Risk Management in the Supply Chain
In our current global marketplace, it doesnt matter where parts or subassemblies come from. What does matter are the cost implications. A major part of the real cost is the result of uncertainties and assumptions that may or may not prove right. For example, is network access reliable and ubiquitous in the locations from which we source? Will the logistics cost be low?
Even more assumptions are made about costs and uncertainties associated with workforce. Training, personnel turnover, and employee productivity are often not taken into consideration, let alone the intellectual property loss. Most importantly, adding nodes to global networks creates complexity, introducing delays and volatility. All these factors may impact not only cost but also the profit and market share of global companies.
Your organizations management must consider how these uncertainties and assumptions impact business results, and how your organization can ensure against associated risks.
Uncertainty as a Cost Driver
The basis of supply chain cost assumptions is the uncertainty in supply, processes, and demand that drive choices of parameters such as service levels, inventory levels, and lead times. Typically, these assumptions are based on historical data. However, sometimes they are the result of simplistic understanding of the underlying dynamics. For example, they assume unfettered access to logistics capacity, preferably sourced at decreasing prices over time. This assumption is questionable because of demand outpacing supply in Southeast Asia, exactly the region where most manufacturing takes place.1 Other assumptions include availability, independent of price or location. Parts shortages, rising parts prices, and quality problems are indicators that these assumptions are wrong in the current market.2
The misperceptions of supply chain managers are typically grounded in experience. The even bigger issue is when misperceptions are fed by simplistic views of the world or information without nuance or context. This is one of the root causes of the bullwhip effect: the delay, amplification, and distortion of information, material, and finance flows in supply chains. It is all about making decisions based on limited data and under metrics that drive the wrong behavior and the distorted mental models of how the system behaves.3
The role of inventory is one of the most misrepresented factors in the financial world. Assuming a single number is representative of the health of a company, an industry, a country, region, or the world can be very misleading.4 Just like averages for demand, availability, or lead time are poor drivers for supply chain decision making; inventory is not a one-size-fits-all quantity. It acts not only as insurance, but also as an asset that ties capital or acts as credit collateral. Moreover, inventories are typically lagging in time (as a result of the bullwhip effect). This in turn leads to misguided perceptions and decisions, often aggravated by myths. For example, in a downturn, it is harder to predict when, where, or with what volumes demand will occur requiring more not less inventory.
Delays are part of supply chains and they are here to stay. It continues to take three weeks or more to ship parts or products from Southeast Asia to the U.S. market. This is not taking into account the additional lead time needed to satisfy planning horizons. It means that our current view of the world is typically disconnected from our response, which is based on past data points. Even though manufacturing of, for example, a PC or printer requires very little time, the suggestion that this is somehow disconnected from the inbound supply chain is tenuous at best. Capacity utilization metrics for suppliers reduce our ability to respond to an even greater extent than the lead times. Improved communication can help this, but although this has been a mantra in supply chain management for decades, little proof exists that these lessons are well understood or easy to implement. The quarterly earnings focus doesnt make these changes easy, as it would require forfeiting revenue until the surplus of the incorrect goods is removed.5 This potential earnings discontinuity is hardly an incentive for executives focusing on improving earnings quarter after quarter.6 Neither does it create a route to success in the eyes of financial analysts.
Similarly, the increased complexity of supply chains because of outsourcing has increased the number of hand-offs transfer points of ownership and information each creating a risk for delays and information distortion. Even experts assume unimpeded communication in supply chains: In real life, it is unrealistic to expect that managers of each of the supply chain facilities would not be informed of such a huge change in demand patterns, said David Simchi-Levi, professor of engineering systems at MIT.
Reality is different; even with decades of investment in supply chain management, there are still delays, limited flexibility, lack of visibility, mistrust, poor understanding of how the supply chain works, or behavior-distorting metrics. Forecasting is not obsolete in such a just-in-time environment, as parts and subassemblies still need to be sourced over long supply lines with ample delays and opportunities for information distortion. The bottom line is there is no revenue without the parts to assemble a product. Whether a model that shifts the costs to suppliers is sustainable is questionable. What is clear is that the assumption of a buyers market the ability of vendors to dictate supplier terms and conditions is clearly showing cracks as shortages are occurring and prices are rising.
The Role of Global Supply Networks
Global supply chain networks are the result of an increasingly sophisticated division of labor. Companies select their partners based on their core competencies. However, these decisions are based on dated information and driven by assumptions that may have changed. Outsourcing used to be all about cost but there are many other considerations that should have been equally important, said Rob McMillan of PA Consulting. Companies should make their assumptions explicit and continue to test their validity when outsourcing. This can only be done when managers have a deep and accurate understanding of the underlying processes. Moreover, as the number of players increases, the role of procurement becomes a strategic one. An issue organizations must consider is when outsourcing procurement, they may actually remove one of their key levers in controlling their own destiny the person who has the expertise to monitor and manage the outsourced procurement function.7
Risk Management
Just as ignoring uncertainty and delays is risky, planning and forecasting without indicating confidence levels increases the risk of misinformed decision making. For example, changes in forecasted demand closer to a new product launch can be easily misinterpreted as a change in the market potential. However, when we incorporate our level of confidence in the actual demand, it shows that the range of anticipated demand is narrowing. By looking at the individual numbers, we run the risk of assuming trends or major changes that are no reflection of reality. So not only do business managers make assumptions about products, markets, and customers, they also make assumptions about how to interpret the data.
