Best practices in risk management
It's the domino theory: Supply risks can topple not only product-delivery schedules but also revenue, market position, brand image and stock value. Here's how some leading companies keep the dominoes from falling.
By Paul E. Teague -- Purchasing, 7/14/2007 2:00:00 AM
Mining giant CVRD Inco buys tons of slag cement every year. The company's suppliers get the ground, granulated blast-furnace material from the steel industry, and CVRD Inco uses it as backfill for supporting mineshafts.
Shoring those mineshafts is a critical safety activity and the slag cement is perfect for the job. It's also relatively inexpensive—on average about 10-15% cheaper than Portland cement.
But what would happen to Brazil-based CVRD Inco's budget if the company's suppliers couldn't get that slag cement and were forced to supply the Portland variety? What risk would there be to CVRD Inco's financial operations?
"None," says Wayne Smith, manager of global procurement logistics for the company's Canadian and UK operations.
In return for long-term contract commitments, the suppliers will provide Portland cement at no additional cost when slag is unavailable. "They know the benefits of a long-term relationship outweigh the short-term loss of any Portland substitutions," says Smith.
And there you have a simple, common-sense strategy for avoiding supply chain disruption: eliminating risk by leveraging relationships with existing suppliers.
If only supply chain risk management was always so simple.
Maintaining continuity of supply by mitigating risk has always been a critical part of supply chain management. Now, a recent study by SAP and BrainNet based on interviews with 62 chief procurement officers (CPOs) concludes that risk management is growing in importance. With companies sourcing off-shore from low-cost and sometimes unstable countries, and with commodities prices more volatile than they have been for years, it's no wonder CPOs are finding risk management so complex. Or, that they're finding so many risks.
Just listing potential risks can make even the calmest purchasing or supply chain executive paranoid. Kevin Hendricks, formerly of the University of Western Ontario, and Vinod R. Singhal, of the Georgia Institute of Technology, studied 800 examples of supply chain disruptions. The most common risks that caused the disruptions were, in order: part shortages, ramp/rollout problems, order changes by customers, production problems, development problems and quality problems.
But there are many more risks than evident on that short list. There are also:
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Natural disasters. Energy firms and chemical manufacturers along the Gulf Coast have spent nearly two years trying to repair the damage to their infrastructure from Hurricane Katrina.
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Infectious disease. Many companies sourcing in Asia feared the threat of disruption from the Bird Flu.
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Regulatory pressures, particularly in such industries as biotechnology and pharmaceuticals.
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Financial health of suppliers.
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Geo-political tensions in some parts of the world.
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And even the transitioning to new suppliers, parts or processes.
Moreover, the risks today are, well, riskier. Executives have learned that it's not just continuity of supply that's affected: It's the company's financial performance.
Hendricks and Singhal found in their study that 33–40% of companies that have a disruption in supply suffer lower stock returns relative to their benchmarks. Some could also suffer from damage to their brand name, says Dennie Norman, principal strategist for worldwide marketing at SAS, in Cary, N.C.
And then there are the missed opportunities in the market because of late product delivery; loss of revenue; shrunken profit and loss of market share. Purchasing and supply chain executives need a playbook for risks, says Norman. "They need to assess the value at risk and decide what to worry about, what not to worry about and when it makes sense to pay a premium to keep your business rolling."
 Stocks take a hit during supply chain disruptions. Average returns the year (250 trading days) before the announcement of the disruption can be nearly 14% below a company’s benchmark. Even though the market may not know about the disruption at this time, it is feeling it. The effect of the disruption is stronger on the day of the announcement even though the magnitude is lower. The low returns linger for three years, showing that disruptions have long-term effects. |
Tools of the trade
Having good supplier relationships is one of the first lines of defense, as CVRD Inco's slag-cement contingency plan shows. The company also has arrangements with long-term tire suppliers Bridgestone and Goodyear to maintain supply. One of those suppliers even will send the CVRD Inco product from a competitor if necessary.
"We pride ourselves on the long-term relationships we have with suppliers," says Smith. "We respect each other's lean times, but we also expect them to have contingency plans."
But beyond practicing the basics of good supplier relationships, purchasing executives are also investing in tools that help them assess risks and plan mitigation strategies. Many software companies offer risk-management products. Smith and his team at CVRD Inco use software from Quadrem's Quest system to access and assess potential suppliers. "It's our hub," Smith says. SAS has a consulting solution available now on a limited basis called the SAS solution for Supply Risk Management. Open Ratings' product includes financial information on suppliers as well as predictive-analysis features.
Some companies, such as chemicals and plastics manufacturer Dow and pharmaceutical manufacturer GlaxoSmithKline, are developing their own tools for risk management. Dow, in Midland, Mich., calls its tool PRAM (Procurement Risk Assessment and Mitigation).
