Managing supply chain risks

Henry Ford, the founder of Ford Motor Company, owned his own timberlands, his own glassworks, his own rail lines and even a rubber plantation in Brazil. Vertical integration brought supply and production functions in-house to ensure a high degree of control.

But only when globalisation began to take root in the 1980s did the supply chain paradigm truly shift, as companies started roaming the world in search of the lowest possible manufacturing costs. At the same time, they began borrowing from the Toyota Motor Corporation text book, embracing just-in-time inventory and other lean manufacturing techniques that emphasised speed and cost reduction.

The consequences of these changes have been dramatic; we now live in a world where the largest shoemaker does not actually make shoes, but only designs and sells them. Where the largest direct seller of personal computers does not so much manufacture its products as assembles them from components sourced elsewhere.

In one industry after another, supply chains have been stretched farther than ever before – just when the lean, just-in-time production schedules have made the consequences of a break more severe.

The effect has been to create new vulnerabilities, especially to catastrophic events. US companies which received supplies via the Mississippi River through the port of New Orleans, for example, might have imagined that contracts with multiple shippers protected them against transport risk. When Hurricane Katrina struck in 2005, nothing moved through New Orleans.

Supply disruptions can reduce a company’s revenue, cut into its market share, inflate costs, and threaten production and distribution. They can damage its credibility with investors and other stakeholders, impairing stock market performance and thereby driving up the cost of capital.

The risks

The risks to supply chains are a mixture of exposures, including:

• Traditional property-related risks, such as fire, natural disasters (some due to climate change), power-grid blackouts and equipment breakdowns

• Thefts, violence and terrorism

• Political and currency risks, such as the collapse of a supplier in the wake of political upheaval

• Fraud, including increased vulnerability from

centrally driven resource planning systems

• Cyber attacks and IT systems failures

• More demanding customers, accustomed to precise specification and rapid delivery

• Shorter product life cycles, due to greater product variety and substitution, as well as an emphasis on continuous innovation and flexibility

• Complex compliance issues, in various jurisdictions

• Breakdowns in communications with suppliers.

Some companies have accepted all this as the new cost of doing business – and paid dearly when it has gone awry. It is not necessary. Whether they manage all production in-house or outsource significant responsibility for the assembly, production or delivery of products, businesses still have tremendous opportunities to reduce their supply chain risks. To do so, they must understand how the risks have changed, identify the priority points where problems could occur and take appropriate measures to prevent them from harming the business.

An effective risk management programme needs to be holistic in nature and draw on the expertise, not just of the company’s risk management team, but of all functional arms of the enterprise, including sales, marketing, purchasing, operations and finance. It operates in three distinct stages:

1. The prevention of potentially disruptive events

2. Control of the small percentage of events that cannot be prevented

3. Measures to mitigate the impact of those that do occur, including insurance.

Preventing disruptive events

The most effective way to manage supply chain risks is to prevent them from happening, and using data and statistical analysis is an important way of doing so. Loss analysis and engineering data, for example, have provided clear guidelines how to prevent fire in manufacturing plants. The challenge today is to extend that effort to a supply chain that may stretch around the globe and include a vast array of independent suppliers, shippers and other vendors, over whom the company has no direct control and which, in every instance, add a new layer of risk to the supply chain.

“We routinely underestimate – or simply ignore – the degree to which disasters can disrupt businesses.

It begins with taking the time to identify key products, revenue drivers, core business processes and locations in the supply chain – from procurement of raw materials to delivery of finished goods – as well as the types of events that could impact them. The next step is to develop strategies to prevent these pinch points from squeezing shut.

Traditionally, businesses sought locations for manufacturing facilities where there was a suitable labour force and reasonable proximity to raw materials and customers. They also looked for sites that were not exposed to flooding or storms, had good access to transportation networks and were located in countries with stable governments and reliable legal systems (still important for construction of new plants abroad).

