7 Reasons Why Tesla Will Benefit From The Crisis — #4: Vertical Integration (Video)

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The true issues of a crisis are usually not the root cause of it, but rather the consequences and the ability of your organization to respond to them.

With regard to the coronavirus we’re dealing with at the moment, although it is bad, it’s still just a virus. Companies are suffering because of its impact on their businesses’ ability to continue production, services, and sales.

If your organization is able to respond and keep humans separated and not contracting the virus, it can do well. To be clear, I am not downplaying how severe the impact of the crisis is on everybody, in our ability to continue life as we know it as well as sustain our economies and companies. However, we should distinguish between the direct and indirect impacts. Further, indirect impacts may apply to an industry, like the automotive industry, but not be the same for every company.

We live in a world of complex worldwide supply chains that form what is like a secret network of suppliers and production steps. Parts, semi-finished and finished products, are often shipped a few times around the world before consumers finally have them in their hands and ready to be used. It’s a busy supply chain world unintendedly hidden from the consumer that is orchestrating whatever is needed from far away to be assembled like magic at one point in time, all of a sudden making sense and coming together as a complete product. The more complex your supply chain is with regard to suppliers and levels of semi-finished goods, the less transparent and known it is.

A vehicle has a few thousand parts. All of them are built, manufactured, and shipped often over many steps — including many suppliers that deliver to other suppliers who do something with the product before they pass it to the next supplier. It’s complex and includes a lot of opportunity for error and failure, as the end product only works if it all comes together as required in the right time and with no single part missing. If one is missing or late, you won’t be able to finish your product, you won’t be able to sell it, and with that you are not in business anymore. If one is too early, you pay a higher price, run into many logistics issues, have extra labor you no longer need, and have storage and logistic costs. For decades, the supply chains of the automotive industry have been optimized as much as possible for just-in-time production to optimize costs. They are not designed to cope well with a pandemic.

A supply chain is only as valuable as its weakest part, and if you have many parts, like in a vehicle, you have many opportunities to have a weakest part that is missing or does not work as it supposed to. That’s the dilemma of complex products, and having worked +20 years in supply chain management for different industries, I can testify it did not get less complex in the last 2 decades, but rather more. Complexity is vulnerability, and the pandemic we are in reveals without mercy the weakest parts of our supply chains.

If that is true, the question arises, would reduced complexity and a simpler supply chain help to make a company stronger? The answer is, yes, but it’s hard to do and would increase costs. Since all large automotive companies have done the opposite, they have low costs but are also more vulnerable to any impact on their supply chain.

Automotive supply chains are the most complex in the world partly because leading OEMs have outsourced more parts and services to suppliers to optimize costs and focus more on marketing and sales. That worked very well for decades as costs came down and sales went up. All large automakers became the manager of the supply chain instead of being part of it. If all do that, you compete against similar supply chains until the moment a new company appears that does not play to the same rules, and that company is Tesla.

Since the corona crisis hit the auto industry, a 30–50% decrease in sales with nearly zero production output has happened, but the interrupted and broken supply chains will be a larger problem after consumers come back.

When restrictions start getting lifted and demand increases, likely also through incentives, the question will be how quickly supply chains can be reactivated. Many people may claim it does not matter much since all automakers have the same issue, but the reality is that if you have longer and more complex supply chains with more suppliers, you will need more time to get the processes in place and deliveries going again. If you just have a few suppliers, that effect won’t matter much.

Most people who realize how bad production downtime is at the moment of the crisis underestimate the impact of a broken, interrupted supply chain after production starts again. The day will come when all large automakers could start if they had the parts and services orchestrated, but some parts will be delayed and missing for a longer period because a supplier — or the supplier of a supplier — can’t deliver. If one part is missing, all needs to stop and the total cost of half-finished inventory is going up dramatically. 

Therefore, it’s not only that you can’t produce, but while you try to do so, your cost goes up too. All of that is happening in an environment designed for mass production and very high capacity utilization — sometimes up to 80–90% is needed to make a profit. That’s a big negative on the bottom line and can weigh heavily on your quarterly financial results. In other words, the ramp curve will be financially more negative than the time the production lines stood still and workers stayed at home. While all are focusing on the time of the coronavirus crisis, I believe the focus should also be on the time when the crisis starts to end. At that time, most automotive companies will experience the worst of the impact. In other words, the worst is still to come.

An automotive production downtime of let’s say 2 months can easily lead to a production loss of +4–8 months in complex supply chains, while it’s more likely 3–4 months for simpler supply chains, considering the ramp-up curve.

What is a simple supply chain? It’s a company that has the majority if not most supply of parts and services located within the company.

Why is that helpful? Having control of your own organizational elements makes you more agile, responsive, flexible, and resilient to influences in a crisis.

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German automakers call a situation in which a lot of parts are produced in house a high production depth, which is similar to what the rest of the world calls vertical integration.