Individual procurement professionals have been testing a new approach to managing uncertainty in supply chains. By carefully analyzing both historical data and forecasted trends, they create an insurance against unpredictable, but probable changes in our inbound supply chain. Rather than looking at a single forecasted number, they create scenarios for probable ranges in demand, parts availability, and parts price.
Hewlett-Packard has been successful differentiating itself with the (patented) tools it has created to support procurement professionals in evaluating scenarios and making decisions on how to mitigate against the supply risk. HP realized over $40 million savings in 2003 over a spend of $700 million and the risk management approach is already close to a $1.5 million spend in financial year 2004.
HP experiences significant sourcing uncertainties. These uncertainties are a result of unpredictability of part availability, part pricing, and customer demand. To be successful in managing this risk, the proper metrics, organizational incentives, and supply chain understanding needs to be in place. Part of the challenge is measuring the impact of uncertainty of business performance. Just like car insurance, risk management requires an investment in anticipation of a return. For example, we can protect ourselves against demand uncertainty by adding flexibility or inventories. Does this cost outweigh the cost of lost sales? Similarly, how much can protection against parts price changes cost in relation to the revenue as a result of uncompetitive pricing or margin to meet market prices?
Measuring the impact of risk management is one thing, aligning the metrics of the people involved with the desired behavior adopting risk management requires additional investment and changes to the culture and division of labor. For example, we may implement a risk management strategy and the scenarios we tried to protect ourselves from never materialize. Just as we may buy car insurance and nothing ever happens. It is critical that the procurement people involved do not get penalized for making that investment. Similarly, acknowledgement of successful risk management activities by individuals is a critical success factor. Companies ability to squeeze costs out of the supply chain may also be a barrier, as managers assume that these savings will continue to materialize and not necessarily perceive the need for investment and increased cost. Finally, Enrons treatment of financial risks has created some unfavorable perceptions about protection against uncertainty. This actually proves the premise of this article, that assumptions that are not made explicit, lack visibility, and lack context and understanding for decision making are a lethal combination.
By exploring scenarios regarding how the uncertainty in customer demand, parts prices, and parts availability can influence your organizations total costs, you can proactively manage the associated risk with your suppliers. The implementation takes advantage of structured contracts measurable, verifiable, and binding commitments to a quantity or price. Examples of structured contracts are fixed or flexible quantities, fixed or flexible price, price-caps and price floors, and fixed commitments with upside flexibility.
Conclusion
Risk management is an opportunity to address the uncertainties that are an inherent part of supply chains. It provides an insurance against unpredictable, but not unlikely events. The challenges in implementing sound supply chain practices also apply to risk management. Managers will need a better understanding of the complex networks they use to provide products and services to their customers. They need to convince their staff to adopt new processes. This change management effort has to happen in the context of record-high task loads, globally dispersed teams, short-term metrics, and limited appreciation of the complexity and inherent delays. The intellectual capital drain of people with a deep and experiential understanding of a companies supply chains will make this effort even harder.8
Implementing risk management requires more then a top-down effort. Employees immersed deeply in the organization need to be supported in nurturing this asset. Otherwise, companies run the risk of not reaping the benefits of this very powerful tool to mitigate the impact of uncertainties and delays that are part of the daily life in supply chains. Companies and academia have to continue collaborating to ensure that the lessons from supply chain management are captured and disseminated in a meaningful way. Ignoring the barriers for implementation will continue to hamper the realization of the potential of supply chain management. Otherwise, the lack of understanding will continue to drive misguided decision making.
Managers need to accept that ongoing change is inherent for global companies and that guiding their principal assets in the knowledge economy, their employees need all the support they can get to adopt new processes. The vision of using risk management requires an ongoing organizational effort to make it a success in our complex and uncertain world.
Endnotes
1 Robert Guy Matthews, A Surge in Ocean-Shipping Rates Could Increase Consumer Prices, The Wall Street Journal, November 4, 2003; Daniel Machalaba, The Wall Street Journal, November 12, 2003.
2 Tech Sector May Suffer, The Wall Street Journal Online, March 14, 2003; Patrick Barta, Price Increases in Asia Fan Inflation Fears in U.S., The Wall Street Journal, April 12, 2004.
3 H. L. Lee et al., The Bullwhip Effect in Supply Chains, Sloan Management Review, Spring 1997, Vol. 38, No. 3, pp. 93-102.
4 Ahead of the Tape, The Wall Street Journal, March 12, 2004; U.S.- Manufacturing Sector Booms in a Low Inflation Environment, BNP Economic Newsletter, December 16, 2003; Moodys Credit Trends, Moodys Investor Service Press Release, January 16, 2004.
5 For example, a major consumer packaged goods company missed revenue from one of their brands for over two quarters as a result of moving to a vendor-managed inventory program.
6 Justin Lahart, Corner Office Thinks Short-Term, The Wall Street Journal, April 14, 2004.
7 Business Process Outsourcings (BPO) Fragmented Future, Forrester Research, September 2003; Industry survey, Gartner Research, May 2003; Increases in Outsourcing Require More of Purchasing Professionals, A Multi-Country Study of Strategic Topics in Purchasing and Supply Chain Management, CAPS Research, 2001.
8 Peter Senge et al., Fifth Discipline Fieldbook, Doubleday, New York, 1994; Amputating Assets: Companies That Slash Jobs Often End Up With More Problems than Profits, U.S. News and World Report, May 4, 1992.
