Cover Story: Rethinking Risk

Supply chain executives are discovering new ways to apply technology and innovative processes to the challenge of managing uncertainty


As a pioneer, HP has had to develop much of the process and many of the necessary tools to support the process from the ground up, according to Nagali, who founded HP's Procurement Risk Management (PRM) Group five years ago and continues as its leader. "We had to develop everything from scratch, including the mathematics that underlies the framework, the software tools and the process," explains Nagali, who came to HP with a background in risk management and financial engineering. He is quick to add that, although HP has branded its new process as Procurement Risk Management, the company is applying PRM throughout its supply and demand chain.


HP is using the PRM process to address what it views as the three fundamental uncertainties in its business: uncertainty in demand (whether for components on the inbound side, or for HP's own products on the outbound side), in the cost of components, and in the availability of components. Through the PRM process, the company's staff employs software tools developed in-house to explicitly quantify these uncertainties using a forecast scenario approach. For each component being considered, each of the three uncertainties is represented by "low," "base" or "high" scenarios to model the overall supply chain uncertainty for the component. Nagali believes that this approach has two fundamental differences with the "conventional" supply chain approach: first, traditionally, supply chain has considered demand and availability uncertainty, but not cost; and second, while forecasters have typically acknowledged uncertainty of supply to one degree or another, planners have not attempted to quantify the uncertainty at the component level across a company's spend.

Based on its assessments, HP devises strategies to proactively manage the risk associated with each particular component or commodity. Typically, the strategy calls for crafting agreements with suppliers that allow the risk to be shared and co-managed by both HP and the vendor. The key to the process is segmenting the demand for a component and then coming up with low-cost, more efficient means of satisfying low-risk demand (orders for a component that are closer to a sure thing) and more flexible, albeit potentially higher-cost means of meeting higher-risk demand (orders that have a higher probability of not being placed). For example, if the company is 100 percent certain that it will need 200 units of Component A, it could put in place a contract for a fixed quantity of that component with a supplier at a lower price. But if the probability that HP will need 50 more of that component is less than certain, the company might ink a flexible quantity contract with the supplier up to that number of units at a higher per-unit price. And for the next 25 units, for which demand is highly uncertain, HP's strategy might be focused on making spot buys of the component if and when the demand reaches that level.

Sharing the Risk

The point of these agreements, of course, is not only that HP gets a degree of assured supply at a fixed cost, but also that the company is not merely offloading the risk associated with a particular component onto the supplier. "These are bilateral deals between HP and the suppliers, wherein we manage each other's risks through deal terms," Nagali says. "When HP makes quantity commitments, it reduces the supplier's risk, and when you reduce the supplier's risk it also reduces the uncertainty in his manufacturing and planning processes. And when you remove that uncertainty, the cost structure comes down and that incremental value is shared with HP as a material cost discount."

The value of that discount to HP varies depending on the commodity. For industry standard components used by a variety of components in the tech sector, the savings might be smaller because the risk to the supplier is lower — if HP doesn't buy the component, someone else will. But for custom components unique to HP, where the supplier is entirely dependent on HP's demand uncertainty and is therefore assuming all the risk, making quantity commitments has a greater ameliorative effect on the supplier's exposure, and therefore the savings that result from those commitments are bound to be larger. To date Nagali says the company has reaped some $100 million dollars in incremental value from the PRM process.

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