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 retail’s
reaction to the media’s frantic declarations of an economic recession. Retailers, trying to avoid
being stuck with surplus inventories (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, it
was 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 purposes –
bottlenecks. When a vendor has a bottleneck, any upward fluctuation in demand translates

© Copyright 2010, Eliyahu M. Goldratt

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 market
share 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. It’s 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 hasn’t 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 long
lasting 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. We’ll
swing 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.
 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.

© Copyright 2010, Eliyahu M. Goldratt