House Of Cards

Jan. 14, 2005
Just-in-time deliveries, lean inventories and tight relationships with key vendors. The quest to minimize supply-chain costs has maximized vulnerability. Have manufacturers gone too far?

As companies extend their sourcing networks and buy more parts and product from China, India, Eastern Europe and the Middle East -- to say nothing of the added complexity required to sell more products in these regions -- their operations become more exposed to political and natural disruptions. Beyond everyone's impression that everything they buy these days is made overseas, one indicator of this growing globalization is the fact that the amount of finished goods, components and materials imported into the United States has increased for 26 of the past 30 years, climbing at a 9% compound annual rate, according to the U.S. Census Foreign Trade Division. The flow of imports has declined only during years of economic recession.

At the company level, any disruption in this flow of goods has a direct impact on financial performance. Analyzing the effect of announced supply-chain problems on 500 publicly traded firms, researchers at the Georgia Institute of Technology and the University of Western Ontario found that the stock prices of these companies dropped 10% on average. Not only that, their sales and operating income remained flat for two years after the supply-chain trouble was announced.

To avoid such hits to shareholder value and keep material flowing, supply-chain executives are analyzing the impact of unexpected events -- terrorist attacks, power outages, labor strikes -- and they're making contingency plans. World-class risk managers are also looking at those events that have a higher probability of occurrence -- sudden DRAM price increases or congested ports on the West Coast delaying holiday deliveries -- and they're adjusting their procurement strategies to be more responsive.

Hewlett-Packard has developed tactics for managing a growing percentage of its procurement spending that helps the company respond to sudden changes in customer demand or commodity prices. Rather than aligning its operations and the operations of its suppliers to point forecasts, HP is quantifying uncertainty. For example, by assigning risk factors to its purchasing plans for components such as memory, hard drives, flat panel displays and lenses, HP can structure what are essentially options contracts with suppliers based on low, base and high demand scenarios. For the low scenario, the company might enter into a fixed quantity contract, for example, and then meet additional demand through a flexible quantity contract, and high-end demand through spot-market purchases.

"Effectively, you can match a quantity term with a pricing term with a cash-flow term to build a contract structure that best suits your business requirement," says Venu Nagali, a consultant in HP's procurement risk management program.

These requirements vary by business unit. The consumer PC segment typically wants absolute best cost. The commercial printer business might prefer more fixed pricing. Both HP and its suppliers benefit from the reduced overall risk in the supply chain. HP achieves lower total procurement costs. Suppliers benefit from guaranteed, fixed quantity contracts against which they can borrow money and invest in their businesses.

Whether it's anticipated fluctuations in customer demand, or a low probability catastrophic event such as a fire or dockworkers strike, the costs of protecting a manufacturer's supply chain should be likened to the cost of paying for insurance, says Jeff Karrenbauer, president of Insight Inc., Manassas, Va., which offers supply-chain planning services.

"You have to accept, as the military has forever, that the only way to reduce vulnerability is to have some redundancy. The more dependent you are on one location, you're more vulnerable by definition," says Karrenbauer. If you have redundant capacity, you might never have to use it, but if you need it, you will be glad it's there.

In addition to inventory and capacity, the classic method for maintaining supply-chain redundancy is secondary and tertiary vendors. It's a good strategy whether your source is domestic or halfway around the world. Karrenbauer recalls a U.S. manufacturer that was reliant upon regular shipments from a single local supplier that was shut down one day by the Environmental Protection Agency for repeated violations. "What's the difference from that and an Al Qaeda attack?" he asks.

Before they will pony up the cost for supply-chain insurance, executives must first be aware of the need. In addition to explaining the benefits in financial terms that company leaders will understand, as a precedent Karrenbauer suggests that supply-chain managers look to the IT department. If you ask people in IT what they will do if the mainframe or servers go down, they will pull out a black book that contains detailed backup procedures, procedures that they test regularly, which allow them to guarantee to top management that the systems will be back up and running within a certain period of time. Supply-chain backup plans are nowhere near as robust, he says, but they should be. A company's supply chain is as mission critical as its IT systems.

