Don’t Tweak Your Supply Chain—Rethink It End to End

Hong Kong–based Esquel, one of the world’s leading producers of premium cotton shirts, faced a quandary in the early 2000s. Apparel and retail customers such as Nike and Marks & Spencer had begun asking the company about its environmental and social performance. Its leaders anticipated scrutiny from other customers as well, since more of them were demanding that a greater portion of the cotton in their shirts be grown organically. But the crop required a lot of water and pesticides, especially in poor and rapidly developing countries, where Esquel’s cotton was grown and processed.

Though Esquel’s executives wanted to strengthen the company’s already serious commitment to social and environmental sustainability, they realized they couldn’t simply demand that the farmers who supplied extra-long-staple cotton just reduce their use of water, fertilizer, and pesticides. A mandate like that could be catastrophic for the farmers and their villages. Most of Esquel’s cotton came from Xinjiang, an arid province in northwestern China that depends mainly on underground sources of water. The traditional method of irrigation there was to periodically flood the fields—an inefficient approach that created a perfect breeding ground for insects and diseases. Heavy pesticide use was a necessity.

Productivity was an issue, too: A switch to organic cotton could cause crop yields to drop by as much as 50%. Even though the climbing demand for organic cotton was likely to boost prices, Esquel couldn’t expect them to rise enough to compensate farmers for the lower yields. Indeed, apparel companies and retailers had made it abundantly clear that they would not be willing to pay a big premium for clothes made with organic cotton.

Complicating matters even more, organic cotton fiber is weaker than that of conventional cotton and has different physical characteristics. It would need extra processing, leave a greater percentage of scrap during fabric manufacturing, and require chemicals and dyes more environmentally harmful and more expensive than those used on conventional cotton. All this would add to costs and cancel out some of organic cotton’s green benefits.

How could the shirtmaker provide the products customers demanded, conduct environmentally and socially responsible business in China, and protect its own profit margins?

Companies up and down supply chains in numerous industries confront the same challenge: A well-intentioned individual action or demand aimed at making a business greener can create a long string of unanticipated consequences that collectively dwarf the benefits.

The mounting pressure to conduct business in a sustainable fashion comes from various stakeholders—customers, shareholders, boards, employees, governments, and NGOs—and most corporations respond in a reactive, piecemeal way. They demand that suppliers change their materials to environmentally friendly ones. They ask suppliers to move manufacturing operations closer to end markets to reduce transportation-related carbon footprints. And they tweak their own operations by replacing ordinary lightbulbs with compact fluorescent lamps, recycling more of their materials, refurbishing and reusing products, using more energy-efficient equipment, and so on.

I call these actions substitutions: swapping one material, vendor, location, production step, or mode of transportation for another. Although each change might seem worthwhile, such actions can, when you factor in the unintended consequences, end up raising financial, social, or environmental costs and lead to supply chains that are not, well, sustainable.

Instead, companies—throughout the supply chain, not just at the end—should take a holistic approach to sustainability and pursue broader structural changes than they typically do. These may include sweeping innovations in production processes, the development of fundamentally different relationships with business partners that can evolve into new service models, and even collaboration with multiple companies to create new industry structures.

This is one of the most important conclusions to emerge from an ongoing research project I’ve been leading at Stanford Graduate School of Business. During the past seven years, my colleagues and I have studied supply chains in seven industries: agriculture, apparel, automobiles, electronics, high tech, retail, and resources (such as mining, steel, and cement). In addition to Esquel, we’ve looked at Adidas, CEMEX, the European Recycling Platform, Flextronics, Hewlett-Packard, Li & Fung, Netafim, Nike, Posco, Rio Tinto Iron Ore, Safeway, Smart Car, Starbucks, Toyota, Wal-Mart, and others.

In particular, we have focused on environmental and social responsibility in developing markets. Such economies provide the biggest opportunities for improving the environment, but they also entail the biggest risks. The widely publicized recalls of tainted pet food and lead-laden toys and children’s belts made in China and the suicides of workers at a contractor’s electronics factory in Shenzhen have driven home the reality that stakeholders increasingly hold corporations accountable for their supply chain partners’ actions. Given the tremendous environmental damage that the explosion in manufacturing is inflicting on China, companies that source from China should expect their suppliers’ greenness—or lack thereof—to come under more-intense scrutiny.

Clearly, sustainability issues are adding complexity and risks to the already daunting challenge of managing global supply chains. This suggests that companies need to pursue structural change much earlier than most currently do. Actions taken by Esquel and Posco, the South Korean steelmaker, are good examples of what I mean by structural change.

Esquel.

