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Supply Risk – Increasing importance in a weak economy

In my last post on this blog I had talked about Supply Chain being a strategic lever in a declining economy. I had indicated that one of the key areas for companies to focus was in managing Supply Risk in a robust manner to accommodate shrinking capacities and supply failures.  I think that Supply Risk is a fairly complex variable which is not always looked at unless an enterprise faces “supply failure”. In this posting I wanted to try and disaggregate Supply Risk to a degree and provide a framework to think about it.

Let’s consider the example of the automotive industry in the United States. A significant fall in demand due to the economic recession has led to unprecedented reduction in demand from all the major automotive manufacturers. The Automotive value chain supported a substantial supply chain [$ trillion/ X% of US GDP]. These suppliers predominantly supplied GM, Ford and Daimler Chrysler; but also supplied in a small measure to ancillary industries. There are multiple instances where companies that depended in some measure on this vast network of suppliers are now subject to significantly greater supply risk.  Say a GE Wind buys heavy duty, high precision bearings from the same supplier that supplies crankshaft bearings to GM for for automotive engines – understanding these risks is key to managing Supply Risk effectively.
Value Chain Risk
1. Capacity for a product of strategic importance [Volume or Value]
a. Available capacity in market versus demand
b. %age Capacity committed to buyer
c. Exposure to other industries
2. Strength of supplier fundamentals
a. Sustainability of supplier’s economic model
b. Relative position in peer group
c. Investment in product development and growth

Supply Chain Risk
1. Commodity type supplied by the supplier [Strategic/ Leverage/ Routine/ Bottleneck etc]
2. Relative supply performance
3. Strength of relationship
4. Exit barriers [for buyer]
a. Product Development and Design IP ownership
b. Specialized tooling [since high cost, depreciated tooling is valuable]

Country Risk
1. Currency Risk [driven by local economy]
2. Political Risk [buying from Africa for example]

The critical question most companies are asking – and there are more and more everyday in this economy – How do we understand what our Supply risk is? How do we manage it down or mitigate it? I would propose that any discussion of this Risk in particular has to be in context of impact on Buyer [your client or employer] in the event of a possible failure of supply, either voluntarily by supplier or through supplier going bankrupt.  

Establishing Context for a Supply Risk Evaluation

Having established the context, I would propose that this risk has to be evaluated in context of the entire supplier base, commodity strategy and lastly at the level of an individual supplier. All three steps are essential [to some degree] to successfully understand and mitigate risk.
Step 1: Supplier Base Assessment
This essentially is a high level assessment of the entire supplier base. Assessing risk across a buyer’s supplier base is important as it quickly identifies primary drivers of risk and allows buyer to focus on mitigating the highest risk elements first.

Step 3: Commodity Strategy
Evaluating Risk in context of commodity should be a critical component of establishing a winning commodity sourcing strategy. The key questions answered here are:
1. How much of buyer spend [e.g. high pressure oil seals for a Hydraulics Manufacturer – a critical item] is focused on a single supplier?
2. How much of the lead supplier’s capacity is committed to buyer?
3. What alternative sources of material does buyer have?
Strategies for “Strategic products” versus “Routine” or “Leverage” products are very different.

Step 2: Supplier Performance
Supplier performance is a key input into the evaluation of risk from a performance failure standpoint. These are fairly well understood and part of most supplier performance management systems

Mitigation strategies
Do not be the company that discovers they have unaccounted for risk in the supply chain when a strategic supplier you place a purchase order is no longer in business! Mitigation strategies range from having a supplier performance balance score card closely monitored through a real time dashboard [Tactical] to a fully functionality Supplier Accreditation program [Strategic].
While the tactical approach addresses the immediate risks, it does not provided adequate insight into the future. Additionally, the performance score card is fairly transactional in nature. Most suppliers will not share information that they are at financial risk voluntarily. They may continue to perform well till the last day of operations completely blind-siding the Buyer. Agreed that this is an extreme scenario but it is plausible without a more complete approach to Supply Risk.
The supplier accreditation program is in some ways the “Cadillac” of Supply Risk mitigation strategies. A well constructed program would take into account both Performance/ Commodity strategy as well as assess fit from a future strategy standpoint [position in Value Chain/ brand recognition etc]. It will identify and enforce a true partnership across multiple forums. The deeper information exchange and engagement would enable the buyer to identify potential risks early and address them proactively – replacing those suppliers that continue to pose significant risk.
Have you assessed supply risk for your organization lately? Do you have a Supplier Accreditation program in place to mitigate supply risk? I look forward to your comments on this blog…

 

Comments

Saurabh, really interesting thoughts, could not have been more timely. I was reading that at least 65% of the automotive suppliers in US are under severe financial stress and many companies are waking up to this mammoth reality.

Study of Risk is probably as old as Murphy’s law, adage in Western culture that broadly states: "Anything that can go wrong will go wrong." An American newspaper in Norwalk, Ohio printed this verse in 1841:

I never had a slice of bread,
Particularly large and wide,
That did not fall upon the floor,
And always on the buttered side

The hard truth cannot be wished away, but irony is that the best of organizations will face the worst of risks, the more efficient and optimized the supply chain, the more prone one would be to the risks (unless this has been factored in the SC design). Most of the supply chain improvement practices have been to remove redundancies be it going lean, reducing inventories or single sourcing. These leave the highly efficient supply chains with very little back up and the potential damages can be really significant.

