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Preparing for the Black Swan Risk Mitigation and Planning for Procurement and

the Supply ChainISM Risk Management

August 20, 2012

Rob Handfield, PhDCo-Director, Supply Chain Resource Cooperative

Bank of America University Distinguished Professor of SCM

Introductions…Rob Handfield, PhD• Bank of America University

Distinguished Professor of Supply Chain Management, NC State University

• Director, Supply Chain Resource Cooperative – top 3 MBA SCM programs in the US

• Adjunct Professor, Manchester Business School

Research and consulting supply risk projects with different industries including:

• Bank of America• Biogen Idec• Boston Scientific• BP• Cardinal Health• Chevron • ConocoPhillips • Duke Energyr• General Motors• GlaxoSmithKline• Honda• Northrupp Grumman• LyondellBasel• Spectra Energy• Shell

Current Partner Companies

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Agenda

• The Global Market Picture• Why think about Complex Adaptive Systems?• Issues Facing Industry Executives in this context

– Commodity Volatility– Global Footprint and Regulatory Challenges– Supplier Risk– Talent management– Global footprint

• Building an Agile Organization

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Global Economic Woes Foreseeable for Some Time to Come

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Multiple mixed signalsemanating from global markets makes forecasting & strategic planning for 2013 and beyond

extremely challenging

Global Risks are Frequently Generating

Supply Chain Disruptions

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2005 2006 2007 2008 2009 2010

Caterpillar

TornadoOxford

MS

H1N1 Outbreak

Global Recessio

n

Iceland volcanoHealthca

re

FallujahOffensiv

e

Sadr CityBombing

s Mumbai Attacks

Japanese Earthquak

e

TsunamiIndian Ocean

Business Failures: Bear Stearns, Lehman Brothers,

TARP,

Global Recession

HurricaneKatrina

Surge inAfghanista

n

ToyotaAccelerato

rRecalls

SARSOutbreak

Libyan Crisis

Greek Politic

al Chaos

Chinas stimulus package

French Strikes

Hurricane Katrina

20122011

Thai Floods

Agenda

• “Black Swan” Events• Common Errors in Forecasting and Risk Mgmt• Approaches for Reducing Impact of Unplanned

Events• Case Study: Pandemic Scenario Planning

Survey Results

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Global Risk Events Overlap and Impacts Compound

Dealing with Risks is the Normal Operating State

AFP – Frederic J. Brown

Sept 2001 Terrorist Attacks

Conflict in Iraq

Hurricane Katrina

SARS/H1N1 Virus

West Coast Ports Lockout

Iceland Volcano

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• Cost of supply chain “glitches” – average of 10.28% decrease in shareholder value at time of announcement, with share price recovery (if firm does recover…) in roughly 60 trading days.1

• Cost of crises – sharp initial decrease of almost 8%, with full share price recovery (if firm does recover…) in roughly 50 trading days. 2

• 69% of CFOs, Treasurers & Risk Managers at Global 1000 companies in North America & Europe view fires/explosions and supply chain disruptions as leading threats to top revenue sources.3

1 Hendricks and Singhal, “The effect of supply chain glitches on shareholder wealth,” Journal of Operations Management, Vol 21, 2003, pp. 501-522. Supply chain glitches include parts shortages, order changes by customers, production problems, product launch problems, quality problems, engineering changes, weather-related problems, capacity and equipment problems, IT system problems, etc.2 Knight and Pretty, “The impact of catastrophes on shareholder value,” The Oxford Executive Research Briefings, 22 pages. Crises include Johnson & Johnson Tylenol product tampering, Union Carbide Bhopal gas leak incident, Pan Am Lockerbie plane crash, Occidental Piper Alpha Oil Platform explosion, Exxon Valdez oil spill, Perrier Benzene contamination, etc. 3 Green, “Loss/Risk Management Notes: Survey: Executives Rank Fire, Disruptions Top Threats,” Best's Review, Sept. 1, 2004

Why Should Companies Manage Supply Chain Risks Like Other Risks?

