Mitigating Risk in the Supply Chain

When I began my career in manufacturing some 35 years ago, I don't remember much talk about supply-chain risk. Yes, we worried that supply could be disrupted, but quite frankly we dealt with those issues as they occurred. Although we strived for "just-in-time" inventories, we generally maintained "just- in-case" inventories and could easily withstand most outages. Most supply chains were regional, and we worried about potential labor-union work stoppages or a delivery truck breaking down en route. Although this description is somewhat oversimplified, supply-chain risk was not as complex or potentially damaging as it is today.

Besides supply disruption, which has evolved to include risks associated with material scarcity, natural disasters, political instability, and financial collapse, today's corporations must deal with additional significant risks exacerbated by the rapid global transparency of information affecting corporate reputation and even brand image. In this year, alone, we have seen the disruptive impact of a major earthquake in China, the Icelandic volcano, the Times Square bomb scares, and the Gulf Coast oil spill. The financial effects on supply chains from these incidents is already tens of billions of dollars and will surely be much higher before full resolution and a return to normal operating conditions are achieved.

The importance of mitigating risk and preserving corporate reputation is underscored by a 2007 study conducted by the global public-relations firm Weber Shandwick in conjunction with the opinion research firm KRC Research, which surveyed 950 business executives worldwide to evaluate reputation risk. The survey found that 63% of a company's market value is attributed to reputation. Nearly nine out of 10 survey respondents concurred that there has been a growing trend of corporate reputation risk. The report cited a 2005 study by the Economic Intelligence Unit, the research arm of The Economist, which showed that reputation risk is nearly three times greater than the risks from terrorism and natural disasters and surpasses regulatory, human-capital, information-technology, and market risks. Weber Shandwick's corresponding research showed that global media coverage of reputation risk has grown from being practically nonexistent in 1990 to almost daily mentions in 2007.

Reputational risk is at an all-time high and evident by several recent examples such as recent problems with corporate giants Toyota (i.e., automotive recalls) and British Petroleum (i.e., Gulf Coast oil spill). The question for all responsible executives is: "What is our preparedness to avert preventable risks or respond rapidly to minimize damage should an unpredictable event occur?"

Despite the importance of mitigating risk, companies may not be sufficiently prepared. Successful risk mitigation in today's complex environment takes a combination of policy, standard processes, technology, strong leadership, and analytical research.

Five important trends in risk-management preparedness

A comprehensive supply-chain risk-management strategy must involve five key principles: cash-flow management, a balance of low-cost versus low-risk sourcing, strategic-procurement initiatives, incorporation of sustainability practices, and responsible spending. These elements are further detailed below.

Sensible cash-flow management. With the changing environment of increased regulation, price controls, generic-drug competition, and longer and more expensive research and development cycles, pharmaceutical and biotechnology companies have become much more focused on supply-chain cash-flow management strategies (following the lead of other industries that began implementing these strategies as many as 25 years ago). These strategies consist of a combination of programs that strive to better balance cash inflows versus cash outflows. The supply chain contributes to cash-flow improvement initiatives by reducing inventory and extending payment terms to suppliers. Both strategies, when improperly applied, can and have created increased risk and significant financial consequences that far exceeded the gains. I know of at least one major corporation that mandated 60-day payment terms (from 30 days) when the credit markets were collapsing. This approach seemed almost reckless when considering that for every one million dollars spent with a supplier, a 30-day payment extension only results in a one-time working-capital improvement of $6667 in capital costs (derived from a theoretical savings of 8% × $1 million × 1/12 = $6667). This amount is a very small gain if it also contributes to the financial demise and subsequent closure of a key supplier.

There is much validity to the idea that the faster cash flows through a supply chain, the less cash is needed to sustain the financial viability of that supply chain. More and more, leading companies are thinking that way. Large corporations such as Syngenta (Basel), Bank of Scotland (Edinburgh), and GlaxoSmithKline (London) are adopting supply-chain financing programs and putting into place technology enablers that allow suppliers to decide when they want to be paid, and of course, at what discount.

Better balance of low cost versus low risk. Global supply chains have been under development across many industries for the past several decades. Low-cost country sourcing has been on a steady rise for the past 15 years, with corporations leveraging low-cost labor pools for the procurement of goods and services. Most large corporations today have well-defined programs in India and China. As these markets have matured, companies are now sourcing from new low-cost sources located in Eastern Europe and other Asian countries. In general, outsourcing can be risky as evidenced by the issues that Boeing went through with the production of its Dreamliner airplane production, which included major delays, postponed revenue, and lost orders. Massive problems with component deliveries in 2007 led to a two-year delay in aircraft launch and some $2 billion in charges to fix supplier problems (1).

Outsourcing, combined with low-cost country sourcing, is even riskier. The US Food and Drug Administration's recall of heparin in 2008 due to contamination of lots produced in China is another example. In this heparin recall, the drug was oversulfated as Chinese heparin manufacturers were unethically cutting the medication with chondroitin sulfate to cut down on manufacturing costs. This incident had devastating impacts on those who had chosen to use this Chinese supplier. FDA reported that there were hundreds of serious adverse reactions and scores of deaths among patients that had taken the heparin (2).

The hard lessons learned from this incident have made it important for companies to reevaluate their low-cost country sourcing strategies. They are evaluating risk versus cost and rebalancing their supply strategies to less riskier profiles.

