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CHAINalytics LLC
                                                                                     Thought Leadership
to reduce costs, over-concentrates one of three operating elements: a location,
unforeseen risks everyday with security, government, partner ability, quality issues,
strategy creates. In this extreme, a firm might ship 100% of its freight on a single
1) Identify centralized ‘risk’ elements. Firms must first identify where a large
customer, supplier, or partner goes bankrupt. When Kmart filed Chapter 11,
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CHAIN alytics


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CHAIN alytics

  1. 1. CHAINalytics LLC Thought Leadership March 2003 To be published in the April 2003 edition of Chief Logistics Mitigating Supply Chain Risks Officer magazine - J. Michael Kilgore In 1997, Toyota had to shut down 20 automotive plants, halting production of 14,000 cars a day. Aisin Seiki’s plant, the sole location to produce P-valves for Toyota’s operations, had burnt to the ground. Toyota’s single sourcing of this $5 part was a strategy meant to lower costs, but it ended up creating an enormous risk that exposed the firm to financial loss. While this type of failure doesn’t occur everyday, the supply chain strategies that lead to it do. When a firm takes a traditional, cost “…focus on leveraging minimization approach to supply chain strategy, it often increases its risk of failure or economies of scale often yields increases its overall cost. results that over-concentrate resources.” While traditional supply chain redesign efforts can minimize the cost of supply chain designs and logistics operations, their focus on leveraging economies of scale often yields results that over-concentrate resources. These solutions remain optimal as long as nothing changes, but they are extremely fragile to exceptions, failure, or changes in cost. And since most traditional approaches fail to consider the hidden costs of this over concentration, these best made designs and plans heighten the risk of service failure, increased cost, and capacity imbalance. So how can a firm avoid these catastrophic events? It must manage risks, not ignore them. Without an analytical approach to managing the risk these approaches create, supply chain managers will continue to make decisions based purely on cost minimization or with only a subjective assessment of risk. To balance highest profit strategies against the flexibility and responsiveness required to deal with real-world change or failure, a firm must balance operating costs with supply chain risk. This analytical risk mitigation enables firms to tie risk management into strategic and tactical analyses, thus reducing overall costs, avoiding service disruption, and better balancing capacity and demand. Traditional Approaches Lead To An Over-Concentrated Supply Chain Developing supply chain strategies supported by tools from vendors like i2 Technologies and Baan/CAPS Logistics can help firms optimize production, streamline logistics, and reorganize their supplier base. Most Fortune 500 companies use these tools to minimize the cost of their supply chain designs, inventory deployments, and logistics operations -- and boast of their results. Dell Computer “…analytical risk mitigation anticipates saving over $1 billion through better network design and Wal-Mart plans enables firms to tie risk to reduce operating costs by 7% through enhanced transportation practices. management into strategic and tactical analyses…” But in most cases, the realized benefit falls short of the projection, leaving many firms still striving to achieve the significant ROI promised in the initial analysis. Why? Because traditional approaches ignore uncertainty and variability. Often a firm performs this cost minimization analysis by incorporating most likely costs, demands, and operating characteristics, but this sole focus fails to capture certain risks associated with customers, suppliers and internal operations. Without considering the probability of change to lead times, customer expectations, and the underlying cost drivers, the firm will create a network design that increases susceptibility to and magnitude of supply chain risk. This supply chain risk is created when a firm, looking Copyright 2003 Chainalytics LLC Page 1 of 6 March 2003
  2. 2. to reduce costs, over-concentrates one of three operating elements: a location, organization, or flow. While leveraging economies of scale by concentrating operating elements is generally a smart thing to do, over-concentrating locations leads to an extremely fragile supply chain that ignores the risks of change or failure. This supply chain risk is heightened when a firm concentrates operations at any type of location, including a distribution center, service center, plant, port, or partner facility. While shifting production or distribution to one centralized facility may reduce facility and inventory costs, it increases a firm’s exposure to catastrophic events. For example, when a food manufacturer produces an item in only one plant, a quality issue will not only stop all item production, but it