Shareholder Value Impact Is About the Same Magnitude and Duration for Supply Chain Risk Events and Traditional Crises

“Black Swan Events”

An event with three attributes:1.An outlier, that lies outside the realm of

regular expectations, because nothing in the past can convincingly point to its possibility.

2.It carries an extreme impact.3.In spite of its outlier status, human nature

makes us concoct explanations for its occurrence after the fact making it explainable and predictable.

Source: Nassim Taleb, New York Times, April 22, 2007.10

Strategies for Managing Commodity Volatility

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The track record on predicting Black Swan events is not good….

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Sigma (“”) is a measure…

Statistical Regularity ≠ Predictability

* EPMO = Events per million opportunities

• Variation in commuting time by subway can be modeled by bell curve with almost all values falling within 3 std. deviations•BUT – what is the probability of being hit by a coconut under a palm tree while on vacation? (“coconut uncertainty”)•How to forecast an event that is 20 ? 30 ?

Expectation

Unpredictable events

Variation

6 variation= 3.4 events per

Million OpportunitiesSIGMA DPMO * YIELD

1.0 691,462 30.8538%

2.0 308,538 69.1462%

3.0 66,807 93.3193%

4.0 6,210 99.3790%

5.0 233 99.9767%

6.0 3.4 99.9997%

SIGMA DPMO * YIELD

1.0 691,462 30.8538%

2.0 308,538 69.1462%

3.0 66,807 93.3193%

4.0 6,210 99.3790%

5.0 233 99.9767%

6.0 3.4 99.9997%

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Source: Mykridakis, Hogarth and Gaba, “Why Forecasts Fail”, MIT Sloan Mgmt Rev., Winter 2010.

Six Common Executive Mistakes in Trying to Manage Uncertain Events

Common Mistakes1. Thinking you can manage risk by

predicting extreme events.2. Convincing your team that

studying the past will help manage risk.

3. Not listening to good advice about what you shouldn’t do.

4. Assuming risk can be measured by standard deviations.

5. Confusing mathematical equivalency with psychological equivalency.

6. Focusing on being lean without considering the importance of redundancy.

Instead, focus on:1. Gauging how your company will be affected, and

how your supply chain partners will be impacted.

2. Recognizing there are no “typical” failures or successes, as global randomness is inherently unstructured in nature.

3. Thinking of risk mgmt in terms of preservation of profits and retention of shareholder value.

4. Avoid underestimating the size of the class of rare events that can impact supply chain.

5. Looking at multiple measures of risk from multiple perspectives, not just the best case scenario which increases risk appetite.

6. Avoiding leverage, and identifying strategic redundancies in the supply chain that are critical in the event of something going wrong. Source: Taleb, Goldstein, and Spitznagel, The Six Mistakes Executives Make in Risk Management,

Harvard Business Review, October, 2009.14

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Three key elements of supply chain disruption management

Disruption Discovery

Disruption Recovery

Supply Chain Redesign

Supply Market Intelligence Enables Supply Chain Risk Mitigation

• Disruption Discovery– What type of detection and

intelligence does a firm need to detect disruptions?

• Disruption Recovery– Once the disruption is discovered,

how does a firm effectively recover from a disruption?

• Supply Chain Redesign– How can a company strategically

re-design its supply chain over time to become more resilient and avoid or easily mitigate future disruptions?

16Time

Imp

act

of

Dis

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($

, C

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Acc

ou

nt,

Ma

rke

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are

)

DISRUPTIONDiscovery(A) Recovery (A)

Impact(A)

Discovery(B) Recovery (B)

Impact (B)

Disruption Discoveryand Recovery time (B)

Disruption Discoveryand Recovery time (A)

Disruption A

mplifiers

(Glo

balization and Com

plexity)

Visibility Systems

Excess Resources

The key is planning, NOT forecasting. The ability to respond is a function of how well your organization has considered and planned for the worst case scenario.

