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By Anand Iyer

As supply chains organizations gravitate toward a "build anywhere, source from anywhere" mindset, the risks associated with procurement and managing supply lines assume greater proportions.

Examples of real-world procurement risks include long-term contracts at unfavorable prices, excessive dependence on one geography or supplier and supply disruptions due to natural disasters. A few examples:

• The New York Times reported last November that 90 percent of Southwest Airlines' fuel needs for the fourth quarter of 2007 were hedged against higher fuel prices compared to just 20, 30 and 40 percents for Delta Airlines, Continental Airlines and American Airlines, respectively.
• In 1995 an earthquake in Kobe, Japan, led to the closures of that country's two largest ports, resulting in more than $100 billion in damages to supply chains worldwide.
• More recently, a blue-laser-diode shortage caused Sony to slash projections for the PlayStation3 launch in late 2006 by 2 million units.

Supply chain challenges and disruptions such as these may have a negative impact on average operating income and return on sales by more than 100 percent for two years or more after an incident occurs, according to an article by Vinod Singhal and Kevin Hendricks titled "The Weakest Link: New Study Quantifies Financial Fallout from Supply-Chain Malfunctions," in the February 2, 2004, issue of Georgia Tech Research News. Perhaps that's why AMR Research, in a January 3, 2007, report called "Managing Risk in the Supply Chain – A Quantitative Study," by Mark Hillman and Heather Keltz, finds that "nearly 50 percent of firms plan to implement or evaluate [supply chain risk management] technology in the next 12 to 24 months."

Influencers of Risk

Proactive management of supply risk often requires a continuous evaluation of risk factors across the decision continuum – from the design of the procurement network to the actual movement of supplies from origin to destination.

Many of the factors that determine the risk affinity of a supply chain are established in the design stage. In many industries, the first stage where supply chain risk is determined is product design. It is not uncommon to see excess and obsolescence charges for specialized components that are used in a few products or sold in a small number of geographies.

From an operational standpoint, procurement risk management (PRM) begins with the design of the supply network. Our definition of design encompasses the identification of suppliers, the design of the sourcing protocols as well as the definition of contract terms. Although most discussions of risk center on supply volumes, price volatility is an important consideration as well and may require the use of financial strategies that borrow from Wall Street's playbook.

Another well-known source of procurement risk is demand uncertainty. Demand uncertainties coupled with price volatility require supply chain organizations to identify and operate in a narrow zone that keeps at bay the triple threats of unmet demand, excess/obsolescence and unnecessary financial commitments. This is particularly true for industries that experience the "long tail phenomenon" where there are a few high volume products and many medium- and low-volume products. Well-designed supply networks can increase the size of the operational safe zone by providing recourse to feasible alternatives.

In addition to design decisions that account for risk, companies must also carefully consider operational factors that could potentially disrupt the flow of supply. For example, a two-week labor strike at U.S. West Coast ports in 2002 stranded more than 200 ships and 300,000 containers because other ports did not have the capacity to accommodate redirected shipments. Supply disruptions may also be the result of natural disasters, strikes, terrorism, mechanical failures, research and development delays, or unexpected logistics challenges, such as customs-clearance delays.

As more supply chains stretch across the globe, complexities increase and require a careful cost-versus-benefit analysis for each risk-mitigation strategy.

Phases of Risk Management

Even the best-managed companies can be overwhelmed by the prospect of rationally and proactively balancing the potential negative effects of risk factors against the cost and benefits of implementing risk-mitigation strategies. In fact, it quickly becomes clear that managing risk can be at odds with other strategic initiatives, such as reducing inventories and cutting costs. Therefore, effective risk management requires a careful consideration of the appropriate balance among customer service levels, cost and working capital within an acceptable risk tolerance.

In addition, all risks are not equal. They must be identified and categorized along a scale on the basis of the severity of the impact of the risk and the likelihood of occurrence. Obviously, risks with high severity that are most likely to occur should be the first priority.

These are complicated scenarios requiring substantial computing power and sophisticated analysis capabilities. All risk-analysis approaches have two phases, although the specific techniques used in each phase vary widely. The first phase of risk analysis is risk identification and consists of determining the sources of risk, the dependencies among them and the likelihood of occurrence. For example, the loss of a supply source in one location may cause a shortage of transportation capacity in a different area where an alternate supply source is available. The second phase is response analysis and involves determining potential options to hedge against the risk while assessing the impact in terms of both cost and benefit.