Prevention better than cure

Supply Chain risk keeps CFOs awake at night, yet commonly they say they don’t have the time, staff or budget to deal with it, finds the 2008 Supply Chain Business Forum.

Supply chain disruptions are becoming more frequent.

According to a recent Accenture survey of 151 industry executives in the US, 73 per cent had experienced significant disruptions in the last five years.

Despite this, further research by Aberdeen Group reveals less than half these companies have systems in place to manage and respond to disruptions.

Professor Vinod Singhal of Georgia Tech in the US, and chair of a panel exploring the financial impact of supply chain disruptions at the recent 2008 Supply Chain Business Forum, believes executives have too many risks to manage, so it’s a question of where to focus limited resources.

Singhal told the invitation only Forum, an initiative of international supply chain expert John Gattorna, that while terrorist attacks, natural disasters and other highly publicised supply chain disruptions generate discussion and concern, the industry still doesn’t really know where to direct its energies.

“Most executives can see the value proposition of improving efficiencies and reducing costs,” Singhal says, “but they have a hard time getting a handle on the economic consequences of supply chain disruptions.”

“This may prevent them from making investments and changes that could mitigate the risk of disruptions.”

By way of example, Singhal points to last year’s product recalls at Mattel.

“The company wouldn’t have expected its Chinese suppliers to be using lead paint,” he says.

“Similarly, Airbus wasn’t able to predict development woes which caused delays to the delivery of the A380.”

Vinod Singhal is the author of the most comprehensive and detailed analysis published to date on the long term performance effects of supply chain disruptions.

Based on a study of 800 large public firms in the US, Singhal finds that supply chain disruptions result in stock prices between 33 to 40 per cent lower than their benchmarks over a three year period.

This starts one year before, and ends two years after the disruption has been announced.

“Essentially, companies don’t run to straight to the market when they have a problem,” Singhal says.

“They wait for the right moment and in the meantime try and fix it.”

“If the problem doesn’t get fixed they eventually have to tell the market what’s happening.”

“When a company announces the supply chain disruption to the capital markets, there’s an instant negative response and on average, we see a 7 per cent drop in share price for each of the 800 companies,” Singhal explains.

“More interestingly, about 6 months before the announcement we see a 12 to13 per cent underperformance in the share price.”

“In the six months before an announcement, the stockmarket may not know the reason for the problem, but negative effects can already be felt,” Singhal says.

“These bring the stock price down. After making an announcement, the company might put mechanisms in place to recover, but the competition starts to take advantage of the situation and we see another drop to about a 10 per cent underperformance in the following year.”

Disruptions also increase risks to the brand.

“What we found is that volatility following a disruption increases by about 21 per cent over a 2 year period,” Singhal says.

“This means the stockmarket perceives the company to be very risky; one that’s failing to manage its supply chain and make money.”

“Uncertainty about whether a company will actually survive reduces its credibility with customers and creates uncertainty in the market.”

Singhal describes a 13.5 per cent hike in share price volatility in the year after the disruption compared to volatility in the year before the disruption.

“Volatility is also very critical because it affects your ability to raise capital at affordable rates,” Singhal says.

“It affects investors who might be forced to sell shares in the company if the volatility poses unacceptable levels of risk to their portfolios.”

Not surprisingly, Singhal’s research finds disruptions have a significant effect on profitability.

“After adjusting for industry and economic effects, the average impact of disruptions is a 107 per cent drop in operating income, 7 per cent lower sales growth and an 11 per cent growth in costs,” he says.

“Companies that were making a lot of money before the disruption are making losses by the time they deal with it,” Singhal says.

“Profitability drops firstly because the disruption means customers are not getting the product. Sales drop off by about 7 per cent, quite a big number for most companies.”

“Secondly, the disruption increases costs by about 10 per cent because along with fixed costs, the company has to take action to recover from the disruption.”

“Overall, this amounts to a 107 per cent drop in profitability.”

Panellist Professor Martin Christopher of the UK’s Cranfield School of Management says trends exacerbating supply chain risk include leaner, more complex global supply chains, the centralisation of production, reductions in the supplier base, and outsourcing.

“Supply chain efficiency isn’t just about speed,” he says, “but about agility, or the ability to move from one speed to another.”

“However, a conflict arises for lean companies in that the key to agility is capacity.”