The key is planning, NOT forecasting. The ability to respond is a function of how well your organization has considered and planned for the worst case scenario.

Disruption Discovery and Recovery

A process for supply chain continuity planning

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Challenge your team to identify not the EVENTS, but the major areas impacted internally or in your supply

chain

Exercise: Think of recent “near misses” or disruption that resulted in a major business impact…..

Examples• Iceland volcano• Storms or weather• Supplier mergers or

acquisitions• Bank failures• HSSE near misses?

Post-mortem lessons learned?• Inventory positioning?• Contract reviews and re-

negotiations?• Dual sourcing agreements?• IT systems redundancy?• Others?...• What are the implications

for WHO should be on a supply chain continuity team?

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Begin by classifying internal enterprise functions that would disrupt operations or limit growth…

Enterprise &Supply ChainBusinessCritical?(bottleneck,Single source,Etc.)

Likely to be impacted?(Direct impact or proximity to threat)

High

High

Low

Ware-house

Call Center

Logistics

FieldSupply

RetailAssociates

Janitorial

SalesAgents

IT Systems.

OperationsPurchasing

Acct.Payable

HealthProviders

CafeteriaBenefits

Maint-enance

FacilitiesHVAC

Software

CustomerBilling

Legal

High likelihood, high impactHigh Opportunity, Low-Hanging Fruit

Security

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Identify critical assets/parties in the supply chain that would be impacted…

Enterprise &Supply ChainBusinessCritical?

Likely to be impacted?(Physical proximity or directly dependent on resource)

High

High

Low

DirectMaterials

Call Center

ThirdPartyLogistics

FieldSupply

Distrib.

Janitorial

FieldSupport

IT Maint.

EnergyIT Systems

Insurance

ContractMfg.

FoodServicesOffice

Supplies

ContractResearch Facilities

Maint.

Billing

LabServices

Legal

High likelihood, high impactHigh Opportunity, Low-Hanging Fruit

Security

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Impact

Ris

kStep 2:

Initial Impact Assessment

(Decision Tree)

IncludedH/M or L

Step 3:Supplier Risk Assessment

1 Performance 2 Supply Chain3 Financial4 HR5 Continuity6 Relationship

Excluded (L)

HighOr

MediumStep 4:

(H/L, M/M and M/H)Scorecard, Auditing

Step 4:(H/H and H/M)

Mitigation Strategy

Classify each party/relative to risk and impact, and establish mitigation requirements

Step 1:Generate/Validate

Initial Critical Supply Chain List

L

L

M

M

H

H

Mitigation Strategy, Scorecard

Mitigation Strategy, Scorecard

Scorecard, Auditing

Scorecard, Auditing

Scorecard, Auditing

No Action

These steps represent a supplier risk management

strategy.

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PerformancePerformance

CAUSES (Categories of Predictive Measures)

DisruptionEVENTS

CONSEQUENCES (Impacts)

Human ResourcesHuman Resources

Supply Chain DisruptionSupply Chain Disruption

Financial HealthFinancial Health

EnvironmentalEnvironmental

RelationshipRelationship

Quality, Delivery, Service ProblemsQuality, Delivery, Service Problems

Supplier Union Strike,Ownership Change, Workforce Disruption

Supplier Union Strike,Ownership Change, Workforce Disruption

Supplier LockedTier II StoppageSupplier LockedTier II Stoppage

Supplier Bankruptcy (or financial distress)Supplier Bankruptcy (or financial distress)

Disasters (Weather, Earthquake, Terrorists)Disasters (Weather, Earthquake, Terrorists)

