The “New” Normal: Supply Chain Considerations for Manufacturers…
Post COVID-19, and in the Hostile Trade and Climate Wars
Of the many negative effects of the COVID-19 virus, including death, social isolation, emotional alienation, educational disruption, and economic destruction for millions of Americans, the exposure of supply-chain vulnerabilities in many US industries pales in relative comparison. However, for the US economy to function in the “new” normal, many US-based manufacturers will have to find both new, more reliable, and, perhaps more importantly, flexible, local sourcing strategies and protections for the foreseeable future.
Future similar international and regional economic disruptions are not speculative. Whether they are caused by structural or speculative financial market crashes (the savings and loan scandal, dot-com bubble and 2008 financial crash), geopolitical clashes (9/11, Brexit, treaty revisions like the United States-Mexico-Canada Agreement, political crackdown in Hong Kong, aggressive EU regulators and the US-China trade wars), or environmental/climate-based events (Fukushima nuclear accident, Mauritius oil spill, severe floods in India, more hurricanes in the Caribbean, larger wildfires in California), US manufacturers must expect, factor and protect against these certain future significant business disruptions now. Not after they hit again, since we’ve seen that such on-the-fly responses are woefully insufficient.
These alternative, localized and more secure supply logistics will also be needed as the result of the increasing focus on, and demand for, American-sourced and manufactured parts and products in the hostile international trade environment. Regardless of the upcoming election results, Americans will now rightfully expect that US-based companies will not be as vulnerable to foreign-initiated financial, environmental and public health disasters as they were recently shown to be. Further, once they get back on their collective financial feet, both American companies and individuals will more than likely be willing to pay higher prices for American-sourced and made products if they know that part of that increased cost is related to such supply localization, especially since more localized sourcing supports the now de facto consumer expectation that US companies incorporate climate and other environmental concerns and protections in their business operations.
Thus, rather than a cost-negative for US manufacturers, supply chain adaptation and protection in the new normal can provide many companies with an opportunity to increase their sales to a nationally loyal and socially conscious customer base, and ensure both future viability and profitability even in the event of as-of-yet indeterminable disasters down the road. This article provides a few, of numerous, potential changes that manufacturers can consider as they navigate their way through their new supply reality.
Contracts for Alternative Supply
All manufacturers who have survived the COVID-19 crisis to this point should have identified their company-specific supply-chain vulnerabilities by now. For those who haven’t, that is clearly step one. Every manufacturer needs to objectively review their supply lines, and to the greatest extent possible in terms of both immediate and future planning, change to US-based suppliers either as primary suppliers or, at the very least, as contractually-bound alternative suppliers who can be relied upon in the event of supply disruption triggered by future market drops, legislative sanctions, environmental catastrophes and public health crises.
The importance of contractual assurance for continued supply functions should not be underestimated. Verbal or hand-shake reliance is not sufficient. Such contracts can lock-in details about volumes, cost (e.g. current cost of the product, plus some percentile thereof given the emergent conditions), delivery terms and requirements, and even potential exclusivity or right-of-first refusal, from the US-based supplier. Even if suppliers take advantage of the current difficult environment with regard to the up-front amount required to induce them to enter such contracts at this time, by including lower amounts for each year that no event is triggered under the contract, manufacturers can reduce their cost of entering such agreements on an annualized basis commensurate with the absence of any triggering event over a given period of time.
In addition, such alternative, US-based supply contracts should enhance borrowing opportunities, terms and amounts in the event of future market or public health crises. Clearly, lenders will be more likely to extend funds to companies with the foresight to have such contractual protections compared to those who do not. Similarly, future supply protections should increase insurance underwriting terms and policy limits, since they mitigate against some business loss that insurers do cover. Even if some insurers start to offer COVID-like coverage in commercial liability policies and business interruption clauses (which is doubtful in the private insurance sector), the cost of any such insurance would more than likely be excessive compared to the type of alternative supply contract envisioned above.
Emergency Inventories
To the extent possible, US manufacturers should also establish and maintain “emergency” inventories of the parts and raw materials necessary for continued production in the aftermath of a significant, uninsurable business interruption. Such emergency inventories should be established at levels that would allow the company to maintain normal, uninterrupted production for at least three (3) months. To the extent that a manufacturer does not need to tap their own emergency inventory in response to a crisis, such excess parts and materials could be sold to companies whose supply chains have been disrupted. Such an informal, but effective supplemental supply system would reward the sellers for their rainy-day forethought, and add another layer of supply security to the over-all economy in the wake of a financial, environmental or public health disaster like COVID-19. In addition, maintenance of emergency inventories of parts and materials could help to reduce any resulting government-based assistance (e.g. the $2 trillion “Payment Protection Program”), which, in turn, could help to reduce federal and state budget deficits for decades to come.
Since the maintenance of such “emergency” inventories would, among other things, at least arguably provide a potential public benefit to the US economy, including both companies and, down the chain, to individual consumers, US manufacturers and their industry organizations should also consider lobbying for emergency inventories to be tax deductible, rather than just a reduction of gross receipts, as inventory is currently treated by the IRS. If deductible, emergency inventories could generate a net operating loss for a company, or a loss that may be used to deduct income from prior or future tax years. At the very least, emergency inventories should be depreciable, which could provide US manufacturers with additional annual tax deductions to off-set their increased costs of purchasing emergency parts and materials.
Need for Domestic Political Risk Protection
Finally, the COVID-19 virus has raised legitimate questions about what many companies (and individuals) see as the contradictory and unnecessary heavy-handedness and excessive over-reaching of some state and local government responses to the alleged public health threat caused by the virus, and their apparent lack of concern for the significant, and in many cases permanent, negative economic effect that those responses had on companies trying to survive the crisis. Unlike any past financial or public health crisis in this country, the COVID-19 virus was the first time that state and local governments compelled involuntary business closures, as opposed to allowing market conditions to determine whether a business could continue to operate. In the past, some businesses would fail in the wake of a financial crisis, but some would not. Some businesses thrived in a crisis environment, and increased both revenue and market share specifically because they came into the crisis with better balance sheets, and/or were more flexible operationally than their competitors.
Consequently, the COVID-19 governmental-imposed business shut-downs are in some ways akin to the sort of conduct that less-than-quality foreign governments occasionally inflict on US companies. For such potentially risky foreign ventures, US companies can purchase “political risk” insurance for interference in their overseas operations, such as that offered by the U.S. International Development Finance Corporation. However, if some state and local government responses to the COVID virus are going to become the playbook for future public health crises in this country, then there may be a need for “domestic” political risk insurance. Since there were hundreds of different, inconsistent and constantly changing state and/or city-specific government responses to the virus throughout the country that allowed some businesses within an industry to re-open quickly while other companies within that same industry were forcibly closed for months, it is only reasonable to offer companies some form of insurance in the event of a state or local government ordering them to close their otherwise viable going concern for an alleged public health crisis.
Matthew A. Peluso, Esq. is an attorney in Princeton. He has 30 years of experience in advising and representing companies in commercial, anti-trust, environmental and insurance matters. He can be reached at: (609) 306-2595. His e-mail address is: mpelusoesq@live.com. His experience can be reviewed on his firm website: www.matthewpelusolaw.com. The opinions expressed by Mr. Peluso in his article are not intended to provide legal advice. Anyone interested should consult a qualified attorney prior to making any significant business or legal decision.