Risk Mitigation: Supply Chain Safety Net
Meeting demand without overinvesting in safety stock can be a real balancing act. Risk mitigation strategies protect shippers from landing hard when supply chain disruptions occur.
Japan’s Supply Chain Aftershock
Taking Stock of Financial Risk
In a near-perfect world, supply and demand would wobble and waver, then—in harmony with historical context and predictive hedging—find some semblance of balance. But when an unforeseen force topples formalities, there’s no quick fix for chaos.
Consider the litany of natural disasters that have sent shockwaves through supply chains over the past few years: Iceland’s Eyjafjallajökull volcano eruption in 2010; the earthquake and tsunami that struck Japan in March 2011; severe floods in Thailand that followed four months later; and Hurricane Sandy in the United States in October 2012. Then add the social and economic dis-ease spread by financial contagions—draconian realities that still resonate in many parts of the world.
Global supply chains are fraught with risk. Supply and production lines span continents, and are pulled so taut through continuous optimization that any blip of the radar threatens to snap routine, and cause disruptions. That’s the cost of doing business.
"Companies have been optimizing their supply chains, offshoring for cost purposes, and keeping inventories low for just-in-time efficiency," says Perry Rotella, group executive of Jersey City, N.J.-based information services firm Verisk Analytics’ supply chain risk analytics business. "All that builds risk into their networks. Companies can’t optimize without factoring in these elements."
The greatest defense against any unseen exception is knowledge. Even a scant understanding of a supply chain’s risk exposure can help companies make necessary preparations before the inevitable eventually happens.
According to Carlos Alvarenga, principal in professional services firm Ernst & Young‘s operations finance and risk practice, supply chain risk management falls into three buckets:
- Physical mitigation. Think safety stock, multiple suppliers, and excess capacity. A good example is a car lot, which hedges against demand volatility. It’s the most common tactic of the three.
- Analytical mitigation. This category takes the shape of sales and operations planning, forecasting, and collaboration. It often places an emphasis on control towers and real-time visibility of transportation and materials movement. This application is widely used, but less so than physical risk management.
- Financial mitigation. This approach is used by a smaller set of companies, and deals with supply chain risk from a completely different perspective. It addresses financial risk problems, as opposed to disruption or physical flow issues.
Most companies are well-versed in managing the physical part of the supply chain. Academic supply chain curricula cater to this perspective more than the financial side, says Alvarenga, who also serves as senior research fellow at the University of Maryland’s Robert H. Smith School of Business.
Natural hedges are common ways for companies to allay risk. But this presents challenges for supply chains that are running lean with less inventory.
"Shippers are trying to drive more efficiency in their supply chains. Historically, they have expanded their sourcing, manufacturing, and distribution, which has created a fragmented supply chain," explains Kim Wertheimer, executive vice president, strategic development, for Netherlands-based global third-party logistics (3PL) provider CEVA Logistics.
When the economy tanked in 2008, shippers contracted. They rationalized networks to be more efficient, drive velocity, reduce costs, and improve service quality. With fewer redundancies, exposure to risk only grew. When a global catastrophe the likes of Japan’s earthquake and tsunami struck, supply chains were greatly impacted (see sidebar).
This event had a concussive shock on U.S. industry, notes a 2011 Congressional Service Report titled Japan’s 2011 Earthquake and Tsunami: Economic Effects and Implications for the United States.
"Japan plays a major role in global supply chains, both as a supplier of parts and as a producer of final products," the report states. "In this age of just-in-time production processes, even a small disruption in the provision of a single component can wreak havoc on an entire product line.
"Japan’s production of automobiles, semiconductors, and electronics is likely to be affected the most," the report notes. "But companies in the United States that rely on Japan for critical components such as electronic parts, batteries, or transmissions for electrical vehicles also will be affected."
The Japan disaster affected production directly. The 2010 volcanic eruption in Iceland, on the other hand, created an ash cloud that specifically disrupted transportation. Shippers moving high-value and time-sensitive product were forced to find airfreight alternatives, chartering flights and re-routing shipments around the European air space. Few, if any, contingency plans could have addressed such billowing circumstances.
