Question
A Total Cost Approach To Understanding Supply Chain Risk
Answer
1. Introduction
It is essential to have a broad understanding of what risk is and what form it can take in the purchasing and supply chain context. This understanding provides a basis for categorizing and measuring risk, and can lead to a better understanding of decisions that either implicitly or explicitly involve risk.
Despite the magnitude of these expenditures, firms often treat purchasing as a functional, rather than strategic, part of the organization. Furthermore, the cost structures of many firms have evolved such that there is a need both for efficient quick response and cost-effective risk management. Changing competitive environments often require cost cutting and efficiencies, while other situations in the business or external environment can call for risk taking in order to achieve market expansion.
Purchasing comprises a significant portion of the cost structure of most firms. Typically, firms spend between a half and three-quarters of their revenue in the supply chain, with suppliers providing the goods and services required for the firm to deliver value to its end users. For example, manufacturers such as Ford and General Motors spend approximately 70% of sales on purchased goods and services, while public utilities typically spend over 80% and firms in service industries often spend 50% or more.
1.1. Definition of Supply Chain Risk
The first question might be, “What is supply chain risk?” Although it is possible to make use of a risk concept and risk metrics for the purpose of comparative shopping for an insurance policy to cover a supply chain, it is more meaningful to see the insurance policy as just one element in a total cost approach to managing supply chain risk. This is because the total cost approach attempts to capture all relevant sources of supply chain risk, all mechanisms for managing the risk, and their interaction, while the insurance policy may address only a subset of these issues. More commonly, the insurance analogy is quite inappropriate because supply chains deal with risk in the manner of the gambler who recognizes that taking risks can add value. An initial risk screening may identify events or confluence of events that might result in an adverse impact upon an important supply chain outcome such as revenues or product quality. An assessment of the probabilities and severities of these impacts can serve as a risk profile providing useful information to decision makers. Yet such a quantitative risk profile may not readily lead to decisions impacting cost and revenue. Failure mode analysis provides a detailed mapping of ways in which a product or process can fail and is the most natural access point to decisions on redesign to improve the risk profile by reducing the probabilities and severities of failure occurrences. Although risk is conventionally treated as epistemic, that is probabilities of known events, it is decision making under deep uncertainty, i.e. where we cannot at any reasonable cost ascertain the relevant probabilities and severities, that calls for new decision analytic tools and may lead way to another distinct form of decision making about whether to take calculated gambles, that is contingency planning, in the form of risk averse strategies option pricing and hedging. Failure to distinguish between these different forms of assessing risk can lead to simplistic decisions that are inappropriate or suboptimal. An illustrative example would be a decision by a major oil company to exit a retail fuel market in response to environmentalist protests about an oil spill event that was rated; its probability of occurrence was not known.
1.2. Importance of Understanding Supply Chain Risk
We know intuitively that understanding supply chain risk is important, but it is less clear which risks really matter. We suggest that not all supply chain risks are equal. The risk management literature often presumes that firms should be concerned with all risks that could impact firm performance. However, not every risk will have an impact on the performance of a given supply chain and some risks will have a small impact. Understanding which risks are most likely to occur and which risks will have the greatest impact on supply chain performance is critical to formulating risk management strategies. A failure to assess the likelihood and impact of risks can lead to expending too much resource on protecting against low probability risks with little pay off and insufficient protection against high probability risks with potentially devastating consequences. A total cost framework to understanding supply chain risk aims to give firms a clearer understanding of which risks matter most. A supply chain wide understanding of risk is also important. Every firm in a supply chain shares the risk of any event that has the potential to affect the supply chain. Consider the likelihood of a disruption to supply chain production. This risk affects the performance of the firm whose production is disrupted and all other firms that are reliant on that production. Traditional risk management approaches tend to focus on firms protecting themselves and fail to take into account the implications of their risk mitigation strategies on the remaining supply chain. A supply chain wide understanding of risk goes beyond identifying risks that affect individual firms and examines the impact and management of risks that affect the whole supply chain.
2. Factors Affecting Supply Chain Risk
2.1. Internal Factors
2.1.1. Demand Variability
2.1.2. Inventory Management
2.2. External Factors
2.2.1. Supplier Reliability
2.2.2. Market Volatility
3. Traditional Approaches to Supply Chain Risk Management
3.1. Reactive Risk Management
3.1.1. Impact of Reactive Risk Management
3.1.2. Limitations of Reactive Risk Management
3.2. Proactive Risk Management
3.2.1. Benefits of Proactive Risk Management
3.2.2. Challenges of Proactive Risk Management
4. Total Cost Approach to Supply Chain Risk Management
4.1. Definition of Total Cost Approach
4.2. Components of Total Cost Approach
4.2.1. Direct Costs
4.2.2. Indirect Costs
4.2.3. Risk Mitigation Costs
5. Implementing a Total Cost Approach
5.1. Data Collection and Analysis
5.2. Identifying Critical Points of Failure
5.3. Developing Risk Mitigation Strategies
5.4. Monitoring and Evaluating Risk Mitigation Efforts
6. Case Studies
6.1. Case Study 1: Automotive Industry
6.2. Case Study 2: Food Industry
6.3. Case Study 3: Technology Industry
7. Conclusion
7.1. Summary of Key Findings
7.2. Recommendations for Future Research
A Total Cost Approach To Understanding Supply Chain Risk