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Copyright 2010, Eliyahu M. Goldratt

The Power of Cause and Effect 2

August 2010

Eliyahu M. Goldratt

In January 2009, the electronics component industry, facing an unprecedented drop in

orders in December 2008 (by 50%) had planned to immediately react with a massive cut of its

workforce. A proper analysis done at that time, [foot note 1: The power of cause and effect

by Goldratt (January 2009)] revealed that this expected reaction was not needed and that it

would lead to grave consequences. Unfortunately, most electronics component manufacturers

did lay people off - just to face, less than three months later, a surge in demand. All the signs

are indicating that these companies are now about to make a similar mistake which will lead to

even graver consequences.

In December 2008 the drop in demand for the component manufacturers was not a

result of a drop in consumer demand for electronic consumer goods. As a matter of fact, the

dollar value of purchases of electronic consumer goods, in all the major markets of the world,

did not drop by more than 2 to 3 percent, and in terms of units sold actually increased. Rather,

the drop in demand for the components manufacturer was an unavoidable result of retails

reaction to the medias frantic declarations of an economic recession. Retailers, trying to avoid

being stuck with surplusinventories (which in the case of electronics consumer goods will

shortly become obsolete inventories) naturally took immediate actions to reduce their

inventory levels. Which meant a drastic reduction in the amounts ordered by retailers. For

those who realized that the drop had nothing to do with actual drop in consumer demand, itwas apparent that once retailers reduced their inventories the demand would jump back to the

pre-economic-scare levels. Since the retailers (together with the wholesalers) are holding

about three to four months of inventories it was obvious that around April 2009 the demand on

component manufacturers would return to normal. That was exactly what actually happened.

Alas, during the first half of 2009, not just the retailers reduced their inventories, the

electronics assembly companies did it as well. When the scare was over and companies

(retailers as well as electronic assemblies) had adjusted to the new reality they naturally

wanted to gradually restore their inventories to the proper level; their orders reflected not just

their current consumption but also the quantities needed to raise back their inventory levels.But, increasing back inventories is governed by different factors than reducing inventories.

The speed at which inventories can be reduced is governed by the rate of clients purchasing.

The speed at which inventories can be increased is governed by the amount of excess capacity

the vendor has. Even if we assume that by mid 2009, electronic component manufacturers had

succeeded to bring back their capacity to 2008 levels (and considering the time it takes to hire

and train people, this is a very optimistic assumption) it means that, on average, the electronic

component manufacturers had no more than 15% excess capacity. With this amount of excess

capacity to refill even two months of inventory will take more than a year. The problem is that

during that time, when the orders are inflated to reflect the need to increase inventories, the

demand is higher than the capacity available; vendors have - for all practical purposesbottlenecks. When a vendor has a bottleneck, any upward fluctuation in demand translates

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into longer lead time to satisfy client order. Any increase in supply lead time causes the client

(electronics assembly) to realize that it should further increase its inventories. This phenomena

opens the gates to inflated internal demand (orders from assembly to components) when

actually the external demand (purchases by consumers) is relatively stable. Does it happen?

Do we witness a surge in internal demand?

A recent article published by Wall Street journal entitled: From snowmobiles to cell

phones, a scramble for parts, reports on ongoing shortages of electronic components that is

intensifying since the beginning of the year (2010). The most alarming fact that is reported in

this article is that recently the supply lead time has elongated from ten weeks to twenty weeks.

This phenomenon ensures that in the near future electronic assembly companies will continue

to increase their inventories and the component manufacturers will become more and more

confident that future demand is on the upswing. Not being able to supply all the demand and

being under increased pressure from impatient clients will, no doubt, lead component

manufacturers to the conclusion that continuing to operate with the existing level of capacity is

limiting the profit that they can realize today. Moreover, since it also endangers their marketshare it is limiting the profit they will be able to make tomorrow. There is little doubt that, in

the current frame, very few components manufacturers are not contemplating to heavily invest

in increasing their capacity and many have already approved the needed investments.

The problem is, of course, that the demand is not real. Its not a demand driven by the

consumer purchases; consumer purchases of electronics consumer goods have remained

relatively stable in the last two years. It is a demand driven by the supply chain internal

adjustments. Once again companies that are participating in the supply chain ignore the most

fundamental rule: As long as the end consumer hasnt bought, no one in the supply chain has

really sold. But, this time the mistake, if not stopped now, will have much graver and more longlasting ramifications.

It takes time to significantly increase capacity; to open new plants. These efforts have already

started. It stands to reason that within one or maximum two years new capacity will be

operational. What must happen then? Additional capacity will collapse the delivery lead times.

When lead times plummet the client quickly reevaluates the amount of needed inventory levels

and readjusts downward accordingly. Readjusting the inventory level downward will have an

immediate and drastic impact on the quantities ordered, and as a result supply lead time will

shrink further. From the above cause and effect logic it is clear that once the new capacity will

be operational the strong demand that we witness now will, in almost no time, vanish. Wellswing into a period where the increased supply will be much higher than demand. And we all

know what will happen then; prices will drop.

Exactly when their investments (their expansion plans) have been completed, those

companies will face a reality where , not only the demand vanishes but also prices drop. The

problem is that not only those companies that have confused internal, supply-chain demand

with consumer demand will suffer. The problem is that also companies that analyzed the

situation properly and resisted the temptation to invest in more capacity will also suffer. They

will suffer from the resulting too low prices. The increase of capacity of their less analytical

competitors will also erode their prices, and significantly lower prices are poison to profitability.

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Copyright 2010, Eliyahu M. Goldratt

Convincing competitors to refrain from investing now in additional capacity should be

the number one concern of any component manufacturer. I think that there is only one

effective way to convince competitors to freeze their investments in additional capacity, and it

is to convince the competitors that instead of investing heavily in more expensive capacity that

will become productive a year or more from today, it is possible, within weeks, to reveal much

more capacity from existing operations. I urge consumer electronics manufacturers that have

done it to reveal their actual achievements: to release into the public domain, and in

particularly to their competitors, the details of what they have done, the time that it took to

increase production and the magnitude of the increase.