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Supply chain resiliency: From insight to foresight
Sustaining shareholder value by hardening the enterprise against external risks.
Major flooding in Thailand in October 2011 disabled electronics component manufacturers for months and disrupted worldwide supply chains across the electronics industry. The havoc caused consumer product shortages during the holiday season, and the financial impact lasted for most of 2012. The damage to shareholder value, customer loyalty, and brand value are harder to calculate, but are likely to still be ongoing for some OEMs.
Natural and manmade external disruptions to supply chains-as well as the ensuing long-term financial consequences-are spurring supply chain professionals, senior executives, and corporate boards to rethink their approach to risk. After two decades of pursuing more efficient supply chains with risk-mitigation strategies aimed at swift disaster recovery, companies are pivoting toward more proactive and adaptive supply chains.
This shift has come as supply chain executives-and investors in their companies-have learned just how much external disruptions can degrade corporate performance. As incidents such as the Thailand floods increase in frequency, the risk grows that they will destroy shareholder value and customer loyalty, which took years to build. In one seminal study, companies that suffered supply chain disruptions experienced as much as 40% lower stock returns and took two years to fully recover from the shock. Faced with such consequences, corporate boards are starting to realize that the supply chains they have built are as fragile as they are efficient, and that being great at disaster recovery is not good enough.
Today's supply chains are well prepared with contingency plans to recover fairly quickly from some disruptions. But fairly quickly no longer satisfies shareholders and customers. Supply chains and the enterprises they serve need to become resilient-that is, better at sensing and responding to threats before they cause acute, sustained, and possibly catastrophic financial consequences.
The art and science of anticipation requires new types of information and analysis. To manage efficient supply chains, supply chain managers have traditionally used insight derived from operational metrics. Resilient supply chains, on the other hand, depend on foresight, scenario modeling, and predictability. Operational metrics, valuable as they are, look to the past or present. To attain foresight-and thus, enable resiliency companies need broader sources of data about external risks and their potential impacts.
Why resilient supply chains?
Robust economic research confirms the destructive power of supply chain disruptions. According to the most thorough study to date, by Kevin Hendricks, of the University of Western Ontario, and Vinod Singhal, of the Georgia Institute of Technology, disruptions damage stock price, profitability, and share-price volatility. Their research uses publicly available financial data for companies involved in 827 announced disruptions from 1989 through 2000.
The authors concluded that disruptions, whatever the cause or timing, do lasting damage. The average company in the study sample saw its total shareholder returns lag industry benchmarks by anywhere from 33% to 40% during a three-year period, starting one year before and ending two years after the date the disruption was announced. The average share price was 135% more volatile in the year after that disruption than the year before the disruption. Most troubling of all, the average company in the sample reported operating income declines of 107%, sales falling by 7%, and cost increases of 11% after adjusting for industry and economy effects. Those are, without question, material changes in corporate performance and, thus, of board-level concern. Under current corporate governance law, senior executives open themselves to litigation from shareholders and questions from regulators if they fail to take adequate precautions against disruptions.
The floods in Thailand, for example, may be a case of inadequate precautions-with severe consequences. Thailand is the world's second-largest producer of hard-disk drives, accounting for 25% of the total, and the floods severely tightened the supply of drives for computers, smartphones, and other mobile devices. HIS estimates that worldwide hard-disk drive production declined 26% from the third to the fourth quarter 2011, a fall that continued through most of 2012, nearly doubling prices for a time. At least one hard-drive manufacturer has yet to fully recover from the disaster and has lost market share to a rival that did not rely as heavily on Thai suppliers.
Make room for external risks
Resiliency demands a new mindset on the part of supply chain managers. For as long as the concept of supply chains has existed, supply chain managers have focused primarily on the risks in supplier operations. Their goal has been to keep the right inventory moving through the right pipeline at the right speed. They have managed and mitigated risk by tracking metrics such as product quality, on-time delivery, cost, responsiveness, financial viability, and operational capability. These metrics provide a snapshot of how the supplier is performing at any given moment, and supply chain managers have continually improved their metrics and tracking technology. Today, they can tap unprecedented amounts of such data using dashboards designed for operational decision makers.
Now, though, the high cost of external disruptions is spurring organizations to focus as much on data outside the supply chain as within it. But surveys suggest that many supply chain managers have been slow to broaden their information horizons. As a result, they are overlooking or minimizing significant risks (see sidebar "The wide variety of external risks" at the end of this article).
Supply & Demand Chain Executive magazine recently conducted its 2013 Global Outsourcing & Supply Chain Risk survey of 220 supply chain professionals. Nearly one-third of respondents-65%-said the financial impact of supply chain disruptions of all types is increasing. In the same survey, more than 86% said their supply chains had experienced disruptions within the past two years that had material impacts on business continuity.
The survey asked respondents to identify levels of concern for various supply chain disruptions. The most concern surrounded supplier viability/failure, followed by natural disaster/weather. The category of least concern was manmade disasters (see figure below).
