Risky Business

Aug. 1, 2004
Risky business Optimizing an organization's financial performance requires ongoing analysis of the key risks spanning the entire supply network that connects

Risky business

Optimizing an organization's financial performance requires ongoing analysis of the key risks spanning the entire supply network that connects suppliers, manufacturers, distributors, retailers and customers. Analyzing supply chains with the perspective of risks gives organizations a better understanding of the potential sources of a disruption, and, most importantly, the potential financial impact resulting from the disruption.

To speak the language of risk in this way does not introduce a totally new concept to supply chain managers. Cost/benefit analysis is a close approximation. A risk-based approach helps an organization distinguish risks that lead to potential costs, allowing comparison with potential rewards. An understanding of the risks and rewards not only can help minimize potential losses from existing operations, it also can help organizations take advantage of new opportunities while mitigating associated risks.

Given the focus on creating and managing cost-efficient global supply chains, companies are developing a variety of strategies, including the outsourcing of non-core activities. By definition, outsourcing can encompass any relationship with a third party that provides goods and services to the company. Activities that are outsourced most likely had been performed within the organization prior to spinning them out. Typical outsourcing activities may include:

  • Logistics
  • Manufacturing
  • Information technology (IT)
  • Back-office operations, including human resources, payroll, benefits, accounts payable and receivable
  • R&D.

An organization's decision to outsource is predicated on reducing costs and improving performance. This article focuses on outsourcing relationships that impact an organization's supply chain and its ability to identify and financially quantify any and all associated supply chain risks.

While it is clear why organizations enter into outsourcing arrangements, most find themselves unable to model the risks and corresponding probabilities, and to map these outcomes to their financial statements. In the past, outsourcing was used to ensure that an organization met its cost savings goals, which often neglected the outsourcing risk and the resulting financial impact to the organization, its customers and other stake-holders.

Although outsourcing risk varies by the activity outsourced and industry dynamics, certain basic risk elements are consistent. These common elements provide the framework for a working financial model that incorporates risk, probability and the potential financial impact.

A recent example in the pharmaceutical industry demonstrates some of the elements of risk when manufacturing is outsourced. A global pharmaceutical company had outsourced the production of a key drug to a third party. The pharmaceutical company held the marketing rights to this new drug. The outsourced manufacturer had a major disruption and, as a result, was unable to provide the drug per the agreed upon terms. Due to the late delivery, both the pharmaceutical company and the outsourced provider suffered significant financial losses in terms of lost market capitalization and reduced revenues.

Even though outsourcing is common in the pharmaceutical industry, several key financial risk considerations are often overlooked or underestimated due to cost, development considerations, capital investment, uncertainty, etc., that could have a major impact on future company performance.

To reflect accurately the risks and financial implications of outsourcing, it is necessary to construct a financial framework. This framework must incorporate the basic elements that affect operational and financial outcomes. Prior to building a financial model, an organization must first identify the supply chain risk categories (see sidebar below), which may include manufacturing, contract service level agreements, material quality, supplier capability, geographic location and/or inbound logistics.

This is accomplished through the use of a proven methodology and tool that incorporate a series of questions and experience to identify potential risk areas. The information gathered is reviewed, scrubbed and scored based on leading practices and experience.

Once the key risk areas are defined, critical risk drivers are identified to support risk quantification analytics. Examples of supply chain risk drivers are lead times, single-source suppliers, Customs clearance times, material availability, level of customer customization, returns, key supplier financial strength, port location, etc.

In our example, the client was evaluating several potential locations for outsourcing a significant portion of its manufacturing. The company had gone through a rigorous process to quantify the potential cost savings due to outsourcing, but this process did not include a meaningful risk-adjusted supply chain assessment and potential financial impacts in the event of a disruption. Based on the previously mentioned supply chain risk assessment methodology, a set of key risk drivers was developed and a relative risk profile was created for each of the four regions.

The next step was to apportion the percent of total risk by risk category. This process was completed by using the supply chain assessment tool, client interviews and subject matter expertise. In this example (see sidebar, p. 40), five critical categories and their corresponding risk drivers were identified. Risk drivers were established for all five areas to define scorecard information used to link events with their potential financial impacts.

Once agreement was reached on the framework, the risk drivers were incorporated into a financial model that mapped their respective economic impacts to the financial statements. In the case of lead-time, local finished goods inventory levels were maintained at 10 days, which translated into a cost of approximately $2.8 million.

Several factors influenced inventory levels, including lead-time from supplier location, in-transit time to the port by truck and shipping lane requirements for export. This process was repeated for each risk category to develop a list of key risk drivers and the financial statement linkage.

Mapping the risk categories to the financial statements provided management with a fact-based approach to identifying and quantifying risk. In the case of manufacturing risk, several scenarios were run to calculate the financial impact on revenue, cost of goods sold and inventory. The scenarios were based on manufacturing location, risk profile, interdependencies and key assumptions.

Through this process, a desired risk profile was created using economic impact data from the modeling exercise to determine the appropriate outsourcing portfolio. This risk-adjusted portfolio enabled the company to make outsourcing decisions based on operational, financial and risk factors. In addition, the company can develop a scorecard to measure and monitor the key drivers to proactively manage the supply chain(s) to both maximize performance while mitigating risk

By including the identification and quantification of supply chain risks, an organization's confidence with its decision-making process is improved. As the complexity of supply chains continues to evolve, organizations should begin to institutionalize the concept of risk and reward into their processes.

As our example showed, by adopting a risk-adjusted supply chain management approach the company gained an improved understanding of the financial implications that outsourcing brought to its organization. As a result, it found itself in a stronger, more competitive position - fully able to leverage its outsourcing capabilities in order to meet customer demands regarding cost, quality and timeliness while effectively managing the underlying risks associated with outsourcing. LT

Greg Meseck is a senior vice president and co-practice leader of the supply chain risk management practice at Marsh (www.marsh.com), a risk consulting firm.

Supply chain risk categories

An organization's supply chain risk profile is comprised of all of its operational risks surrounding the management of its supply chains. The categories for grouping supply chain risks are:

  • Outsourcing
  • Inventory
  • Customer
  • Product
  • Technology
  • Geography.

By identifying and quantifying these risks — and managing the total profile as a portfolio — an organization can optimize the long-term performance and reliability of its supply chains.

Risk Allocation - Example

1. Lead Time — 15%

  • Port location
  • Distribution center location
  • Local inventory levels
  • Supplier location
  • Transportation mode

2. Manufacturing — 40%

  • Total production to facility capacity
  • Volume of contract manufacturing production by location
  • Product type outsourced
  • Contract terms by contract manufacturer
  • Licensing agreements
  • Level of integration

3. Material Quality — 10%

  • Single source supplier
  • Formal qualification process
  • # of qualified suppliers
  • Frequency of reviews
  • Supplier audit process
  • Key supplier lead times
  • Local availability

4. Inbound Logistics — 20%

  • Transportation mode
  • Customs clearance time
  • Warehouse location(s)
  • Inventory levels
  • Local carrier - domestic
  • International carrier - international

5. Supplier Financial Stability — 15%

  • Private company
  • Public company/sub. of global company
  • Domestic public company
  • Financial info availability
  • Contract terms
  • Length of relationship
August, 2004

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at a glance

This article offers risk management strategies to help companies identify key outsourcing opportunities.