127
7
Operational Risk
Imagine a company that sells some of the hottest products on the planet
with just a few products representing a disproportionate share of revenues.
Imagine further that this company has relied on a single Chinese sup-
plier and location to build these products. And imagine even further that
this Chinese supplier is secretive, oen showing an unwillingness to share
information publicly, particularly about labor problems. If this scenario
sounds operationally risky (and strategically risky as well), you just g-
ured out why Apple has made a decision to diversify its supplier base by
expanding its outsourcing to a second supplier located in Taiwan.
is chapter will discuss the many potential operational failures through
the prism of the four pillars of supply chain risk—supply risk, demand risk,
process risk, and environmental risk. We will prole operational risks that
happen every day in these four areas. We’ll also discuss these risks in the
context of two basic operation horizons and present a program that tradi-
tionally has been utilized to mitigate and manage operational risks.
OPERATIONAL RISKS
By far, a disproportionate set of supply chain risks will be categorized
as operational since this category includes internal and external quality
problems, late deliveries anywhere in the supply chain, service failures due
to poorly managed inventory, problems related to poor forecasting, and a
thousand other events related to operational performance failures. is
section discusses the operational risks that are part of supply risk, demand
risk, process risk, and environmental risk. e two prevalent horizons
aecting supply chain risk management are the operational horizon,
128 • Supply Chain Risk Management: An Emerging Discipline
covering 0–45days into the future, and the tactical horizon, which nor-
mally covers 1–18months into the future.
Supply Risk
Referring back to the discussion in Chapter2 regarding the four pillars
of supply chain risk, the supply management profession is by far the most
mature discipline within the supply chain arena when it comes to iden-
tifying, assessing, mitigating, and managing risk. Procurement profes-
sionals have been leveraging techniques to mitigate and manage risk for
more than 50years. Let’s briey identify operational and tactical risks that
reside within this risk pillar every day. In no particular order, we have sup-
plier lead times, supplier quality, supplier prices, supplier insolvency and
bankruptcy, supplier delivery issues, fraud, corruption, counterfeit parts
and components with subtier suppliers, and inbound logistics. To further
focus our discussion, we’ll classify these risks into supplier, logistics, and
fraud, corruption, and counterfeiting. Table7.1 can be used as a reference
throughout the supply risk discussion.
Supplier Risks. As mentioned, procurement professionals have been
trained for many years to think about risk and contingencies, probably
much more so than any other discipline within the supply chain commu-
nity. One of the main reasons is most manufacturers’ cost of raw material
represents approximately 50%–70% of their total cost of goods sold. at’s
a huge portion of the total cost of nished products and an abnormally
large risk element to the organization.
As shown in Table 7.1, the traditional approach to handling sup-
plier risk has been to use buer inventory or statistically derived safety
stock to absorb volume shocks or delays or supplier delivery and quality
issues. One of the traditional techniques many procurement professionals
have been trained to execute to ensure better pricing and better delivery
has been placing more and more of their raw material requirements with
one supplier. is traditional thinking and training was driven by the
premise that when a company’s purchase requirements become a larger
portion of a supplier’s order board, that supplier will bend in terms of
price and do its best to demonstrate solid delivery performance because
of the risk of losing those orders and volume.
is procurement strategy worked well in a stable environment before
globalization and supply market volatility. What actually took place is
many companies got a bit complacent performing their due diligence.
Operational Risk • 129
Buyers assumed a bit too much in terms of continued performance and
found out through disruptions, supplier insolvency, supplier quality issues
and much more, that relying on one supplier for a major portion of a com-
pany’s purchase needs might not be the best strategy when it comes to
managing risk across an entire organization.
Logistics Risks. Around the year 2000, during the Internet and e- business
boom came the concept of Business Process Outsourcing (BPO). IBM was
a big proponent of this concept within its own supply chain and promoted
doing what you do best and outsourcing the rest. Why did IBM and many
other companies embrace this approach to supply chain management?
