Cover Story: Rethinking Risk

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

Venu Nagali is the Distinguished Technologist & Leader, Procurement Risk Management Group, HP.
Venu Nagali is the Distinguished Technologist & Leader, Procurement Risk Management Group, HP.

Venu Nagali has a piece of advice for supply chain executives looking to undertake a risk management initiative. "Most people think having a great piece of software solves the problem," says Nagali, who has been heading a supply chain risk management initiative at technology solutions provider HP, "but the biggest lessons for us have been that, first, you have to change people's mindset about risk, and second, you have to put in place a rigorous business process to make this [type of initiative] work."

Those lessons have clearly paid off for HP, as Nagali estimates that the company has saved more than $100 million dollars in incremental value over the five-year lifespan of the project. But beyond the savings, Nagali says the initiative is helping HP to achieve the even greater goal of mastering the uncertainty inherent in its global supply chain.

Increasing Focus on Risk

Supply chain risk management has garnered increasing attention of late, and for good reason. First, as companies have outsourced greater portions of their supply chain, they are left with direct control over smaller and smaller segments of the total supply chain, heightening exposure to factors outside their control. Second, as supply chains have expanded globally, enterprises have become subject to political, social and even geological events occurring throughout a much broader area than in the past. Meanwhile, compliance mandates such as Sarbanes-Oxley make it imperative for companies to understand the impact of external events on their bottom lines.

Third, as manufacturers have assiduously sought to simultaneously take as much inventory out of the network as possible while increasing the speed with which products (especially new products) move to market, margins for error have become slimmer, amplifying the potential impact of unanticipated events. And, finally, as the technology analyst firm Industry Directions points out in a white paper entitled "Inventory Liability: Managing Risk in the Electronics Supply Chain," traditional advanced planning systems have not been set up to deal with the unexpected. "Production planning is designed to optimize resources within stated constraints to support the operating plan, but a plan is only as good as the known constraints — and it is virtually impossible to identify the real constraints when the plan is built."

Supply chain executives are keenly aware of the panoply of risks threatening the integrity of their supply and demand chains. A recent survey of manufacturers by ARC Advisory Group showed that their list of concerns includes shortages of key materials or components (cited as a concern by 45.8 percent of respondents); catastrophic loss of factory and business disruption at a key supplier (37.5 percent for both); and poor forecasts of sales and profitability of new products, dependence on overseas suppliers and delayed introduction of a new production line or process (25.0 percent for all three).

And yet ARC found that companies have made greater progress in assessing supply chain risks than in getting a handle on them. "Companies lack a strategic approach to risk management," write Steve Banker, Sid Snitkin and Adrian Gonzalez in "Supply Chain Risk Management," a report on ARC's survey. "They neither assess all of their risks in a consistent, uniform way, nor do they apply common approaches to risk evaluation and management." That may well be the case, but this article examines efforts underway at three different companies that are confronting various aspects of risk in their supply chain, beginning with technology company HP, which has been a pioneer in turning supply chain risk management into a cross-functional business process addressing a broad swath of its spend.

Getting Proactive at HP

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.

Beginning in 2000, the PRM team at HP has trained about 750 people across several different functions at the company on the risk management approach, including procurement, finance, engineering, planning and marketing. HP also routinely trains staff at its suppliers on PRM, educating senior vendor staff about the shared benefits to be gained from proactively co-managing risk. The company is applying PRM to both direct materials and to indirect materials and services, such as advertising, power and spare parts. Supply chain risk management has been spreading rapidly throughout the organization, according to Nagali, who says that last year PRM affected $3 billion of HP's spend. The company's goal is to double that number in 2005. The project started with a focus on those items with the greatest uncertainty — such as memory, where cost uncertainties are quite high — and on those items with the greatest impact on the bottom line — such as components for product lines that have high margins. But Nagali believes that the PRM principles are broadly applicable and will eventually cover a significant portion of HP's total spend, with the potential for significant savings.

The key lessons that have emerged from the project to date, according to Nagali, are, first of all, that putting in place a PRM strategy requires changing people's approach to risk. "You've got to have people thinking differently," he says. "You have to change the mindset so that people understand that they can identify the risks, quantify them and manage them." And second, the PRM business process must be cross-functional. "It's not just one function on its own that can do this. You have to have the different players working in harmony."

Supplier Risk Management at Yazaki North America

Automotive industry supplier Yazaki North America has instituted a risk management program designed to identify potential problems with the company's own suppliers that could lead to supply disruptions. Based in Canton, Mich., Yazaki North America produces vehicle power and data solutions, providing electrical technologies to virtually every major automotive manufacturer and many of their top-tier supply partners.

Given the demanding nature of the automotive supply chain, Yazaki has, of necessity, made risk management an integral part of its supplier approval process. The principal driver, according to James Karakos, supply risk manager for Yazaki, is the size of the company's supply base, which comprises about 1,000 enterprises. "Around 75 percent of our suppliers are in the $1 million spend category," Karakos explains. "That means that our spend is highly diversified, and of course this poses the problem of tracking too many suppliers."

