Friday, June 27, 2008

Balancing Global Risk and Return

Balancing Global Risk and Return

To get the most from your global supply chain, take a strategic view of managing risk. But don’t neglect the tactics. by David Bovet

No matter the risks, global supply chains continue to grow longer and more complex as companies push deeper into uncharted territory in search of lower costs. As a result, the questions surrounding what managers should do about risk have never been more pressing. Do you add tons of inventory, quietly ripening toward obsolescence? Build myriad backup plans, most of which you’ll never draw on? Or rethink the whole thing and retreat from the cost-saving sourcing deals that are driving you into far-flung lands in the first place?

While there are no easy answers—and, in most cases, no “right” answers—there are frameworks for thinking about how to manage risk more effectively and reach the right balance with potential return that will show benefits to supply chain managers, strategic planners, and C-level executives alike.

The key is, first, to examine your basic supply-to-market strategy to ensure you are following the course that best supports your business, and, second, to determine the right tactics to support your strategy. This two-step process may sound simple enough, but to execute it correctly you must have a firm grip on your company’s core strategies, be willing to invest in new forms of internal analysis such as portfolio modeling, and be prepared to make decisions that might fly in the face of organizational precedent.

Strategy first

In order to effectively balance risk and opportunity, product manufacturers, distributors, and retailers need to periodically rethink their strategies for going to market. There are two ways to strategically address the burgeoning nature of risk: (1) shorten the supply chain in order to reduce cycle time and disruption risk or (2) optimize the portfolio of supply chain sources and locations in order to gain flexibility through diversification. Many innovative companies have used the first approach effectively, but it does have its limitations—indeed, it prevents a company from taking full advantage of the economic benefits of extending the supply chain globally.

For firms set on driving their supply chains deeper into new markets, the second strategic approach may offer some as-yet-untapped advantages. The idea of optimizing a company’s portfolio of sources, assembly locations, and distribution points derives from financial portfolio theory and offers a valuable framework for assessing risk/return tradeoffs. The goal here is to create a supply chain strategy that best fits the overarching needs of the firm through a process of modeling that clearly shows decision makers the benefits and risks of different sourcing tactics. Through portfolio modeling, firms can mix and match different tactics in pursuit of the arrangement of sources, locations, and so on that maximizes the supply chain’s ability to support a specific company strategy.

Creating a portfolio starts with developing a set of alternative supply chain designs that support the business in different ways. For example, one design might emphasize speed to market, another might focus on manufacturing quality, a third might home in on cost. In parallel, supply chain risks associated with each design are identified, classified, and quantified. The projected returns and risks can then be modeled and plotted on a spectrum. The optimal solution will lie along the “efficient frontier,” representing the set of options with the highest return for a given level of risk. The key here is to combine supply chain elements whose disruption risks are not directly tied to each other. In other words, you are seeking to minimize the likelihood of a domino effect in which a problem at one stop in the supply chain imperils others. There may be several effective strategies to choose from, offering different combinations of risk and reward.

Through a graphical representation of the portfolio approach, everyone can see the underlying assumptions, which can be changed to explore different scenarios. Managers can update costs, risks, and other data in the model and periodically convene a group of decision makers from other functions to revisit supply chain strategy decisions or test new concepts. This ensures that executives from across the organization understand the alternatives and tradeoffs and commit to successful implementation.

Portfolio modeling offers several advantages. First, it is understood and practiced by CFOs and allows supply chain executives to make the case about risk in terms that senior management understands. Second, it appropriately focuses on the business value that supply chain management can deliver—through satisfied customers, capital efficiency, and low operating costs—for a given level of risk. This framework can also adapt to changes in supply chain strategy in light of shifts, over time, in relative costs and perceived risks.

Then, down to tactics

Once the strategy is in place, many ways exist to reduce risk. Here are practical steps any company can take:

Demand management

1. Improve demand planning with distributors and retailers by being closely connected to customers through shared demand forecasts, vendor-managed inventory, and other joint systems. The goal is to reduce the risk of being blindsided by demand shifts.

