The Weakest Link

In mid April the Icelandic volcano Eyjafjallajökull spewed ash across northern Europe, grounding flights across the continent. Hundreds of thousands of travellers were left stranded and after only a few days without air transportation, supermarkets announced that supplies of exotic produce were running low.

John Hurrell, chief executive of the Association of Insurance and Risk Managers (AIRMIC), said its members were knocked sideways by the unprecedented disruption and few had contingency plans in place. As the dust finally settles and normal conditions return, the affected companies will take a long look and try to determine what, if anything, they could have done differently. What is evident is that managing supply chain disruptions has become an increasingly taxing question for big business.

Ford’s interwar system of vertical integration is often used as an example of how much things have changed. The company owned steel mills, mines, railways and even a rubber plantation in Brazil to guarantee continuity. But by the 1980s such vertical integration had apparently been consigned to history as businesses began to outsource their supply needs across the globe.

The greater expertise of suppliers has allowed management teams to focus on core activities and their scale and flexibility has reduced the cost of making finished goods. With improved communications technology, just-in-time delivery has allowed businesses to cut waste from their supply chains and, as the manufacturing capacity of Asian economies has developed, it has become possible to source components and finished goods more cheaply.

Through much of the last two decades, the logic of extending supply chains seemed unchallengeable. Control and cost were exchanged for flexibility and risk, and given the global economy’s health the trade seemed to be a good one.

But the recent global economic crisis has exposed the problems inherent in these complicated networks. As suppliers struggled and folded, their customers in turn found production grinding to a halt and orders left unfilled. Some businesses were hit doubly hard as it was the first time their global supply chains had been tested in a downturn.

Hurrell and Paul Hopkin, AIRMIC’s technical director, are grappling with how big businesses can meet the challenges of the new environment.

"The global scale of things has changed," Hopkin says. “Undoubtedly supply chains were less complicated because in 1991-92 China wasn’t the force that it is now and the UK had a much bigger manufacturing sector." In previous downturns, companies had the reassurance of having a much greater proportion of their business in-house making adapting to circumstances easier. "Since the start of the decade a lot of organisations have moved towards extended supply chains," Hurrell explains. "They’ve therefore left themselves with having to change a business model of which much is outside the scope of their own organisational framework, and that creates complexity in implementation."

Hurrell and Hopkin believe that the challenge for their members is to keep up with changes happening within their organisations and externally. Despite the lack of growth in the world economy during 2009, the balance of global GDP is still shifting from West to East, meaning keeping up is even more difficult.

"The observation over the last few years is that everything gets faster," Hopkin says. "Looking at where we’re going at that speed, it’s opening up new geographies, technology and business models, all of which are going to impact on risk maps."

Appetite for action

AIRMIC is a London-based organisation that represents the insurance buyers of major UK companies, as well as those from smaller businesses, and conducts research and publishes standards on risk management. In recent years, examining supply chains has been a growing priority.

Hurrell and Hopkin believe that a major change of emphasis is needed in the way companies develop their strategies. "The risk management function shouldn’t be something separate that runs in parallel to the rest of the organisation," Hopkin says. "It should interface with the organisation, keeping a cap on risks and encouraging others to be aware of them."

Achieving that will require a cultural and organisational shift in many companies. Hurrell illustrates this point by caricaturing a traditional firm’s attitude: "The board sitting on the top floor of the building would actually look at reward and the risk manager, probably in the basement somewhere, would look at risk and the two would not come together effectively.

"There should be a much closer alignment between risk and reward. In other words, it’s absolutely fine to take a significant risk provided you expect a significant reward; it’s not fine if the reward isn’t there. Only by bringing these two disciplines together can you make effective decisions."

AIRMIC encourages businesses to develop clear positions on their risk appetite at the board level. "This is not always done," Hurrell says, "or if it is done, it’s not well communicated throughout the organisation."

In terms of assessing a supply chain this can be difficult: the rewards are seductive but the risks are harder to assess and often buried deep in the network.

Hurrell and Hopkin do not think this has to be a major problem, it just requires an intelligent approach. "It’s more about assessing the potential risk within your own organisation," Hurrell explains, "and determining what the consequences in terms of its business model and its reputation would be if one part of the supply chain were to fail in some way."

Hopkins notes that risk managers need to ask challenging questions. "What would happen if a component was no longer available?" he asks. "Business continuity planning is one of the fundamental issues of risk management."

Risk appetite is also important because it provides companies with a benchmark against which to measure their decisions. There might be cost advantages to sourcing a part in a developing country but greater political instability or a weaker legal system could outweigh them. A supplier in a developed country might be more expensive but provide better reliability.

