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What price will the supply chain pay for resiliency?

At one time, a factory in Denmark run by pharmaceutical firm Novo Nordisk A/S (ADR: NVO) made half of the world’s supply of insulin. Vowing to never run short of a product that people’s lives depended upon, Novo kept a five-year supply in the deep freeze.

Few companies will go to such lengths to maintain optimal inventory levels. However, the anecdote is instructional, especially in light of recent events: While there’s a price to be paid for building resilience into supply chains, there is an even bigger price for not doing it.

The debate will continue long after infant formula manufacturing giant Abbott (NYSE: ABT) fully resumes production at its Sturgis, Michigan, plant, the country’s largest baby formula manufacturing site. The plant was closed in February after regulators launched an investigation into possible links between formula produced there and a series of infant bacterial infections and two deaths. Abbott, which makes almost half of all formulas consumed in the U.S., also announced a voluntary recall of its general purpose and metabolic formulas, the latter made for infants with special needs.

On Monday, the Abbott Park, Illinois-based company and the Food and Drug Administration entered into a consent agreement allowing Abbott to restart operations at Sturgis within two weeks after FDA sign-off. Once the site restarts — and there is no timetable yet for that to happen — it will take six to eight weeks for the product to be available on store shelves, Abbott said. 

In the meantime, Abbott is airfreighting formula daily to the U.S. from its plant in Ireland. The White House is also looking to ease restrictions on the flow of foreign imports, which are effectively rendered anticompetitive due to high tariffs. About 98% of the U.S.-made formula is consumed domestically. Four companies control about 90% of the U.S. market.

It’s hard to imagine a product with a profile so aligned with the resiliency model. Infant formula is a health necessity. Formulas are perishable and are difficult to manufacture. Not surprisingly, inventory turns are fairly high. According to current Census Bureau data, infant formula inventories turn, on average, 25 times a year when using sales data as the benchmark. Turns drop to 13 times a year when the calculation uses the cost of materials.

There is acute market concentration. According to 2017 Census data, 13 facilities operated by the top four producers accounted for 45.2% of the value of infant formula shipments. The status quo is amplified by the trade barriers shutting out foreign competition. In addition, trade barriers continue to shut out foreign competition. 

Add to that the supply hits caused by product stockpiling and supply chain disruptions in the wake of the COVID-19 pandemic and it is hard to imagine why alternate production nodes weren’t already in place to prevent one off-line plant from taking so much slack out of the system. 

Manufacturers of infant formula “shouldn’t have a single point of failure,” Willy Shih, Robert and Jane Cizik professor of management practice at Harvard Business School, said in an interview Tuesday. “Companies should be able to split production between multiple sites.”

In practice, however, it’s not so cut and dried. Domestic manufacturing is likely to remain concentrated because only a few players have the economies of scale to support high-volume, continuous flow production. Holding buffer inventory of baby formula might be responsible public health practice, but it runs counter to what Shih called the “good operating practice” of lean production and inventory management. 

In general, businesses investing in resilient operations face the challenge of pricing in and passing on their increased expense. Companies that stockpile inventory, or that add manufacturing and distribution capabilities to ensure adequate product availability, need to recover the costs of carrying the goods. However, a consumer comparing products on a store shelf is interested in the selling price, not in how much a company spent to hold and distribute the product. 

Consumers might absorb the marginal cost of a relatively small investment scaled over high-volume unit production, said Shih, but in an environment of rising prices for almost everything, efforts to recoup a significant resiliency investment will meet with consumer resistance. What’s more, investors will not look kindly on companies tying up their capital for the purposes of creating buffer stock.

“Everything is about price,” said Shih. “We are in a race to the bottom.”

Jason Miller, a logistics professor at Michigan State University’s Eli Broad College of Business, said the dearth of foreign-sourced products is the biggest obstacle to building resilience in the baby formula supply chain. There is nothing that can be done, he said, to change the massive economies of scale on the production side or that distributors continue to hold relatively limited inventories.

Since COVID-19 turned supply chains upside down starting more than two years ago, there has been much discussion over the need to shed long-established just-in-time production techniques in favor of more resilient operations. The needle will be difficult to move. The costs of adding facilities and inventory will be compounded by shortages of warehouse space and various forms of labor. Still, it remains a high-visibility issue in boardrooms and C-suites alike. That is especially the case at Abbott, a 134-year-old company and one of the world’s most respected brands.

“I’m sure they will rethink how they do things after this,” said Shih.