Comprehensive strategic-procurement initiatives. One can make a strong case that many supply-chain disruptions and corporate reputation/brand image disasters are preventable, even in the case of natural disasters or other seemingly unpredictable force majeure-type events. A corporation's procurement organization has the ability to significantly reduce the risk associated with these occurrences by conducting collaborative strategic-sourcing initiatives that ensure their companies are protected from myriad potential risks. Strategic sourcing is a pragmatic and structured procurement process. This process is conducted over several steps and includes: rigorous internal and external analysis; development of multiple strategic options weighted for risk and cost; strategy selection made collaboratively with business stakeholders; well-orchestrated negotiation; and detailed implementation planning, supplier selection, and ongoing supplier management, including continuous-improvement activities.

Best-practice organizations also use technology to develop solutions to enable the creation, storage, and management of hundreds, if not thousands of risk-management action plans associated with all critical purchased goods and services (see sidebar, "Implementing a risk-mitigation action plan").

Implementing a risk-mitigation action plan

As supply complexity and associated risk continues to increase, more companies are recognizing the need to improve their procurement organizations and are engaging third-party assistance to upgrade their strategic sourcing and technology capabilities.

Sustainability. As corporate-reputation and brand-image disasters become more frequent, there are other issues that companies with global supply chains need to address. These broad concerns involve human rights (e.g., child labor, working conditions, unfair pay), global warming, and other environmental impacts. The pharmaceutical and biotechnology industries are also feeling the effects of animal-rights groups that want to ensure the ethical treatment of animals. Nongovernmental organizations (NGOs) play a role in influencing customers, shareholders, and investors. As with most ideologies designed to promote social change, adoption rates by corporations can be classified into three main groups: laggards, followers, and leaders, with the majority of companies acting as followers.

Risk-management preparedness

When it comes to embracing sustainability and green behavior in manufacturing and product specifications, several large corporations such as GlaxoSmithKline (London), Proctor & Gamble (Cincinnati), Diageo (London), and Unilever (London) achieved material cost savings, enhanced brand image, and generated increased demand for their products through innovative changes in primary and secondary packaging components. Examples include reducing corrugated box and cardboard carton-wall gauge, buying board and paper-based components from certified forests, using recycled board and paper, reducing wall thickness of polyethylene containers, and switching to up to 100% recycled polyethylene. These types of changes can reduce the amount of material used, increase the amount of material being recycled, and reduce the overall associated carbon footprint. There is a positive relationship between sustainability and green behavior in enhancing brand image and generating greater sales revenue as a result (3).

Diagnostic test for supply-chain risk mitigation

Responsible spending. The economic meltdown of 2009, the resulting attempts of government bailouts, the many government stimulus programs, and the healthcare overhaul serve to show how the changing environment led to closer examination of corporate spending and has placed an increased emphasis on responsible spending policies and practices. As sales have slumped, more companies have taken a serious look at how to buy goods and services in a way that reduces spending.

An example from outside the pharmaceutical and biotechnology industries is the luxury expenditure policy, which is imposed on companies receiving funding under the Troubled Asset Relief Program, commonly referred to as TARP or RCP, the federal program under which the US government purchased assets and equity from financial institutions to strengthen the financial sector. The guidelines set limits for entertainment or events, office and facility renovations, aviation or other transportation services, and other similar items, activities, or events. The pharmaceutical and biotechnology industries should take note. A similar scenario is conceivable as the government may take more responsibility for healthcare, and closer scrutiny will be paid to how discretionary budgets are spent. As a result, corporations are reevaluating policies and practices that govern how their goods and services are purchased.

Elements to assess supply disruption

A simple diagnostic test can assess whether a company is adequately prepared for supply-chain disruptions or mitigating reputational risk. Key questions to consider are:

• Does a company have a comprehensive supply-chain risk-management program in place?

• Does the supply-chain risk-management program have well-documented policies and procedures in place that adequately protect the company against the types of issues that are generating enormous news today (e.g., supply-chain disruptions such as geopolitical instability, natural disasters, financial collapse, inconsistent quality, contamination, and counterfeiting; corporate responsibility such as human rights violations and environmental concerns; and employee responsibility such as fraudulent activities, discrimination, and harassment)?

• Are employees trained and certified in their understanding of these policies on an annual basis?

• Is there a systematic process and data-management repository in place to ensure rapid and proactive response to unexpected events?

• Are corporate responsibility and supply-chain risk-management a top priority among the company's senior executives?

The answers to these questions provide insight into whether a company is adequately prepared to mitigate risk in its supply-chain activities.

Gregg Brandyberry is a partner of Wildfire Commerce, senior advisor of AT Kearney procurement and analytic solutions, and former vice-president of procurement, global systems, and operations for GlaxoSmithKline, 629 Overhill Road, Ardmore, PA 19003, tel. 215.327.5739, greggbrandyberry@wildfirecommerce.com

References

1. D. Gilmore, Supply Chain Digest, May 7, 2009.

2. FDA, Information on Heparin (Rockville, MD), www.fda.gov/Drugs/DrugSafety/PostmarketDrugSafetyInformationforPatientsandProviders/ucm112597.htm, accessed June 30, 2010.

3. "The 2010 Global 100 List," Corporate Knights, www.global100.org/annual-reviews/2010-global-100-list.html, accessed July 15, 2010.