TABLE7.1
Supply Risks
Supply Risk Cause Horizons Traditional Remedies
Supplier lead
times
Material/ capacity issues Both Buer stock, larger order
quantities
Supplier
quality
Manufacturing processes Both Contract verbiage,
penalty clauses, inbound
inspection
Transportation
lead time
Breakdowns, acts of God,
customs issues
Both Contract verbiage,
penalty clauses
Subcontractor
availability
Initial source can’t deliver Both Contracts for potential
capacity reservation
Supplier
pricing
Performance issues, contract
changes, breach of contract
Tactical Due diligence, phone- fax,
and possible visits
Time delay Customs, lack of
performance
Both Buer stock, rescheduling
nal delivery
Disruption Labor issues, natural
disasters, terror
Both Buer stock, safety stock,
second source capacity
Import delays Customs paperwork, port
strikes, labor issues
Both Additional freight
forward companies, calls
to government contacts
Supplier
insolvency
Poor management, acts of
God, force majeure
Both Loans, law suites,
litigation, and second
sourcing
Fraud/
corruption
Poor government oversight Both Fines, penalties, and
operating restrictions
Counterfeit
material
Poor government oversight Both Fines, penalties, and
operating restrictions
Supplier
delivery
Manufacturing issues,
quality issues, customer
requirement changes
Both Buer stock, warehouse
inventory, second source
130 • Supply Chain Risk Management: An Emerging Discipline
One reason was companies found that there were many organizations
around the globe that could do certain business functions better, faster,
and cheaper. And at that time, as the Internet was exploding on the sup-
ply chain scene, there was renewed interest in exploiting the World Wide
Web to collaborate with these new BPO organizations and new partners
to drive overwhelming top- line growth.
With that belief,a new industry called third- party logistics, or 3PLs, was
born. A quick story about the chemical industry in 2000 will perhaps pro-
vide some context regarding the growth of 3PLs. During this period the
chemical industry was still vertically (i.e., functionally) aligned in terms of
supply chain management. ere were several reasons that many organi-
zations had not embraced the concept of supply chain management. First,
many organizations had very good prot margins and did not see the need
for change. Second, the “chemists” were still running chemical compa-
nies and lacked supply chain knowledge. And third, the chemical industry
was still an asset- intensive industry that believed in the benets of verti-
cal integration.
During this time, a few leading- edge chemical organizations began
benchmarking their total logistics costs associated with inbound and out-
bound material delivery as a percent of total sales. e numbers were alarm-
ing. On average, the chemical industry’s transportation costs were more
than 10% of sales. As the industry benchmarked against other industries,
it came to the conclusion that while chemical companies were good at
breaking down hydrocarbons, these companies were not so good at logis-
tics. As a result these companies, like so many in other industries, out-
sourced their logistics to companies that could service their needs at a
much reduced rate.
If we scan Table7.1 and view the logistics risks, we’re not saying the BPO
approach has totally eliminated logistics risk. However, these outsource
providers have developed many tools and techniques to manage risk for
their customers. Many of the traditional remedies are still being leveraged
but by a new industry that tends to have much more experience in global
trade and has invested in more advanced tools and techniques.
Fraud, Corruption, and Counterfeiting Risks. e European Banking
Board has developed a set of baseline denitions for their employees and
their customers to follow. Fraudulent practice means any action or omis-
sion, including misrepresentation, that knowingly or recklessly misleads
or attempts to mislead a party to obtain a nancial benet or to avoid
an obligation. Corrupt practice means the oering, giving, receiving, or
Operational Risk • 131
soliciting, directly or indirectly, of anything of value to inuence improp-
erly the actions of another party.
1
Counterfeiting occurs when something
is made in imitation so as to be passed o fraudulently or deceptively as
genuine.
2
is portion of supplier risk is far too large to dig deeper into at
this time, but we will talk at length about fraud, corruption, and counter-
feiting in Chapter8.
Demand Risk
Demand management has always been a dicult discipline by deni-
tion. Part of this is due to the tendency of forecasts that are almost always
wrong to some degree. Demand management and forecasting techniques
and solutions have been available to the supply chain profession for over
80years. ere are hundreds of deterministic, statistical solution provid-
ers that provide companies with the ability to scan historical sales to arrive
at a forecast using techniques such as least squares, time series analysis,
and regression analysis. We’ll talk in more detail about these techniques
in Chapter10, but for now we’ll segment the demand risk discussion into
customer risk, product risk, and logistics risk.
Customer Risk. As shown in Table7.2, there are plenty of risks on the
customer side of the equation. e demand issue tends to get the most
focus because the purpose of demand estimation is to project what a cus-
tomer will buy, when they will buy it, and how many they will buy. With
complex supply chains and large product portfolios, not even considering
global markets, seasonal products and other extraneous factors, the task
is somewhat daunting.
Forecast error is a key risk in demand management that requires atten-
tion. e reason we focus on this risk, is that it runs from 10% error of
forecast versus actual at the aggregated product family level to more
than 40% error at the stock- keeping unit or item level. (Forecasts almost
always become less reliable as the forecasts become more granular rather
than aggregated.)
e traditional remedy to mitigate forecast error has been to statistically
calculate safety stock and develop buer stocks at choke points through-
out the supply chain. e supply chain profession has been working for
more than 50years to mitigate the risk of attempting to project what their
customers will buy and balancing supply to ensure superior service levels
to those customers. And industrial customers are in no way exempt from
providing additional risk to this pillar of supply chain risk. Customers
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