The challenge for the company's procurement staff has been to identify potential financial problems at a current supplier before they force the supplier into bankruptcy or otherwise impinge on the supplier's ability to meet its commitments. In the past, the procurement team would do the normal due diligence during the selection process — for instance, running a Dun & Bradstreet report on the supplier — but the company did not have a monitoring process in place subsequent to the supplier's selection. As a result, Yazaki could potentially be blindsided by a supplier bankruptcy, forcing the company to expend significant resources to identify a new supplier, ramp up production and expedite shipments to avoid falling short in deliveries to Yazaki's own customers.

Avoiding Crises

To address this issue, Yazaki took two steps. First, the company engaged the services of Open Ratings, a provider of predictive supplier performance technology intended to provide advanced warning and analysis of supplier problems. Open Ratings aggregates a variety of business information into a database containing some 100 million company records, covering financials, performance information, government data and so on. Yazaki uses Open Ratings' SBManager to collect and manage reports on its entire supply base.

Second, Yazaki formed a cross-functional three-person team with representatives from the procurement, legal and finance functions to meet on a weekly basis and assess the health of the company's suppliers based on the Open Ratings reports and on secondary "triggers," such as word-of-mouth coming from Yazaki's staff, public announcements regarding change in management or news that a supplier has lost a major customer. By aggregating and reviewing this information on a regular basis, Karakos says that Yazaki has a better chance of identifying financial, service or quality issues at a particular supplier before those issues can affect overall performance.

When an issue with a supplier pops up on the team's radar, additional resources from affected Yazaki manufacturing facilities or business units may be brought in to help decide what action to take in response. That response could include identifying a new source of supply for the components coming from the supplier or putting the supplier on "business hold" until the issue is resolved. "But the default option for Yazaki is first to help the suppliers resolve these issues," Karakos says.

Yazaki has only been using the new supplier risk management process for a few months, so the company is still gauging its return on investment in the initiative. Karakos says that the majority of the ROI on this type of project will come through cost avoidance — avoiding the premium freight, testing and validation costs, overtime, poor quality and other costs of the supply chain disruption that could result. "If you can forecast one or two crises per year and take the necessary actions in advance, it pays back your investment," Karakos says.

Making Risk Management Fashionable at Luxottica

Risk runs deep in the fashion world, where every season the industry's producers must make educated guesses about what will be "in" and ensure that they have enough product on the shelf to meet that demand, but not so much that they get stuck with containers full of obsolete goods.

Unsurprisingly, the fickle winds of fashion affect any number of product categories outside apparel, even, it turns out, eyeglasses. Just ask, Alin Udrea, senior manager for production planning at Agordo, Italy-based Luxottica Group Spa, which produces prescription frames and sunglasses. Udrea, who is responsible for all planning, production and procurement of materials for both the wholesale and retail sides of Luxottica's business, says that the average life span of one of Luxottica's products (numbering more than 2,500 models and more than 30,000 stock-keeping units) is about 18 months, while the lead time for the products is typically two to three months. "If you compare the short lifecycles with the long lead times, the major risks that we have are either obsoletes on finished goods and backorders," he explains.

With its business growing globally, Luxottica has taken several steps to deal with these risks. First, the company has been consolidating its planning and forecasting process for the wholesale and retail sides of its business, including for the LensCrafters and Sunglass Hut chains that Luxottica acquired in the U.S. market. The company also has initiated collaborative forecasting with 20 of its major suppliers of finished goods. On the production side, the company has been working to implement lean manufacturing practices to reduce its lead times and thin out its inventory liability, while on the distribution side, Luxottica has consolidated its operations in Europe down from separate warehouses in each of the countries in which it operates to a single distribution center in Italy.

In addition, Luxottica is deploying an inventory optimization application from a solution provider called ToolsGroup to help determine the right inventory mix. The company will use ToolsGroup's DPM solution to analyze and optimize stock levels for all finished products in a distribution network comprising five sites, one central warehouse and 26 distribution centers. Specifically, Luxottica's goals for the solution include gaining the ability to position inventory to promptly satisfy customer needs, allowing production to quickly adjust to market changes, reducing inventories and global logistics costs, and improving forecast accuracy.

In the first six months of using DPM forecasting algorithm, Luxottica was able to reduce its stock levels by 10 percent while maintaining the same service levels, and subsequently the company was able to reduce manual intervention in the planning process by 50 percent, while then progressively increasing service levels. Implementing the DPM solution also allowed the company to roll up its forecasting for the retail and wholesale sides of its business into an integrated process.

And yet the uncertainty inherent in Luxottica's business is only rising as its products become increasingly fashion-oriented, and Udrea says that the company will have to continue to work to find ways to ameliorate that uncertainly. "The risks in our industry are becoming higher and higher every year," he says, adding, "We were able to reduce our forecast error by 5 percent this year, and that is very interesting progress, but we will continue to push the system to get more positive results like this."

