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Value Chain Risk Management William Grey and Dailun Shi IBM T.J. Watson Research Center November, 2001 Key Business Trends • The pace of business is accelerating, and there has been a dramatic increase in uncertainty • A difficult business climate is exacerbated by heightened competition • Supply chains are not only more efficient – but also riskier • Customers (and the equity markets) are becoming increasingly unforgiving Enterprise Risk Management is an integrated approach for managing risk across the firm Enterprise Risk Factors Market Risks Foreign exchange Interest rates Equity prices Commodity prices Operational Risks People Processes Systems Procedures Policies Supply Chain Business Risks Enterprise Risks Credit Risks Accounts receivable Vendor financing Notes receivable Liquidity Economic Reputational Supply Chain Technological Legal risk Regulatory risk Environmental risk Value Chain Risk Management Applies this Approach to the Extended Supply Chain customers design service / support store point of sale suppliers local delivery outbound inbound manufacturing distribution Three key value chain flows are subject to risk Design Buy Build Sell Ship Support Financial Flows Customers Suppliers Information Flows Physical Flows SCM Enterprise Risk Taxonomy Enterprise Risks Core Business Risk Value Chain Risk Non-core Business Risk Operational Risk Event Risk quality systems legal quantity policies regulatory price procedures political complexity serviceability timing processes people Recurring Risk Credit risk Market risk liqudity risk interest rate vendor financing commodity prices debt risk equity prices covenant violation foreign exchange hazard economic natural account receivable reputational account payable Tax Risk Studies in Risk • • • • • • • Nokia / Ericsson (Supply risk) Cisco Systems (Supply-demand management risk) Lucent Technologies (Credit risk) IBM (Supply risk) Micron Technologies (Price risk) Nike / i2 (Technology risk) Firestone / Ford (Quality, reputational risk) Value Chain Risk Management Process Risk Management Strategy Implementation Strategic Changes Planning/Execution Changes Risk Identification Risk Characterization Risk Management Strategy Formulation Organizational Changes Financial Risk Management Insurance Risk Identification • Techniques – Scenario Analysis – Historical Analysis – Process Mapping • Basis for consistent framework to uniformly identify, assess and manage risks • Dynamic process - requires periodic reviews • Standard categories for identifying risks • Common language for communicating risks Risk Characterization • Assess the nature, impact and importance of risks • Balance quantitative vs. qualitative analysis • Measurement Metrics – – – – – Probability of occurrence Severity of the potential impacts Loss distribution function Value at Risk Stress Test / Simulation outputs Risk Categorization Severity of Impact Establish mitigation measures and contingency plans; insure Too expensive to insure: Take steps to reduce frequency or severity. Consider divesting if returns don’t justify risk. High Severity Low Likelihood High Severity High Likelihood I II Low Severity Low Likelihood Low Severity High Likelihood III IV Probability of Occurrence Monitor periodically for change in status Deploy operational changes and controls to reduce frequency of occurrence Interactions between risks and value chain processes (examples) Sourcing Manufacturing Marketing and Sales Distribution and Logistics Support Quantity - Component shortfalls impact production, hurting sales, and potentially damaging reputation for service and reliability. - Poor capacity planning constrains production output. - Poor demand - Poor supply chain forecasts result in design and execution either missed leads to excess revenue inventory. - Poor production opportunities, or planning result in excess inventory - Poor inventory production throughout the supply positioning prevents constraints or excess chain. products from inventory. reaching customers, hurting revenue. - Poor warranty forecasting leads to under stocking spare parts. This causes poor customer satisfaction and loss of market share. Price - Unexpected price volatility in procured components increases revenue and profit variability. - Excess capacity - Poor pricing increases production decisions hurt market costs. share, resulting in foregone profit margins, or excess inventory. - Poor support network design and execution increase expediting, causing higher logistics costs. Quality and - Low-quality - Low yields can Serviceability purchased parts constrain production impact manufacturing output, reducing yields, hurting sales. revenue. Also affects customer satisfaction and -Poor quality affects reputation, and customer satisfaction increase warranty and reputation, and and support costs. increases warranty -Selecting suppliers and support costs. with poor or erratic service affects - Poor quality affects production, reducing obsolescence, and revenue and creates obstacles for damaging reputation. marketing and sales - Poor supply chain design and execution increase the need for expediting, thus increasing logistics costs. -Certain sales - Poor supply chain processes work well design or execution for certain