you cant outsource risk

you can't outsource risk

You Can't Outsource Risk: Creating Resilient Supply Networks

Establishing a more appropriate balance between cost and risk is the surest way for a company to create a truly resilient business, capable of managing and mitigating the impact of inevitable events.

The increased frequency of natural disasters has turned supply chain risk into a headline-making issue. “The Great Hard Drive Shortage of 2011” is one of the most memorable and widely covered recent supply chain disasters. Catastrophic flooding in Thailand brought the country’s manufacturing sector to its knees. Because of widespread flooding in one manufacturing “cluster,” hard drive suppliers for the world’s leading computer companies (including Intel, Dell and Apple) were knocked out, resulting in millions of dollars in losses.

Even manufacturers whose facilities were spared by the flooding and remained fully operational were not immune to production delays. Manufacturers like Samsung struggled to get key hard drive parts from their suppliers and were unable to meet demand. Thailand—the world’s second-largest manufacturer of hard drives—produces 40% of the industry’s supply.

Disruptions in the global supply chain due to extreme weather events have exposed the vulnerabilities embedded in the system. Companies and their suppliers have taken on more and more avoidable risk, as a by-product of cutting costs. The cumulative effects of layered avoidable risk has infected the entire supply chain system, threatening industries and economies. The preservation of the physical infrastructure—and its impact on the viability of the global supply chain—can indeed be managed, but it is often an afterthought. All too often, business decision-makers underestimate their companies’ vulnerabilities while overestimating their level of natural disaster preparedness.

You Can't Outsource Risk

Prior to the supply chain revolution of the “just-in-time” era, companies maintained larger backup inventories and built redundancies into their own production lines, giving manufacturers a cushion of safety. Sure, a company’s capital expenses may have been larger, but it enjoyed more transparency into its overall risk. During the Great Hard Drive Shortage of 2011, by contrast, computer companies were reportedly carrying only a two- to four-week backup inventory of hard drives. Industry consolidation meant that 20% of the world’s hard drives were being produced in just two facilities. Both were shut down by the flood.

As supply chains continue to grow longer, more complex and more global, the likelihood of disruption increases. Managing the confluence of issues factoring into the complexity of supply networks requires a more sophisticated approach. Today’s business leaders must look at aspects of supply chain risk as an organic whole in which vulnerabilities and risk overlap and intersect. By taking a 360-degree approach to their risk, executives can make better decisions to prevent supply chain disruptions and mitigate their impact when they occur.

This is not to say that the evolution toward global supply chains over the past 30 years was a bad thing. The modern emphasis on lean supply chain management has increased efficiency and reduced costs. However, the relentless focus on costs has created an environment in which companies and suppliers have lost sensitivity to the business and operational risk of the low-cost option. They have lost sight of the fact that you can outsource production but you cannot outsource the risk. Risk is retained.

Outsourcing without understanding the risk is playing with fire. As companies subcontract and outsource to suppliers in parts of the world that have high geographic and political risk, they should account for these factors in their financial calculus. Unfortunately, political and geographic risks are buried in complexities that make process difficult.

Recent conflicts in the Middle East and Africa demonstrate how easily political risk can spill over borders to disrupt supply chains. The conflict in Syria creates an obvious risk to would-be Syrian suppliers. But, as the conflict in Syria metastasizes and influences terrorist/pirate attacks, it also impacts those suppliers using Suez shipping routes. In Africa, a growing multinational political movement to reduce the influence of Chinese companies has also added risk to the flow of minerals and fuels that supply Chinese enterprises.

But it is weather-related business interruptions of the past two years that have led to the most comprehensive reexamination of the world’s supply map. Thailand and Taiwan, as well as China, lie at the very heart of the world’s supply chains for many key categories of goods, particularly high-value electronics and critical automotive subassemblies. From a geological and climatological perspective, however, these countries are all prone to significant risk from earthquakes and typhoons. Furthermore, post-event analyses of such recent disasters such as the Thai floods have revealed a new layer of risk—emergency response decisions. At the height of the Thai flooding, emergency management authorities used the few tools at their disposal to steer water and mud away from major population centers, creating the unforeseen consequence of flooding economic zones and manufacturing centers.

A Fundamental Rethink of Vulnerabilities

What does interlocking risk signify for the business leader of today? It requires a fundamental rethink of supply chain vulnerabilities to ensure that no single factor, such as short-term cost benefit, outweighs the long-term risk of crucial supply chain interruptions. Physical property risk assessment needs to be augmented by assessments of both political and geographic risk.

Facilities construction and maintenance that meet the highest standards for risk protection are still required, but smart companies are also conducting integrated reevaluations of their global footprint. They are asking questions such as, “Do we need to have manufacturing in flood- or earthquake-prone areas?” North Africa, for example, where some garment manufacturers are now locating final assembly plants, has less natural disaster risk than Asia. Brazil, Uruguay, Paraguay and Argentina have fewer earthquakes than Colombia, Chile or Venezuela.

Overall political factors will strongly affect a country’s ability to build infrastructure and recovery resources, so smart companies are also looking closely at whether they are over-reliant on transportation infrastructure. During the Thai flooding, for example, many well-protected businesses had property that remained physically unscathed but, with a crippled infrastructure, they could not get their goods to market.

Traditionally, weighing labor cost differentials against shipping costs found the cost savings more than covered the financial risk of extending the supply chain. That simple equation fails to factor in geographic and political risk, let alone reflect new transformations in the world economy. With the margin of error slimmer than ever, successful companies will be the ones that not only understand their vulnerability but accurately measure their risk.

The old equation needs to be thrown out the window. Establishing a more appropriate balance between cost and risk is the surest way for a company to create a truly resilient business, capable of managing and mitigating the impact of inevitable events.

Jeffrey J. Beauman is vice president, manager, all risk underwriting for FM Global, one of the world’s largest business property insurers. In this position, he ensures the company is positioned to meet the underwriting needs of its diverse client base worldwide. He joined the company in 1985 after serving eight years in the United States Navy and is based in FM Global’s corporate offices in Johnston, R.I.

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