The results indicate that supply chain managers may place insufficient weight on external disruptions, especially manmade disasters, labor disputes, and geopolitical instability. Perhaps organizations feel they are immune to these risks, or they have not analyzed the ripple effects on suppliers. Perhaps the relative lack of concern for labor and wage disruption exists because today's supply chain managers have grown accustomed to operating in a buyer's labor market.
Whatever the reasons for lack of concern, the idea behind foresight-driven resilient supply chain management is not to discard or downplay supplier viability. The idea is that supply chain managers have achieved a high degree of mitigation for operational risks and now need to broaden their focus and consider external risks and vulnerabilities stemming from interdependencies within the entire global operating environment. To do so, they need to develop new sources of information about those risks and predictive models that incorporate them.
This approach to supply chain strategy involves using unconventional information sources, some of which might appear downright fanciful on first inspection-for example, how could a strike by sanitation workers delay computer deliveries? If companies can better read the environment around their supply chain, they can avoid some risks and minimize others.
The resilient supply chain
It sounds counter-intuitive, but the very efficiency of today's supply chains, continually honed during the past decade by technology, lean principles, Six Sigma programs, and the like, has rendered them more vulnerable to disruptions. When supply chains operate at top efficiency, for example, there is little inventory flexibility. At any time, 80% of inventory is somewhere within the supply chain, leaving little available in case of a major disruption.
With their strong orientation toward efficiency, today's supply chains are optimized to either avoid or handle high-probability operational problems, which they do well. They are not optimized for once-in-a-decade, low probability disasters. That is no accident. The high cost of preparing for a low-probability event would seem to far outweigh any potential benefits.
Hendricks and Singhal take a different view. "In many instances," they wrote in Supply & Demand Chain Executive, "supply chain investments and initiatives should be undertaken not because they reduce costs but because they increase the reliability and responsiveness of supply chains. Such investments and initiatives should be viewed as insurance against avoiding destruction of corporate performance, should disruptions happen, and they should be justified on this basis and not cost savings."
The investment Hendricks and Singhal advocate aims to harden the enterprise against foreseeable, if infrequent, emergencies. Much of the investment is in information and analytics that help companies prepare long before a crisis. Among the information today's supply chain managers rarely factor into their risk assessments are weather patterns, country-risk analysis, maritime shipping intelligence, fuel costs, labor rates, economic forecasting, and parts and commodity prices and availability. Properly weighted and correlated with other data, such information streams can help companies anticipate potential disruptions and predict their possible impact.
Another look at the floods in Thailand offers a chance to examine how OEMs could have thought differently about the risks in the region. With a new appreciation for external risks, supply chain managers might have raised a red flag when they realized that all the local suppliers to the disk-drive industry were located on a flood plain. Analysis of historical weather data would also have shown that disastrous floods, although rare, are not unprecedented. Moreover, the floods came during the monsoon season, a predictable occurrence. The convergence of all these factors on a single industry in a single region could have caused OEMs to find or establish alternate sources in other regions. That step alone would have created more resilient supply chains.
Foresight and predictability
Companies that want to build resilient supply chains should first take a close, critical look at their supply chain's operating environment and interdependencies. That means assessing the geographies and climates where suppliers (and suppliers' suppliers) operate; the political, labor, and regulatory situations in those regions; and other external factors most likely to disrupt a particular supply chain's operations.
The next step is to develop a predictive analytical framework of internal (to both the enterprise and supply chain members) and external sources of information about the various risks their supply chains most likely face, including:
- Dependencies on macro and regional economic, sovereign, or sociopolitical risks
- Global security threats and vulnerabilities in critical infrastructure, supply chain, assets, and operations
- Logistics and trade-flow fluidity in global movements across international, domestic, and local networks
- Supply-base inputs, economic influences, and scenarios for sourcing, pricing, and availability of critical commodities and materials
- Shifting market, technology, and competitive landscapes that may change supply-and-demand networks
- Regulatory change and non-financial reporting obligations to shareholders
- Supplier viability and vulnerability, with multi-tier relationships across the supply base to pinpoint supplier interdependencies and vulnerabilities
After assessing each risk factor, the next step is to map the corporation's supply chains to those external risks, determine the most likely sources of disruption, and model scenarios that can provide foresight into how they might be handled. Those scenarios should allow for interdependent external risks that could converge and interact.
It is important to take an enterprise perspective during this exercise. A supply-chain-only perspective limits the risk mitigation effort to matters more directly controllable by supply chain specialists, who typically focus on total cost savings achieved, attainment of cost-savings targets, purchase-price variance, on-time delivery, and similar metrics. They are superb tools for measuring and driving efficiency. They do nothing to harden the enterprise for greater resilience. When testing for resilience, supply chain professionals need to broaden their scope to take into account enterprise impacts such as reduced share price, increased operating risk, increased share-price volatility, lower stock returns, and reduced profitability.
