Mitigating Supply Chain Risks. J. Michael Kilgore President Chainalytics LLC (770) ;

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1 Mitigating Supply Chain Risks J. Michael Kilgore President Chainalytics LLC (770) ; 89 th Annual International Supply Management Conference, April 2004 Abstract. Is your supply chain at risk of failure? Are your existing supply chain strategies increasing that risk? In 1995, an earthquake hit the port town of Kobe Japan, destroying 100,000 buildings and shutting down Japan s largest port for 26 months. This great disaster forced 1,000s of firms to alter production, distribution, and inventory strategies just to survive. Procter and Gamble and Texas Instruments had to move their headquarters. But the worst part was that four major automotive firms had to halt production of more than 50,000 cars as parts couldn t make it through the destruction. While this type of failure doesn t occur everyday, the supply chain strategies that lead to it do. When a firm takes a traditional, cost minimization approach to supply chain strategy, it often increases its risk of failure or increases its overall cost. While traditional supply chain redesign efforts can minimize the cost of supply chain designs and logistics operations, their focus on leveraging economies of scale often yields results that over-concentrate resources. These solutions remain optimal as long as nothing changes, but they are extremely fragile to exceptions, failure, or changes in cost. And since most traditional approaches fail to consider the hidden costs of this over concentration, these best made designs and plans heighten the risk of service failure, increased cost, and capacity imbalance. So how can a firm avoid these catastrophic events? It must manage risks, not ignore them. To balance highest profit strategies against the flexibility and responsiveness required to deal with real-world change, a firm must balance operating costs with supply chain risk. This analytical risk mitigation enables firms to tie risk management into strategic and tactical analyses, thus reducing overall costs, avoiding service disruption, and better balancing capacity and demand. Firms Are Increasing Their Risk Of Supply Chain Failure. Supply chains fail for many reasons. Labor strikes, natural disaster, machine breakdowns, political instability, and last minute customer changes all contribute to supply chain failure. These failures come at different levels of magnitude as does their impact. There are macro failures like the Kobe earthquake. There are tactical failures like the AZF plant explosion in Toulous, France last year that shut down local transportation for weeks or the recent Nor easter that halted air transportation for days. And finally, operational failures like a carrier break down whose impact is felt at a localized level. But it doesn t matter the level of failure nor does it matter whether it was your fault. When your supply chain fails due to a natural disaster or partner s material delay, your firm will pay dearly. A recent study by Vinod Singhal at Georgia Tech s DuPree College of Business found that supply chain glitches negatively impacted stock prices by nearly 20%. As a matter of fact, supply chain glitches had more of an impact on stock price than any other corporate event including new product introductions, IT investments, plant closings, and even stock splits. And

2 even more alarming, when supply chain failures were caused by suppliers or customers, the shareholder impact was greater than when internal operations caused the failure. While internal glitches reduce shareholder value by 7%, even more substantial, supplier and customer gaffes reduced it by 8% and 11% respectively. While a firm can t always anticipate internal failure or supplier glitches, it often increases its exposure to these failures by choosing a cost minimization strategy that drives it to overconcentrate operations in too few suppliers, facilities, or routes. This over concentration causes the firm to be disproportionately impacted by these unexpected events making it vulnerable to future cost increases and stressing its ability to serve customers effectively. The result? Increased exposure to operational and financial supply chain risks. Each day firms deal with financial uncertainty driven by exogenous factors, including currency, interest rates, and commodity futures. While firms don t control these rate changes, many firms increase their impact by putting too many eggs in one basket. As a firm puts a higher proportion of its assets into one supply chain element, any major change to a financial metric will more greatly impact overall cost. For example, a company might reconfigure its network by centralizing inventory -- a strategy that reduces inventory carrying costs but increases outbound transportation costs. And while this strategy might reduce overall costs, a dramatic swing to cost drivers like interest rates or fuel prices would mean that total costs actually increased more with the new configuration than if the firm had left the network alone. In fact, in the last 24 months alone, interest rates have dropped 63%, while fuel prices have increased 48% in the last 12 months. Without factoring the risk or rate of these changes, any network strategy could actually cost a company millions (Figure 1). Figure 1: Supply Chain Risk Alters Optimal Strategies When Strategy Was Selected... Centralized Decentralized However with current costs. Centralized Decentralized Costs Outbound Transportation Inventory Carrying Luckily, firms have mechanisms like insurance and financial hedging that can protect them against higher interest or commodity prices. While insurance may reimburse you for buildings

