Industry Supply Chains and the Global Economy
Updated: Jul 1, 2022
Leaders "escape" the gravitational pull of their respective industries.
In physics, “escape velocity” is the velocity at which an object “escapes” the gravitational pull of another object. The escape velocity of the earth is calculated to be 6.951 miles per second (or approximately 25,020 miles per hour). An object that travels at that velocity will no longer feel the gravitational pull of the earth (the actual escape velocity is dependent on the distance from the surface of the earth; the farther away the object, the lower the escape velocity). For reference, the recent Blue Origin Shephard 4 spacecraft achieved a velocity of 2,284 miles per hour and the Virgin Galactic spacecraft achieved a velocity of approximately 2300 miles per hour.
In business, “escape velocity” has become a term for “escaping” from the inertia of old ways of doing things in order maintain a positive trajectory or grow faster. Older products and processes must be continually renewed, and new products and processes created to maintain or improve competitiveness. In recent years, the term “transformation” has come to mean the same thing. More recently, companies are urged to undergo a specific type of transformation called “digital transformation.” Much of the headline language for transformation implies it is an event; a company “transforms” from one state to another or “escapes” from old ways of doing business to new ones. However, this is not true; companies must be in a continuous state of transformation because the minute they escape from the gravitational pull of one way of doing business, they create a new gravitational pull for a new way of doing business.
The purpose of this preamble is to consider that industries create a certain gravitational pull that is created by physics – the types of products they make, the machinery and labor required, and the way products are delivered to and consumed by customers. This is borne out by our research, which offers interesting insights into the operational characteristics of industries and their respective and unique gravitational pulls.
Industry Gravitational Pull and Setpoints
The gravitational pull of an industry is a sort of setpoint, based on the physical nature of its products, its inputs (supplier), and its customer base; in other words, its ecosystem. This gravitational pull manifests itself in a certain operational model that includes gross margin, operating margin, return on invested capital, and cash flow. At an aggregate industry level, research shows that these metrics change very little over time. We call these numbers operating model setpoints. Even structural changes, such as offshoring, do not change the overall setpoints of an industry. They simply shift structure and costs from one place to another.
That said, a significant number of companies in every industry achieve “escape velocity;” they operate consistently above the gravitational pull of industry setpoints for things like operating margin, ROIC, and cash flow. They do this by focusing on providing superior products and delivering superior service from their supply chains. Digital transformation thus far has separated winners from losers but has yet to move the dial on industry setpoints. There is a thesis that says that we are in the early innings of digital transformation and that the next phase could lift the operating characteristics of all boats, manifesting itself in uplifted aggregate industry numbers and productivity that drives wage increases.
This research is ongoing and is based on a data set of more than 2300 public companies across 19 industries with supply chains, including materials, goods-producing, transportation, distribution, and retail. This data set is good proxy for global supply chains and for the global economy. Aggregate information within each industry and across all industries offers interesting insights into the operational state of global supply chains, and their progression over the past decade. The data set includes operational data on a trailing twelve-month basis and for the past 11 years dating back to 2010. It also includes market capitalization information, which is important for ongoing research into the linkage between superior supply chain management and market performance, as determined by investors. An earlier summary of this research was published in Supply Chain Quarterly in February, 2021 (What type of supply chain drives market cap leadership?). A summary report is also available for download at this link.
I’ve taken the data and created a flow picture that approximates a supply chain view. The below diagram provides this view, along with the number of companies in each industry and their aggregate revenue. In total, the data set represents 2,347 companies with aggregate annual revenue of $27.8 Trillion on a trailing twelve-month basis (as of June 25, 2021). The data set will evolve through time as companies are added and deleted (deletions are done as companies merge or go private, or if data otherwise becomes unavailable).
Figure 1 – Industry Data Set Expressed as a Supply Chain
The same chart format is used to provide a summary of four key variables that are important to companies and supply chains: gross margin, inventory turns, operating income, and return on invested capital (ROIC). The chart below shows this information for each industry on a trailing twelve months (TTM) basis as of June 25, 2021.
Figure 2 – Trailing Twelve Months (TTM) Industry Aggregate Averages for Gross Margin, Operating Margin, Inventory Turns, and ROIC
When looking at TTM results, some industry numbers reflect dislocations caused by the pandemic. For example, the transportation industry shows zero percent operating margin and a negative return on invested capital (at an aggregate industry level). This is largely because airlines are included in the transportation industry; all airlines ran significant negative operating margins for most of 2020 and the first quarter of 2021.