To manage the trade-offs among environmental sustainability, social responsibility, and business performance, Esquel helped independent farms and those it owned in Xinjiang try sustainable-farming techniques. For example, it assisted them in adopting drip irrigation to decrease their water use and in establishing natural pest- and disease-control programs, such as breeding disease-resistant strains of cotton, to reduce reliance on pesticides. (The new variety of cotton plants also produced stronger fiber, resulting in less scrap during fabric manufacturing than conventional cotton did.)

Esquel also introduced different harvesting techniques. Previously, farmers used chemical defoliants to induce leaves to drop to the ground so that machines could easily collect the crop. The shirtmaker suggested handpicking instead. Even though that would be more laborious up front, it would make for a cleaner harvest, saving the need to remove dirt and impurities later and reducing waste.

In addition, Esquel changed its supplier-customer relationships with independent farmers to be more like partnerships. For example, to enable farmers to invest in the new techniques, it teamed up with Standard Chartered Bank to provide microfinancing. And to decrease their risks, it started to place orders for cotton when it was planted and guaranteed payment of whichever price turned out to be higher at harvest—a company-set minimum or the prevailing market price.

As a result of these efforts, the yields of the organic farms in Xinjiang that serve Esquel more than doubled from 2005 to 2007; today they are the highest of any kind of cotton farm in China. Farmers’ income has increased by 30% since 2005. And at a time when demand for organic cotton around the world is soaring, Esquel has secured a dependable, major supply.

The company improved its own manufacturing, as well. It developed new processes for washing, ginning, and spinning organic cotton fiber; created dyes that employed greener chemicals than those used to color conventional cotton fiber; and reduced the use of other chemicals in fabric manufacturing.

Posco.

In a bid to make its steelmaking process more environmentally friendly, Posco had for years undertaken a host of discrete initiatives to conserve and recycle water, reduce its energy consumption, and control pollution. For example, it introduced continuous casters that allowed newly made steel to be rolled into products before it had completely cooled, which cut energy consumption by about 10%. It developed water management and reuse techniques that enabled the company to produce a ton of steel with just 3.8 cubic meters of water. And it recycled nonferrous slag—a by-product of steelmaking—by selling it to companies that used it to make cement and other construction materials.

Posco’s managers thought they were doing all they possibly could to be green. Then a challenge arose that made them think otherwise. China’s voracious demand for steel caused global prices of high-grade iron ore to rise sharply in the 1990s and the early 2000s. Making matters worse, oil prices also shot up, significantly increasing the cost of shipping the ore from distant mines. These trends prompted Posco to join forces with its equipment supplier, Siemens VAI: The companies set out to create a radically new technology that would cut costs and carbon emissions by using cheaper, lower-quality iron ore from mines much closer to Posco’s mills.

The Finex steelmaking process is the solution they came up with. It can use cheaper bituminous coal and common iron ore powder, eliminates the need for coking and for sintering, and, compared with conventional steelmaking, requires substantially less energy and produces much lower levels of greenhouse gases and other pollutants. It has reduced the costs of building a new steel mill by 6% to 17% and slashed the operating cost by 15%. Posco has used the technology successfully in Korea and has reached an agreement with the Indian government to build a Finex mill in Orissa.

Figuring out how to pursue structural change and manage the trade-offs may sound daunting, but it doesn’t have to be. It can be tackled in a systematic fashion. In the rest of this article, I offer some guidelines and best practices.

Manage Sustainability as a Core Operational Issue

The only way companies can recognize and navigate trade-offs or conflicts in their supply chains is to treat sustainability as integral to operations. They should consider it alongside issues such as inventory, cycle time, quality, and the costs of materials, production, and logistics.

Recognizing this, Nike has made its supply chain managers—rather than a separate corporate social responsibility group—accountable for identifying possible sustainability improvements, implementing them, and tracking their performance. For example, in China, where the company has about 150 contract factories, its supply chain managers regularly evaluate existing and potential contract manufacturers on operational, environmental, and social-compliance measures. As part of this exercise, the managers consult a database of polluters maintained by the nonprofit Institute of Public and Environmental Affairs (IPE)—something many multinational corporations fail to do, according to Ma Jun, IPE’s founder. When working with suppliers to improve their operational performance, Nike also trains them to boost their environmental and social performance.

To do all this at your company, start by mapping internal supply chain operations. Identify where environmental and social-responsibility problems or opportunities lie. Evaluate alternative ways to make improvements that may require trade-offs between the two types of performance. As you weigh your options, consider their potential social impact. After you choose and implement initiatives, continually measure their performance to ensure that you’ve achieved the right balance of environmental, social, and conventional operational considerations.