In recent years, information systems have in fact dramatically improved communications among manufacturers and their suppliers and customers, says Jay Swaminathan, an operations professor at the University of North Carolina, Chapel Hill, N.C. "Smaller uncertainties in the supply chain, like deliveries being late, which used to cause disruptions in the supply chain, are getting less and less because of information flows," says Swaminathan. "More information flow means that little variations do not affect the system in a big way."

Technology has helped, he says. Radio-frequency identification is hot today, but it's only the latest advancement in the ability to track material and parts. Such developments have supported the ongoing process integration among suppliers and manufacturers, which takes the form of just-in-time deliveries, vendor-managed inventory, and the sequencing of parts (seats and dashboards packaged in order to match up with vehicles as they roll down the assembly line). As the supply chain has become more and more synchronized, supply-chain partners have become more adept at managing minor glitches. They've had to become more adept. Any disruptions, an hour-long shutdown at an automotive assembly plant for example, can be costly.

Even though the tightest vendor relationships tend to follow the dollars, manufacturers are realizing that the sudden unavailability of even a low-value part can have a far-ranging impact, says Jeff Ryan, senior vice president with Verticalnet, a supply management software and consulting company based in Malvern, Pa. If it touches enough product lines, a $100,000-per-year supplier of fasteners could impact $500 million worth of sales. He sees more companies looking beyond their top-tier suppliers and developing contingency plans around these lesser-value items.

When sourcing from low-labor-cost countries, Ryan states, world-class procurement organizations do not follow a purely price-focused mindset. A price quote from a Chinese supplier won't factor in the cost of higher inventory levels and additional inspection. Other risks are even more difficult to quantify.

"If you don't know how to put a price tag on certain economic or political risks, you can't build it into your optimization objective function, where mathematically you could solve for the best total dollar solution. But that doesn't mean you can't still think through the problem," says Ryan. By looking at various scenarios -- for example, comparing the costs of a product sourced 90% domestic and 10% abroad, 80% domestic and 20% abroad, through 10% domestic and 90% abroad -- one can develop a total cost curve that shows where the price benefits taper off, and how much the increased risk of purchasing a higher percentage of parts or products from a foreign supplier would save. Managers can then determine if that savings is worth the risk, and how much they're spending to protect themselves.

Some companies have decided not to source certain parts and products from the Far East, or reduced their activity there, because of the increased risk, notes Shoshanah Cohen, a consultant with PRTM based in Mountain View, Calif., who has done a lot of work with electronics firms. The low-labor content of such products, plus the transportation costs and the total delivery lead time, can even turn the basic price equation around. Cohen bristles at the notion promoted by some people in her industry of a zero risk, zero inventory supply chain.

"Every time you add distance and time to the supply chain, by definition the amount of inventory you need to carry goes up. You either have to be smarter about making that variability lower, or you need to make the supply chain take less time. There's only so many buttons you can push," she says.

Cohen likens the responsive supply chain to a lean factory steeped in visual management cues that send out signals when problems pop up. While there is no physical location where a manager can stand and see everything that's happening in the supply chain, that's what IT vendors are striving for with their promises of end-to-end visibility. Again, for such initiatives to succeed, business partners will have to further integrate their processes, which will increase the amount of risk that needs to be managed..

"If you're talking about a 12-week supply chain, and it takes weeks and weeks and weeks for signals to travel up and down the supply chain, by the time it goes up and comes back, it's completely out of date," says Cohen. "You need to set things up so that as things are changing, you can react to that. That involves much deeper involvement with customers and suppliers."

Whether a manufacturer is managing risks in component prices, or planning for the possibility of a major disruption, observers agree that successful risk management requires a cross-functional approach. Corporate objectives must take precedent over departmental measures, which may require a senior executive with overall supply-chain authority to force the optimum tradeoffs for the business. At the operating level, planning people who know demand uncertainty need to work with procurement teams who know supply and cost uncertainty. It also requires an ongoing effort.

"There's always uncertainty in your business," states HP's Nagali. "There's component pricing, which can go up or down. There's demand, which can go up or down. So there's always a reason why you should do risk management."

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