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Are Supply Chains Too Lean?

Updated: Jul 1, 2022

Data from 19 industries across more than a decade do not support this assertion. Why, and where do we go from here?

In February 2021, Warren Buffet published his annual letter to shareholders for the year 2020. This is one of his more notable letters in the past decade, and, as always, full of useful information. Towards the end of the report, Mr. Buffet reveals an interesting data point about his company, Berkshire Hathaway:

“Recently, I learned a fact about our company that I had never suspected: Berkshire owns American-based property, plant and equipment – the sort of assets that make up the “business infrastructure” of our country – with a GAAP valuation exceeding the amount owned by any other U.S. company. Berkshire’s depreciated cost of these domestic “fixed assets” is $154 billion. Next in line on this list is AT&T, with property, plant and equipment of $127 billion.”

He goes on to say:

“Our leadership in fixed-asset ownership, I should add, does not, in itself, signal an investment triumph. The best results occur at companies that require minimal assets to conduct high-margin businesses – and offer goods or services that will expand their sales volume with only minor needs for additional capital." (bold emphasis added here).

Many people have attributed global supply chain challenges of the past 18 months to supply chains simply being “too lean.” Article after article has proclaimed that decades of cost cutting have made supply chains vulnerable, indeed fragile to volatility. In this interpretation, “lean” equals minimal levels of inventory, capacity, and labor, with very little room for error. But how does one know what minimal means? And how do we make this assertion that supply chains are too “lean?” Are Warren Buffet’s $154B in domestic fixed assets too low? (For reference, Berkshire Hathaway had a total of $187B in property, plant, and equipment (PP&E, net of depreciation) on its balance sheet at the end of 2020 (the $154B number he quotes is the USA portion).

It seems intuitive that companies would strive for “leaner” operating models, and that over time they would, as Warren Buffet notes, create models that “expand sales volume with only minor needs for additional capital.” Furthermore, decade-long digitalization efforts would presumably show that software is replacing physical assets in alignment with the thesis that “software is eating the world.” Furthermore, assets are made up of metals, petroleum products, and other commodities and consume a lot of resources to create, something we should be looking to reduce to have less of an impact on the planet.

But more than a decade worth of data doesn’t support any of this. Industries require just as much or more fixed assets per dollar of revenue today and operate with fewer inventory turns than they did a decade ago. How can this be if the prevailing orthodoxy is that supply chains have become too lean? Let’s investigate, try to explain what is going on, and then offer some suggestions on what should be next for companies and industries.

Property, Plant, and Equipment – the Assets Needed to Make, Move, and Store Product

Let’s first examine PP&E, or as Warren Buffet calls it “business infrastructure.” The chart below is a list of the top 20 public companies globally based on the net value of PP&E on their balance sheets at the end of 2020. (Note: this analysis includes operating leases as part of PP&E). Berkshire Hathaway is indeed number 1 for US companies, but comes in at number six globally, behind four oil and gas companies and a utility. (Note: this looks at all industries; normally we would not include Berkshire Hathaway in a supply chain analysis since they are considered in the insurance industry).

Figure 1 - Global Public Company Leaders in Fixed Assets (PP&E, net of depreciation)

As you can see, the list is dominated by oil and gas, utilities, and telecommunications companies. It’s also interesting to note that there are two retailers on the list: a brick-and-mortar retailer (Walmart) and an internet retailer (Amazon). Amazon is on the list not just because of its warehouses, but because of the data centers it needs to run its own operations as well as those of other companies through Amazon Web Services. Amazon added $50B in PP&E in 2020 and another $50B in the first three quarters of 2021, effectively doubling its fixed asset base in a little over 20 months (through September of 2021, its net PP&E stood at $199.3B).

In other words, Amazon increased its physical asset base in 20 months by the same amount it had accumulated in its first 25 years in business. Furthermore, it had $57B in capital expenditures over the past twelve months, which is 40% of the total capital expenditures of the 180 global retail companies we track. In a year in which the word “unprecedented” has been used too much, this is a stunning pace of investment – of Rockefeller and Carnegie-like scale. Consider that this is roughly six percent of the $1T infrastructure bill just passed by the US Congress, spent by one company in the span of one year. From the time that Warren Buffet penned his 2020 letter to the end of the third quarter of 2021, Amazon passed Berkshire as the US leader in fixed assets. Its growth will likely slow, but it won’t be long before Amazon has the largest physical asset infrastructure of any company in the world.