will also hamper all future sales and profits. In 2002, the largest meat recall from Pilgrim’s Pride retracted 27 million pounds of meat and shut down its Franconia, PA plant for over a month – negatively affecting sales by “…over-concentrating leads to $30 million and operating costs by $5-10 million in one quarter alone. While the an extremely fragile supply economies of scale produced tremendous cost advantages, this concentration in a chain that ignores the risks of single location led to dramatic consequences. change or failure.” Concentration in any one organization like a customer, supplier, labor union, carrier, or even a firm’s own operation can also increase risk of supply chain failure. If a firm single sources from one vendor, its risk of service failure is greatly increased. Why? Because a dependency on a single source can lead to an inability to manufacturer finished goods and service demand. In late 1999, Motorola’s inability to get components caused it to reduce its 2000 sales forecast even though its phones were in high demand. But firms can’t focus solely on alternative production strategies to eliminate risk. Disruptions that occur to partner operations will almost always ripple through to each firm’s supply chain and cause it to face service issues as well. When a firm constructs its supply chain around too few lanes, regions, or modes of transport, this concentration of flow heightens the risk of operational failure. The 11- day strike-induced shutdown of 29 West Coast ports last fall had immediate and long- term impacts on importer and exporter profits. From grapes to routers, US companies lost over $10 billion in spoiled product, delayed production, and lost sales when 500,000 cargo containers piled up on their way to global customers. And it’s not just labor strikes. Regional wage hikes, state regulatory shifts, political strife, or even weather can impact customer delivery, production schedules, and overall logistics “Service disruption is more likely to occur when a tactical failure costs. or even a major catastrophe affects a highly concentrated Over-Concentration Increases The Risk Of Supply Chain Failure network.” Supply chains fail for many reasons. Labor strikes, natural disaster, machine breakdowns, political instability, and last minute customer changes all contribute to supply chain failure. While a firm can’t always anticipate these events, it often increases its exposure to the event by choosing a cost minimization strategy that drives it to over-concentrate operations in too few suppliers, facilities, or routes. The result? This over-concentration of locations, organization, or flow causes the firm to be disproportionately impacted by these unexpected events – making it vulnerable to future cost increases and stressing its ability to serve customers effectively. The result? Increased exposure to supply chain risks: service disruption, major swings in cost components, and/or capacity imbalances. Service disruption is more likely to occur when a tactical failure or even a major catastrophe affects a highly concentrated network. For example, the 1997 UPS labor strike not only stopped firms from delivering product to customers, it also hit corporate profits as some firms opted to pay excessive transportation costs to meet delivery windows. And it’s not just labor strife. Firms encounter both foreseen and Copyright 2003 Chainalytics LLC Page 2 of 6 March 2003
  3. 3. unforeseen risks everyday with security, government, partner ability, quality issues, and acts of nature, that when left unattended, increase cost and disrupt service. Any organization is highly vulnerable to major swings in cost components like transportation when these components make up a high proportion of overall cost. For example, a company might reconfigure its network by centralizing inventory -- a strategy that reduces inventory carrying costs but increases outbound transportation costs. And while this strategy might reduce overall costs, a dramatic swing to cost drivers like interest rates or fuel prices would mean that total costs actually increased more with the new configuration than if the firm had left the network alone. In fact, in “Any organization is highly the last 24 months alone, interest rates have dropped 63%, while fuel prices have vulnerable to major swings in cost components when these increased 48% in the last 12 months. Without factoring the risk or rate of these components make up a high changes, any network strategy could actually cost a company millions (Figure 1). proportion of overall cost.” Figure 1: Supply Chain Risk Alters Optimal Strategies When Strategy Was Selected .... Centralized Decentralized However with current costs …. Centralized Decentralized “As a firm concentrates its production or distribution across Costs a few facilities, it is less able to respond quickly to swings in Outbound Transportation Inventory Carrying demand.” A firm runs the risk of capacity imbalance when it concentrates its operating elements around fixed, variable, or inventory-based capacity. As a firm concentrates its production or distribution across a few facilities and thus reduces its overall capacity, it is less able to respond