Mitigating Supply Chain Risk

Tags: Risk Management

Today's logistics and supply chain managers grapple with volatility, risk, and uncertainty. Learn what you can do to prepare for the unexpected.

Asking "How's the weather?" can be much more than a conversation starter. For logistics and supply chain professionals, it may be a way of anticipating potential problems.

Tornadoes, hurricanes, floods, earthquakes, and other natural disasters can cause major supply chain disruptions, and it can take weeks or months to recover from their effects. Some businesses are still dealing with the aftershocks of the March 2011 earthquake and tsunami in Japan.

Although supply chain managers should be taking active measures to reduce future disruptions, many organizations lack a formal process for evaluating and minimizing risk, says Jim Lawton, president and general manager of supplier management firm D&B Supply Management Solutions. That can lead to paralysis: being overwhelmed by the vast array of risks—where to begin?—or over-analyzing and trying to discover and address every risk.

To begin developing a risk management program, consider what you need to make your business successful. Evaluate the risks in the context of your business: What actions do you want to see occur, and when? What processes and technology do you need to make that happen? When does it need to happen?

Watch out for pitfalls, such as assuming an item's cost represents its significance, cautions Lawton. He cites an example of a highly engineered screw that a company needed to complete a subassembly. That screw didn't show up on the list of critical components that the company needed to carefully monitor, and its supplier wasn't among the strategic relationships the company managed closely. Yet, an interruption in the screw's supply disrupted the subassembly's production.

Shedding a Tier

To avoid the need to manage every supplier of every nut and bolt, many companies develop virtual vendor masters, says Lawton. These include Tier-1 suppliers and relevant or critical Tier-2 suppliers. Part of what they are outsourcing is the Tier-1 supplier's ability to manage Tier-2 supplier risk.

The same process a manufacturer might use to manage component supply risk can be applied to other industries and to logistics service providers.

"Japan's earthquake, tsunami, and subsequent problems at the Fukashima nuclear power plant illustrated how compounding disasters can affect a whole region," explains Jim Kelly, CEO of Huntington, N.Y.-based cost reduction and risk mitigation solution provider JV Kelly Group Inc.

"Most manufacturers have plans for Tier-1 supplier disruptions, but many are starting to consider how Tier-2 and Tier-3 suppliers interact," he continues. "Often, the answer is that they supply more than one of the manufacturer's Tier-1 suppliers, which adds a level of risk."

For example, a third-party distribution center (DC) may be served both inbound and outbound by carriers that provide services to other outsourced and in-house DCs. One of those carriers closing its doors could affect several DCs and the customers or plants those facilities serve.

Another critical factor in planning is competing for resources that grow scarce after a disruption. "A Tier-2 disruption means more competition for resources—whether components or raw materials used in manufacturing or logistics services—not only among your first-tier suppliers, but potentially from the larger marketplace as well," Kelly notes.

Consider the example of the St. Johnsbury Trucking Company, a Northeast carrier that fell victim to a slow economy and closed its doors in 1993. Shippers who had been using St. Johnsbury in the northeastern United States tried to shift to other carriers—all of whom had been steadily reducing capacity to cope with lower freight volumes. As a result, competition for resources was intense.

Check the Indicators

Many logistics professionals are concerned about the next St. Johnsbury in their carrier network. One supply chain risk factor they are scrambling to cover is their service providers' dependability. Weaknesses in your carriers' financial health, capacity, and performance can introduce problems in your supply chain, so it's wise to evaluate these factors periodically.

Some carrier performance and financial indicators can help predict potential problems. For example, companies experiencing financial difficulty often pay off debts to improve their credit. Though this may not be an absolute indicator, it can be meaningful along with other signs.

Reduced maintenance spending is another tactic carriers might use to improve their cash position. If you experience missed appointments due to mechanical breakdowns and increased damage claims, reduced maintenance might be a root cause and raise some questions about a carrier's financial condition.

Financial matters aren't shippers' only concern about their carriers. In the past 12 months, shippers have turned their attention to validating carrier capacity, says Paul Martyn, vice president of supply chain strategy at BravoSolution, a global supply management software and professional services provider with U.S. headquarters in Chicago.

Martyn recommends assessing a carrier's "asset footprint" by overlaying your shipping lanes and needs with carrier capacity and performance.

"Using sophisticated tools to provide visibility on performance measures as well as price, shippers can monitor carrier relationships and performance in specific lanes," he explains. "This can reduce the time between measuring risk and response. You can't predict every disruption, but by measuring more often, you can model how to respond."

Cost pressures often lead to an undue emphasis on benchmarking rates instead of carrier performance. "Rates are important, but set and measure performance goals with the carrier, then share results," Martyn says. "You may want to keep a percentage of your business with carriers you know, but discussing and measuring performance builds trust with both carriers you use and new carriers you may want to try."

Through this process, shippers can better match their network to carrier capabilities, which helps create appropriate alternatives if your business changes, or a disruption occurs.

From an operations perspective, performance measures can lead to better alignment of processes among the shipper, carrier, and consignee. Those efficiencies can provide savings that are reflected in rates. Quantifying benefits in other areas—such as reduced damage or fewer paperwork errors—can help in evaluating rate performance, as well. Saving a few pennies per mile might be driving higher freight damage costs and poor customer service.

Put It In Writing

Another important factor in mitigating supply chain risk is ensuring that supplier and service provider contracts protect your company's interests. With U.S. imports continually increasing and exports in the trillions of dollars, companies are getting involved in more global sourcing arrangements and long-distance relationships with international suppliers, notes Dina Ribbink, assistant professor of operations management, University of Western Ontario.

