News media have been trying to interpret the economic and commercial ramifications that will come about as a result of the US elections earlier this month. How will tariffs be used in policy and what will that mean to consumer goods prices and manufacturing supply chains? What are the risks to industrial contractors of anticipated cuts in federal government spending? How will regulations change in areas like telecommunications and emissions? How will bond markets price 10 year Treasurys?
No doubt, industrial firms are facing highly disruptive policy changes. But if we zoom out for a minute, highly disruptive policy changes are the norm. Emissions, finance, energy, telecommunications, trade, healthcare and lots of other areas have been subject to significant regulatory change in the last two decades. To wit: when adding 70,000 pages to the Federal Register is considered a light year for new regulations, policy change is the norm, not the exception. Add to that non-policy sources of volatility - labor strikes, electrical blackouts, markets that failed to materialize, armed combat - and it is accurate to say that industrial firms have been subject to non-stop, if not increasing, volatility in their operating environments.
Wall Street rewards consistency in free cash flows above all else. Consistency in cash flows mollifies bond markets, which gives equity investors confidence that there will be ample cash for distributions through buybacks and dividends.
In manufacturing companies, strong operating cash flows are achieved through highly efficient production processes, from supply chain to transportation. Just-in-time inventory management is one of these practices. JIT flatters the balance sheet by minimizing cash tied up in raw materials inventory and in Property, Plant and Equipment (warehouse space) to hold that inventory. As implemented, though, JIT creates tight coupling within a production system: a hiccup in fulfillment from a supplier interferes with the efficiency of the entire production process (e.g., Boeing parking work-in-process in what is actually an employee car park due to a lack of fasteners earlier this year).
In short, industrial firms can throw off copious amounts of cash, but their processes - implemented as tightly integrated, complex systems - are fragile. Nassim Taleb pointed out this same phenomenon in financial markets: interlocking dependencies create systemic fragility. By way of example, the beaching of the Ever Given looked like a black swan event, but it was not: the problem wasn’t a global transportation problem, but a lack of robustness in end-to-end production processes themselves.
The more rigid the underlying processes, the more acute the need for external stability. Right now, uncertainty about policy change is creating external instability, rendering internal decisions about supply chain, shop floor, distribution and capital investment difficult to model, let alone make.
If constant volatility from one source or another is the new norm, "optimization" in manufacturing is no longer as simple as securing timely delivery of raw material inputs, squeezing labor productivity, and designing production plans around cheaper energy prices. Nor is optimization easily protected through crude contingency plans like holding excess raw materials as a hedge against supply chain disruption. An optimized production system must be not just tolerant to but accommodative of volatility.
Contemporary manufacturing operating systems solve for this.
- Digital twins enable production modeling, simulation of disruptive events, and modeling of production responses to combinations of disruptive events.
- Adaptive manufacturing - software defined production that integrates design with digital printing and robotic assembly - accelerates research and development and reduces friction created by NPI.
- Flexline manufacturing allows Porsche to switch from making a combustion vehicle to an electric vehicle to a hybrid vehicle, in any sequence, all on the same line. The line is orchestrated with autonomous guided vehicles and does not require retooling or reconfiguration.
“Optimization” in a volatile world prioritizes resiliency over efficiency.
Wall Street gives a pass to companies when operations underperform due to external forces, because external forces are outside the control of the company. CEOs are graded on how well the company reacted to external disruption. But at some point, equity analysts and activist investors will figure out that manufacturing operations are unnecessarily vulnerable to external shocks. Why is the company not sufficiently resilient to take more of these changes in stride? At how many AGMs will we hear the same excuses?
There is need and opportunity to invest, but the climate isn’t conducive to investment. These are tech-heavy investments, and tech is still paying for largess during the immediate pre-COVID years, when CEOs were fired for showing insufficient imagination for how to spend cheap capital to digitally disrupt their industry. Unfortunately, a post-mortem analysis on that era exposes that not only did too many of the investments made during that time come to naught, the propensity to use contract labor and subsequent employee turnover meant no intangible benefit like institutional learning materialized (even of the "we know what doesn’t work" variety). They were just boondoggles that vaporized cash.
Tech has a bruised reputation and capital is more pricey now, just in time for manufacturing to find itself at a crossroads. The intrinsic sclerosis of legacy manufacturing operations forces industrial firms to react to external changes. If they had intrinsic flexibility, they could respond rather than be forced to simply react. With volatility the new norm, tech investments into modern manufacturing processes and technology are a pretty good bet.
A good bet, but with competing gamblers. Tech ("with your money, and our ability to spend your money…") and legacy manufacturing (fixed production) have to figure out how to partner with capital (10 year Treasurys are north of 400 bps) to make it a profitable bet. There’s a visible win, but the CIO, CTO, COO and CFO have to get out of the way.