William Grey and Dailun Shi
IBM T.J. Watson Research Center
November, 2001
Value Chain Risk Management
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 Risks
Market RisksForeign exchangeInterest ratesEquity pricesCommodity prices
Business RisksEconomic ReputationalSupply ChainTechnological Legal riskRegulatory riskEnvironmental risk
Operational RisksPeopleProcesses SystemsProceduresPoliciesSupply Chain
Credit RisksAccounts receivableVendor financingNotes receivableLiquidity
Enterprise Risk Factors
Value Chain Risk Management Applies this Approach to the Extended Supply Chain
distribution
customers
store point of sale
local delivery
outboundinbound
manufacturing
suppliers
design
service / support
Three key value chain flows are subject to risk
Design Buy Build SupportShipSell
Financial Flows
Sup
plie
rs
Custo
mersInformation Flows
SCMPhysical Flows
Enterprise Risk Taxonomy
quality
quantity
price
complexity
serviceability
timing
Value Chain Risk
systems
policies
procedures
processes
people
Operational Risk
Core Business Risk
legal
regulatory
political
hazard
economic
natural
reputational
Event Risk
liqudity risk
vendor financing
debt risk
covenant violation
account receivable
account payable
Credit risk
interest rate
commodity prices
equity prices
foreign exchange
Market risk
Tax Risk
Recurring Risk
Non-core Business Risk
Enterprise Risks
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 Formulation
Risk Identification
Risk Characterization
Strategic Changes
Planning/Execution Changes
Financial Risk Management
Insurance
Organizational Changes
Risk Management Strategy
Implementation
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
High SeverityLow Likelihood
I
High SeverityHigh Likelihood
II
Low SeverityLow Likelihood
III
Low SeverityHigh Likelihood
IVSeveri
ty o
f Im
pact
Probability of Occurrence
Too expensive to insure: Take steps to reduce frequency or severity. Consider
divesting if returns don’t justify risk. Establish mitigation measures and contingency plans; insure
Deploy operational changes and controls to reduce frequency of occurrence
Monitor periodically for change in status
Interactions between risks and value chain processes (examples)
Sourcing Manufacturing Marketing andSales
Distribution andLogistics
Support
Quantity - Componentshortfalls impactproduction, hurtingsales, and potentiallydamaging reputationfor service andreliability.
- Poor capacityplanning constrainsproduction output.
- Poor productionplanning result inproductionconstraints or excessinventory.
- Poor demandforecasts result ineither missedrevenueopportunities, orexcess inventorythroughout the supplychain.
- Poor supply chaindesign and executionleads to excessinventory.
- Poor inventorypositioning preventsproducts fromreaching customers,hurting revenue.
- Poor warrantyforecasting leads tounder stocking spareparts. This causespoor customersatisfaction and lossof market share.
Price - Unexpected pricevolatility in procuredcomponentsincreases revenueand profit variability.
- Excess capacityincreases productioncosts.
- Poor pricingdecisions hurt marketshare, resulting inforegone profitmargins, or excessinventory.
- Poor supply chaindesign and executionincrease the need forexpediting, thusincreasing logisticscosts.
- Poor supportnetwork design andexecution increaseexpediting, causinghigher logistics costs.
Quality andServiceability
- Low-qualitypurchased partsimpact manufacturingyields, hurting sales.Also affects customersatisfaction andreputation, andincrease warrantyand support costs.-Selecting supplierswith poor or erraticservice affectsproduction, reducingrevenue anddamaging reputation.
- Low yields canconstrain productionoutput, reducingrevenue.
-Poor quality affectscustomer satisfactionand reputation, andincreases warrantyand support costs.
- Poor quality affectsobsolescence, andcreates obstacles formarketing and sales
-Certain salesprocesses work wellfor certain customersegments, but are toocostly to addressother segments.Revenue and profitdecline.
- Poor supply chaindesign or executionresults in poorserviceabiliy,reducing customersatisfaction, andlimiting ability to fulfillservice models suchas VMI and JIT.
