Baby formula is just the latest supply chain crisis — we should be asking why

The infant formula shortage is the latest high-profile supply chain crisis, and as we have seen it is causing dangerous shortages for many new parents. Much has already been reported on the Food and Drug Administration (FDA) shutting down Abbott Nutrition’s Sturgis, Michigan factory halting formula production, so I’m not going to rehash that. But we also see critical shortages in many other goods like essential medicines, and in the years ahead we will likely see other hiccups. What we should be asking is why. More often than not the answer lies in a simple question: Who’s going to pay (more)? Let’s examine this from first principles.

There’s not enough slack capacity

The infant formula crisis has many unfortunate circumstances, including shutting down a factory that accounted for a major portion of domestic supply. That took a significant amount of the country’s capacity offline. But it also reflects a lack of slack capacity in the system. There weren’t other factories that had a lot of spare capacity to quickly step in. Why is that? Well, typically you want to run a factory at a high-utilization rate, because then you can spread your fixed operating costs over as many units of production as possible. If your company wanted to sell product that came from factories with lower utilization so that you had more slack, you would have to charge more. But consumers don’t see the value imbedded in a higher price on the store shelf, so they likely would buy a similar product that didn’t have that “resiliency” priced in. In other words, consumers don’t want to pay.

Insufficient inventories to cover emergencies

The next question we might ask is: Why don’t companies stockpile more inventory in case of emergencies like this? The answer once again is that it costs money, in some cases a lot. It costs money to carry inventory — you have cash tied up because it costs you something to make the product, and until you sell it you don’t get the cash back (plus presumably a profit). And those carrying costs have to be recovered, so once again that means you have to charge more. As a consumer comparing products on the store shelf, you don’t really care if one company spent more money carrying inventory, you look at the selling price. And generally, you don’t want to pay more if manufacturer carried more inventory to protect you in case something went wrong.

A lot of investors look askance at companies that have a lot of cash tied up in inventory as well. “Why do you have so much cash tied up in inventory?” they might ask. “How often are you turning it?” Lower inventories, less cash tied up — these things make investors happy.

For infant formula and “dated” products — ones that have a limited shelf life (and a sell-by date), you really don’t want to carry a lot of inventory. Consumers will pick the products with the farthest out sell-by date, and if you have too much stuff hanging around you might end up scrapping what you can’t sell before it expires. That forces your costs up, which means you have to charge more. But again, no one wants to pay more just because you decided to carry more inventory.

There are exceptions, of course. A number of years ago, I had the opportunity to tour the Novo Nordisk factory in Kalundborg, Denmark. At the time, that factory made half the world’s supply of insulin, which was super impressive in its own right. But the Novo people also saw it as their responsibility never to run short since lives depended on insulin, so they had a five-year supply in the deep freeze. Now Novo is an extraordinary company, and I imagine there are others who do similar things, but it tends to be the exception rather than the rule.

Concentration of supply

For many products, we have watched as industries have been winnowed down to fewer suppliers. In the early days of the pandemic, we saw meat shortages as COVID-19 tore through packing plants, shutting them down. Decades ago, there were many small packing plants spread around the country, rather than a few giant plants. As one could imagine, having a lot of small plants is more resilient than a few big ones, because if a big one goes offline, you take out a greater share of overall capacity. But bigger plants benefit from economies of scale, which means they are more efficient. Their fixed costs and overhead can be allocated across higher volumes of product, so they can sell at more competitive pricing. Back in January 2020, I brought a class to visit a factory that made 45 percent of all the microwave ovens in the world. You name the brand, and they probably made some models there. It was a sight to behold. But this company was by far the low-cost producer. Economies of scale often means smaller players get driven out because they aren’t cost competitive. Will consumers pay more because the product came from smaller, less efficient factories? Probably not, unless it’s an artisanal product or something with a lot of uniqueness. More generally, that’s why we have fewer factories supplying the market. Because consumers won’t pay more.

A race to the bottom in pricing

We live in a very price conscious society, especially when we feel pressure from inflation, as we are now. But “everyday low pricing” and Sunday circulars that lead with price reinforce this behavior. We also see it in the behavior of Group Purchasing Organizations, whose mission is to drive lower prices for things like prescription drugs (generics in particular). But that means big producers with scale economies win, high-cost (but local) domestic producers driven out of the market, and a lot of production going to foreign producers in low-cost countries. That leads to long supply chains that are subject to all the congestion delays and disruptions that we have experienced, because consumers don’t want to pay more.

Logistics bottlenecks make everything worse

On top of all these problems, the logistics bottlenecks of the last two years are making everything worse. There aren’t enough truck drivers, warehouse workers, people to work in grocery stores. It’s just like when you have an accident cause a clogged freeway, and the traffic crowding causes more accidents which then make the jam even worse. That’s what supply chains look like. Knock-on effects coupled with knock-on effects. If you are in the logistics industry trying to fulfill consumer demand, you are not having a happy time.

Pantry inventory

One could argue this is the reason many consumers horde toilet paper, or when they hear of a looming shortage they go out and stock up on whatever is next. In effect, consumers hold the inventory if they are worried about shortages, and the cost to them of carrying it is out of sight, out of mind. When I was in the consumer products trade, we often called this “pantry inventory.”

For the sake of all those parents with infants, let’s hope the baby formula shortage gets better fast. In the meantime, we can contemplate the consequences of nobody being willing to pay for resilience in supply chains. One thing is for sure, this won’t be the last hiccup.

Willy C. Shih is the Robert and Jane Cizik professor of management practice at the Harvard Business School. His research focuses on global manufacturing and supply chains. Follow him on Twitter: @WillyShih_atHBS