Supply Chain Risk Management Teams are between a Rock and Hard Place

Stephen DeAngelis

April 22, 2014

“Most managers know that they should protect their supply chains from serious and costly disruptions,” write Sunil Chopra and ManMohan S. Sodhi, “but comparatively few take action.” [“Reducing the Risk of Supply Chain Disruptions,” MIT Sloan Management Review, 18 March 2014] One of the reasons that so little action is taken is that risk management programs cost money and the return on investment is hard to demonstrate if such programs are really working. Chopra and Sodhi recognize this dilemma and admit, “Solutions to reduce risk mean little unless they are evaluated against their impact on cost efficiency. After all, financial performance is what pays the bills.” Such evaluations, however, can be tricky to make — until disaster strikes. A truly catastrophic disruption can put a company out of business. Trying to balance risk and cost efficiency can put so much heat on supply chain professionals that Steve Hall likens the situation to a crucible. [“Supply chain risk: a crucible for tomorrow’s CPOs,” Procurement Leaders Blog, 25 January 2012] Like Chopra and Sodhi, Hall insists, “Businesses need to do more in tackling risk in the supply chain.”

Adding to the pressure is the fact that supply chain professionals know there is little relief in sight. That’s because the complexity of supply chains continues to increase. Mickey North Rizza, from BravoSolution, insists, “As supply chains have evolved to value chains, so too have the methods for supply chain risk management. Value chain risk management requires a broader integrated strategy, focused on reducing the risk at each point in the value chain, while balancing risk and resiliency.” [“The Missing Future Risk Management Elements,” SupplyChainBrain, 20 March 2014] Rizza is even more pessimistic about the state of corporate risk management than Chopra, Sodhi, and Hall. He believes that 99 percent of companies still have a ways to go. He writes:

“If your supply chain is like the top 1 percent of companies, you can finally check the supply chain risk management box, because you have reduced your exposure to supply chain risk. You have a mechanism to look at tier-n supplier financials, inventory, logistics, natural catastrophic events, open orders, etc. You know that you are now prepared and ready for almost any event.  Congratulations! Of course the true test will be the first disaster that pushes against the plan and processes. Remember supply chains evolve, ebbing and flowing based on the business needs and requirements. The same is true for supply chain risk management.”

Chopra and Sodhi state the obvious when they note that “supply chain efficiency” and “supply chain resiliency” are not the same thing. Resiliency adds costs (e.g., “increasing inventory, adding capacity at different locations and having multiple suppliers”) while efficiency activities search for ways to reduce costs. They assert, however, that there is a connection between the two activities.

“Both require dealing with risks, recurrent risks (such as demand fluctuations that managers must deal with in supply chains) require companies to focus on efficiency in improving the way they match supply and demand, while disruptive risks require companies to build resilience despite additional cost. Disruptive risks tend to have a domino effect on the supply chain: An impact in one area — for example, a fire in a supply plant — ripples into other areas. Such a risk can’t be addressed by holding additional parts inventory without a substantial loss in cost efficiency. By contrast, recurrent risks such as demand fluctuations or supply delays tend to be independent. They can normally be covered by good supply chain management practices, such as having the right inventory in the right place.”

For the most part, they believe that companies have done a good job addressing recurrent risks. Concerning disruptive risks, they ask, “How should executives lower their supply chain’s exposure to disruptive risks without giving up hard-earned gains in financial performance from improved supply chain cost efficiency?” They admit that this is a tough question to answer because “disruptions are usually well beyond a manager’s control, and dealing with them can affect a supply chain’s cost efficiency.” They see two choices: Do nothing or do something? They assume that doing nothing is the worse choice. When considering what to do, they recommend adopting strategies that control “the amount of complexity” in the supply chain. Such strategies can reduce both risks and cost “which is a win-win.” They recommend “two strategies for reducing supply chain fragility through containment while simultaneously improving financial performance: (1) segmenting the supply chain or (2) regionalizing the supply chain.” They also recommend that companies design business continuity plans since no company is immune to disruption. Concerning the first strategy — segmentation — they write:

“Large companies can segment their supply chains to improve profits and reduce supply chain fragility. For high-volume commodity items with low demand uncertainty, the supply chain should have specialized and decentralized capacity. For its fast-moving basic products (typically, low margin), it may be worthwhile to … source from multiple low-cost suppliers. … This reduces cost while also reducing the impact of a disruption at any single location, because other suppliers are producing the same item. For low-volume products with high demand uncertainty (typically, high margin), companies can take a different approach and keep supply chains flexible, with capacity that is centralized to aggregate demand. Even when production is centralized, the supply chain needs to be flexible to avoid concentrating risk in a single plant or production line. … Practically speaking, this level of segmentation may not be feasible for small companies lacking sufficient scale. … Supply chains can and should evolve over time in response to product life cycles or experience with a new market. Early, when sales are low and demand uncertainty is high, managers can pool recurrent risk and minimize supply chain costs by centralizing capacity. But, as sales increase and uncertainty declines, capacity can be decentralized to become more responsive to local markets and reduce the risk of disruption. In addition to separating products with different risk characteristics, managers should consider treating the more as well as the less predictable aspects of demand separately. They should view such an approach not only as a way to cut costs but, more importantly, as a way to lessen the risk of disruption. Some utility companies use this approach. They employ low-cost coal-fired power plants to handle predictable base demand, and they then shift to higher-cost gas- and oil-fired power plants to handle uncertain peak demand. Having two or more sources of supply reduces the impact of disruption risk from a single production facility.”

The second strategy — regionalization — is probably going to be implemented by a lot of companies. In past posts, I’ve argued that within the larger context of globalization, regionalization is going to become a growing trend. It simply makes sense to manufacture products in the region in which they are going to be purchased and used. Concerning this topic, Chopra and Sodhi write:

“Containing the impact of a disruption can also mean regionalizing supply chains so that the impact of losing supply from a plant is contained within the region. … Since rising fuel prices increase transportation costs, regionalizing supply chains provides an opportunity to lower distribution costs while also reducing risks in global supply chains. … As transportation costs rise, global supply chains may be replaced by regional supply chains. … With oil prices much higher today, the most cost-effective network is more distributed, with multiple plants even within a single country like China. … Regionalizing often helps companies reduce costs while also containing the impact of disruptive events such as natural disasters or geopolitical flare-ups to a particular region. In the event that there is a problem, affected markets can be served temporarily by supply chains in neighboring regions. In many product categories, companies are deciding to regionalize their supply chains to serve even developed markets. … Although companies decide to regionalize supply chains to achieve lower costs, they also consequently ‘de-risk’ their overall supply chain.”

As noted above, no company is immune to supply chain disruptions and Chopra and Sodhi assert that, when they do occur, “researchers have identified three stages of response: (1) detecting the disruption, (2) designing a solution or selecting a predesigned solution and (3) deploying the solution.” They continue:

“Given that many companies have invested in a variety of information technology systems for monitoring material flows (such as delivery and sales) and information flows (such as demand forecasts, production schedules, inventory level and information about quality) to ensure performance and manage recurrent risks, another win-win strategy is to leverage these systems to contain the impact of supply chain disruption incidents by ensuring the company can react quickly to such incidents. Such IT systems can be a win-win: They can reduce the impact of risk incidents by enabling a quicker response by screening for possible disruptions. To leverage the benefit further, the time required to design supply chains can be significantly shortened if a company and its partners can develop contingent recovery plans for different types of disruptions in advance. … Building on the two containment strategies described above, detection, design and deployment become simpler and faster when the supply chain is segmented or regionalized.”

Rizza asserts, “Value chains are the new supply chain; smarter, more encompassing and focused on mutually beneficial outcomes.” Good risk management strategies will throw a wide net over the entire value chain. “Now [is the time] to move from supply chain risk management to value chain risk management,” Rizza concludes. “If done right, this shift will result in greater resiliency for the entire value and supply chain. And individual business will learn how to quickly address the issues by focusing on the entire value chain success vs. only one aspect.” It takes constant vigilance to keep a supply chain resilient and efficient. I agree with Chopra and Sodhi that efficiency receives a lot more attention than resiliency and that inattention to resiliency can threaten the whole business. Unfortunately, supply risk management issues seldom rise on corporate priority lists until after a disaster strikes. That’s why risk managers often find themselves between a rock and hard place.