quickly to swings in demand. Just recently, firms that configured their network with a high fixed capacity and little inventory found it difficult to ramp down quickly as a recession and the threat of war drove demand downward. And likewise, firms that embrace JIT practices often can’t respond quickly to events that impact capacity. In September 2001, Ford Motor had to shut down its auto plants for 7 days. Its lean manufacturing strategy – one of high fixed capacity and low inventory – backfired when it couldn’t get parts across the Canadian border as a result of the 9-11 border shutdown. Mitigating Supply Chain Risks Today, most firms take a passive approach to risk management. When a firm is indifferent to risk, it focuses on cost minimization without any regard to the risk this Copyright 2003 Chainalytics LLC Page 3 of 6 March 2003
  4. 4. strategy creates. In this extreme, a firm might ship 100% of its freight on a single carrier because it’s the cheapest alternative, and therefore fail to have contingencies if that carrier stops service. An even more common approach is subjectively factoring risk by applying qualitative or intuitive constraints. In this case a manufacturer might assume that making a product in only one plant exposes the firm to service and capacity risks, but it can’t quantify the relationship between cost and risk and therefore determine the best number of production facilities. These subjective, simplistic approaches of cost or risk minimization don’t work for most situations. To manage supply chain risks effectively, firms can’t treat “Firms need to employ a higher optimization as a single mathematical exercise that chooses the right answer to level of sophistication in managing supply chain risk – reduce cost or risk. Instead, firms need to employ a higher level of sophistication in analytical risk mitigation.” managing supply chain risk – analytical risk mitigation. What is it? Analytical risk mitigation is a rigorous methodology that quantifies the relationship between cost and change to underlying factors like the network, suppliers, or demand. This approach enables a firm to find the balance between a static, “assume nothing changes” strategy, and a catastrophic “assume everything changes” strategy. The firm can then define a set of scenarios that ultimately best balance cost minimization with overall risk. Through this scenario analysis, a firm picks the most realistic strategy that factors cost, profit, and risk, and thus better projects true future costs and profits (Figure 2). Figure 2: Analytical Risk Mitigation Determines The Optimal Strategy Supply Chain Cost w /o Risk Risk Adjustment Cost $130 $120 $110 10 45 25 100 95 85 “The firm can balance cost minimization with overall risk.” A B C Alternatve Strategies Risk Adjustment = Σ Event Probability x Cost Impact Applying Analytical Risk Mitigation By deploying analytical risk mitigation, firms can diversify their risk with a nominal cost increase and deploy a strategy that will yield the lowest long-term cost. And by building risk analysis into supply chain decision-making, firms can outline the risk potential in advance of failure. To create supply chain strategies that weigh supply chain risk against the cost of mitigating the risk, firms should employ this step by step analytical risk mitigation framework: Copyright 2003 Chainalytics LLC Page 4 of 6 March 2003
  5. 5. 1) Identify centralized ‘risk’ elements. Firms must first identify where a large proportion of operating activities are tied up in a single location, organization, or flow. To do this, firms should create a holistic map that includes all supply chain nodes from source to customer. To capture the true service, cost, and capacity risk associated with each node, a firm must audit network and inventory strategies for areas where location, organization, or flow centralization might increase risk – like where it has unionized labor contracts or single sources (see Figure 3). Once each node’s risk is outlined, the firm should evaluate groups of nodes for additional risk. For example, a firm may have diversified across three West Coast ports – which protects it in case of “Firms must first identify where a natural disaster – but provides no additional protection against unionized a large proportion of operating labor strife. activities are tied up in a single location, organization, or flow.” Figure 3: Firms Should Identify Highly Concentrated Risks 0-24% 25-50% Low 51-75% Medium 76-100% High Total In % Activity in Concentration Network Top One Quotient Organizations Suppliers 100 5% Manufacturers 5 80% Carriers 25 20% W arehousers 2 50% Customers 5000 15% Labor Unions 3 50% Locations Raw Material Suppliers 150 20% Ports 1 100% Component Plants 10 28% Assembly Plants 3 60% Logisitics Facilities 20 10% Flows Global Lanes 200 10% Modes of Transport 5 30% “Risk is created when a firm has Political/Geo Regions 8 55% a highly concentrated location, organization, or flow and no strong contingency.” 