“While it’s not seen as desirable to have idle inventory, there may be a role for some slack in the supply chain to mitigate the risk of disruption.”

“It’s true that everyone is facing cost pressures and building in slack capacity can be expensive,” concurs Vinod Singhal.

“But there are certain critical nodes in the supply chain where building slack could prove an essential strategy. These are the points in the supply chain at which a break down will cause devastation”

“Using single sourcing for example has been very popular in the last 10 years but it can cause supply chain stress,” Singhal adds.

“If you have a single source supplier that fails to perform you’re in trouble.”

“An alternate source of supply is the obvious answer.”

Mitigating supply chain risk is essentially about prevention rather than cure.

Panellist David Bird, director of PriceWaterhouse Coopers’ Risk Advisory Division says mitigating risk requires companies to develop and monitor long term processes which lower risk without impacting operational efficiency.

“Companies should scan the environment for opportunities to reduce risk without major investment,” he says.

“They should frequently question the cost to benefit ratio of certain strategies, such as buying insurance to transfer risk.”

Vinod Singhal argues the problem with transferring risk is that it’s difficult to quantify exposure.

“With automobiles or property damage for example, you can price the risk very well,” he says.

“Not so for risks relating to the structure of the supply chain.”

“It’s true that insurance companies are getting more active in supply chain risk management, but I’m not sure they’ll be prepared to cover economic impacts that are consistently difficult to quantify.”

Singhal says there’s no escaping the fact that mitigating risk requires an arduous process of assessing the primary sources of risk your company might be facing.

“A company must analyse how frequently certain risks might happen and what the consequences might be,” he says.

“The mindset for many companies is to source low cost products from China for example, but they need to understand this involves risk.”

“So the first step in any mitigation strategy is to understand what’s happening in the supply chain.”

“Companies can’t be expected to deal with every kind of risk, but once you have some kind of risk ‘map’ then you can start to put counter strategies in place.”

Singhal says one of the main difficulties in dealing with disruptions is the lack of supply chain visibility.

“With visibility at critical points, whether on the supplier or customer side, I come to know about problems today rather than next week,” he explains.

“Visibility is a very good way of getting early signals of what’s going on in your supply chain. It takes time, but it’s simple and it doesn’t have to cost millions.”

In addition, a lot of companies are investing in lead time reduction to mitigate risk.

“If lead times are long, bad things can happen,” Singhal quips.

“If time is short, there’s less chances of things going wrong. Short lead times also have other benefits, such as the ability to reduce the inventory you carry and forecasting becomes easier.”

“If you reduce lead times, visibility is automatically increased,” he adds.

Panellists agree developing a risk management culture at the highest level is essential to prevent and respond to supply chain disruption.

“People don’t pay much attention to risk management on the supply chain side,” Vinod Senghal observes.

“There’s an unwritten code of failing to give credit for fixing problems that never happen. Managing the supply chain well is simply expected.”

“Companies need to develop a healthier culture for supply chain risk management as opposed to financial risk. This must start at the C-level.”

“Once management understands the risk, investments can be made to develop the required capabilities to deal with that risk.”

Singhal says Wal-Mart is a case in point, deploying a dedicated group to monitor risk related to weather alone, such as hurricanes or snow storms.

“That’s a commitment Wal-Mart’s top management has made,” Singhal says.

“Company people have a clear understanding that it’s a very important aspect of the business.”

“The second thing with respect to culture is that people who see potential risks should be willing to communicate it up the ladder.

“Often when there’s a risk, people don’t want to talk about it. So you really have to build a culture where people are very open, even when it’s bad news.”

Supply chain speak these days is all about new and better ways to create shareholder value. Vinod Singhal says it’s equally important to avoid destroying it.

“Without a rigorous approach to risk mitigation and management, any investment made to reach high performances levels could be wasted,” he says.

“Once you create value you need to take action to preserve it. You might make a lot of money, but if you lose it all, what’s the point?”

Held at the Sofitel Hotel in Werribee, Victoria, the 2008 Supply Chain Business Forum was hosted jointly by the Institute for Logistics and Supply Chain Management at Victoria University, Melbourne, and Macquarie Graduate School of Management, Sydney.

The next Forum is scheduled for February, 2010in the Hunter Valley.

Leave a Reply

Send this to a friend