Any Bump in the Road
All it takes is one glitch in a complex, demand-sensitive supply network to completely halt production. There’s no surefire way to safeguard supply chains from these types of exceptions. But companies can minimize risk by taking certain steps.
"Shippers may maintain dual sources of supply where it makes sense economically," says Wertheimer. "But they also need to consider the robustness of their transportation network, and ability to leverage multimodal alternatives—air, ocean, or ground—as well as various routing options."
Nearshoring is another possibility. While locating production closer to demand can reduce transportation costs and increase demand responsiveness, risk aversion shares equal billing.
"Nearshoring enters the discussion as well, because it shortens the supply chain and reduces risk and volatility," Wertheimer says. "It becomes a matter of balance."
All Along the Control Tower
Shippers also turn to third-party logistics and forwarding partners as an extra measure of security, recognizing the advantages they deliver beyond just execution.
"When companies are concerned about supply chain risk, they are more thoughtful about pre-positioning inventory or materials in certain areas—even to the extent of using CEVA’s network to position materials closer to the point of consumption," says Wertheimer.
But the logistics sector is developing capabilities beyond that. Analytical mitigation is an intermediary’s domain. When companies adopt more sophisticated supply chain best practices, they often rely on value chain partners to provide cover in terms of facilities, IT systems, and labor.
The supply chain "control tower" has become a widely bandied buzzword, providing a technology foil to fourth-party logistics and lead logistics provider models. In CEVA’s world, the concept means having dedicated teams working closely with customers to manage material flows through its systems and processes.
For example, CEVA set up shared customer operations in Europe, North and South America, and Asia. Control towers comprise anywhere from 10 to 20 multi-lingual operations personnel, with the concept of being able to provide 24/7 visibility across a common global platform.
"Individuals managing particular accounts can track orders and shipments, respond to disruptions, and communicate back to the customer or supply base," Wertheimer notes.
CEVA sees control towers as an extension of the shippers’ supply chain. Sometimes, where there is critical mass and it makes sense, the 3PL will establish customer-specific facilities that might be co-located with distribution operations. For example, in the automotive sector, CEVA operates a dedicated control tower on site at a crossdock with one of its large manufacturing customers.
Access to this type of visibility and centralized control allows shippers and service providers the latitude and agility to react to demand signals or disruptions more quickly. But it’s not just a matter of handling the exceptions. Supply chain variability happens daily—from weather to flight delays to supplier production and quality issues.
"Shippers can utilize our networks, teams, and control towers," Wertheimer says. "In some cases, we set up response groups with a customer or in specific areas, to manage through the disruption."
The best protection against supply chain risk is developing some sense of probability. Technology has evolved to a point where companies can mine a lot of useful data that they can juxtapose with historical context to predict the likelihood of disruptions.
Companies such as Verisk Analytics help firms assess and simulate potential risk exposure. "We work with companies to model their network, provide the ability to look at different scenarios, then apply risk elements," says Rotella. "We can help them better understand the value at risk for each supplier, route, and location."
Planning for the Unpredictable
Part of the challenge companies face is that all risks are not equal. Leading indicators often precede weather and even political disturbances, allowing companies to plan for problems. But some natural disasters and weather phenomena are 100-year events. "What’s the business case for planning such a contingency?" asks Rotella.
Companies have to compartmentalize their exposure, look at risk holistically, then prioritize accordingly. Rotella cites a pharmaceutical manufacturer that Verisk is currently working with to help safeguard product flow from point of supply to demand. Special considerations apply for moving time- and temperature-sensitive, high-value medications. Determining how to re-route shipments and keep flows moving is no small challenge.
"December poses a risk because of holiday shipments," explains Rotella. "If a storm occurs during that time, it could cause a disruption. So the pharma manufacturer wanted to use our weather analytics and predictive modeling to get out in front of these problems.
"Look at the Iceland volcano eruption," he continues. "Who could have predicted that event? When something like that happens, a company needs resilience in its network to respond."
When companies grasp the actual value at risk, they can begin to take steps to mitigate these concerns. Many turn to physical hedges or logistics partners to provide cover.
Some companies take advantage of predictive analytics to drive competitive advantage. For example, using its climate risk management solution, Verisk helped a roofing manufacturer gain better control over demand planning by looking at extreme weather events.