The following chart gives a better view of the value of these key metrics for a representative year. This chart gives the aggregate average for gross margin, operating margin, inventory turns, and ROIC across the years 2010 – 2021 (TTM). This smooths some of the effects of the pandemic and gives a more accurate view of the operating characteristics of each industry. These values are essentially the “gravitational pull” setpoints for each industry. For example, the automotive industry operates, on average, with gross margin of 17.8%, operating margin of 5.2%, inventory turns of 7.2, and ROIC of 5.8%. These metrics do not change much when looked at on the basis of a five- or ten-year moving average.
Figure 3– 2010-2020 Industry Aggregate Averages for Gross Margin, Operating Margin, Inventory Turns, and ROIC
Industry Setpoint – Gross Margin as an Example
Gross margin is revenue minus cost of goods sold (it can also be expressed as a percentage of revenue). An industry aggregate view of gross margin is attained by aggregating all revenues for all companies in the industry and subtracting the aggregate of all costs of goods sold for all companies in the industry (expressed as a percentage by dividing by aggregate revenue).
At an industry level, gross margin shows, in general, the following: 1) how much purchasing an industry does; 2) how much processing or value it adds to those purchases; and 3) how much pricing power it has in selling its products. For example, the automotive industry is a low gross margin industry. This means that it purchases a lot of materials; adds a lot of value to those purchases in terms of manufacturing and assembly; and does not have significant pricing power due to competition (its pricing power has improved more recently due pandemic-related supply shortages).
Figure 4 – Aggregate Industry Gross Margin (Aggregate Revenue minus Aggregate COGS divided by Aggregate Revenue); TTM = trailing twelve months as of June 25, 2021.
This chart shows that, in general, gross margin at the industry level changes very little over time (at least for the past ten plus years; there will be some anomalies for TTM and 2020 numbers because of the effects of the pandemic; for example, transportation, which includes airlines saw a significant decline in gross margin in 2020 and on a TTM basis). It is essentially a characteristic of the industry, its physical structure, and competition.
That said, there is a wide range of gross margins across the companies within an industry, as companies pursue different strategies with different products. Some companies make low gross margin commodity products while others make high gross margin premium products. Nevertheless, companies generally want to achieve escape velocity to move beyond their industry setpoints. For companies that are already there, this may mean continued innovation to protect their position. For companies operating below industry setpoints, they may want to figure out how to move beyond commodity products towards products with greater pricing power. In all cases, companies want to learn how to turn their supply chains into strategic weapons that enhance their products and improve their pricing power. Supply chains that are operated strictly from a cost perspective will never escape the gravitational pull of their industry setpoints.
Some Insights – Examining Physical Assets, Materials, and Labor
At an aggregate industry level, it requires the same amount of physical assets (property, plant, and equipment), materials (inventory), and labor today to generate revenue as it did a decade ago. This fact seems difficult to believe considering the amount of investment companies have made in digital transformation. This is examined in the discussion that follows.
Is Software Replacing Physical Assets?
The 2010 Marc Andreesen thesis that software is eating the world was based on his observations; he shows several examples (retail, music, payments, supply chain, travel) to prove it. Today, it is largely taken as gospel. Previously I used US Bureau of Economic data to show that this was in fact happening (Is Software Really Eating the World?).
Nonetheless, the data from this large data set indicate that companies are not reducing their physical assets as a percentage of revenue; in fact, in the aggregate companies have increased their physical assets over the course of the past ten years, as shown in the chart below. How can software be eating the world if companies are still increasing their physical assets as a percentage of revenue?
Figure 5 - Aggregate Industry Physical Assets (PP&E and Inventory) as a Percentage of Aggregate Industry Revenue; TTM = trailing twelve months as of June 25, 2021.
The fact is that software is not yet eating the world. The real fact is that – at least thus far – physical assets are continuing to grow, but software is growing much faster, making it appear that software is eating physical assets. Software is an increasing slice of the overall asset pie, but the pie itself is also growing. Companies today require just as many – or more – physical assets to generate a dollar of revenue as they did ten years ago.