One way of striking a balance is to build close partnerships across the supply chain to control some degree of the risk. By working with a supplier, its processes and standards can be optimised and brought up to required levels. Ongoing audits can then ensure that quality is maintained. This strategy works best for big companies and Japanese car giant Toyota is famous for making extensive use of it, going as far as acquiring minority stakes in parts manufacturers.

Considering the long-term financial health of partners is also important. "Companies really should not be keeping other businesses they rely on at the edge of bankruptcy," Hopkin says. "In the retail sector there is often such a close dependency on a single retailer that it wouldn’t take much of a hiccup to push suppliers under. Along the supply chain people are looking to the continued existence of partners as something they want to support."

Hurrell adds that the risk posed by all components is not equal. "The consequence of a supplier who makes wing mirrors going down may be just as liable to interrupt the manufacturing process as one that makes brakes or steering parts," he says. "However, the potential for reputational damage will be very different.

"The manufacturing director is looking at how to get cars off the production line, whereas the risk manager is looking at how to protect the reputation of the company and which one of 10,468 parts could potentially have a major strategic impact on the business."

Companies stake their brands on their supply chain and Hurrell outlines four main areas that ought to be a priority: quality, safety, ethics and reliability. Ethical issues are a particular problem as consumers expect a certain standard from corporations at the same time as they are using suppliers who might not share their own good practices.

Toymaker Mattel found this out when it was revealed that one of its Chinese suppliers was using uncertified lead paints, which could have poisoned children.

Such incidents highlight the degree of risk companies are exposed to but, by identifying potential problems early, more effective contingency plans can be developed. "An organisation I worked for looked for preferred nation status," Hurrell explains.

"When a supplier has difficulties that reduce its output, it means you’re the first customer they offer to supply."

He adds that this is of most value when two competitors are making use of the same supplier: "It’s important to not just understand your own position but what impact an event will have on the wider market."

This point was proved when a fire knocked out a microchip manufacturer in New Mexico from which mobile phone makers Nokia and Ericsson were sourcing parts. Nokia quickly swung in to action, forcing the supplier to dedicate production at other plants to meet its orders. News of the fire did not reach Ericsson’s senior management until two weeks later, by which point its rival had already struck.

While business can take out insurance against risks of a similar scale, insuring supply chains is notoriously difficult given their complexity and the fact that disruptions cannot always be traced back to a single event. In spite of this, Hurrell and Hopkin believe it can play a role in mitigation strategies.

"Insurance is an important safety net but that’s all it is,” Hopkin warns. "I see it as one of the tools available to companies but certainly not the starting point."

Plan for problems

Insuring against a one-off event such as an earthquake or a fire is common and products such as liability insurance can also be used but contingency planning is still the core issue.

"If a component is no longer available, it doesn’t matter whether it’s because a supplier has gone bankrupt or if a factory has burnt down,” Hopkin says. "The consequences are potentially the same and the customer needs plans in place."

Although stretching supply chains increases certain risks, Hopkin and Hurrell are clear that there are strong business reasons why it has been done and it is important not to lose sight of these.

"It’s driven by cost, but what you also get out of a well constructed supply chain is greater expertise: you subcontract the manufacturing of widgets and you find someone who can make them better than you can," Hopkin says. "It also offers greater flexibility. When you want ten widgets one week, that’s what you buy. If you have a hugely successful order come in and need 1,000 widgets, you can get those without distorting your own business."

Besides, even Ford’s system was not without its problems. Its inflexibility was demonstrated by the advent of synthetic rubber in 1945. Suddenly, owning a plantation on another continent was an unnecessary burden and having been beset by other troubles for years before, the company sold it to the Brazilian Government for a loss of $20m.

Hopkin and Hurrell return to the importance of integrating risk management into an organisation’s long-term strategy.

By assessing potential problems and having contingencies in place and settling on a level of risk appetite, businesses can confidently reap the benefits of outsourcing their supply chain."

Although we can talk about the risks embedded and what should be done to reduce them, risk managers cannot argue that a plan is too complicated or too dicey and that it should be abandoned," Hopkin says. "These things are done for compelling reasons and their job is to support the achievement of wider supply chain goals.

There might be some changes of emphasis but complicated supply chains will have long-term value to businesses seeking to maximise profits and gain competitive advantage. The challenge will be finding ways of controlling and mitigating the risks but the ideas set out by Hurrell and Hopkin demonstrate that the beast can be tamed and its power put to work.