Supply chains and equitable growth

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The U.S. economy has undergone a structural transformation in recent decades. Large firms have shifted from doing many activities in-house to buying goods and services from a complex web of other companies. These outside suppliers make components, and provide services in areas such as logistics, cleaning, and information technology. Although this change in the structure of supply chains began decades ago, neither public policy nor business practice have adequately dealt with the challenges posed by this restructuring. As a result, weakness in supply chains threatens U.S. competitiveness by undermining innovation and contributes to the erosion of U.S. workers’ standard of living. This essay suggests policies to promote supply chain structures that stimulate equitable growth—that is, policies that both promote innovation and also insure that the gains from innovation are broadly shared.

The role of supply chains
in the U.S. economy

A supply chain links companies, often in multiple industries and multiple locations, to design, produce components, assemble and distribute a final product, such as a car, a computer, or a restaurant meal.¹ For much of the 20th century, a significant part of the U.S. economy was characterized by supply chains that were vertically integrated.² Beginning in the 1970s and 1980s, large firms in many industries began to sell off assets and outsource work. Today, a lead firm typically designs products and directs production by multiple tiers of suppliers in many locations, but does not own most of these suppliers.³

Supply chains made up of these financially independent firms are now the largest driver of firms’ costs. The average U.S.-based multinational firm buys intermediate inputs that comprise about 75 percent of the value of its output; a domestically owned firm buys intermediate inputs equal to about 50 percent of output value.⁴ Contrary to the common impression, most of these suppliers are domestic, even in manufacturing.⁵ These outsourced supply chains differ from vertical integration in that the lead firm does not own supplier facilities. The lead firm benefits from this arrangement by gaining access to products made by suppliers with experience in making similar products for multiple customers and by not being responsible for subsidiaries’ fixed costs.

These supply chains also typically differ from economists’ model of perfect competition, in which transactions between firms are at arm’s length and the only information that crosses firm boundaries is price information. In contrast, many suppliers make products specifically tailored to meet the needs of the lead firm and frequently exchange information with the lead firm regarding designs, production processes, and future plans. Lead firms find this arrangement advantageous because they are able to quickly obtain components tailored to their specific needs. The complementary disadvantage is that firms are often unable to change suppliers easily.

On one hand, sharing suppliers with other lead firms has significant benefits, such as shared knowledge across customers and reduced fixed costs. On the other hand, lead firms may lack incentive to invest in upgrading the supplier’s capabilities if that supplier may also use those capabilities to serve a competitor. Firms’ success depends upon having robust networks of suppliers, but no one firm is responsible for keeping these networks healthy.

Implications of supply chain
structure for innovation

Because innovation is concentrated in manufacturing—two-thirds of private-sector research and development is performed in manufacturing—this section looks at supply chains in manufacturing only (data is not readily available for innovation in other sectors.)⁶

Firms with fewer than 500 employees are an increasing share of manufacturing employment, accounting for 42 percent of such workers in 2012. These small firms struggle at each phase of the innovation process. They are only 15 percent as likely to conduct research and development as large firms. Small firms also struggle to obtain financing and a first customer to help them commercialize a new product or process. Finally, small manufacturers have trouble adopting new products or processes developed by others, due to difficulty in learning about and financing new technology. As a result, small manufacturers are only 60 percent as productive as large firms.⁷

A skeptic may ask why large lead firms cannot innovate enough to support their entire production network. But problems such as reducing the vibration of a wind turbine requires holistic problem-solving; a machine composed of many parts that exert strong forces on each other cannot simply be divided into one problem for the gearbox manufacturer to solve, one for the rotor manufacturer to solve, and another for the assembly team to solve. Limiting innovation to lead firms deprives the supply chain of insights that come from being very close to a particular type of production or use.⁸ In addition, long-term supplier-customer relationships built upon trust and collaboration best facilitate progress toward these goals; lack of such relationships accounts for many of the problems U.S. industries face in moving new technologies from lab to market.

Implications of supply chain
structure for job quality

Workers are employed in supply chains in a variety of ways. Instead of being hired directly by lead firms as regular employees, workers may be hired by temporary help agencies and are often referred to as “contingent workers.” Alternatively, they may be hired as regular workers at supplier firms or as independent contractors.

A variety of studies find that these forms of outsourcing of employment, especially as carried out in the United States, typically create undesirable outcomes for workers in areas such as wages, benefits, job security, and safety.⁹ Contingent workers earn 10.5 percent less per hour and 47.9 percent less per year than non-contingent workers, and are more likely to suffer workplace injury.¹⁰ Workers employed at suppliers, even as regular workers, generally earn less than workers at lead firms, which tend to be larger.