It might also come as a surprise that some software-intensive companies have large physical asset infrastructures. For example, at the end of 2020 Alphabet (Google) had $97B in PP&E, which is 25% more than General Motors. Likewise, Microsoft and Meta Platforms (Facebook) had $71B and $55B in PP&E, respectively. Both Alphabet and Microsoft grew their physical infrastructures twice as fast as sales in 2020. This is due to the high cost of data centers and the high level of competition in the market for cloud services.

Asset Intensity

The absolute level of physical assets tells only part of the story. We like to look at the “asset intensity” of a business, defined as PP&E (net, including operating leases) divided by revenue. This is an expression of the amount of money a company must invest in physical assets to generate a dollar of revenue and is critical to understanding if we are getting leaner. For example, a lot of Mr. Buffet’s physical assets are tied up in two very asset-intensive industries: railroads and energy. Railroads and energy companies of the type owned by Buffet typically require more than $2 worth of assets for every $1 of revenue (and in many cases much more). Furthermore, they must continue to invest in these physical assets at a rate of 15% or more of revenue every year (this is expressed as capital expenditures).

Figure 2 shows the asset intensity of 19 industries with supply chains for the past twelve years. The chart is based on data from 2,375 global public companies, representing close to $31T in revenue. Asset intensity is calculated by adding up all the net PP&E for all companies in an industry and then dividing by all the revenue for all companies in an industry.

Figure 2 - Industry Fixed Asset Intensity (Aggregate net PP&E / Aggregate Revenue; see footnote 1))

This chart shows clearly that companies have not become “leaner” regarding fixed assets, at least not since 2010. In fact, if you look at trailing twelve month (TTM), 2019 and 2018 numbers (considering 2020 is a pandemic-induced revenue trough year), asset intensity is up in most industries when compared to 2010. These data clearly do not support the often quoted “cost cutting has caused supply chains to become too lean.”

What About Inventory (Materials)?

Global inventory turns are about 5.9 on a trailing twelve-month basis. This means that the world is sitting on about two months of materials in various forms (raw materials, WIP, finished goods) at any given point in time. Is this too lean? Should it be three months?

How have inventory turns evolved over the course of the past ten years? Just as asset intensity has gone up in the past ten years, inventory turns have gone down in most industries. Figure 3 shows aggregate inventory turns for 19 industries with supply chains from 2010 to today. Aggregate inventory turns are calculated by adding up all the cost-of-goods sold for all companies in an industry and dividing by all inventory for all companies in an industry.

Figure 3 - Aggregate Industry Inventory Turns (Aggregate COGS / Aggregate Inventory)

Figure 3 shows that inventory turns have been relatively flat but have gone down marginally in most industries when comparing TTM results and 2019 results with 2010. These data clearly do not support the often quoted “cost cutting has caused supply chains to become too lean.”

What About Labor?

It’s clear there’s a labor shortage across today’s global supply chains, particularly in critical need areas such as trucking. The following table shows the amount of revenue per person in each industry, calculated by adding up all the revenue for all the companies in an industry and then dividing by the sum of all the people working at those companies (again, this chart is based on 2,375 public companies representing $31T in revenue on a trailing twelve-month (TTM) basis.

Figure 4 - Industry-Level Revenue Per Employee (Aggregate Revenue / Aggregate Employees)

This is a measure of productivity, since revenue is a measure of output. However, it does not reveal if headcount was grown by offshoring functions to low-cost countries, thereby lowering the cost per head. In any event, on the surface, it reveals that people productivity is relatively flat across the decade, which is consistent with what economists have been saying. Interestingly, it does show a significant uptick in productivity on a TTM basis, which is also consistent with what economists have been saying.

Nonetheless, these data clearly do not support the often quoted “cost cutting has caused supply chains to become too lean.”