George Stalk, a senior partner with Boston Consulting Group, explains why American companies are facing a supply chain challenge unlike anything they've seen before and discusses some strategies that can help to address it, as found in his new book titled 5 Strategies You Need Right Now (Harvard Business Press, 2008).

BF: The title of your new book suggests that there is some urgency around the strategies it discusses. Where's the greatest urgency?

George Stalk: Of all the subjects we discuss in the book, the supply chain is probably the closest to being in a crisis. It's a crisis that's going to be forced upon everybody. If we just assumed for the moment that bridges are not falling in the river in Mississippi or in downtown Montreal and that everything was in perfect shape, we would still have a crisis looming because the demand for the load on our infrastructure is far exceeding its capacity. There are not going to be any major roads or railroads built in the United States, and even if you look at major airports, there have been four airports built in the United States in the past 40 years. All but one were replacement airports.

The whole system is coming under strain. At the same time, the logistics practices of most industries were laid down in the '60s and '70s. This means that they were established in a period when transportation costs were coming down. They were laid down in a period when response times were improving constantly because of the improved quality of the logistics system. This is all reversing. Costs are going up, response times are lengthening and — worse — the variability of the response time is increasing, just completely upsetting these economics in the very same way that the economics across the ocean can be upset by the choking ports.

BF: Those ports you are referring to are the West Coast ports of the United States, which you point out are very quickly reaching their combined container loading and unloading capacity. You refer to this as a riptide — where the huge surge in goods washing up on American shores is overtaking our handling capacity. How can companies respond to the riptide?

Stalk: There are things that you can do to sidestep the riptide phenomenon, such as in terms of reducing time, improving procurement processes, going to air freight. There are things that you can do on the land side as well, such as buying preferred positions on carriers. Going direct store-to-ship instead of through distribution centers is a way to avoid exposing your entire network to the infrastructure problem.

All of these come at a cost, though, many of which people don't often carry in their minds when they initially react to these increased expenses. Things such as the hidden costs we described in the riptide book — the cost of a stockout, the cost of an overstock. These are huge costs compared to some of these logistics cost numbers.

BF: Is there a real-world example that can help to illustrate the challenge that the riptide presents?

Stalk: Well, we have one client who's a supplier of women's fashion clothes. When we first started working with them, looking at what they could do to improve their Asian sourcing, it was because we were helping them to advance from being fairly standard — if you can be that in the fashion industry — to being much more fashionable. We were speeding up their fashion cycles and increasing the frequency with which they introduced new products, and we immediately ran into supply chain problems.

This is a short vignette. They were at 30 percent air freight when we started doing this work; they are now at 95 percent. The 30 percent they had when we started the work was kind of like an “Oh, rats” type of 30 percent — where the thinking was that if things went wrong, to “send it by air.” This is a common approach for companies — including the automotive companies, which will ship engine blocks by air if they have to. The 95 percent right now is planned. They know that they're paying a higher price, but 15 percent air freight cost to save 90 percent lost gross margin is a good investment. And 15 percent air freight cost to avoid a 45 percent markdown is a good investment. This is why they're so high. This is going to be true all across the supply chain; companies are going to see this.

BF: Is the impact of the riptide being discussed in boardrooms today? Is the discussion as meaningful as it needs to be?

Stalk: The blockage, or lack of awareness, is often due to the way companies are organized. If I go talk to UPS and FedEx, they get it. Instantaneously, they see what's going on, and clearly they see the power of selling the notion of avoiding stockouts and overstocks.

But when we talk about their client companies, their experiences are similar to my experience with our client companies, which is that if I go to a major retailer — and I've been to many of them — the CEO gets it. Beyond that, even if I talk to the head of the supply chain, he or she is measured on cost. As long as they're bringing cost down, they're doing great; when costs go up, they're doing badly. Rarely are the merchandising people measured on stockouts, so they don't get punished.

BF: What types of supply chain challenges does China itself face?

Stalk: Before now, it was thought that the biggest thing that could go wrong for China would be for the whole supply chain problem to wipe out their economic attractiveness, because of the stockouts and overstock problem, and the on-ground logistics costs. But this is not really going to matter because China and that whole part of the world already have more than 50 percent of their exports being inter-Asia. Everybody thinks that the U.S. is carrying China along. Not really. They're about to carry themselves along quite nicely.

As late as 2001, people said that China would never develop beyond the coast because there are no roads. Well, the roads have been fixed. It's actually a great example of five-year plans that actually happened. In a totalitarian society, they fix the roads; there are lots of roads in China now.

BF: Where is the weak link?

Stalk: Well, the next problem China is running into is rail. They don't really have the rail infrastructure. What's interesting is that their air-freight system appears to be developing in a way to overcome the rail problem and the road problem. China, in the next ten years, is going to build something like 90 airports. Meanwhile, we have only built four major U.S. airports in 40 years. They're becoming probably the largest network of air freighters.

The analogy to cell phones is so clear. Cell phones in Asia, Africa, Mexico, and South America became the predominant form of telecommunications as opposed to land lines because at the time they decided to catch up, land lines had become very expensive and time-consuming.

Cell phones are much more expensive to operate but less expensive to put in place. It's a fixed and variable cost trade-off. … The number one market for cell phones in the world now is China. The number one market for refrigerators is China, for washing machines is China, for TV sets is China. Sony introduced its newest flat-screen TV in September not in Japan and not in the U.S., but in China.

BF: What does it mean to have the largest market for something?

Stalk: Well, it means that the center of innovation shifts to that market. You don't find new products showing up in small markets; they show up in the big markets. The center of innovation is going to shift, or it will at least shift in the sense that there will be other centers of innovation besides the U.S. and Europe.

We spend a lot of time talking about U.S. infrastructure. When I started exploring this phenomenon, I looked at Europe, and initially Europe looked like it had less of a problem because it actually invests more in its ports than the U.S. does. They actually have an inter-waterway system that's much more evolved than in the U.S. But their roads are at capacity. Their railroads are abysmal. People think of Europe as having great railroads — well, those are the high-speed passenger transport.

From a freight standpoint, it's terrible, and it's terrible because Spain has like three of its own systems, so they can't even get a train across Spain without having to change systems. In between countries, you change systems. The net effect is that 70 percent of the freight in Europe goes on the roads because of that, whereas in the U.S., 70 percent goes on the rails. Europe's cruising for a bruising. Everything I've said about the U.S. is actually true in Europe, but for different reasons.

Now watch George Stalk discuss [1] how companies can leverage the concept of dynamic pricing.