Wages are typically lower at suppliers than at lead firms because of the barriers to innovation discussed above, which reduce productivity; the absence of pressures to reduce wage differentials within a firm due to norms of fairness; and greater pressure on wages at outside suppliers, which are more easily replaced than are internal divisions.

Market and network
failures in supply chains

Three forms of market failure contribute to the central tendency of U.S. supply chains to suppress innovation and make jobs worse:

• Free-rider problems between firms. When a lead firm makes investments in upgrading its suppliers—by providing technical assistance to suppliers, training supplier workers, or helping them invest in new equipment—some of this improved capability will often spill over to benefit a supplier’s other customers, including the lead firm’s rivals. Lead firms thus have less incentive to invest in their suppliers than would be socially beneficial.¹¹
• Siloes within firms. Internal conflicts between departments within a lead firm can mean a focus on finding suppliers with low prices rather than on those providing high quality and innovation. An easy way for firms to evaluate their purchasing departments, for example, is the extent to which they reduce the price per unit they buy. A purchasing agent could thus be rewarded for choosing a supplier whose costs are $1,000 less than a rival supplier’s—even if that supplier’s skimping on quality control later causes the shutdown of a production line that costs the operations department $100,000. It may seem unlikely that sophisticated companies would fall prey to such problems, but quality and innovation are harder to measure than prices, and their benefits often accrue to departments other than purchasing.¹²
• Profit protection. Outsourcing of work often reduces workers’ access to profits earned by the lead firm. Organizational structures tend to minimize wage differentials within firms, due to both norms of fairness and to a desire to promote cooperation within an organization. Firms with a high degree of market power have lots of profits to protect, which they often do by adopting policies that make their suppliers interchangeable, even at a cost to efficiency.¹³

The result of these market failures is an emphasis in the United States on arm’s length rather than collaborative governance of supply chains, and a hollowing out of productive eco-systems, as firms set up incentives for their purchasing departments that privilege supplier firms that can win competitive bidding wars. These “winners” tend to be small firms with low expenditures on overhead costs, covering such things as salaries for managers and engineers and worker training. In extreme cases, such as garment production or janitorial services, competition is so fierce that firms compete in part by violating laws on safety, minimum wages, overtime, and disposal of toxic waste. In the rare instances in which these firms are caught, they often can file for bankruptcy and re-open under another name.¹⁴

Policies to promote innovative
supply chains with good jobs

Outsourcing has its advantages, principally in making possible a potentially efficient division of labor in which specialist firms can achieve economies of scale and diffuse best practices by serving a variety of customers. Yet lead firms’ zealous embrace of the non-collaborative version of this strategy has resulted in significant weaknesses in innovation and job quality in the United States. Tackling these challenges will help address some root causes of wage inequality and productivity stagnation in U.S. manufacturing and service industries. Policies in five areas will help:

Encourage firms to adopt collaborative supply-chain practices

Public support for economic growth has long focused on the diffusion of physical technologies, yet the diffusion of operational insights may be just as valuable. Evidence suggests supply chains with more collaborative practices are more innovative.¹⁵ The next Administration should use its convening power to encourage lead firms to take steps such as:

• Offer suppliers assurance that they will receive a fair return on investments they make in new technologies and in upgrading their capabilities. In order to become partners in innovation, suppliers need to develop better capabilities in product and process design, and to upgrade equipment.
• Promote information-sharing and make changes in their own operations as a result of supplier suggestions. A key insight from the Toyota Production System is that firms and workers who are close to production have access to information not easily available to those at the top of the chain.¹⁶ Firms that establish mechanisms to learn from their suppliers can significantly improve cost and quality.
• Use a “total cost of ownership” approach when making purchasing decisions. Firms should consider impacts of sourcing decisions on quality and innovation as well as on price per unit purchased.¹⁷ Forming long-term, collaborative relationships with highly competent suppliers may be in a firm’s best overall interest, yet purchasing departments are not always incentivized to consider these benefits.

Nurture productive eco-systems of firms, universities, communities, and unions

One reason for the struggles that small- and medium-sized U.S. firms face is that they are “home alone,” with few institutions to help with innovation, training, and finance.¹⁸ For reasons of both equity and efficiency, these firms should not depend solely on their customers for strategic support.