We were having a chat on this the other day and came across this thought of risk management having an industry/manufacturing model angle to it… example, impact of a bearing supply disruption from a particular supplier on an automotive production line (line production) compared to an Airbus (batch/ project production). The risk loss potential in the high speed auto SC scenario is major compared to the aero project despite the high costs involved in the latter. Sizing the risk impact potential correctly is of high significance. Invoking the law of sine’s here, the size of impact could be a function of the duration of disruption and the supply chain velocity.

Again, possibly validating the fact that if one were in the same industry, the bigger impacted would be the company who would have worked on efficiencies to improve the through put times. It means the best of the companies should be the first to draw their efforts towards this piece of their supply chain.

“Σ (I) across the supply chain nodes” could give a dimension to the “risk threshold” of an organization and a good fact to know (don’t know if we have a tool to help us here with this complex algorithm). This may be a very basic hypothesis to draw inferences but empirically no one is spared of the wrath of risk and need of risk management.

Common sense says that risks can be managed by
1) Preventing failures from happening
2) If failed, then detecting failures early and efficiently
3) Once detected, respond to rectify early and effectively

Risk (R)  Probability of Failure ( n) x Detectability ( d) x Impact ( I) or
Risk ( R)  Probability of Failure ( n) x Detectability ( d) x duration of disruption (t) ( from above )
Where t  response agility

and risk management strategies of organizations should address each of these levers

(I)Probability of Failure ( n)

• Profile risk supplies and build redundancies (dual source, near source , balanced sourcing , optimize inventory)
• Improve and track supplier performance
• Forecast failures (statistical modeling)
• Advanced process collaboration


(II)Detectability ( d)

• Invest in global supply chain visibility for live inputs on SC events

(III) Impact ( I)
• Invest in supply chain agility and alerts
• Prepare disaster management plans
• Insure for risks
• Performance metrices on speed of responses

Application of best practices for supplier risk analysis like Altman Z scores , tools for statistical modeling and quantitative prediction of failures, Trade lane and genealogy analysis, inclusion of risk matrices like VaR (Value at Risk) and RAROC in corporate performance management are a good start to assessing the SC risks. Risk Management programs will benefit from investment in supply chain visibility and performance management and collaborative supply management . Of course, these need to be viewed in a different lens with caution on the risk strategy when selecting from the multitude of solutions available in the market.

Interesting thoughts Saurabh… Amazing follow up by Pradeep as well.. I do agree with the fact that a lot of suppliers in the US are financially stressed, but when demand drops as low as 40 %, you can’t expect suppliers to be shielded even if they had the best of supply chain designs… Ironically, all the financial knights, the so called Goldmann Sachs and the Lehman Brothers (pioneers of VaR and other financial models) of the world themselves didn’t know how to manage risks and ended up as major contributors to the financial mess…

The mathematical equations sound great and I can tell you that automotive firms do all that kind of stuff in their FMEA (Failure Mode and Effects Analysis) program as part of product development…The same would look excellent if extended to the supply chain…

Automotive firms across the globe today have excellent supplier assessment methodologies to evaluate their suppliers for all kinds of supply chain metrics along with risk. The 3 A’s (Agility, Alignment and Adaptability) of the supply chain is also evaluated for suppliers short to long term commitments. All firms today have a good accreditation program along with systems to measure on going performance for quality, delivery and compliance. But despite all this, things can go wrong if a major macroeconomic change happens. This is a cyclical phenomenon and can only be managed to a certain extent.
Coming to the point of OEM’s trying to manage risk; I would say the things are reversed when it comes to the automotive scenario. Suppliers have an automatic diversification of their portfolio as they cater to many customers. Lot of automotive buying happens from emerging markets and the suppliers over here are diversified further in terms of risk due to domestic consumption. But if the entire industry slumps, suppliers got to just sit and pray for the recovery to happen. Risk is a key issue in today’s supply chain scenario and is also given importance in the latest version of the SCOR model.
Effective supplier collaboration has always been a need and can be a very good tool to manage risk effectively. It’s beyond obvious that firms have to keep a watchful eye on their suppliers as part of their risk management strategy and systems must be in place to track financial and operational data. There are firms like D&B who can help with financial data analysis and other third party agencies for operational data analysis. But supplier collaboration would go a long way in estimating the risk quotient of a supplier in terms of on ground intelligence. It might be a little expensive affair, but can be a good long term strategy. Firms in the US buying from emerging economies have to be more focused towards their suppliers and have local guys go and visit them once in a while. This along with data transparency on volumes and key data can be a good tool in managing risk and having your supplier as a value enhancer in the longer term scenario.

