Many companies are approaching risk management for their production and supply chains by embracing nearshoring and friend-shoring to move some operations to countries with smaller risks. However, this is not as straightforward a move as it may look. Basic theories about risk management tell us that it is especially important to diversify, and that mathematics matters more than how we perceive risks.
Years ago, while I was studying for my MBA at the University of Texas in Austin, there was a portfolio management course professor who had extensive practical experience with investments in different situations worldwide. He always reminded us: “Don’t try to see which companies are great or bad. Just remember mathematics. You must diversify your portfolio and construct it properly – i.e. the values of the assets you invest should not correlate.”
At the time, GE was a very successful company and its CEO Jack Welch was a business celebrity. But our professor warned us that even the best companies fail one day. And many business heroes eventually lose their reputation if they don’t know when to stop. He predicted one day that even GE would have problems. Of course he turned out to be right about GE – and sooner than we had expected.
He also said that luck is important in business. Sometimes companies and leaders are lucky; another day their luck can turn sour. The reason he told us this was to make it clear: forget about trying to guess who is doing well, who is lucky, or who has the right timing. Do the math and diversify your investments.
Nearshoring vs friend-shoring How is this relevant for supply chains and production locations? As with stock markets, we can of course make some estimates about which locations are safer, where the price level is stable and which ones are reliable. But it is still very hard to really know these things for sure. Things can change. Just think about software companies in Ukraine, businesses caught up in lockdowns in China, or the future risks for Taiwan or the US after the 2024 presidential elections. How much can we really know?
Yes, we can make estimates and risk analyses, but that’s not the same as knowing for certain. That’s why it is important to take a systematic approach, not just think about how things look now.
Nearshoring and friend-shoring are becoming more popular trends. If these terms are new to you, nearshoring is where a business moves its operations to a nearby country from a greater distance. For example, a US company may do its sourcing or have production in Mexico, while a German company would have them in Poland or Romania.
Friend-shoring is where a group of countries with shared values deploy policies that encourage companies to expand manufacturing within that group. The goal is to prevent less-like-minded nations from unfairly leveraging their market position in key raw materials, technologies, or products to disrupt a country’s economy, or the economy of its allies. This is quite a natural development in the current situation where the world is again becoming more divided, and we start to see an emerging ‘cold war’ involving technology businesses.
Moving from one risk to another
But while friend-shoring sounds pragmatic and safer on paper, it’s important to understand that it doesn’t automatically remove your risks. Friendly countries can still be linked to other countries outside of your friendly network – you must understand those links too.
Also, it may be the case that you will need things that your friendly network members cannot supply – e.g. certain materials, energy, or competence. So you cannot just work with friends. Just as no country can produce all things by itself, neither can a friendly network. And of course, history is full of examples where your ally today may be your enemy tomorrow.
Friend-shoring is useful and helps to handle several things, but it’s important to see its limits. As an analogy, if you’re looking at your investment portfolio and you see that tech shares are now risky, but banks make better money with higher interest rates, you might think, “Okay, let’s move all the money from tech stocks to bank stocks.” That might be a good move for a time, but it is not really professional risk management or portfolio management. We tend to make educated guesses. But they’re just guesses.
The future of supply chain management
Supply chains and production locations are only a couple of examples of global dependencies. But similar principles can be applied to other things too – for example, which market you want to sell your products to. Businesses must understand their networks and be able to do professional risk management for them.
Professional risk management requires several competencies to understand global risks. A business should understand politics, economics, business, and also mathematics to model all those things systematically.
This matters because systematic modeling is often not done properly. Enterprises gather reports, consultants and local experts, and evaluate all that information. But compared to investment portfolio management models, this is a very simplified – even amateurish – approach.
COVID, the Ukraine war, and tension between the US and China have reminded all businesses to think about their global risks properly. But many businesses are still in an early phase of doing it systematically and professionally. Consultants and workshops are a good start, but much more systematic models are needed.
This also means we need more data analytics, clear metrics, and systematic updates when businesses and situations change (which they do, all the time).
I wrote earlier about how network analytics could be used to better understand geopolitics and global supply chain networks. Network analytics can see how risks spread in networks – even when the root cause is further away in the network, yet still impacts you. This is a good idea, but we must also remember that technology alone won’t solve the problem or make risk assessment more effective.
The good news is that none of this is unexplored territory. There are plenty of good examples of portfolio management, social network analysis and risk evaluation tools. It is now the time to put them to systematic use.