The Risk of Being Reactive

As the examples in this article demonstrate, companies appear to be approaching various aspects of their total supply chain risk. And yet we again return to the ARC Advisory Group's assertion, cited above, that enterprises have failed to date to take a comprehensive, enterprise-wide — let alone a supply chain-wide — approach to address the risks inherent in any supply network nowadays.

The greatest risk, perhaps, is that a company will remain in a reactive mode and not put in place the processes and technologies necessary to anticipate threats to their supply networks before disruptions occur. As George Devlin, chairman of Vivecon, a Mountain View, Calif.-based supply chain risk management solution provider, says, "We know that uncertainty is a fact of life, and companies need the ability to be proactive in managing that uncertainty."


    Perspectives on Risk

    Bob Eckles, Industrial Marketing director, Intermec Technologies Corp. (Everett, Wash.), a provider of wireless enterprise network equipment and auto-ID solutions, believes that the key to reducing risk in the today's extended, global supply chains is greater visibility into where goods in motion are at any given moment, and the two keys to increasing visibility are better business intelligence (BI) tools and, critically, better data.

    "All the big software companies are starting to talk about business intelligence, being able to give you monitors and dashboards and different types of visibility tools to see what's going on in the supply chain," Eckles says. "Well, the BI tools are wonderful for giving you data in a very rapid manner, but my question is, how do you know if the data are good? You might just be making bad decisions faster based on bad data."

    Eckles suggests that bar code, radio frequency identification (RFID) and other auto-identification technologies can help companies improve the precision of their supply chain data by allowing goods to be tracked, accurately, while in motion. "We're moving away from a transactional environment to an event-driven environment, and over the next couple of years we'll see that everything's going to be tracked in real time at the event level."

    The winners in this environment, Eckles says, will be not only those companies that can best make use of the data coming in from their own suppliers and respond more rapidly to events, or even anticipate events, in their supply chains, but also those companies that can provide the most useful, the most accurate data to their own customers, so that the customers can take action to avoid any supply chain disruptions.

    Sidebar: Perspectives on Risk

    Jim Lawton, vice president of Marketing, Open Ratings (Waltham, Mass.), which provides supplier-oriented risk management solutions, sees a move among supply chain executives to become more proactive in managing their enterprises' risks, in part by more actively monitoring their suppliers, but also by working more closely with their suppliers to address issues in their vendors' supply chains.

    "We're working with a company in the Boston area," Lawton says, "and as a result of trying to drive cost out of the system, they're making it more and more difficult for some of their suppliers to be competitive. Sometimes their suppliers will do smart things to reduce costs, and sometimes the suppliers will do some not-so-smart things to reduce cost and put themselves in the position where they can't effectively survive as a company. This company wants help in figuring out when they're squeezing too hard and putting suppliers out of business. Maybe pushing hard is the right thing to do, and maybe the supplier will go out of business, but this company is also a very strong proponent of Lean and Six Sigma, so maybe they'll choose to send in some of their Six Sigma black belts to help a supplier figure out how to make improvements."

    Having this type of visibility into the state of a supplier can have enormous value, Lawton says, and he points to another Open Ratings customer, a heavy equipment manufacturer, that has estimated the cost of a major supplier going under at around $1 million a pop. "If they can help that supplier avoid bankruptcy, that saves them money," Lawton says.

    Sidebar: Perspectives on Risk

    Sridhar Tayur, CEO, SmartOps Corp. (Pittsburgh, Pa.), which provides supply chain and inventory optimization solutions, says that while the sensitivity to risk in the supply chain has increased in recent years, managing risk can itself be risky if a company opts to minimize its exposure to potential supply chain disruptions by over-compensating and holding too much inventory as a buffer. "A certain amount of strategic inventory needs to be kept somewhere in the supply chain, but not everywhere in the supply chain, and not every item," he says.

    The tension between managing risk and managing inventory has been especially acute in those enterprises that have been pursuing lean manufacturing and lean supply chain strategies. The inclination of a lean expert is to squeeze as much inventory out of the supply network as possible, but lean manufacturers must understand that not all inventory is bad. Tayur is a proponent of applying a stochastic process to managing inventory, by which he means using a sophisticated, systematic methodology to account for the time-varying uncertainty of key supply chain parameters as a way of determining the right amount of inventory that should be kept at various points in the supply chain.

    One challenge in making this type of planning work, Tayur notes, is ensuring that all the parties across the enterprise are on the same page and understand the enterprise's overall goals for balancing inventory and risk. "The operations guy is measuring cost of goods sold, and the sales guy is looking at revenues and sales, so clearly there's a tension there," he says. The key to resolving this tension is bringing all the interested parties to the table and having them arrive at a consensus on the company's level of risk-aversion based on an understanding of the total supply chain costs involved.