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Operations Management Best Practice

Countering Supply Chain Risk

by Vinod Lall

Executive Summary

 

Introduction

In March 2000, a fire at a Philips semiconductor factory damaged some components used to make chips for mobile phones. Ericsson and Nokia—two of Philips’ major customers—responded to the event in very different ways. Ericsson decided to let the delay take its own course, while supply chain managers at Nokia monitored the situation closely and developed contingency plans. By the time Philips discovered that the fire had contaminated a large area that would disrupt production for months, Nokia had already lined up alternative suppliers for the chips. Ericsson used Philips as a sole supplier and faced a severe shortage of chips, leading to delay in product launch and huge losses to its mobile phone division.

Today’s global supply chains are complex and lean while efficiently delivering products and services to the marketplace. These supply chains involve a rigid set of transactions and decisions that span over longer distances and more time zones with very little slack built into them. As a result they are susceptible to several types of risk. These risks include operational risk due to demand variability, supply fluctuations and disruption risk due to natural disasters, terrorist attacks, pandemics, and breaches in data security. Such risks disrupt or slow the flow of material, information, and cash, and put billions of dollars at stake due to stock market capitalization, failed product launches, and the possibility of bankruptcies. In the above example, Ericsson lost 400 million euros after the Philips semiconductor plant caught fire; another example occurred when Apple lost many customer orders during a supply shortage of memory chips after an earthquake in Taiwan in 1999. Supply chain executives and managers must visualize and have a clear understanding of these risks along the entire supply chain, starting from the sourcing of raw materials to the delivery of the final product or service to the consumer. Once these risks are identified, they need to be scored on the likelihood of occurrence, and their impact must be quantified. Resources must then be used to mitigate or eliminate elements of high risk.

Types of Supply Chain Risk

Supply chain risks can be classified into different types depending on their origin. These include supply risk, demand risk, internal risk, and external environment risk.

Supply risk: These are the risks on the supply/inbound side of the supply chain. Supply risk may be defined as the possibility of disruptions of product availability from the supplier or disruptions in the process of transportation from the supplier, to the customer. A supplier may be unavailable to complete an order for a number of reasons, including problems sourcing necessary raw materials, low process yield due to increased scrap, equipment failure, damaged facilities, or the need to ration its limited product among several customers. Transportation disruptions occur while products are in transit and add to the delivery lead time. They may be caused by delays in customs clearance at borders, or problems with the mode of transportation, such as the grounding of air traffic.

Demand risk: Demand risk is the downstream equivalent of supply risk and is present on the demand/outbound side of the supply chain. It may be due to an unexpected increase or decrease in customer demand that leads to a mismatch between the firm’s forecast and actual demand. Increase in customer demand leads to depletion of safety stocks, resulting in stock-outs, back orders, and the need to expedite. A fall in customer demand leads to increased costs of holding inventory and, inevitably, price reductions. Other sources of demand risk are dependence on a single customer, customer solvency, and failure of the distribution logistics service provider.

Internal risk: This is the risk associated with events that are related to internal operations of the firm. Examples include fire or chemical spillage leading to plant closure, labor strikes, quality problems, and shortage of employees.

External environment risk: These risk elements are external to and uncontrollable from the firm’s perspective. Examples include blockades of ports or depots, natural disasters such as earthquakes, hurricanes or cyclones, war, terrorist activity, and financial factors such as exchange rates and market pressures. These events disrupt the flow of material and may lead to plant shutdown, shortage of high-demand items, and price increases.

Strategies for Supply Chain Risk Management

Strategies for managing risk must be a part of supply chain management and must include processes to reduce supply chain risks that at the same time increase resilience and efficiency. Firms typically use basic strategies of risk-bearing, risk avoidance or risk mitigation, and risk transference to another party. The goal of risk-bearing is to reduce the potential damage caused by the materialization of a risk, and to be successful requires that early warning systems be installed along the supply chain. The main goal of risk avoidance is to reduce the probability of occurrence of a risk by being proactive, while under risk transfer the potential impact of risk is transferred to another organization such as an insurance company.

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Further reading

Books:

  • Chopra, Sunil, and Peter Meindl. Supply Chain Management: Strategy, Planning & Operations. 3rd ed. Upper Saddle River, NJ: Prentice Hall, 2006.
  • Sheffi, Yossi. The Resilient Enterprise: Overcoming Vulnerability for Competitive Advantage. Cambridge, MA: MIT Press, 2007.

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