Supply Chain and Inflation: Issues and Impacts

Increased Costs of Production

Higher raw material and other production costs can arise from strained global supply chains. For example, the US Producer Price Index, which measures the change in the selling prices received by domestic producers for their output, rose by 11.1% for the 12 months ended in May 2022; supply chain disruptions created shortages, which drove up prices, which then created more disruption. Inflation, in turn, complicates procurement as buyers must turn elsewhere to find the materials they need at a price they can afford. The increased costs often get passed on to the final customer, subduing demand.

Reduced Purchasing Power

Unchecked inflation arising from supply chain problems can erode consumers’ and businesses’ purchasing power. The US Consumer Price Index, excluding volatile food and energy costs, rose 0.2% for urban consumers in June 2023, but it had risen 3% in the prior 12 months, driven by supply chain troubles in cars, auto parts, and home furnishings—in addition to gas and oil price spikes—according to the Bureau of Labor Statistics. By comparison, during 2022, year-over-year CPI increases ranged from 7% to 9%. Growth in the US, Japan, and euro area countries is forecast to slow to 0.7% in 2023, from 2.6% in 2022, according to the World Bank.

Increased Transportation Costs

Transportation costs are also inflationary for supply chains, as seen at the pandemic’s peak when surging online orders outpaced the ability of shipping containers to deliver them, leading to global port congestion and raising shipping costs. By autumn 2022, the shipping price of a sea container on the benchmark route from Shanghai, China, to Los Angeles, California, had fallen to about a third of its 2021 level, and diesel fuel prices were lower, reflecting reduced port congestion. Freight costs have fallen as the US Federal Reserve’s biggest interest-rate increases since the 1980s have tamped down consumer demand.

Reduced Availability of Resources

Hiccups in production or transportation of resources can fuel inflation. For example, China’s pandemic-related factory shutdowns crimped production and shipments for global markets, and in 2022, war in Ukraine interrupted commodities shipments, triggering inflation in grain prices. Shortages of some goods spill over to cause a dearth of others. For example, a 2020 computer chip shortage led automakers to cut production, pushing up car prices. Sectors of the economy that depend on chips saw price inflation on their finished goods as decades’ worth of investments in just-in-time delivery systems unraveled.

Increased Prices Passed to Consumers

Effective competition can lower prices, and competitive markets tend to have lower, more stable prices. But when companies in competitive markets pass on price increases to customers, that can boost inflation. There are ways for producers to avoid blanket price increases during periods of supply chain stress—for example, by adding surcharges for rush orders or small lot sizes, only charging for scenarios that significantly strain their operations.

1. Increased demand for goods and services

Increased demand contributes to supply shortages if supply chains can’t produce or transport goods and services fast enough to meet it. For instance, pandemic demand for goods including computers, bikes, kitchen appliances, furniture, and other home improvements taxed global supply chains, which weren’t prepared for the influx of orders. Going forward, businesses are steeling themselves against future demand spikes and supply chain disruptions with better inventory management.

2. Labor shortages

Pandemic shutdowns led to shortfalls of workers in sectors including manufacturing, ground shipping, air travel, and grocery retail, contributing to supply shortages. But even as pandemic restrictions eased, labor shortages remained. In the United States, 4 million people quit their jobs in May 2023, 9.8 million new job openings were posted, and the unemployment rate remained near its all-time low. Ongoing labor shortages in manufacturing, transportation, logistics, construction, and engineering have curtailed production and delivery of industrial and consumer goods, creating scarcity and driving up prices.

3. Global supply chain disruptions

Supply chain snafus can contribute to shortages by upending longstanding just-in-time manufacturing strategies, which relied on manufacturers getting key components just as they were needed for assembly. When shortages of some goods hold up production, the effect can ripple through supply chains. Prominent examples include the logistics and shipping upheavals that ignited the 2020 chip shortage and subsequent lack of vehicle supply. Around the same time, housewares and hardware retailers waited weeks or months to get finished goods onto ships, presenting a shortage to consumers.

4. Tariffs and other trade barriers

Since many companies source materials globally, tariffs intended to protect a country’s domestic industry can lead to higher input costs for producers there. On the other hand, trade liberalization tends to boost supply by increasing competition and widening the variety of production inputs available to manufacturers. A 3.4% increase in tariffs on inputs decreases productivity by an estimated 0.4%, according to a 2020 study published in the Journal of Policy Modeling.

5. Currency fluctuations

A strong US dollar that spurs inflation in the developing world can raise prices for crucial inputs into manufactured goods—most prominently the prices of gas, oil, and other energy that producers rely on to forge and deliver their products. A historic example is the Asian financial crisis of the late 1990s, in which a sell-off in currencies led to construction delays and plummeting industrial demand for energy.