PRAM resulted from a major effort the company undertook after Hurricane Katrina. "We had a robust crisis-management process at the time," says Paula Tolliver, global purchasing director for raw materials and corporate services at Dow. "But we have numerous suppliers in the Gulf region and had to source from different regions to avoid a significant negative impact." Dow decided to beef up its crisis-management program.
Dow procurement developed PRAM by bringing together risk strategies from other company functions such as finance and combining them into one tool. Using PRAM, procurement works with Dow's businesses and suppliers to determine what the impact would be of certain risks, assigns a probability to the risk, and then brainstorms mitigation strategies. The company puts the plans in place on paper and then models the risk again on a computer to see what impact the plan would have if the risk really materialized. If the mitigation plan works, great. If not, Dow goes back to the drawing board.
Results have been good so far. In one case, one of Dow's businesses recognized the risk of single sourcing a raw material for one product that impacted $125 million of profit. The supplier was in a hurricane district. Dow found a second supplier.
In another case, Dow realized that a raw material critical to another product that represented $80 million of margin was at risk of being banned by regulators. Instead of waiting for that to happen, the company found a substitute material and two suppliers for the substitute. They even cut the cost of the material.
Says Tolliver, PRAM enables purchasing to discuss the risk of potential disruptions in terms the company's separate businesses understand. "Originally, one of the barriers to taking action to mitigate risk was finding the resources to mitigate it," she says. "Now, purchasing has conversations with the businesses and with suppliers and works through the problems."
Dow is using the tool to gauge the risk with raw materials first. The goal is to put about $2 billion of raw-material spend through the PRAM process by the end of 2007 and the remaining $4–5 billion for raw material by the end of 2008.
Qualitative and quantitative
U.K.-based GSK, for its part, has developed a tool it calls RiskTrak. The company launched version two of the tool in June. Scott Patterson, the procurement executive in charge of implementing RiskTrak, describes it as a Lean process that expands the scope of the company's risk-mitigation action plans. "It allows us to not only document risks qualitatively but also quantitatively," he says. He and his team base the quantitative data on information plotted on an "assessment matrix." It's basically a document that contains criteria agreed to by the company's quality, production, consumer-health and contract-manufacturing groups for ranking risks by likelihood and consequence.
One recent event proved the value of RiskTrak. Says Patterson, a key supplier had a problem at its site that prevented it from supplying material to 28 different GSK locations.
"Once notified of the incident, we did a quick search on RiskTrak to find where we used the supplied material and learned how many of our products it affected," he says. RiskTrak also showed which sites used only a single source for the material and which dual sourced. "Sites that didn't use RiskTrak had nil or virtually nil stock," he says. The company is moving stock around globally to make sure all sites are adequately equipped to continue production.
Meanwhile, diversified manufacturer Eaton Corp., in Cleveland, is using Open Ratings' tool to check on the financial viability of many of its approximately 100,000 suppliers. "As supply chains extend, we add more distance between supplier and factory, so we have to assess risk," says Rick Jacobs, vice president of supply chain management. Additionally, Eaton had been acquiring several smaller companies—about nine in 2005—and needed to know more about the suppliers it was getting with those acquisitions.
The company launched its risk-management initiative first in its truck group. One result: Eaton got an early warning that one supplier was about to go bankrupt, so procurement was able to develop alternative suppliers before a crisis ensued.
At ITT, in White Plains, N.Y., executives have addressed an-often-hidden risk to operations: the taking on of a new supplier or the adoption of a new part or manufacturing process. Tom Weikart, corporate director of global strategic sourcing, says the company has put in place "transition managers." Their job is to make sure changes in suppliers, in designs and in processes go smoothly.
Recently, a transition manager discovered that a new project was going to require Underwriters Laboratories certification, and so began the process early for getting the certification. "Without that knowledge and the action of the transition manager," Weikart says, "ITT may have had to delay the project for an extended period."
ITT has also adopted a co-production process for critical parts. Says Weikart, "If a natural disaster or geopolitical tensions look like they'll affect supply from low-cost-country sources or other sources, we can pull production back to the U.S. and produce the parts ourselves."
They haven't had to do that yet. But, they're ready if the need arises, and that's at the core of a robust risk-management strategy.
| Acknowledgements | ||
| Executive Editor Tom Stundza contributed to this story. | ||
For other Purchasing articles on risk management:
Supply Chain Strategies: Commodities forecasting: It's all in your head
Trends: Boston Scientific aligns sourcing organization with corporate goals
Risk management: Immigration issue impacts the supply chain
Benchmark survey: Immigration and supplier risk
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