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By Adam Kelly, Senior Partner, DLA Piper
The global shortage of semiconductor chips continues to wreak havoc on supply chains and manufacturing operations around the world, grounding production at some of the biggest brands and disrupting hundreds of industries.
The auto sector has been particularly hard hit, with automakers vying for the supply of microchips against big tech companies. As vehicles become more technologically advanced, automakers are increasingly reliant on microchips to produce their latest models. Modern cars can contain around 3,000 microchips used in various parts including digital displays, driver assistance systems, processors, brakes, power steering and many more.
Manufacturing microchips involves an elaborate process, taking about three to four months and requiring a biosecure environment that can be disrupted by the slightest presence of contaminants, including human skin cells. The clean rooms in which the microchips are manufactured require air 10,000 times purer than the outside air. Microchips begin life as silicon which is etched into wafers using a complex process before being shipped to manufacturers for use in electronic products around the world. Asia currently produces the majority of the world’s microchips, with the United States having a 12% market share. The US government recently pledged $50 billion to support microchip manufacturing and research in a bid to claim a bigger share of the market.
What caused the shortage?
- When the pandemic hit, automakers halted production and stopped ordering microchips, reducing inventory levels. At the same time, lockdown restrictions caused demand for consumer electronics to surge, so tech makers started stockpiling chips.
- As restrictions began to be lifted, the automotive sector began to recover much earlier than expected, causing a severe shortage of chips on production lines and resulting in fewer chips entering the market due to consumer adoption. technology manufacturers.
- A limited number of microchip suppliers worldwide.
- Extreme weather and recent fires have disrupted major factories in the United States and Japan.
- The use of just-in-time inventory systems designed to increase efficiency and reduce waste by only receiving parts when needed, reducing inventory costs. While it can be an effective system in times of predictable supply, it is not robust to dealing with supply and demand shocks or economic downturns.
What are the short and medium term consequences?
- A spike in the cost of microchips.
- Fewer cars made and older technologies used in new vehicles.
- Inflated prices for used vehicles and longer wait times for new models.
- Shortages of electronic consumer goods (game consoles, computers, televisions, smartphones, etc.) and rising retail prices.
- Further factory closures and layoffs in industries waiting for more microchips.
- Slower development of new technologies such as 5G and the Internet of Things.
The effects of the shortage are expected to continue into 2022, with demand for new vehicles and technology increasing as Covid-19 restrictions are lifted. Microchip makers are currently running “super hot” production lines as they rush to meet the surge in demand.
Contractual measures to mitigate disruptions
Review your terms of purchase to ensure:
- Longer term supply of microchips.
- Ordering procedures meet your operational requirements.
- Appropriate contractual remedies are available in the event of supply disruption/failure.
- The Force Majeure and Material Adverse Change clauses do not compromise performance and adequately address the continuing risks of COVID-19 and its variants. They should also address how termination rights, liability and payments are affected if such relief is invoked.
- Termination rights are suitably constructed for both parties.
- Contractual terms comply with the latest legislation offering significant protection, for example the Corporate Insolvency and Governance Act 2020.
- Most favored customer entitlements are used to provide purchasing advantage during limited supply periods.
- Delivery/performance terms have been properly drafted to ensure timeliness, failures have legal consequences and all possible remedies are explored in the event of a breach.
Downstream supply agreements should be flexible enough to loosen commitments in the event of unforeseen events.
Operational measures to mitigate disruptions
- Prioritize the use of chip in popular models.
- Try advancing the delivery of chips that have already been ordered.
- Engineered solutions – consider using legacy technology/workarounds. Some automakers are replacing digital speedometers with analog versions. Consider removing features that customers rarely use.
- Consider updating inventory control systems and manufacturing resource planning programs for high-risk parts. These programs highlight problem areas by measuring delays and cycle times throughout the production process.
Longer term considerations