With this kind of approach, Esquel greatly improved both its sustainability and its overall operational performance in its vertically integrated business, which includes cotton farms, spinning mills, weaving and knitting operations, and final assembly. Each area has reduced energy consumption through process improvements, recycling, and the construction of thermal power plants; increased use of organic cotton; and decreased use of chemicals in dyeing. These environmental initiatives have also led to operational improvements: less scrap, lower cost, more-stable production, and fewer production stoppages and late deliveries to customers.

Coordinate with Adjacent Operations

Often, an internal operation can achieve only limited sustainability improvements on its own. Its adoption of a new material, component, or technology may require changes in adjacent units. Conversely, customers’ operations often constrain the extent to which you can modify your own. For example, if a customer requires you to deliver once a day, you may not be able to fill up a truck, even though partial truckloads waste energy.

Start coordinating efforts by identifying all the overlapping activities. Then, working with the other parties, explore improvements you could make together that would transcend what any of you could achieve on your own. Since your priorities may differ, the metrics to track progress will have to be comprehensive enough to cover the interests of all operations.

When Esquel applied this approach, it found that its individual operating units typically didn’t work together to become greener and, as a result, had missed opportunities. For example, in fabric production, a softener and chemicals used to improve seam strength and prevent threads from slipping were added to give the fabric a standard feel. But some of these chemicals were going down the drain during the garment-washing process. In response, Esquel developed a new recipe that reduced the amount of softener and anti-slippage agents but achieved the same feel. The company saved more than 1 million RMB annually, and it significantly decreased the waste discharged during garment washing.

Supply chain partners need to collaborate even on seemingly mundane sustainability initiatives, as the U.S. supermarket chain Safeway discovered when it set out to reduce the carbon footprint of packaging materials for products it received from manufacturers. The company examined transportation conveyances (boxes, pallets, wrappings, and such) and assessed several alternatives, including different kinds of pallets and slip sheets. Quantifying the environmental impact of each with a widely used life cycle assessment tool, Safeway discovered that the delivery frequency, the routing to different distribution centers, and the mix of products on a truck had to be modified for each conveyance. The company then worked with key manufacturers such as Procter & Gamble, Kimberly-Clark, and General Mills to implement changes. Safeway and its partners had to agree on a comprehensive set of environmental measures and goals for tracking progress in reducing emissions, energy consumption, and solid waste produced, along with parameters for standard operating costs.

Examine the Extended Supply Chain

After you’ve sought opportunities with adjacent internal operations and direct customers and suppliers, don’t stop. Turn your attention to your suppliers’ suppliers and your customers’ customers—the extended supply chain. It’s a critical step, not just to identify more-ambitious structural changes that could generate even greater payoffs but also to better manage risks.

Mattel learned this the hard way in 2007, when the discovery of lead paint on its toys damaged the brand and forced the company to conduct an expensive recall. A Chinese governmental agency traced the paint’s source to a third-tier supplier, which had sold a batch of leaded yellow pigment to a paint company and had provided fake certification that it did not contain lead. The paint company had then sold the paint to Lee Der Industrial Company, one of Mattel’s longtime contract manufacturers. Ignorance about the extended supply chain had left Mattel vulnerable to a single glitch upstream.

To avoid Mattel’s travails, map out the members of your broader supply network and zero in on sustainability-related risks and opportunities. Figure out which performance indicators must be monitored to ensure that all members meet agreed-upon standards and targets. For instance, it’s clear that Mattel needs to fully see the detailed specifications of the materials in its toys (including the lead content of the paint), the level of quality control efforts, and the results of inspections throughout its extended supply chain. Augment your own audits by consulting government agencies and NGOs that keep tabs on companies’ social and environmental performance.

Once you have identified the vulnerabilities in your extended supply chain, you can collaborate with members to make improvements. To prevent a recurrence of the lead paint fiasco, Mattel may have to work with its first- and second-tier suppliers to detect issues early and train third-tier suppliers to keep problems from occurring in the first place.

That said, engaging members of the broader supply network in this manner can be extremely challenging—especially if they are several tiers below you, located far away, and based in developing economies, where secrecy is often the norm. Many companies hesitate to share information about their operating and environmental performance with other members of the extended supply chain out of fear that it might be used against them in contract negotiations or get leaked to competitors or regulators. So, you typically will have to educate members about why transparency is needed and how the information will be used.

To make major structural changes, parties must align their incentives. This may involve altering payment schemes or using other types of incentives—for example, providing direct aid in the form of training or subsidies—so that all partners believe they will benefit from the collaboration. Such alignment is the key to the sustainability of the sustainability initiatives, as Wal-Mart discovered. In 2005, when Wal-Mart initially mobilized its massive supplier network to join the company on its journey to become more environmentally responsible, it set aggressive goals for its suppliers to reduce energy consumption and the negative environmental impacts of their production processes. Concerned that these measures would increase their costs without necessarily improving their revenues from Wal-Mart, many small and midsize suppliers in China did little or nothing. So Wal-Mart tried to mitigate their risks and increase the benefits of participating: It invested in training, codeveloped delivery processes that would cut suppliers’ costs and its own, and provided guarantees of the quantities it would purchase from suppliers in the medium term. The carrot approach worked. In a 2009 audit of more than 100 Chinese factories serving Wal-Mart, the nonprofit Business for Social Responsibility found that they had become 5% more energy efficient in the program’s first year.