6. Natural disasters or extreme weather events

Disasters such as hurricanes, droughts, and wildfires can halt production and transportation, contributing to supply shortages. One of the most well-known examples is the 2011 earthquake and tsunami in Fukushima, Japan, which knocked semiconductor wafer and auto plants offline. In another instance, a 2010 volcanic eruption in Iceland grounded airplanes, causing companies to switch to ground or ocean shipping and cutting off flows of goods in Europe. The global food supply chain is especially susceptible to issues stemming from rising sea levels and extreme weather, according to the World Trade Organization, so as these phenomena continue, they could lead to food supply shortages.

7. Political instability or conflicts in certain regions

Abrupt regime changes or armed conflicts disrupt countries’ ability to both make and export products. For example, the Russian invasion of Ukraine in 2022 upended supplies of key goods, such as Russian natural gas used in European industry. Ukrainian grain exports also initially fell, though later recovered. Insurers also cite risks to factories and cargo shipping from nations experiencing political unrest. For example, in South Africa in 2021 after the imprisonment of its former president, rioters damaged warehouses and factories and set fire to trucks carrying goods, causing major food shortages.

8. Lack of access to raw materials

As mentioned in previous examples, reduced access to materials including metals, petrochemicals, lumber, and computer chips can hamper production of finished goods, including homes and cars. This can drive up costs: Overall construction costs, including costs for raw materials such as wood, reinforcement steel, and concrete, rose 13.5% in the year leading up to April 2022, nearly double the pace of calendar year 2021, according to analytics and risk assessment firm Verisk.

9. Inadequate infrastructure or transportation networks

Infrastructure and transportation problems can lead to widespread shortages of goods as logistics operators struggle to move, for example, finished goods from a manufacturing facility to a warehouse. Such issues arose at the pandemic’s onset: Asian ports had too few shipping containers to accommodate demand, while in the US containers piled up as ports were short of workers to unload them. Bottlenecks in these inadequate networks can drive up prices, as they did mid-pandemic. Prices have since subsided. As of mid-2023, the price of moving goods to the US West Coast from Asia fell sharply from the year-earlier period, reaching pre-pandemic levels.

Stress Test Your Supply Chains

Companies can use planning software to model scenarios in which supply chains are placed under stress, to test their resilience. For instance, they might model the effects of a sudden surge in demand or a natural disaster that cuts off the flow of goods from an overseas supplier. They can build the results into risk assessments of suppliers and make plans to capture production data from direct suppliers and those who supply them in order to gain business insights. Cloud-based supply chain command centers can help companies assess which materials are most crucial to their production and plan for inflationary events accordingly.

Conduct a Risk Assessment of Crucial Suppliers

Previously, low cost was paramount in supply chain management, and contingency planning for disruptions, including disease outbreaks and natural disasters, was given short shrift. Now, businesses need to conduct risk assessments of their key suppliers that take financial stability, quality, and logistics into account. Companies also increasingly face pressure from consumers and regulators to show their products are made with materials or fibers that don’t come from forced labor or other oppressive arrangements, and risk assessments can also look at suppliers’ vulnerability to bankruptcy or cyberattacks. If suppliers are constrained or become insolvent for any of these reasons, that cuts off supply chain inputs, hampers production, and creates an inflationary situation.

Create a Backup Plan

Companies are increasingly adopting a strategy known as “China plus one,” which involves adding a manufacturing site in India or Southeast Asia to Chinese manufacturing operations to mitigate high transportation costs that come with inflation while heading off potential supply shortages. For example, Apple made more than $7 billion worth of iPhones in India during its 2022 fiscal year, and Google has moved some of its Pixel phone production to Vietnam. Microsoft has manufactured some Xbox consoles, which used to be made exclusively in China, in Vietnam.

Businesses are also adopting “local for local” strategies, conducting operations and working with partners in regions nearer to customers. For example, Intel is building chip plants in the US, Germany, and Poland. And General Motors has announced plans to invest more than $7 billion in four Michigan plants, in part to ensure strategic battery production for electric trucks in the US.

Be Flexible

The market’s desire for more flexible supply chains reaches back to pandemic-era shutdowns of Chinese factories and ports, which triggered a need for global backups. In finding alternative suppliers, leaders should remember that basic materials such as lumber, fabrics, and plastic are easier to source beyond China than complex machinery, electronics, or precision casting. Businesses might also consider flexibility in inventory management and manufacturing, moving away from a just-in-time approach that involves buying materials and goods as needed and keeping as little as possible in stock. These systems were built for cost, not risk, and weren’t designed for the supply chain stresses that inflation brings. They’re yielding to a just-in-case approach as companies keep more stock on hand.