Policies that nurture small firms, local universities, their communities, and unions could help the firms leverage their advantages over their larger brethren in nimbleness and strong community ties. Germany’s Mittelstand (medium-sized firms) are the backbone of the German manufacturing sector due to the help they get from community banks, applied research institutes, and unions.¹⁹ In the United States, the unionized construction sector has developed structures that create good jobs and fast diffusion of new techniques, even though the industry remains characterized by small firms and work that is often intermittent. Building trades unions work with signatory employers to provide apprenticeships, continuing education programs, and portable benefits.²⁰

Federal technology assets should be better deployed as well, continuing the work begun by the Obama White House Supply Chain Innovation Initiative.²¹ National labs can be encouraged to work with small as well as large firms, for example, and the Manufacturing Extension Partnership can expand its efforts to work with entire supply chains (rather than firms one by one) to identify sources of inefficiency. A century ago, the federal government played this role in agriculture by funding land grant universities, which led not only to the creation of knowledge, but also created durable networks of researchers and practitioners through which such knowledge could quickly spread.²²

Promote formation of supply chains in industries that advance national goals

The free-rider problems discussed above are likely to be particularly acute in forming collaborative supply chains for new products, such as improved solar panels or wind turbines. These industries face additional market failures leading to underinvestment in addressing climate change. The Obama Administration’s Clean Energy Manufacturing Initiative helps to move new technologies out of the laboratory and into production. It would be useful to explicitly address the incentive and information issues in supply chains for producing and installing these products. The next administration could convene firms throughout the supply chain to engage in value analysis to improve product designs, to uncover hidden pockets of inventory, and to adopt total-cost-of-ownership techniques.

Promote good jobs and high-road strategies

Much research documents the ways that firms can utilize “high-road” policies or “good-jobs” strategies to tap the knowledge of all their workers to create innovative products and processes.²³ High-road firms remain in business while paying higher wages than their competitors because their highly skilled workers help these firms achieve high rates of innovation, quality, and fast response to unexpected situations. The resulting high productivity allows these firms to pay high wages while still making profits that are acceptable to the firms’ owners. Collaborative supply chain governance plays an important role in providing the stability needed to support these strategies, from which lead firms also benefit.

Dis-incentivize low-road production strategies

Even in collaborative scenarios, wages are often less than in the old vertically integrated model. The corrosion of labor union power enables outsourcing, and the increase in outsourcing has, in turn, further decreased workers’ bargaining power.

Thus, as important as it is to “pave the high road,” it is also important to “block the low road.”²⁴ The Department of Labor has begun to take advantage of modern supply chains’ emphasis on “just-in-time” delivery, recognizing that reduced inventories make regulators’ threat to shut down suppliers for violation of wage and hour laws a more potent threat.²⁵ New policies could combine such sticks with some carrots. The federal government could offer technical assistance, for example, to help small garment manufacturers move away from the existing low-road model, in which ill-trained workers typically do one simple operation to a garment and then pass it on to the next worker. Instead, these firms could adopt a more agile production recipe, one that involves more broadly trained and higher-paid workers collaborating in teams—a high-road model sustained by greater productivity and reduced lead times.

Government should implement collaborative supply-chain practices within its own purchasing, building on the Obama Administration’s nascent efforts to measure total cost of ownership and to ban supply chains with recent violations of labor and other laws from selling to the government.²⁶

Current outsourcing practices allow lead firms and their suppliers to reap the benefit of paying workers only when needed, while the risks of being left without earnings are borne by workers. Several proposals could improve the balance here: encouraging work-sharing in downturns (which would make hiring regular workers less costly), continuing to improve the portability of benefits across firms, and promoting schedule stability.

Retooling supply chains for equitable growth

Decisions about how to structure supply chains matter greatly for working Americans, yet this topic rarely takes a front seat in policy discussions of how to address rising inequality and stagnating productivity. In order to promote equitable growth, policymakers must understand how the economic pie is created—not just how it is divided.

Fundamental changes in the way supply chains operate threaten U.S. economic competitiveness by undermining innovation, and erode American workers’ economic security. The rise over the past few decades of supply chains with small, weak firms leads to an increased presence of firms that innovate less and pay less. It is unlikely and undesirable, however, that the United States would return to the often bureaucratic and stifling vertically integrated supply chains of the mid-20th century.

We can do better. This essay outlined government and corporate policies to promote both more innovation and better job quality in supply chains. In particular, more collaborative supply chains and better-supported local eco-systems could significantly improve the viability of “good jobs strategies.” The way the economic pie is created affects the way it is divided.

(For more detail on these proposals and the analysis behind them, see Susan Helper and Timothy Krueger, “Supply chains and equitable growth,” Washington Center for Equitable Growth, September 29, 2016.)