The question of whether a company has deeper or lower vertical integration is not how many suppliers a company has. Many believe if you count the parts a company sources, you know to what extent they are vertically integrated, but that’s not even near the truth. It’s more about how many companies are involved in all levels of the supply chain, including tier 1-X suppliers and how complex the relationships are between those companies. A so-called “Bill of Material” can illustrate that relationships and complexity in terms of parts, but the different workflows and logistics relationships are an order of magnitude more complex. Just think about the fact that a tier 2 supplier needs a special kind of support material — be it an oil drill or other product — but since he can’t get it any more due to the crisis, he can’t work on the part another supplier is waiting for. You are going to be directly impacted from a supply shortage of a material that does not even go into your product.

I could go on to describe what vertical integration is about and how complex it is, but I wanted to make it clear that it’s not what most believe it is.

If you ask a company, they will be able to explain the parts they need and may even be able to list some of the parts their direct suppliers need, but that’s usually it. The complexity after that level in terms of parts literally explodes exponentially, and no one has transparency or a true overview.

Having truly understood that, you may get a sense and feel what it means for a company to be able to adjust, restart, and ramp up production in a time of severe crisis, like the one we are experiencing, compared to a company that has outsourced everything it could for decades and built reward systems around that outsourcing.

Tesla didn’t insource production to be more vertically integrated because Elon Musk found it a good idea to be better prepared for a potential pandemic. Rather, Tesla was forced by the market to do so to be able to produce at all. You will find more information about this in my article “Vertical Integration is Value Integration.”

The irony is that Tesla is today more vertically integrated and for that reason better prepared to get out of the supply chain challenges quickly because of the competition forcing Tesla into that situation.

Like Sandy Munro said correctly in the 3rd Row Tesla podcast, the relationships between an OEM and a supplier is “like a marriage.” If under stress, a lot can go wrong, and if you have many marriages, a lot more can go wrong.

Once auto manufacturers are producing again, they will all ask for the same parts from their suppliers, and if you remember this far back, consider what happened with the shortages of masks and hand sanitizers to protect against the virus. Those auto suppliers will first of all lift prices, and secondly deliver to companies they consider of most importance for their own future. Third, supply shortage will continue for a long time.

This will affect different automakers in different ways, due to supplier allegiances varying depending on the specific product. The truth is that if one part is missing, the line will stand still, and there are many opportunities for that to happen.

That challenge exists for a company with a higher level of vertical integration like Tesla too, but with an order of magnitude lower risk. Lower risk means that Tesla can prepare its internal organization better to overcome shortages and will be quicker in delivering new vehicles.

Not long ago, Gigafactory Shanghai received a huge amount of parts from the US in order to be able to start production, but going forward the Chinese government demanded locating sourcing 100% from China, which was very helpful to reduce risks from suppliers being all over the world. China did that for the good of China, but now it plays into the hands of Tesla. Many have been surprised that Tesla was one of the first automakers that restarted deliveries in China early, while the lockdown in provinces where the majority of China’s automotive industry is located was still in place and they could not produce and deliver vehicles. Reasons for that were vertical integration and local sourcing.

Another answer to the challenge is to use the same parts of the two mass-produced cars Tesla has, which are the Model 3 and the Model Y. If parts that you need or decided to source externally are true high-volume parts with hundreds of thousands needed every year, the likelihood that you get priority for that part from your supplier is high. About 70% of all parts between the Model 3 and Y are identical, which allows you to order higher volumes and get higher priority and higher likelihood of delivery, because your supplier will have larger capacity to produce them and you are a defined A customer. If you add all parts for the Model 3 and Y together, the number of parts that are sourced from external suppliers will be lower than if you calculate for each vehicle individually, as a larger portion of the newly designed parts for the Model Y are produced in house. That’s another overlooked advantage helping Tesla to get the parts it needs to produce.

The vertical integration of Tesla has been born out of desperation, forced on Tesla from the supplier industry, and is now a secret sauce as to why Tesla will come out of the crisis better than any other automaker in the market.

This has been #4 out of my 7 articles about why Tesla has a competitive edge in the time of the crisis. Stay tuned for #5.

Related Stories:

7 Reasons Why Tesla Will Benefit From The Current Crisis — #1 Safety

7 Reasons Why Tesla Will Benefit From The Crisis — #2 Diversification

7 Reasons Why Tesla Will Benefit From The Crisis — #3: Supply & Demand

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Alex Voigt

Alex Voigt has been a supporter of the mission to transform the world to sustainable carbon free energy for 40 years. As an engineer, he is fascinated with the ability of humankind to develop a better future via the use of technology. With 30 years of experience in the stock market, he is invested in Tesla [TSLA], as well as some other tech companies, for the long term.

Alex Voigt has 53 posts and counting. See all posts by Alex Voigt