Managing Risk

Last weekend on 60 Minutes there was a story about mountain climber Alex Honnold.  As if climbing a mountain isn't risky enough, Alex climbs without a rope up shear mountain faces, often higher than the Empire State Building,  hanging on by just his fingertips.  Most of us would never consider undertaking such a risk, however, in our companies, we are constantly faced with decisions that surely effect the health and well being of our business.

You must be prepared, as much as possible, to address whatever Murphy (see Murphy's Law) throws your way.  In the last couple of years, we have seen unprecedented disasters both natural and man made.  From the destruction of New Orleans from the flooding caused by Katrina, to earthquakes in Haiti, Japan, and the Northeast US.  The Japanese quake caused a devastating tsunami wiping out whole cities and causing what may very well be a nuclear melt down.  The recent visit of hurricane Irene to the east coast of the US left many without power for 4 or 5 days.  In the meantime, we have Somali pirates hijacking ships off the east coast of Africa, wars in Iraq and Afghanistan, and revolutions throughout the Arab world.  Even if your company is not directly in harms way, every one of us have suffered some consequences.  In this globally connected world, your suppliers or your supplier's suppliers or someone up the supply chain had their business impacted.

As businessmen, we need to manage the risks to insulate ourselves as much as possible.  The traditional approach to covering risk involves inventory.  Managers would weigh the costs of being out of stock against the cost of keeping 'safety stock' on hand.  Leaving aside for the moment the risk of inventory becoming outdated, (anyone interested in my collection of VHS tapes?), if we can keep enough inventory, a 6 month interruption in our supply from Japan will not bring our production line to a screeching halt.   The cost of taking this defensive posture is enormous.  The more uncertainty in the world, the more defensive inventory we are forced to maintain.  If in addition, you glance over your shoulder at your suppliers, you will notice that they are in the same situation, building inventory as a defense against uncertainty.  This drives up their costs and I can assure you they will eventually need to pass those higher costs on to you.  In fact, if you were to follow this path all the way back to the guy who pulls the raw material out of the ground, you will find that everyone in the entire chain is doing the same thing.  So how do we protect ourselves while at the same time bleeding all of this excess cost out of the process?

The key to managing this risk is information.  You must understand what goes into your products and where it comes from.  You need to see the entire supply chain as far back as you can and share your requirements with all involved.  Tom Collins , VP of Supply Chain Management at Motorola told me that prior to the crisis in Japan he had a very good understanding of his first level suppliers.  He was relieved to find that none of them were directly impacted.  To his dismay, however, he learned that he didn't have a handle on his supplier's suppliers and some of them were shut down for an extended period of time.  Ultimately, this had the potential to severely impact his business.

So how do we begin?  When asked, most companies can produce a complete bill of materials for every product they sell.  From that bill, you need to separate 'commodities' from specialty components.  A commodity item is one that has many sources and can be sourced easily and quickly if your primary supply becomes unreliable.  For these items, a secondary and/or tertiary source should be identified and a relationship established (usually by purchasing some portion of your requirements from this supplier even at a higher cost if necessary).  For example, let's say that your manufacturing process requires 10 tons of salt per week.  You might continue to order 8 tons from your primary supplier and order 1 ton each from two alternate suppliers so you can establish a relationship.  You would look to identify alternate suppliers who could, if necessary, combine to replace the volume from the primary.

This activity is much more difficult for specialized components.  For these, the primary supplier may be the only possible source or the cost to certify a new supplier may be prohibitive.  In this case, you need to go to extraordinary lengths to tightly integrate with your supplier.  You need to understand his production process, at least to the extent that you have a handle on his supply risks and how he is addressing them.  If you can develop a confidence that he is mitigating those risks, then you can reduce your internal defensive costs.  By driving this process back to the ultimate sources, you can reduce your costs while ensuring an uninterrupted supply.