"Taking into account historical data, we can predict the demand for roof shingles three to six months after a hail storm in Illinois," Rotella says. "We can help the company maximize its revenue by getting product out that is affected primarily by weather."
Verisk has also worked with companies to help them better understand the storm track of hurricanes so they know what to do if they have to shut down operations and move manufacturing from one location to another.
In addition, Rotella’s group released a blackout model that estimates the probability of power outages down to the street level based on U.S. power grid mapping.
"The power grid tries to adjust when outages occur," Rotella explains. "Capacity is also an issue. We have modeled a dynamic network that can help companies understand where outages and potential infrastructure issues will occur. This helps many firms with site selection and network optimization."
Whether companies use risk analytics and modeling to cover their assets or seize market share, Rotella sees growing awareness and greater responsibility among shippers. Many are turning to logistics partners to provide support—although the companies themselves are still accountable to shareholders if a disruption occurs.
Compared to physical and analytical mitigation tactics, financial risk management is an area that has been largely overlooked in the supply chain—yet it can have a significant impact on corporate finances.
Natural hedging occurs when a company looks at where a product is bought, then stages production close to those markets. Nearshoring and supply chain regionalization may help reduce transportation costs and increase demand agility, but these strategies also help protect against currency fluctuation. Industries that are global, capital-intensive, or have complicated production and distribution models—such as the chemical, semi-conductor, automotive, and apparel sectors—tend to be more attuned to these financial exposures.
"In anticipation of potential currency risk, companies sometimes change where they manufacture or distribute goods," says Alvarenga. "They also put hedging teams in place, typically as part of the treasury function."
In the day-to-day fray, shippers and service providers are exposed to different financial risks, especially when it comes to currency exchange fluctuations.
"Gross domestic product rates of major economies are the primary indicators we monitor to determine where trade is occurring," explains Tom Holland, vice president and chief financial officer of FedEx Trade Networks, the global freight forwarding arm of the Memphis-based expediter.
Currency flux generally has a greater impact on transportation than any other function. Warehousing is less of an issue—and, if so, a localized one. It’s not the inventory as much as it is the manufacturing. Transportation, accordingly, carries the greatest expense.
Monitoring Transport Costs
"From the supplier side, the exchange risk is not as significant as you think," says Holland. "A lot of forwarding isn’t contractual, so pricing is dynamic. It’s not unusual for an airline or motor carrier to raise rates because of supply and demand balances. Nor is it uncommon for them to adjust pricing in response to changes in the market."
This contrasts with FedEx’s express operations, where all business is contractual. Pricing is less dynamic because it’s an asset-based business.
Shippers that use forwarders to procure transportation benefit because the intermediary passes along the lowest rates. At the same time, when an exceptional situation occurs and costs increase, pricing is similarly variable. But it’s a balance that generally works in favor of the shipper and consignee.
When FedEx Trade Networks sets a price, it generally tries to cost everything out in the currency of its greatest expense.
"If we’re moving a shipment from Europe to the United States using a European carrier, we price it in euros," explains Holland. "Therefore, we don’t have a currency risk. The shipper will pay us and we’ll pay the major expense—which is transportation—in the same currency."
There is one caveat. Many American companies like to conduct all their transactions in U.S. dollars. This requires greater care and diligence to forecast where exchange rates are trending to ensure they don’t significantly alter pricing.
"FedEx Trade Networks may be paying Japan Airlines in yen," Holland says. "When we price it to the shipper, we have to take into account our estimate of how the yen may fluctuate."
That’s the same for any company that enters into a contractual arrangement with a forwarder or transportation provider. It has to consider where the shipment is originating from, the currency it is using, and what it thinks the exchange risk might be.
"Most currencies rise and fall, so shippers don’t have to worry about it," Holland notes. "China’s currency seems to be appreciating historically, so businesses have to take that into account. The euro seems to be better now, but for a while it was unstable."
China’s renminbi has been steadily appreciating against the U.S. dollar at such a steady rate it is almost predictable. The euro, by contrast, has been less stable over the past few years, which requires more vigilance.
"We reviewed how our contracts are set up, in what currency, and our risk exposure if the euro starts to unravel, or if some countries leave the euro and go back to their own currency," Holland says.
