October 2008 | Commentary | IT Matters

Can You Afford to Ignore Supply Chain Risk?

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As companies gravitate toward a "build anywhere, source anywhere, sell anywhere" mind-set, supply chain risks—entering into long-term contracts at unfavorable prices or sub-optimal quality, excessive dependence on one geography or supplier, lead time variability, and supply disruptions caused by natural disasters—assume greater proportions.

Any supply chain setback could negatively impact average operating income and return on sales by more than 100 percent within two years after the incident occurs, according to analysts.

Sources of Risk

To successfully manage risk, companies must continuously evaluate factors across the decision continuum—from procurement network design to supply movement.

In many industries, risk is first determined in product design. For example, it is not uncommon to accrue excess and obsolescence charges for specialized components used in only a few products.

While most risk discussions center on supply volumes, price volatility is also an important factor.

Demand uncertainty is another source of risk. It often requires supply chain organizations to operate in a narrow safe zone that keeps the triple threat of unmet demand, excess/obsolescence charges, and unnecessary financial commitments at bay.

This is particularly true for industries that experience the "long-tail phenomenon," where there are few high-volume products but many medium- and low-volume products. Well-designed supply networks can increase the operational "safe zone" by providing recourse to feasible alternatives.

In addition to design decisions, companies must consider external factors that can potentially disrupt the flow of goods, such as strikes, terrorism, mechanical failures, research and development delays, and unexpected logistics challenges.

As the supply chain increasingly stretches across the globe, multiple hand-offs and legs of movement increase uncertainty.

All risks are not equal, and they must be categorized based on the severity of the impact and the likelihood of occurrence. Risks that are most likely to occur and cause the most severe impact earn top priority.

All risk evaluation includes two phases:

1. Risk identification— determine the sources of risk, dependencies among them, and the likelihood they will occur.

2. Response analysis— examine potential options to hedge against the risk while assessing the financial impact.

The first step in risk identification often involves variants of the Delphi method of predictive analysis.

The Delphi method is a facilitated brainstorm process that engages experts to participate anonymously in iterative sessions and provide predictions with supporting logic. The experts reassess the results of each session until they reach a relative consensus.

Once risks are identified, the response analysis phase focuses on estimating the impact of risk factors across the supply chain. Techniques for analyzing risk-decision clusters fall into the following two families:

Prescriptive decision models include many supply chain optimization tools and are designed to prescribe an answer to a given set of inputs. By systematically analyzing different scenarios, the models provide insight into the interaction between risk factors and supply chain control variables.

Descriptive simulation models are designed to replicate supply chain operations and generate statistics by using a series of simulated inputs. Decision-makers use these statistics to inform their choices.

As supply chains grow longer, increasingly complex, and subject to more potential disruptions, supply management executives must decide whether they can afford not to make risk management a top priority.

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