William Grey and Dailun Shi

IBM T.J. Watson Research Center

November, 2001

Value Chain Risk Management

Key Business Trends

• The pace of business is accelerating, and there has been a dramatic increase in uncertainty

• A difficult business climate is exacerbated by heightened competition

• Supply chains are not only more efficient – but also riskier

• Customers (and the equity markets) are becoming increasingly unforgiving

Enterprise Risk Management is an integrated approach for managing risk across the firm

Enterprise Risks

Market RisksForeign exchangeInterest ratesEquity pricesCommodity prices

Business RisksEconomic ReputationalSupply ChainTechnological Legal riskRegulatory riskEnvironmental risk

Operational RisksPeopleProcesses SystemsProceduresPoliciesSupply Chain

Credit RisksAccounts receivableVendor financingNotes receivableLiquidity

Enterprise Risk Factors

Value Chain Risk Management Applies this Approach to the Extended Supply Chain

distribution

customers

store point of sale

local delivery

outboundinbound

manufacturing

suppliers

design

service / support

Three key value chain flows are subject to risk

Design Buy Build SupportShipSell

Financial Flows

Sup

plie

rs

Custo

mersInformation Flows

SCMPhysical Flows

Enterprise Risk Taxonomy

quality

quantity

price

complexity

serviceability

timing

Value Chain Risk

systems

policies

procedures

processes

people

Operational Risk

Core Business Risk

legal

regulatory

political

hazard

economic

natural

reputational

Event Risk

liqudity risk

vendor financing

debt risk

covenant violation

account receivable

account payable

Credit risk

interest rate

commodity prices

equity prices

foreign exchange

Market risk

Tax Risk

Recurring Risk

Non-core Business Risk

Enterprise Risks

Studies in Risk

• Nokia / Ericsson (Supply risk)• Cisco Systems (Supply-demand management risk)• Lucent Technologies (Credit risk)• IBM (Supply risk)• Micron Technologies (Price risk)• Nike / i2 (Technology risk)• Firestone / Ford (Quality, reputational risk)

Value Chain Risk Management Process

Risk Management

Strategy Formulation

Risk Identification

Risk Characterization

Strategic Changes

Planning/Execution Changes

Financial Risk Management

Insurance

Organizational Changes

Risk Management Strategy

Implementation

Risk Identification

• Techniques– Scenario Analysis– Historical Analysis– Process Mapping

• Basis for consistent framework to uniformly identify, assess and manage risks

• Dynamic process - requires periodic reviews • Standard categories for identifying risks• Common language for communicating risks

Risk Characterization

• Assess the nature, impact and importance of risks• Balance quantitative vs. qualitative analysis • Measurement Metrics

– Probability of occurrence– Severity of the potential impacts– Loss distribution function– Value at Risk– Stress Test / Simulation outputs

Risk Categorization

High SeverityLow Likelihood

I

High SeverityHigh Likelihood

II

Low SeverityLow Likelihood

III

Low SeverityHigh Likelihood

IVSeveri

ty o

f Im

pact

Probability of Occurrence

Too expensive to insure: Take steps to reduce frequency or severity. Consider

divesting if returns don’t justify risk. Establish mitigation measures and contingency plans; insure

Deploy operational changes and controls to reduce frequency of occurrence

Monitor periodically for change in status

Interactions between risks and value chain processes (examples)

Sourcing Manufacturing Marketing andSales

Distribution andLogistics

Support

Quantity - Componentshortfalls impactproduction, hurtingsales, and potentiallydamaging reputationfor service andreliability.

- Poor capacityplanning constrainsproduction output.

- Poor productionplanning result inproductionconstraints or excessinventory.

- Poor demandforecasts result ineither missedrevenueopportunities, orexcess inventorythroughout the supplychain.

- Poor supply chaindesign and executionleads to excessinventory.

- Poor inventorypositioning preventsproducts fromreaching customers,hurting revenue.

- Poor warrantyforecasting leads tounder stocking spareparts. This causespoor customersatisfaction and lossof market share.

Price - Unexpected pricevolatility in procuredcomponentsincreases revenueand profit variability.

- Excess capacityincreases productioncosts.

- Poor pricingdecisions hurt marketshare, resulting inforegone profitmargins, or excessinventory.

- Poor supply chaindesign and executionincrease the need forexpediting, thusincreasing logisticscosts.

- Poor supportnetwork design andexecution increaseexpediting, causinghigher logistics costs.

Quality andServiceability

- Low-qualitypurchased partsimpact manufacturingyields, hurting sales.Also affects customersatisfaction andreputation, andincrease warrantyand support costs.-Selecting supplierswith poor or erraticservice affectsproduction, reducingrevenue anddamaging reputation.

- Low yields canconstrain productionoutput, reducingrevenue.

-Poor quality affectscustomer satisfactionand reputation, andincreases warrantyand support costs.

- Poor quality affectsobsolescence, andcreates obstacles formarketing and sales

-Certain salesprocesses work wellfor certain customersegments, but are toocostly to addressother segments.Revenue and profitdecline.

- Poor supply chaindesign or executionresults in poorserviceabiliy,reducing customersatisfaction, andlimiting ability to fulfillservice models suchas VMI and JIT.