A great article and a great discussion. I read with interest your comments about the impact of automotive supplier failures on nonautomotive industries. I recently blogged about a story a friend had told me about a situation at his work. In his case, an injection molded parts supplier was a sole manufacturer of a key component that went into one of his company’s more popular products. The bulk of this company’s sales, however, went to one of the North American car companies. Because of the downturn, this supplier had found it necessary to declare bankruptcy.
A bit further down, you’ve listed 3 steps to understand and mitigate risk. While I agree with the steps you’ve identified, I have a different take on assessing risk. I think all of us can agree that getting detailed information on our suppliers can be very challenging, especially if the suppliers are overseas. On the other hand, understanding our own buying practices and identifying which component parts are key contributors to revenue (in other words would impact revenue if not available) is much easier to do (assuming we have the appropriate tools) because the data for this determination exists within our own systems. So in my opinion, the first step should be an assessment to determine;
a) Which parts are commodities (I can get them anywhere) and which parts are unique (are unique to my business and/or I can only get them from a single place).
b) Of these unique parts, which have a single source of supply?
c) For those parts that are unique and have a single source of supply, we need to assess the impact of these parts to revenue. If the unique item goes on my flagship product, or is used on many products then the impact to my business is going to be significant if the supplier of this item can’t deliver. Likewise, if the unique item is going into a product that is at the end of its life, or has only occasional demand (spares), then the impact of losing this supplier may not be as significant.
From this exercise we get a list of parts, their suppliers, and their contribution to revenue. A quick sort and some grouping we have a prioritized list of suppliers based on their contribution to revenue.
This prioritized list should be used to focus our efforts on the suppliers that will have the biggest impact on our business should they fail.
Finally, I very much agree with Pradeep’s comments about the need for responsiveness in being able to detect events and respond to them. Even with the best Risk Management practices, there is a possibility that an event happens that you didn’t plan for and for which you have no mitigation strategy. Further, even if you do have a mitigation strategy, that strategy may fail or may not go quite according to plan. (Murphy’s Law again). In these situations, the ability to respond quickly and effectively can be the difference between a major impact to revenue and a minor bump in the road.

Let me take leads from some great pointers from Venkat and John and attempt to build on these thoughts.

Q: Are we absolutely helpless on a 40% reduction in demand
A : Let us remember that Toyota came in with TPS from the embers of another recession to become a great auto leader. Recession taught us (not every one learnt) the concept of frugal engineering, one piece flow and SMED (monetization of time & flexibility). I am sure one risk mitigation activity should be to encourage innovation big time in the organization. One should try to move more of fixed costs into the variable bucket and move to more demand driven one piece production in a demand crash situation as this and still be able to survive. I suppose only the complacent would fall, who did not see and react to this coming. Any wastages at this stage would be criminal and visibility to the depths (should costs, etc.) would be a great asset. Good time to rationalize the input and final SKU’s to the strategic, fast moving and economic ones .

Q : Is FMEA from the auto industry a good tool for risk assessment?
A: Having been there, done it, pioneering the APQP and QS 9000 in the Indian auto industry a decade and half back, I am a strong proponent of FMEA as a good risk tool. But honestly not many give it the respect with the required due diligence. A good start at the “ failure modes” was crash testing around the design / process specs. In a business continuity FMEA these will need to be around business KPI’s (what are these?). The FMEA tool will need to be tailored to that extent.

Agree with John that a product portfolio approach is the way

Global supply base >[filter]> Critical portfolio – Assess & strategize > [filter] > Risky suppliers –intervene > [filter] > zero risk supply base

First filter is a risk product = 2x2 Fn (Probability & Severity)... from the earlier mail.

I am surprised how some organizations still manage 15K to 20 K supplier base. Wonder how tangible it is to manage supplier risks in this scenario, esp if these are spread on a global level. Intelligent supplier portfolio rationalization is important to know the strategic suppliers.

Looking around for more answers and leads on this
1. How many organizations today have a formal supply chain risk management function in the supply chain I still don’t find this as a function listed in best practice industry process models. (SCOR 9.0 has included this in the latest release .)
2. How does one have a total view of enterprise SC risk (remember Σ (I)). (SCOR uses a global charting process). I tried making a list of potential risks and could easily list half a century of them spread along the supply chain processes with not a measure that encompasses them.
3. How does one re-design an existing supply chain for including risk factors? Are there benchmark metrics and audit formats to measure this risk appetite of a supply chain?

On an optimistic note, let us look forward to some great supply chain innovations and some great winners rising from these ashes once the dust settles down.

As I read through this discussion on supply chain risks, I largely agree with the frameworks and approaches various contributors have suggested for understanding and managing the supply risks. However, I also believe, that the current economic environment also provides opportunities and advantages to some. It's perhaps the optimist in me who's looking for the silver lining in the mostly dark clouds of economic uncertainty. Let me take Saurabh Agrawal's example of GE Wind and GM to illustrate my point. If there's a bearings supplier common to GE Wind and GM that traditionallly had to allocate its production capacity and finished goods inventory between those two customers, it's very likely that GE Wind orders were shorted while GM orders were preferentially fulfilled. Does today's economic environment provide an opportunity for GE wind to restructure and renegotiate its supplier contracts to "lock in" better terms and pricing for its bearings needs with fewer selected suppliers? Can the supply chain risks be converted to supply chain rewards?

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