The Starbucks Coffee and Farmer Equity (CAFE) program is another good example. Given consumers’ interest in environmentally friendly food products, Starbucks pursued the goal of making coffee greener by persuading growers to farm more sustainably. But the company had no direct interactions with farmers; it had traditionally purchased coffee from intermediaries such as farm cooperatives, food processors, exporters, and importers. Therefore, it needed to involve the players throughout its extended supply chain, including the coffee farmers, in the effort.

The CAFE program spells out guidelines to promote environmental and social responsibility throughout the coffee supply chain: farming and processing practices that protect soil and biological diversity and conserve water and energy; worker pay that meets or exceeds minimum wage levels where the farms are located; adequate health, safety, and living conditions for workers; prohibitions on child labor; and limits on agricultural chemicals. It also fosters transparency by requiring suppliers to document how much of the money Starbucks pays for coffee actually reaches the grower, often a small family farmer in Latin America, Africa, or Asia.

Suppliers are graded by independent certifiers who largely come from NGOs such as Rainforest Alliance and who follow Starbucks’s criteria. A supplier must score above a certain threshold to be CAFE certified. Starbucks buys first from certified farmers and suppliers and pays premium prices to top scorers and those who show continual improvement. (In 2009, beans from such suppliers accounted for 81% of Starbucks’s coffee purchases, up from 77% in 2008 and 25% in 2005.)

Through the CAFE program, Starbucks offers loans to farmers trying to achieve high scores and provides training and support to ones failing to do so. Those incentives have helped the company lock in high-quality suppliers that are environmentally and socially responsible. With less supplier churn, it has managed to lower its long-term procurement costs and reduce its supply chain risk. For the coffee farmers, CAFE ensures a steady market for beans that can be sold at premium prices. So growers in poor and developing countries are given a chance to earn more-stable incomes and to protect themselves from volatility in world coffee prices.

Look Beyond Your Enterprise’s Networks

Sometimes sustainability challenges are too great for the supply chain of any one enterprise to tackle on its own. Take recycling. A single company may not have the scale to support efficient collection and processing. If that’s the case, the best solution is working with others’ supply chains—even those of competitors. When multiple supply chains use the same materials, consume the same resources, or face the same threats, collaboration may bring cost-efficient, innovative solutions.

Of course, it requires careful planning and execution. The companies in the supply chains should have some objectives and interests in common. They must be able to share resources (processing capacity, labor, or materials) to gain economies of scale. They will have to work out the business model—including whether to establish a new independent entity or a joint venture, or whether to outsource the work to a third party. Finally, the results of the collaboration must be transparent to the participants, who in turn must be willing to share the knowledge and experiences gained from it.

In the early 1990s, many European countries set up inefficient systems for collecting discarded computers, monitors, televisions, household appliances, and other electronic products; recycling as much as they could; and safely disposing of the rest. In each country, a state-owned company took care of everything and charged manufacturers for its costs.

The onerous charges prompted four corporations—Hewlett-Packard, Electrolux, Sony, and Braun—to come up with a better alternative. They formed a joint venture: the European Recycling Platform (ERP). Set up as an independent business in December 2002, ERP has collected and recycled electronic waste for 34 companies in 11 countries. Its pan-European reach allows it to achieve much greater economies of scale than individual state-owned companies can, and the competition has sparked ERP to implement lean processes and become superefficient.

For example, HP’s cost of recycling a digital camera is just 1 or 2 euro cents in Austria, Germany, and Spain, where ERP operates, and 7 euro cents to €1.24 in five countries where state-owned companies still enjoy monopolies. Recycling a laptop computer costs HP 7 to 39 euro cents in the three competitive countries and 88 euro cents to €6 in the other five.

In places where ERP operates, manufacturers’ recycling and disposal costs have fallen by 10% to 35%. ERP has steadily expanded the scope of the products it handles, and its members now include Apple, Dell, Microsoft, Nike, and Nokia. 

Sustainability is no longer a secondary issue. It has become a competitive concern and should be handled accordingly. The core managers overseeing the supply chain, not a peripheral CSR group, must own and tackle it as aggressively as they do cost, quality, speed, and dependability. They must engage the entire supply chain as they seek breakthroughs and try to minimize risks. Companies that take such a holistic approach will steal a march on reactive competitors. They will be sustained.