Misalignment of InterestsMisalignment of Interests

Finished Goods Shipments Stopped Finished Goods Shipments Stopped

Locate and Ramp Up Back up SupplierLocate and Ramp Up Back up Supplier

Emergency Buy and ShipmentsEmergency Buy and Shipments

ReputationReputation

Market Share LossMarket Share Loss

EFFECTSRevenueLosses and Recovery Expenses

OTHERIMPACTSForgoneIncome

Emergency Rework and Rushed FG Shipments

Emergency Rework and Rushed FG Shipments

Recall for Quality IssuesRecall for Quality Issues

Sudden Loss of Supplier Sudden Loss of Supplier

Predicting failure points and potential impacts requires structured brainstorming with SME’s…

Copyright© 2006 Supply Chain Redesign, LLC

Su

pp

lie

r A

ttri

bu

tes

Sit

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tio

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ac

tors

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Strategically redundant assets and plans are required for high risk high impact elements with

business case identified

Develop Potential Mitigation Strategies

· Improved coordination· Increased inventory· New source· Product redesign

Who?

What?

Additional Resources Required to Implement?

Analysis of Potential High Risk Product/

Supplier

Implement Risk Mitigation Strategy

Management Identify

Resources and Implement

Supply Chain Analyst

· Basic information from procurement, mfg. engr., quality

· Key risk drivers

Supply Chain Analyst

Mitigation recommended?

Supply Chain Analyst, MEs, Procurement, Quality as needed

YES

NO

Supply Chain Analyst

· Coordinate/perform activities as needed

We need to re-think current contracting behaviors and recognize risk as a shared component of the relationship….upfront

collaboration can solve many problems that occur later on…

Critical Elements of ContractingWhere do managers spend time in contract negotiation?

25Source: T. Cummins, Commitment Matters, June 2009.

“Classical law views cooperation as being ‘of little interest’ and external to the contract. In part, this is because it assumes a common base of presumed rules by the parties.” – Ian McNeil, 1969

Case Example: Pandemic Exercise

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“While pandemics have happened several times in the past, never before have we had all of the tools of today. Never before have we possessed the wealth of knowledge on the problem and the ability to prepare. The challenge is immense, but so is our will to protect and preserve.” Michael Levitt, Department of Health and Human Services, Pandemic Planning Update II, July 2006.

Pandemic “Dogma”1. Only H1, H2 and H3 viruses could infect humans, H5, H7, and H9 subtypes jumped

from birds to infect people (Incorrect)2. Pandemic viruses emerge from Asia, the cradle of flu viruses (H1N1 originated in

Mexico)3. Pandemics are triggered by antigenic shifts or small mutations which resulted in

the H1N1 virus. (Actually, almost everyone alive has antibodies to H1 viruses).4. Emerging pandemics can be extinguished with quick use of antiviral drugs (this

virus spread before anyone had time to distribute) antiviral drugs)5. Pandemics are easy to spot and occur during flu season (this one started in the off-

season)6. Governments can quickly respond to a pandemic virus once it is spotted (The WHO

took many weeks to actually raise the level of infection to a level that required emergency actions)

7. People will clamor for pandemic vaccine (Many people resisted taking the vaccine in 2009).

8. Vaccine would be ready in time (the length of the spread of the vaccine made it difficult to plan release of vaccines and distribution was problematic).

27Source: Branswell, Helen, Nov 4, 2009, “Flu dogma being rewritten by a strange virus no one pegged to trigger a pandemic”, The Canadian Press.

How well prepared are companies for a pandemic?

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Number of organizations

Create governanceteam

Identify critical resources

Ancillary workforce

Plan for scenarios

Determine Impact on Financials

IT SystemBackup

Emergency Communications

Implement Drill / Exercise

SC Risk Impacts

RedundantResources Training

Best Case: Financial Services Pandemic Plan

29Source: Deepwater Horizon Accident Investigation Report, BP, September 8, 2010, Executive Summary.

Parting ThoughtsBlack Swan events have always been part of our economic climate; only recently have we begun to recognize that uncertainty is part of our fabric, and that successful firms are those who don’t rely on forecasts, but instead plan for uncertainty and exploit their relative position when surprises occur.

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