3 and inventory if your plant burns down, it won t pay your customers if your supplier s does. As a result, your firm must also consider the implications of financial risk on supply chain network costs. Unlike financial risks such as a rate hike in which every firm experiences the same impact simultaneously operational risks are specific to an organization and shaped by the relationships and decisions the company has made regarding its operations. Operational risks like port closures are what keep supply chain managers up at night. The chance that materials don t arrive in time threatens to disrupt service or increase cost on a daily basis. And the problem is that most companies don t do much to prevent these risks from occurring. These operational failures brought on by security, government, partner ability, quality issues, and acts of nature are more likely to occur when a tactical failure or even a major catastrophe affects a highly concentrated network. When a firm constructs its supply chain around too few lanes, regions, or transport modes, this concentration of flow heightens the risk of operational failure. The 11-day strike-induced shutdown of 29 West Coast ports last fall had immediate and long-term impacts on importers and exporters. From grapes to routers, US firms lost over $10 billion in spoiled product, delayed production, and lost sales when 500,000 cargo containers piled up on their way to global customers. And it s not just labor strikes. Regional wage hikes, regulatory shifts, political strife, or weather can impact customer delivery, production, and overall logistics costs. For example, the 1997 UPS labor strike not only stopped firms from delivering product to customers, it also hiked logistic costs as some firms opted to pay excessive transportation costs to meet delivery windows. And it s not just service disruption. Concentrating fixed, variable, or inventory-based capacity in too few facilities will make a firm less able to respond quickly to swings in demand. Just recently, firms with a high fixed capacity and little inventory found it difficult to ramp down quickly as a recession and the War in Iraq sent demand free falling. Likewise, firms that embrace JIT practices often can t respond quickly to events that impact capacity. In 2001 as a result of the 9-11 border shutdown, Ford Motor had to close its auto plants for 7 days when its lean manufacturing strategy of high fixed capacity and low inventory backfired and it couldn t get parts across the Canadian border. And in 2002, the largest meat recall from Pilgrim s Pride retracted 27 million pounds of meat and shut down its Franconia, PA plant for over a month negatively affecting sales by $30 million and operating costs by $5-10 million in one quarter alone. While the economies of scale produced tremendous cost advantages, this concentration in a single location led to dramatic consequences. Mitigating Supply Chain Risks. Firms can t predict what interest or currency rates will be next year, but one thing is certain: these rates will change. This certainly around financial uncertainty allows firms to develop strategies for fending off potential increases in interest rates through strategies like hedging and bets. These strategies for managing financial risk enable firms to manage tactical issues that directly impact corporate profits. While many firms successfully deploy strategies for minimizing financial risk, they fail to develop strategies for operational ones. In fact, most firms take a passive approach to operational risk management today. When a firm is indifferent to this risk, it focuses on minimizing cost without regard to the risk this strategy creates. In this extreme, a firm might ship 100% of its freight on a single carrier because it s the cheapest alternative, and therefore

4 fail to have contingencies if that carrier stops service. Even more common, many firms subjectively factor risk by applying qualitative or intuitive constraints to a supply chain problem. In this case a manufacturer might assume that making a product in only one plant exposes the firm to service and capacity risks, but it can t quantify the relationship between cost and risk and therefore determine the best number of production facilities. So how can a firm avoid these catastrophic events? It must manage risks, not ignore them. Without an analytical approach to managing the risk these approaches create, supply chain managers will continue to make decisions based purely on cost minimization or with only a subjective assessment of risk. And the reality is that these subjective, simplistic approaches of cost or risk minimization don t work for most situations. To manage supply chain risks effectively, firms can t treat optimization as a single mathematical exercise that chooses the right answer to reduce cost or risk. To balance highest profit strategies against the flexibility and responsiveness required to deal with real-world change or failure, a firm must balance operating costs with supply chain risk. This higher level of sophistication in managing supply chain risk analytical risk mitigation -- is a rigorous methodology that quantifies the relationship between cost and change to underlying factors like the network, suppliers, or demand. This approach enables a firm to find the balance between a static, assume nothing changes strategy, and a catastrophic assume everything changes strategy. The firm can then define a set of scenarios that ultimately best balance cost minimization with overall risk. Through this scenario analysis, a firm picks the most realistic strategy that factors cost, profit, and risk, and thus better projects true future costs and profits ( Figure 2). Figure 2: Analytical Risk Mitigation Determines The Optimal Strategy Supply Chain Cost w/o Risk Risk Adjustment Cost $110 $130 $ A B C Alternatve Strategies Risk Adjustment = S Event Probability x Cost Impact Applying Analytical Risk Mitigation. By deploying analytical risk mitigation, firms can diversify their risk with a nominal cost increase and deploy a strategy that will yield the lowest long-term cost. And by building risk analysis into supply chain decision-making, firms can