customer results in poor segments, but are too serviceabiliy, costly to address reducing customer other segments. satisfaction, and Revenue and profit limiting ability to fulfill decline. service models such as VMI and JIT. - Poor quality of support execution affects customer satisfaction, damaging firm’s reputation. Risk Propagation in the Supply Chain Example 1: Price risk is comparatively well-behaved as it propagates through the supply chain Component 1 Computer Chip price +$1 Circuit Board Cost: +$(1+/-є) Component N Assemble BOM High-end Computer Cost: +$(1+/-є) Risk Propagation in the Supply Chain Example 2: Quantity risk is amplified at the point of Bill of Material assembly Component 1 Cost: excess inventory Computer Chip shortage –100 units Circuit Board Shortage –100 units Component N Cost: excess inventory Assemble BOM High-end Computer Opportunity cost: -100 units of lost sales, customer illwill Risk Propagation in the Supply Chain Example 3: Quality risk is amplified as it propagates through the supply chain Component 1 Computer Chip defect Circuit Board Cost: Rework Component N Assemble BOM High-end Computer Cost: field failure, damage to brand/reputation Value Chain Risk Management Process Risk Management Strategy Implementation Strategic Changes Planning/Execution Changes Risk Identification Risk Characterization Risk Management Strategy Formulation Organizational Changes Financial Risk Management Insurance Financial Risk Management • Use of financial instruments – – – – Forward contracts Futures Options Swaps, caps and floors • Use of supply chain contracts (embedded options) • Use of spot markets and new derivatives markets Insurance Probability of loss Controllable Loss Losses Managed by Strategic, Operational, and Financial Means Catastrophic Loss Leading to Default Default Losses Covered By Insurance Size of loss Strategic Risk Management • Application of financial management analogues to the value chain • Value chain restructuring • Risk-based modeling and analysis • Improved visualization Relationship between the Value Chain and Shareholder Value Cost Drivers Revenue Drivers Operating Performance and Profit Value Creation Value Allocation Capital Structure (Debt-equity mix) Shareholder Profit Cost of Capital (Required equity return) Shareholder Value Linkages between Strategic Risk Levers and Shareholder Value Cost Drivers Revenue Drivers Operational Leverage Operating Performance and Profit Value Creation Value Allocation Capital Structure (Debt-equity mix) Operational Diversification & Hedging Shareholder Profit Cost of Capital (Required equity return) Shareholder Value Financial Leverage Financial Diversification & Hedging Linkages between Supply Chain Decisions and Shareholder Value •Revenue Management •Transportation & Logistics •Inventory Policies •Sourcing •Supplier Management Cost Drivers Revenue Drivers Operating Performance and Profit Value Creation Value Allocation Capital Structure (Debt-equity mix) •Outsourcing •Strategic Alliances •Supply Chain Design •New product introduction Shareholder Profit Cost of Capital (Required equity return) Shareholder Value Examples of Strategic Risk Management Supply Chain Design Strategic Sourcing Strategy Leverage Modify using changes in production technology Modify by outsourcing production Diversification Geographical diversification to reduce hazard risk Political unit diversification to reduce political risk and tax risk Geographical diversification to reduce labor price risk Hedging Natural hedging of foreign exchange risk Matching inbound and outbound supply chain capacity and flexibility Matching supply chain capacity to marketing capability Execution Value Chain Restructuring Alternative supply chain interactions Supply chain designed to reduce cycle time and inventory Supply chain simplification to reduce complexity risk Increase by selecting vendors requiring capacity commitments Reduce by consolidating spend to improve flexibility terms Vendor diversification to reduce supply, price and quality risk Vendor diversification to reduce hazard risk Hedge demand volatility with supplydemand matching Natural hedging of foreign exchange risk Single source selected components to reduce complexity Increase information sharing with core suppliers Strategic Risk Management Analytics Low Uncertainty • Discounted Cash Flow Analysis • Sensitivity Analysis High Uncertainty • Scenario Analysis • Decision Trees • Real Options Valuation • Monte-Carlo Simulation • Visualization Techniques Investment 1 Target Probability Probability Example of Improved Visualization EPS Investment 2 Target EPS Risk-enabled Planning and Execution • More accurate specification of decision objectives, deeper analytics • Richer, more complete information – Extensive usage of uncertainty data – Leveraging financial data in supply chain decisions – Leveraging supply chain data in financial decisions • Risk-based measurements and metrics • More timely and effective response to risk events • Extend financial risk management concepts and tools: leverage, diversification and hedging Evolution of Value Chain Risk Analytics Risk Extensions Analytic Intensity Standalone Risk Analytics SCM Integrated Risk Management CRM Real-time Risk Management ERP PLM Data Integration Real-time Risk Monitoring