Things, advancedrobotics, and digital platforms. Companies now have access to new solutionsfor running scenarios, assessing trade-offs, improving transparency,accelerating responses, and even changing the economics of production.Most companies are still in the early stages of their efforts to connect theentire value chain with a seamless flow of data. Digital can deliver majorbenefits to efficiency and transparency that are yet to be fully realized.Consumer goods giant Procter & Gamble, for example, has a centralized controltower system that provides a company-wide view across geographies andproducts. It integrates real-time data, from inventory levels to road delaysand weather forecasts, for its own plants as well as suppliers anddistributors. When a problem occurs, the system can run scenarios to identifythe most effective solution.Creating a comprehensive view of the supply chain through detailed subtiermapping is a critical step to identifying hidden relationships that invitevulnerability. Today most large firms have only a murky view beyond theirtier-one and perhaps some large tier-two suppliers. Working with operationsand production teams to review each product’s bill of materials can revealwhether critical inputs are sourced from high-risk areas and lack readysubstitutes. Companies can also work with their tier-one suppliers to createtransparency. But in cases where those suppliers lack visibility themselves orconsider their own sourcing to be proprietary information, risk managementteams may have to turn to other information sources to do detective work.After mapping upstream suppliers, downstream companies need to understandtheir production footprint, financial stability, and business continuityplans.## Minimize exposure to shocksTargeted measures taken before an event occurs can mitigate the impact of ashock or speed time to recovery. As more physical assets are digitized, forexample, companies will need to step up investment in cybersecurity tools andteams.One of the most important steps is building more redundancy into suppliernetworks. Relying on a single source for critical components or raw materialscan be a vulnerability. In fact, even if a company relies on multiplesuppliers, they may be concentrated in the same place. Taking the time toidentify, prequalify, and onboard backup vendors comes at a cost. But it canprovide much-needed capacity if a crisis strikes. Auditing and diversifyingthe supply chain can have the added benefit of reducing carbon intensity,raising environmental and labor standards, and expanding opportunities forwomen- and minority-owned businesses.One way to achieve supply chain resilience is to design products with commoncomponents, cutting down on the use of custom parts in different productofferings. Auto manufacturers are perhaps the most advanced in this regard,having implemented modular manufacturing platforms that share componentsacross product lines and production sites.Physical assets may need to be hardened to withstand natural disasters. Inregions that are vulnerable to worsening hurricanes and storm surges, this mayinvolve installing bulkheads, elevating critical machinery and utilityequipment, adding more waterproof sealing, and reworking drainage and valves.Many factories that are not air-conditioned today will need cooling systems toprepare for rising temperatures and potential heat waves in some parts of theworld. Plants located in earthquake-prone areas may need seismic retrofitting.Companies can also build more redundancies into transportation and logistics.## When a shock does hit, companies need the ability to respond quicklyThe shift to just-in-time and lean production systems has helped companiesimprove efficiency and reduce their need for working capital. But now they mayneed to strike a different balance between just-in-time and “just in case.”Having sufficient backup inventory of key parts and safety stock is a criticalbuffer that can minimize the financial impact of disrupted supplies. It canalso position companies to meet sudden spikes in demand.The ability to reroute components and flex production dynamically across sitescan keep production going in the wake of a shock. This requires robust digitalsystems as well as the analytics muscle to run scenarios based on differentresponses. When the COVID pandemic hit, Nike used predictive analytics toselectively mark down goods and reduce production early on to minimize impact.The company was also able to reroute products from brick-and-mortar stores toe-commerce sales, driven in part by direct-to-consumer online sales throughits own training app. As a result, Nike sustained a smaller drop in sales thansome of its competitors.When disaster strikes, companies have to be laser focused on cash management.But those at the top of a value chain also have a vested interest inpreserving the supplier networks on which they depend. In the aftermath of theglobal financial crisis, some companies accelerated payments or guaranteedbank loans to give key vendors a lifeline.Coming on the heels of Brexit and a flare-up in US–China trade tensions, theCOVID pandemic has forced businesses to focus on building resilience in theirsupply chains and operations. Not everything that can go wrong actually doesgo wrong, but businesses and governments cannot afford to be caught flat-footed when disaster strikes. Preparing for future hypotheticals has apresent-day cost. But those investments can pay off over time—not onlyminimizing losses but also improving digital capabilities, boostingproductivity, and strengthening entire industry ecosystems. Rather than atrade-off between resilience and efficiency, this rebalancing act mightdeliver a win-win.