Supply management

2. Work with suppliers to create contingency plans. In the wake of 9/11, Continental Teves, a major automotive supplier, activated existing contingency relationships with transport firms such as Emery to supplement air shipments of parts from Europe. After making a same-day assessment of parts flows at risk, Continental Teves was able to rely on prearranged ocean shipping space and increased inventories, thus allowing its customers, including Toyota, to continue operations with little disruption over the following weeks.

3. Diversify sourcing to reduce the risk of catastrophic supply chain failure. Establish backup arrangements by qualifying additional suppliers, without necessarily awarding them significant volume. Geberit, a large Swiss sanitary fixture manufacturer, has adopted a dual sourcing policy. It either retains an existing supplier as a second source, or develops a second source in Asia. Companies can choose to meet 10% to 20% of their needs from a second supplier, which generally will work hard in hopes of displacing the primary supplier. Service-level agreements can call for rapid ramp-up if required.

4. Extend insurance policies to cover overseas suppliers. Contingent business interruption coverage, for example, is typically limited to the U.S. and nearby countries; have it explicitly extended to cover major suppliers located in Asia and other low-cost geographies.

Logistics enhancement

5. To deal with contingencies, employ a major third-party logistics provider with broad resources. One electrical manufacturer recently asked its freight forwarder to provide weekly updates on the best U.S. ports for its inbound product flows from Asia. In essence, the logistics provider becomes a key risk-mitigation agent by continually looking over the horizon on a company’s behalf.

6. Model and optimize inventories on a disaggregated basis, as all components are not created equal. Modeling supply susceptibility to delays leads to finer tuning of safety stocks, which may rise for some parts or finished goods (depending on which point in the supply chain one is looking at) but fall for others. A typical product with a one-week lead time and delivery variability of one day will require 15% more safety stock, for example, if supply variability increases by one day, and 175% more if variability increases by a week.

Supply chain integration

7. Increase product component standardization. The ability to mix and match components from multiple suppliers and plants allows such manufacturers as Dell, IBM, and Herman Miller to make their supply chains more flexible. Reducing product complexity shortens cycle times in normal conditions and speeds response to supply crises as well.

8. Create a centralized product data management system. If the supplier is the only one who knows the actual specifications of products or components, rapid re-sourcing of products can be time-consuming, if not impossible, during an emergency. Centralized product data for immediate consultation or preemptive use helps reduce the risk of disruption. In practice, this means developing a database of product and component designs so that substitute suppliers can be rapidly brought up to speed. Companies that have sole-sourced a key component for years, with-out maintaining control over drawings or other design characteristics, take heed.

9. Raise visibility along the extended supply chain. When inventory is tracked from order placement to reception at a forward distribution center or customer, it can effectively become part of a company’s safety stock. Achieving real time knowledge of the location of parts and products as they flow from distant origins is not easy, to be sure, but trade management software can help track global goods flows and divert shipments when necessary.

10.Monitor specific warning signs of trouble. Tracking a limited number of supply chain risk indicators, such as average train speed, weeks of orders outstanding, component delivery variability, and exchange rate movements, can provide a crucial warning as a problem approaches the tipping point and becomes a dangerous disruption. It is no longer sufficient to track just service levels, lead times, inventories, and logistics costs.

Changing the mindset

By using an appropriate mix of the initiatives outlined here, managers should expect to see real improvements in their supply chain performance.

Of course, incorporating risk considerations into what have historically been highly cost-focused analyses requires a shift in thinking and organizational behavior. To improve the risk/reward equation, compartmentalized decision making must be replaced by cross-functional cooperation.

Participants can come from marketing, sales, sourcing, manufacturing, finance, and risk management. Eliciting full commitment from all these functions might require the CEO’s or COO’s involvement. The long-term trend toward just-in-time delivery combined with strong economic incentives to access the best global supply sources virtually guarantees abundant risks throughout the supply chain. Frictionless commerce remains a utopian vision rather than reality. Where managers can excel, however, is in identifying, quantifying, and preparing for the new realities of risk.

David Bovet is a managing director of Mercer Management Consulting.

This article appeared in the August 2005 issue of Supply Chain Strategy.

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