2) Filter out high-contingency risks. Concentration in itself doesn’t imply risk. Risk is created when a firm has a highly concentrated location, organization, or flow and no strong contingency should the risk materialize. So once a firm has identified risk elements, it can eliminate those risks that have a wide variety of contingencies or where the contingency is of little or no additional cost. For example, if a firm currently runs 80% of its freight with carrier that goes out of business, the firm will have to scramble to choose alternative services but won’t have to shut down operations. Why? Because it has another 1,000 truckload companies that can serve its needs quickly. 3) Estimate the probability of each risk materializing. After a firm has filtered out low impact risks, it must determine the probability that each risk will occur over a given planning horizon. Economic forecasters and industry watchdogs can be good sources for macro issues like global economic plans, interest or labor rates, and union negotiation issues. And firms should at least estimate a risk’s probability when no quantitative data exists. For example, organizational risk will increase – and profits will take a hit -- if a firm’s largest Copyright 2003 Chainalytics LLC Page 5 of 6 March 2003
  6. 6. customer, supplier, or partner goes bankrupt. When Kmart filed Chapter 11, Fleming Foods was forced to reduce shareholder forecast by $.40 per share in anticipation of a sales decrease of $900 million and inventory re-routing of $200 million. 4) Assess the impact associated with each risk. Once a firm knows the risk probability, it has to determine the associated cost and service impacts. For example, if a manufacturer concentrates its production at one plant, the cost of a natural disaster would be huge. With no contingency, they would have to shut down their entire operation. But for an item produced at multiple facilities, the risk would be equal to an incremental contingency -- the cost of “Supply chain glitches reduce overtime labor when production is shifted to other plants. While service, cost, shareholder value by nearly and profit hits are direct effects of poor supply chain performance, 20%” shareholder value is also negatively affected. A recent Georgia Tech study by Vinod Singhal on the cost of failure found that supply chain glitches reduce shareholder value by nearly 20%. And while internal glitches reduce shareholder value by 7%, even more substantial, supplier and customer gaffes reduced it by 8% and 11% respectively. So it’s not just internal risk: firms must also assign the impact that supplier and customer concentration has on supply chain performance. 5) Evaluate the cost of spreading the risk. While reducing risk improves supply chain performance, not every risk should be mitigated. In some cases, the cost of spreading the risk can be greater than the risk impact itself. So for capital-intensive production like automotives, making vehicles at 2 plants vs. 1 isn’t a viable option: spreading the risk across multiple facilities is more costly than a production shutdown at one. By modeling risk into cost minimization analysis, a firm can determine the incremental total cost of adding locations, inventory and capacity, or partners that will reduce risk. Often the incremental cost of reducing these risk points is low for a range of scenarios, resulting in a low cost strategy that reduces the risk of service disruption and future cost spikes. If your firm is still reeling from the series of events that has happened in the last 24 months – the aftermath of 9-11, West Coast port shutdown, economic recession, fuel “This approach – if combined price hikes, and threat of war – now may be the time to develop a risk-adjusted with strong analytical tools, supply chain strategy. To do so, your firm should seek to apply tools and an skilled resources, and a robust approach to scenario analysis – analytical risk mitigation approach that combines risk management and cost will allow firms to develop minimization into one continuous process. This approach – if combined with strong optimal, risk-adjusted strategies. analytical tools, skilled resources, and a robust approach to scenario analysis – will allow firms to develop optimal, risk-adjusted strategies. And with advances in operations research techniques and computing power, strategic tools will soon allow firms to solve for risk potential and cost constraints simultaneously. The end result? Firms will be able to make truly optimal decisions that are robust enough to withstand the unexpected. Chainalytics specializes in providing leading companies advanced consulting and outsourcing services to improve supply chain performance. Specializing in the application of advanced decision sciences technology, Chainalytics supports improved strategic, tactical and operational decision-making in the areas of supply chain strategy, transportation planning and inventory planning. The company's powerful combination of analysis, technology, and methodology enables clients to achieve and sustain double-digit cost reductions and customer service improvements, resulting in millions of dollars of value creation. Chainalytics serves mid- to large-size enterprises with complex supply chains, with special emphasis on companies in retail, wholesale and manufacturing of consumer durable and non-durables. Copyright 2003 Chainalytics LLC Page 6 of 6 March 2003