5 outline the risk potential in advance of failure. To create supply chain strategies that weigh supply chain risk against the cost of mitigating the risk, firms should employ this step by step analytical risk mitigation framework: 1) Identify centralized risk elements. Firms must first identify where a large proportion of operating activities are tied up in a single location, organization, or flow. To do this, firms should create a holistic map that includes all supply chain nodes from source to customer. To capture the true service, cost, and capacity risk associated with each node, a firm must audit network and inventory strategies for areas where location, organization, or flow centralization might increase risk like where it has unionized labor contracts or single sources. Once each node s risk is outlined, the firm should evaluate groups of nodes for additional risk. For example, a firm may have diversified across three West Coast ports which protects it in case of a natural disaster but provides no additional protection against unionized labor strife. 2) Filter out high-contingency risks. Concentration in itself doesn t imply risk. Risk is created when a firm has a highly concentrated location, organization, or flow and no strong contingency should the risk materialize. So once a firm has identified risk elements, it can eliminate those risks that have a wide variety of contingencies or where the contingency is of little or no additional cost. For example, if a firm currently runs 80% of its freight with carrier that goes out of business, the firm will have to scramble to choose alternative services but won t have to shut down operations. Why? Because it has another 1,000 truckload firms that can serve its needs quickly. 3) Estimate the probability of each risk materializing. After a firm has filtered out low impact risks, it must determine the probability that each risk will occur over a given period. Economic forecasters and industry watchdogs can be good sources for macro economic plans, interest or labor rates, and union negotiation issues. Firms should at least estimate a risk s probability when no quantitative data exists. For example, organizational risk will increase and profits will take a hit -- if a firm s largest customer, supplier, or partner goes bankrupt. When Kmart filed Chapter 11, Fleming Foods was forced to reduce shareholder forecast by $.40 per share in anticipation of a sales decrease of $900 million and inventory re-routing of $200 million. 4) Assess the impact associated with each risk. Once a firm knows the risk probability, it has to define the associated impacts. So, if a firm concentrates its production at one plant, the cost of a natural disaster would be huge. With no contingency, they would have to shut down their entire operation. But for an item produced at multiple facilities, the risk would be equal to an incremental contingency -- the cost of overtime labor to shift production to other plants. While cost and profit hits are direct effects of poor performance, shareholder value is also affected. A recent Georgia Tech study by Vinod Singhal on the cost of failure found that supply chain glitches reduce shareholder value by nearly 20%. And while internal glitches reduce shareholder value by 7%, even more substantial, supplier and customer gaffes reduced it by 8% and 11% respectively. 5) Evaluate the cost of spreading the risk. While reducing risk improves performance, not every risk should be mitigated. In some cases, the cost of spreading the risk can be greater than the impact itself. So for capital-intensive production like autos, making vehicles at 2 plants vs. 1 isn t a viable option: spreading the risk across multiple facilities is more costly than a shutdown at one. By modeling risk into an analysis, a firm can determine the incremental total

6 cost of adding locations, inventory and capacity, or partners that will reduce risk. Often the incremental cost of reducing these risk points is low for a range of scenarios, resulting in a low cost strategy that reduces the risk of service disruption and future cost spikes. Conclusion. If your firm is still reeling from the series of events that has happened in the last 24 months the aftermath of 9-11, West Coast port shutdown, economic recession, and fuel price hikes now may be the time to develop a risk-adjusted supply chain strategy. To do so, your firm should apply tools and an analytical risk mitigation approach that combines risk management and cost minimization into one continuous process. This approach if combined with strong analytical tools, skilled resources, and a robust methodology will allow firms to develop optimal, risk-adjusted strategies. And with advances in analytical techniques and computing power, strategic tools will soon allow firms to solve for risk potential and cost constraints simultaneously, making truly optimal decisions that withstand the unexpected. REFERENCES Singhal, Vinod, Putting a Price on Supply Chain Problems: Study Links Supply Chain Glitches with Falling Stock Prices, Georgia Tech Research News, December 12, Van Hoose, David, Pilgram s Pride Corporation Reports First Quarter Results for Fiscal 2003, Janaury 14, Reitman, Valerie, Toyota Motor Shows Its Mettle After Fire Destroys Parts Plant, Wall Street Journal, May8, 1997, Page A-1.

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