Ribbink, who co-authored a study on the impact cultural differences have on contractual relationships, focuses on "contract completeness" as a means to mitigate some of the risk cultural differences and other factors introduce into global supply chain relationships.

"Uncertainty increases if you deal with partners from different cultural backgrounds, and that uncertainty can lead to more opportunistic behavior," Ribbink says. "Cultural background shapes values, expectations, and behaviors. Similarities in the partners' perceptions and background help companies reach more positive negotiation outcomes.

"Complete contracts can spell out expectations to bridge some of the gap created by cultural differences," she continues. Detailed contracts are sometimes associated with higher transaction costs, however, so it's important to strike a balance.

Know the Law

The legal system in the country or countries where the parties are doing business can affect contracts, as well. In a common-law system such as the United States, contracts tend to be longer. In countries where civil law is the system, civil codes are often more inclusive, so some details already contained in the civil code can be excluded from the contract.

Contracts can only go so far in mitigating risk, however. In some countries, the issue can be enforcing contract terms if a supplier defaults.

Arbitration services can help resolve contract issues if the parties agreed to arbitration terms in the original contract. The Hong Kong International Arbitration Centre suggests specifying the terms under which a dispute would go to arbitration, then selecting a venue—preferably a country with a common-law system—and including that in the contract.

When it comes to international trade, the goals are simple. Buyers want to get what they paid for, and sellers want to get paid. "Reaching those goals, however, can be complicated," says Susan Altman, a partner with international law firm K&L Gates.

Altman cautions against inadvertently entering into "electronic consent" through a series of e-mail exchanges. "If you agree to a price and quantity in an e-mail, you may have entered into an enforceable contract," she says.

One way to reduce risk on imports is to deal with a U.S.-based entity. "But the foreign supplier's U.S. entity may have no assets in the event you need to seek a legal remedy, so be cautious," says Altman.

"With foreign contracts, spell out more details than you would with your U.S. purchases," she recommends. "These details can include what legal system applies to the contract; pricing, including currency and what date will be used to determine the exchange rate; delivery and payment terms; and dispute resolution."

If the risks of foreign sourcing sound high, it's because they are. But the value of relationships often outweighs the appeal of opportunistic or transactional behavior. "Even with significant cultural distance between parties, suppliers often won't default because they want to continue the relationship," Ribbink says.

Quantifying Security Risk

Even if you've established strong relationships and solid contracts with all your suppliers and service providers, external events can jeopardize your supply chain. For example, political upheaval, economic protests, national labor actions, and complete regime changes created turbulent conditions throughout the summer of 2011. While the media focused on the human and political struggles, some factors behind the scenes held the attention of logistics and supply chain professionals.

As protests in Egypt mounted and the government toppled, many supply chain professionals focused on the Suez Canal. Disruption of this vital trade link could have been devastating to many supply chains. These events naturally lead to questions about port security.

Ships and Ports Security

After the terrorist attacks of Sept. 11, 2001, the International Maritime Organization developed a set of security procedures known as the International Ship and Port Facility Security Code (ISPS). The purpose of the ISPS is to assess and address risks on a case-by-case basis with measures that reduce the threat to, or vulnerability of, ships and ports.

Ensuring you work with ocean carriers and ports that are ISPS-compliant helps mitigate the risk to your own supply chain. Assessing the effectiveness of measures taken at each port is more difficult, however.

Risto Talas of England's University of Hull Business School has developed an approach that helps ports assess the efficiency of their own security spending against actual performance in reducing that risk. His model, currently applied to terror threats at ports, could be expanded to look at other risks throughout the supply chain.

Talas started by looking at the risks to port terminals themselves, including a bomb introduced by foot, car or truck; introduction of biological agents; mining of the port or structures; or a vessel attacked by suicide boat.

He worked with insurance underwriters to assess risk and probability, and with port security officials to calculate expected losses with no security systems in place, based on the probability of any of the security threats occurring within a 12-month period. In one example, Talas showed an expected loss for one port calculated at $5.6 million.

The simplified formula multiplies the threat by the vulnerability by the consequences. Evaluating security systems individually against each threat enabled Talas to find a correlation between effectiveness and expected loss.

For instance, access control at a port's landside gates have no effect on deterring a waterborne attack. However, gates, fences, access control, and biometric access control have a strong correlation in mitigating risk of a bomb delivered by foot, or a car or truck bomb.

Using those various correlations of effectiveness, Talas was able to show that the risk could be reduced to $1.9 million. He calculated the ratio of risk reduction to spending as $7.13—for every dollar spent on security, risk was reduced by $7.13.

This data allowed the ports to analyze loss by incident type and recognize their weaknesses or greatest vulnerabilities. It also helped demonstrate the value of spending on security, and indicated how to allocate that spend more effectively.

Using what he has learned about assessing security investment against residual risk in this terror-based scenario, Talas is now examining other types of risk. The potential exists to apply this approach to other types of supply chain disruption risks.

The result is one that every supply chain manager would be eager to see: the ability to allocate the right amount of resources to avoid the risks with the greatest probability for disrupting their supply chains and causing the greatest loss.

Recognizing Risk

The sheer complexity of extended supply chains introduces and amplifies risk—whether related to economic stability or physical security. Recognizing where those risks are greatest—and which risks are the most potentially disruptive—can help focus resources on reducing potential losses.

Well-defined business practices, thorough contracts, good physical security, and active planning are just a few steps that can help keep your supply chain whole and strong, no matter what disruptions are thrown your way.