- Poor quality ofsupport executionaffects customersatisfaction,damaging firm’sreputation.

Risk Propagation in the Supply Chain

Example 1: Price risk is comparatively well-behaved as it propagates through the supply chain

Computer Chipprice +$1

Circuit BoardCost: +$(1+/-є)

High-end ComputerCost: +$(1+/-є)

Component 1

Component N

Assemble BOM

Risk Propagation in the Supply Chain

Example 2: Quantity risk is amplified at the point of Bill of Material assembly

Computer Chip

shortage –100 units

Circuit BoardShortage –100 units

High-end ComputerOpportunity cost: -100 units of lost

sales, customer ill-will

Component 1Cost: excess

inventory

Component NCost: excess

inventory

Assemble BOM

Risk Propagation in the Supply Chain

Example 3: Quality risk is amplified as it propagates through the supply chain

Computer Chipdefect

Circuit BoardCost: Rework

High-end ComputerCost: field failure,

damage to brand/reputation

Component 1

Component N

Assemble BOM

Value Chain Risk Management Process

Risk Management

Strategy Formulation

Risk Identification

Risk Characterization

Strategic Changes

Planning/Execution Changes

Financial Risk Management

Insurance

Organizational Changes

Risk Management Strategy

Implementation

Financial Risk Management

• Use of financial instruments– Forward contracts – Futures– Options– Swaps, caps and floors

• Use of supply chain contracts (embedded options)• Use of spot markets and new derivatives markets

Insurance

Probability of loss Controllable Loss

Size of loss

Catastrophic Loss Leading to Default

Losses Managed by Strategic,

Operational, and Financial Means Losses Covered

By Insurance

Default

Strategic Risk Management

• Application of financial management analogues to the value chain

• Value chain restructuring• Risk-based modeling and analysis• Improved visualization

Relationship between the Value Chain and Shareholder Value

Value Creation

Value Allocation

Cost of Capital(Required equity return)

Shareholder Profit

Shareholder Value

Capital Structure(Debt-equity mix)

Cost Drivers

Operating Performance and Profit

Revenue Drivers

Linkages between Strategic Risk Levers and Shareholder Value

FinancialLeverage

FinancialDiversification

& Hedging

Shareholder Profit

Cost of Capital(Required equity return)

Shareholder Value

Capital Structure(Debt-equity mix)

Cost Drivers

Operating Performance and Profit

Revenue Drivers

Value Creation

Value Allocation

Operational Leverage

Operational Diversification

& Hedging

Linkages between Supply Chain Decisions and Shareholder Value

Value Creation

Value Allocation

Cost of Capital(Required equity return)

Shareholder Profit

Shareholder Value

Capital Structure(Debt-equity mix)

Cost Drivers

Operating Performance and Profit

Revenue Drivers

•Outsourcing•Strategic Alliances•Supply Chain Design•New product introduction

•Revenue Management•Transportation & Logistics•Inventory Policies•Sourcing •Supplier Management

Examples of Strategic Risk ManagementLeverage Diversification Hedging Execution

Supply ChainDesign

Modify usingchanges inproductiontechnology

Modify byoutsourcingproduction

Geographicaldiversificationto reducehazard risk

Political unitdiversificationto reducepolitical riskand tax risk

Geographicaldiversificationto reducelabor pricerisk

Naturalhedging offoreignexchange risk

Matchinginbound andoutboundsupply chaincapacity andflexibility

Matchingsupply chaincapacity tomarketingcapability

Value ChainRestructuring

Alternativesupply chaininteractions

Supply chaindesigned toreduce cycletime andinventory

Supply chainsimplificationto reducecomplexityrisk

StrategicSourcing Strategy

Increase byselectingvendorsrequiringcapacitycommitments

Reduce byconsolidatingspend toimproveflexibilityterms

Vendordiversificationto reducesupply, priceand qualityrisk

Vendordiversificationto reducehazard risk

Hedgedemandvolatility withsupply-demandmatching

Naturalhedging offoreignexchange risk

Single sourceselectedcomponents toreducecomplexity

Increaseinformationsharing withcore suppliers

Strategic Risk Management Analytics

Low Uncertainty High Uncertainty

• Discounted Cash Flow Analysis• Sensitivity Analysis

• Scenario Analysis• Decision Trees• Real Options Valuation• Monte-Carlo Simulation• Visualization Techniques

Example of Improved Visualization

EPS

Pro

ba

bil

ity

Target

Investment 1

EPS

Pro

bab

ility

Target

Investment 2

Risk-enabled Planning and Execution

• More accurate specification of decision objectives, deeper analytics

• Richer, more complete information– Extensive usage of uncertainty data– Leveraging financial data in supply chain decisions– Leveraging supply chain data in financial decisions

• Risk-based measurements and metrics• More timely and effective response to risk events• Extend financial risk management concepts and

tools: leverage, diversification and hedging

Evolution of Value Chain Risk Analytics

Data Integration

ERP

SCM

PLM

Real-time Risk Management

Integrated Risk Management

Standalone Risk Analytics

Real-time Risk Monitoring

Risk Extensions

CRM

Ana

lyti

c In

tens

ity