The goal of this admittedly challenging undertaking is to move beyond the insight provided by today's risk dashboards to foresight based on an understanding of the external forces most likely to impact the enterprise. To gain timely access to the right sources of information in an integrated fashion, and to begin the evolution to predictive modeling based on these factors, companies and their supply chain leaders are likely to need a partner or partners. In securing such partners, it is important to look for those who can help:
- Understand enterprise resiliency and guide the company toward that goal
- Redesign efficient but brittle supply chains to become responsive and adaptive networks
- Integrate interconnected economic, geopolitical, and industrial insight into supply chain management
- Enable forward-looking monitoring of supply chain performance with foresight into market dependencies and global scenarios
The resilient supply chain and its impact on the entire organization are important enough to involve corporate leaders from across the enterprise. Initiatives need sponsorship from the most senior corporate executives which might not be such a tough sell considering the high level of interest among boards that are concerned about the potentially enormous impact of external risks on customer loyalty, brand value, and share price.
Today's supply chain risk management involves dashboards that look back or capture the moment; tomorrow's will need to look ahead for more dynamic monitoring and risk management. Most enterprises are in a stage characterized by business continuity assurance. Their enterprise performance includes supply chain risk as an element of disaster recovery or business continuity plans. The next generation-resilience-requires leaders to evolve to a stage in which dynamic disaster recovery is the norm. That is to say, a stage where enterprise performance and supply chain risk are proactively managed, continually monitored, and intrinsically linked. It means expanding the information base to include insight about external influences on enterprise performance to provide the foresight needed to manage foreseeable risks.
The journey toward more supply chain resilience is only beginning. Some supply chains have taken the suggested steps and achieved more dynamic mitigation of external risks, aided by predictive analytics and disparate information sources. But true resiliency is an enterprise transformation. It is a continuous pursuit of excellence and improvement (see chart above). Given the potential harm to corporate performance, most corporate boards will be ready, possibly even eager, to settle in for the long haul.
Learn more about Supply Chain Resiliency.
The wide variety of external risks
Any discussion of external risks should begin with natural disasters. In recent years, we have learned repeatedly that such risks are more disruptive than anything short of nuclear war. The year 2011 was marked by two memorable natural disasters that reverberated through supply chains worldwide: The earthquake-bred tsunami that struck northern Japan in March and the floods in Thailand.
ust as the floods took a huge toll on disk-drive production, the tsunami had a severe effect on production of a type of hybrid memory used in high-end manufacturing processes. Most of the plants that make the memory were located within 15 kilometers of the areas hit hardest by the tsunami. Their recovery from the severe damage caused by the ensuing heavy floods was hampered by the destruction of transportation networks that feed into the region.
Both incidents underscore the risks inherent in the geographical concentration of suppliers. Not only are they vulnerable to natural disaster, their concentration exposes them to manmade disruptions such as political or labor strife. Geographical diversification, then, can mitigate risk.
This lesson can be applied to other regions, such as the Korean peninsula. About 80% of memory chips for electronics come from manufacturers in South Korea. A war with North Korea would, obviously, disrupt far more than memory production. All the same, where would OEMs turn for memory? What are they doing now to make sure a war or other disaster on the peninsula does not stop production of virtually every electronics product? Although the cost of memory manufacturing might be more expensive elsewhere, the electronics supply chain could well benefit from memory production diffusion-just in case.
Labor and wage disputes are another manmade risk. Supply-chain professionals typically consider the wage structure of their suppliers as an aspect of cost, but it is also important for them to consider the ripple effects of labor disputes outside their industry. Several years ago, for example, personal computer deliveries to southern France were halted because of a garbage strike in Paris. That strike had nothing to do with computer makers or suppliers, except that their transport routes led through the city, the streets of which were impassable because of the garbage strike.
Regulatory changes are another external force to consider. The SEC is rolling out conflict minerals regulations mandated under the Dodd-Frank Act. Conflict minerals-tin, tantalum, tungsten, and gold (known colloquially as the 3Ts)-are those mined in conditions of armed conflict and human-rights abuses by armed rebels in Congo, Rwanda, Colombia, and Venezuela (among other places) to fund their insurgencies. They sell the minerals through intermediaries to electronics companies. Dodd-Frank requires audit trails and disclosure of minerals' origins; similar but tougher rules are under consideration by the European Union. How will this new regulatory regime impact crucial supplies?
Here is another issue to consider. Hydraulic fracturing to extract oil and gas takes enormous amounts of water. Supply-chain professionals should factor in the possibility of water shortages or much higher water costs as a result of demand from the hydraulic fracturing industry in North America.
Hydraulic fracturing also illustrates another type of risk-the risks to one industry due to a surge of new demand from emerging industries. Hydraulic fracturing will drive consumption of high-pressure pumps that move water. Those pumps contain high-speed precision ball bearings. As demand rises for these pumps, industries such as aerospace and heavy-vehicle manufacturing that also use the bearings could see supplies tighten and costs rise.
In short, it is a big world full of risk. It is time to give that risk the attention it deserves.
Jr. Gene Long is Vice President of IHS Supply Chain Consulting.
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