- Poor quality ofsupport executionaffects customersatisfaction,damaging firm’sreputation.
Risk Propagation in the Supply Chain
Example 1: Price risk is comparatively well-behaved as it propagates through the supply chain
Computer Chipprice +$1
Circuit BoardCost: +$(1+/-є)
High-end ComputerCost: +$(1+/-є)
Component 1
Component N
Assemble BOM
Risk Propagation in the Supply Chain
Example 2: Quantity risk is amplified at the point of Bill of Material assembly
Computer Chip
shortage –100 units
Circuit BoardShortage –100 units
High-end ComputerOpportunity cost: -100 units of lost
sales, customer ill-will
Component 1Cost: excess
inventory
Component NCost: excess
inventory
Assemble BOM
Risk Propagation in the Supply Chain
Example 3: Quality risk is amplified as it propagates through the supply chain
Computer Chipdefect
Circuit BoardCost: Rework
High-end ComputerCost: field failure,
damage to brand/reputation
Component 1
Component N
Assemble BOM
Value Chain Risk Management Process
Risk Management
Strategy Formulation
Risk Identification
Risk Characterization
Strategic Changes
Planning/Execution Changes
Financial Risk Management
Insurance
Organizational Changes
Risk Management Strategy
Implementation
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
Size of loss
Catastrophic Loss Leading to Default
Losses Managed by Strategic,
Operational, and Financial Means Losses Covered
By Insurance
Default
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
Value Creation
Value Allocation
Cost of Capital(Required equity return)
Shareholder Profit
Shareholder Value
Capital Structure(Debt-equity mix)
Cost Drivers
Operating Performance and Profit
Revenue Drivers
Linkages between Strategic Risk Levers and Shareholder Value
FinancialLeverage
FinancialDiversification
& Hedging
Shareholder Profit
Cost of Capital(Required equity return)
Shareholder Value
Capital Structure(Debt-equity mix)
Cost Drivers
Operating Performance and Profit
Revenue Drivers
Value Creation
Value Allocation
Operational Leverage
Operational Diversification
& Hedging
Linkages between Supply Chain Decisions and Shareholder Value
Value Creation
Value Allocation
Cost of Capital(Required equity return)
Shareholder Profit
Shareholder Value
Capital Structure(Debt-equity mix)
Cost Drivers
Operating Performance and Profit
Revenue Drivers
•Outsourcing•Strategic Alliances•Supply Chain Design•New product introduction
•Revenue Management•Transportation & Logistics•Inventory Policies•Sourcing •Supplier Management
Examples of Strategic Risk ManagementLeverage Diversification Hedging Execution
Supply ChainDesign
Modify usingchanges inproductiontechnology
Modify byoutsourcingproduction
Geographicaldiversificationto reducehazard risk
Political unitdiversificationto reducepolitical riskand tax risk
Geographicaldiversificationto reducelabor pricerisk
Naturalhedging offoreignexchange risk
Matchinginbound andoutboundsupply chaincapacity andflexibility
Matchingsupply chaincapacity tomarketingcapability
Value ChainRestructuring
Alternativesupply chaininteractions
Supply chaindesigned toreduce cycletime andinventory
Supply chainsimplificationto reducecomplexityrisk
StrategicSourcing Strategy
Increase byselectingvendorsrequiringcapacitycommitments
Reduce byconsolidatingspend toimproveflexibilityterms
Vendordiversificationto reducesupply, priceand qualityrisk
Vendordiversificationto reducehazard risk
Hedgedemandvolatility withsupply-demandmatching
Naturalhedging offoreignexchange risk
Single sourceselectedcomponents toreducecomplexity
Increaseinformationsharing withcore suppliers
Strategic Risk Management Analytics
Low Uncertainty High Uncertainty
• Discounted Cash Flow Analysis• Sensitivity Analysis
• Scenario Analysis• Decision Trees• Real Options Valuation• Monte-Carlo Simulation• Visualization Techniques
Example of Improved Visualization
EPS
Pro
ba
bil
ity
Target
Investment 1
EPS
Pro
bab
ility
Target
Investment 2
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