A Three-Dimensional Approach
As supply chain practitioners perfect the science of shipping, they are confronted by one inexorable reality: accidents happen. When they do, all bets are off.
Coming out of the recession, many companies dialed back their supply chains to focus instead on cutting costs and boosting efficiencies. Consequently, supply chains are trending leaner. They are more dynamic and demand-driven. But at what cost?
If there’s one silver lining in the turbulent events of the past few years, it is the insights shippers have gained. Companies are well aware of the risks and responsibilities that exist. Now they have to attach value to those exposures, and identify how to best insulate their supply chains from future disruptions.
Alvarenga counsels shippers to look at supply chain risk from all three dimensions—physical, analytical, and financial. They need to step away from the familiar, and pull new levers to really appreciate the risks that exist in their supply chains.
"If companies don’t do that, they are missing out," he says.
Balancing precaution with preparedness can help companies avoid being an example of the worst-case scenario.
Japan’s Supply Chain Aftershock
Following the tragic and unprecedented Japanese earthquake and tsunami in 2011, supply chains were turned on end. Because of the country’s manufacturing legacy, countless industries were impacted as production stoppages rippled outward.
A U.S. Congressional Research Service report delivered weeks after the accident details some of the consequences:
- A Hitachi factory north of Tokyo that makes 60 percent of the world’s supply of airflow sensors was shut down. This caused Peugeot-Citroen to cut back production at most of its European plants.
- Two Japanese plants accounting for 25 percent of the world’s supply of silicon wafers for computer chips were closed.
- Texas Instruments had to close a factory in Japan for six months, accounting for about 10 percent of its revenue.
- Nippon Chemi-Con Corp.—the largest producer of aluminum electrolytic capacitors used in everything from computers to industrial equipment—shut down four Japanese factories. It was forced to boost production at 10 overseas plants, including factories in Indonesia, Malaysia, and China.
- Nihon Dempa Kogyo—the second-largest maker of quartz components, with a roughly 20 percent share of the global market—relied on operations in Malaysia and elsewhere to compensate for damage to its plant in northern Japan, which assembles quartz components for automotive applications.
Taking Stock of Financial Risk
Because finance is still a relatively new facet of supply chain management, companies sometimes overlook risk factors buried in the ledgers. Here are three financial exposures companies should keep an eye on:
Embedded costs of risk. If you have a value chain and every agent in that chain is hedging its risk, the accumulation of hedges can be significant. “For example, in the automotive industry, someone is pulling metal out of the ground, then sending it to a refinery, on to a steel cord maker, then a tire maker, an automotive assembly plant, then finally to the consumer,” explains Carlos Alvarenga, principal in Ernst & Young’s operations finance and risk practice. “By the time you add up the individual hedges at each point, they can equal 25 percent of the cost of the product.”
Economic and financial risk. Supply chain risks fall into categories—economic and financial. “Economic means the risk is a factor, but hasn’t yet been quantified,” says Alvarenga. “Financial risks exist and have been quantified.”
Using the automotive industry as an example, he cites the way European countries such as Spain were acting before the Eurozone debt crisis. There was a lot of financing and easy capital. Companies were building inventory and production volumes based on an artificial demand signal. As a result, they were carrying a lot of economic risk.
“When the economy turned, that exposure became financial—and all of a sudden, it represented a big problem,” Alvarenga explains.
Similar examples exist today, especially related to weather. Some retailers and manufacturers carry a high economic exposure because of this potential volatility. At what point does it become a financial impact?
“Weather volatility, locational risk related to geography, and demand variability in emerging markets are all significant economic costs and risk drivers,” Alvarenga notes. “If they become financial—and it’s hard to predict when that might happen—companies will have to rethink their supply chains.”
Currency exchange risk. Shippers and consignees need to bear in mind where they are sourcing product from, and how currency instability in those regions can impact costs. “It is naïve for shippers to price their product and transportation in U.S. dollars when they are sourcing from Thailand,” says Tom Holland, vice president and chief financial officer of FedEx Trade Networks. “If the currency changes dramatically, their transportation and product costs may go up as well.
“Businesses need to take that into account,” he continues. “They must consider how exchange rates can alter the equation. They have to factor in where they are sourcing from.”