A more nuanced – and probably accurate – view of this is that software has prevented significant growth in physical assets. In other words, if companies had to invest in physical assets – instead of software – to provide the consumer experience of today (versus ten years ago), then physical assets would have grown dramatically. In fact, this would have been impossible – not just from an ability to invest perspective, but from a physical perspective. Investment in physical assets alone could never deliver the customer experience of today versus that of ten years ago.
Consider ordering any product and having it delivered to your doorstep the following day. This is conceivably possible without software (you could call the company, have someone locate the product, and then have them take the product to a FedEx location for overnight delivery. Think about how much such an operation would cost and how it could never scale to more than a small number of orders. Now consider how software has made this process cost effective, scalable, and ubiquitous. Software has essentially “eaten” all of those physical things that would have been necessary to provide such a service. Even more so, it has made possible this service and many more like it –because providing such a service by physical means is impossible at scale. And software will continue to creep into such processes to make them more efficient, leading to a wave of productivity improvements that have not yet manifested themselves in aggregate industry numbers (or in the measures used by economists).
This has important considerations for sustainability. Physical assets are created through material consumption (metals, chemicals, sand, water, electricity). Companies will want to find a way to lower consumption of these materials per dollar of revenue, and this should ultimately show up on balance sheets as lower physical assets relative to revenue. Now, it is possible that the physical assets on balance sheets (PP&E and inventories), which are denominated in dollars, are shrinking in their material content. There is now way to prove or disprove this. Vaclav Smil, in his book “Making the Modern Word, Materials and Dematerialization” shows that while absolute material consumption continues to rise, it is shrinking as a percentage of GDP in mature economies. (Among the many interesting data points in the book is the fact that in the year 2000 Americans consumed 12 tons per capita of materials (not including food) just for infrastructure (roads, buildings, energy).
Is Software Replacing Physical Labor?
What about the amount of labor needed to generate revenue? It seems that as companies become more efficient, the amount of labor necessary to generate a dollar of revenue should decline over time. For the past decade, this too turns out not to be true. As the below figure shows, the number of people necessary to generate a dollar of revenue has stayed roughly the same in all industries. This is expressed as the aggregate of revenue for all companies in an industry divided by the aggregate for all employees of those companies. Note: there is some fluctuation in these numbers likely caused by a lack of precision in reporting and capturing employee numbers for all companies.
Figure 6 – Revenue Per Employee ($1000) by Industry; TTM = trailing twelve months as of June 25, 2021
It is clear that thus far digital transformation is not a tide that is raising all boats in an industry; rather it is determining winners and losers. Furthermore, its focus appears not to be on cost; rather its focus is on better serving customers and creating new customer experiences. Supply chains that are aligned to this mission are winning against those that have focused largely on cost.
This further indicates that we are likely in the early innings of digital transformation. These early innings are about serving the customer; those companies that do this best have achieved escape velocity from their respective industry’s gravitational pull. Those companies that have not done this have fallen further behind. Leading companies will next turn their attention to deriving efficiencies from the investments they have made to better serve the customer. At the same time, laggards will either adjust or go out of business. Therefore, the next innings of digital transformation will represent a tide that will start to raise all boats. This is also a necessary phase for the sustainability of our planet. It could be years before this phenomenon shows up in aggregate industry numbers. Nonetheless, if this turns out to be true, we are indeed in for quite a ride.
Notes Regarding the Pandemic and IFRS 16
Note that 2020 is an outlier year, as the pandemic caused significant revenue recession in a number of industries. 2010 may also be an outlier year, as the effects of the great recession were still being felt. However, comparing 2018 numbers with 2011 numbers reveals the same conclusion – companies require the same or more physical assets today to produce revenue than they did a decade ago. And this conclusion is consistent across industries – in 2018, thirteen of the nineteen industries studied required the same or more physical assets to generate revenue than in 2011.
Accounting Rule IFRS 16
It should also be noted that companies started adopting IFRS 16 in 2019 and beyond. IFRS 16 is a new accounting standard that requires companies to include on their balance sheets leases for property and equipment. For many companies, these leases may previously have been off their balance sheets. In 2019 and beyond, these leases will typically show up on balance sheets as “right-of-use” assets. To properly understand a company’s efficiency in using assets, this analysis includes the value of these assets in PP&E (starting in 2019). Certain industries, such as consumer goods and restaurants saw a significant increase in their aggregate PP&E because of this accounting rule change. This is largely due to significant increases at a handful of companies.