Today, companies looking to add a new supplier or third party manufacturer can apply the same criteria. Similarly, if they follow strict safety standards in their own facilities, they can choose suppliers that do the same. If the business is important enough, the supplier may even allow the customer to audit its facilities or agree to make safety or security changes to achieve preferred supplier status. Companies that are truly committed to this process sometimes go so far as to look at the suppliers of their suppliers.

Unfortunately, many companies rush to revamp their supply chains without giving much thought to such measures. As they outsource to developing countries, they often unknowingly take on greater exposure to natural disasters, lower safety standards and less predictable legal systems.

The message is not that companies should never outsource to such places, but rather that they need to factor the attendant risks into the decision-making process and weigh them against the potential rewards. Where the risks are deemed unacceptable, they need to find ways to prevent or control them.

Global sourcing can minimise risk

Fortunately, one of the very trends that has increased supply chain risk – globalisation – also provides opportunities to manage that risk. It allows us to site facilities in safer locations, tap into educated overseas workforces and set up production centres closer to sources of raw materials. Globalisation also often increases the choice of business partners.

The trick is to make certain the alternate suppliers really have different risks from their preferred counterparts. If a company needs commodity semiconductor chips for one of its main products and both its preferred and alternate suppliers are located in Taiwan, the same earthquake, or political upheaval could knock both out of commission at the same time.

When companies choose alternate suppliers, they should consider a wide variety of factors to be sure they are really diversifying the risk. For example:

• Do the other suppliers get their electrical power from the same grid as the primary supplier?

• Do they rely on the same transport systems?

• Do they buy their raw materials from the same place?

The fewer affirmative answers, the more reliable the alternate supplier is likely to be.

Controlling disruption

Where risks are deemed small enough to be withstood, or they simply cannot be prevented with certainty, there are measures that companies can, nonetheless, take to control them. For example, they might integrate their order and inventory systems more tightly with suppliers’ systems to guard against communications breakdowns.

A key tool is the supplier contract, which can be used to specify a wide variety of performance and risk management standards. These are particularly effective when paired with appropriate oversight controls.

When catastrophic supply chain disruption occurs, a quick response can help minimise the consequences. To do this, companies need a broad and deep business continuity plan that covers a wide range of contingencies, including sourcing of goods from alternative suppliers or using different transport routes. When companies fall into gaps, it is often because they have looked at risks too narrowly.

Insurance limitations

An ample insurance programme with stable capacity and appropriate conditions is another essential precaution. Traditional property and business interruption wordings and even contingent business interruption extensions are not very suitable for today’s supply chains, but a number of large commercial insurers are currently developing policies intended to match more closely their customers’ exposures.

Insurance, however, should not be in the first line of defence. It can never replace customers who turn impatiently to other suppliers when the company is trying to recover from a major disruption. Nor can it replace the loss of employees, management time, reputation or share price.

Ironically, the biggest hurdle to developing an effective contingency plan is not usually human ingenuity, but lack of imagination. Numerous examples have shown we routinely underestimate – or simply ignore – the degree to which disasters can disrupt businesses and the supply chains on which they depend.

The Kobe earthquake in 1995, for example, closed Japan’s largest port for two months. Among the companies forced to scramble for alternate production and transportation were several of the world’s major auto manufacturers. Toyota alone was unable to produce 20,000 cars on schedule after damage to plants left it short of critical components.

The problem in planning for disasters of such magnitude is that our expectations tend to be coloured by our past experiences – and few have lived through a major fire, much less a major earthquake or hurricane. Similarly, few have much experience managing supply chain risk across oceans and continents.

That said, it would be a mistake to focus only on trying to manage catastrophic supply chain disruptions. Yes, one major disaster can wipe out a company or product line. So, too, can a series of minor disruptions. If companies are consistently a week late meeting customer demand, or their products are missing from retailers’ shelves, the chances of staying in business fall precipitously. Good supply chain management considers customer satisfaction as well as costs.