Why Companies Need a Risk Analysis and Management Plan

By Dr. Karen Pentz
Faculty Member, School of Business, American Public University

Companies are concerned with multiple risk factors on a daily basis, especially when they operate in a global environment. Why, then, are they often blindsided by events that may or may not be anticipated and are often beyond their control?

What Is Risk and Risk Management?

Risk analysis is an important aspect of a global strategy. Risk has been defined as any uncertainties associated with being in business and as exposure to a situation or event whose outcome is uncertain. Global supply chains increase risk because of the numerous uncertainties associated with supply and demand, growing global markets, and shorter product life cycles.

Management expert Christopher Tang suggested that most companies focus on operational risks, rather than on disruption risks. However, both types of risk are inherent to global supply chains.

Supply Chains Require Both Proactive and Reactive Risk Strategies

Vulnerabilities associated with global supply chains call for both proactive and reactive strategies to manage operational and disruption risks. Understanding risk factors is the beginning of developing a risk management strategy; that understanding may lead to enhanced decision-making and the attainment of strategic goals and objectives.

One problem in determining an appropriate risk management strategy is a lack of consensus concerning its various aspects and dimensions. While managers may understand the different types of risk their company faces, they may not implement a risk management strategy due to factors such as its overall cost or the difficulty of setting it up.

In their article in the International Journal of Physical Distribution & Logistics Management, “Global Supply Chain Risk Management Strategies,” co-authors Ila Manuj and John T. Mentzer offer six broad risk management strategies in use today:

• Postponement
• Speculation
• Hedging
• Control/Share/Transfer
• Security
• Avoidance

Any of these hedging strategies can help manage certain risks, such as supply-side risks.

Hedging as a Risk Management Strategy

A brief fire caused by lightning at a Philips semiconductor plant in New Mexico in 2000 quickly became a problem because contamination from the fire interrupted chip production. Both Nokia and Ericsson purchased chips from this plant. While Nokia actively monitored the status of the plant after the fire, Ericsson did not.

By the time Ericsson realized the magnitude of its supply problem, Nokia had already purchased all available chips on the market, leaving Ericsson with a severe shortage. Having streamlined its supply chain to a single source, Ericsson had no Plan B.

Although hedging is commonly thought of as a financial option, hedging strategy in this case refers to how a company manages its supply side of operations. This is particularly important in global supply chains where numerous events beyond a company’s control can disrupt operations.

Having a global collection of suppliers and facilities to reduce or eliminate certain operational risks is a hedging strategy. Its goal is to offset potential damaging events in one part of the world – a crippling flood or typhoon, for example – by having suppliers and/or facilities elsewhere to step in and provide the product.

Companies can have redundant suppliers, but that can be expensive to manage and control. Variables such as fluctuating customer demand, forecasting errors, longer lead times, and supplier performance and quality can quickly cause supply-side problems, such as:

• Too much or too little inventory
• Ordering the wrong inventory
• Failing to fill customer orders due to having the wrong volume or mix of inventory
• Loss of customers

Management needs to understand supply-side risks and how to control them. Is the risk predominantly on the demand side due to quality problems or due to more catastrophic risk because of where the company or suppliers are located?

If there are multiple supply sources or alternatives available, supply-side risk can be reduced. This is where having a hedging strategy to address supply-side risk comes in.

The Benefits of Responsiveness for Companies

A company can be more responsive to customer demand by having sufficient inventory at hand. Responsiveness means a company can react quickly to changes in demand, often with a very short lead time.

Carrying hedge inventory comes at a cost to the supplier, although responsiveness might be a requirement in certain markets. If the goal is to reduce or eliminate certain operational risks, a  well-developed strategy is helpful. However, carrying excess inventory can hurt the bottom line, especially if the product has a short shelf life, quickly becomes obsolete or has high carrying costs.

However, trade-offs are often necessary within a supply chain; no company wants to sacrifice everything just to support customer demand. For example, a company must often make decisions between the amount of inventory to have versus the risk of running out of stock and being unable to fill customer orders. Management must determine just how much inventory is needed to support a hedging strategy, while bearing in mind the costs related to maintaining that inventory.

In an era of uncertain markets, companies might want to consolidate their facilities to reduce their global footprint and associated costs. But a lack of enough facilities in certain regions might lead to weaknesses within the supply chain.

Extended lead times from supply points necessitate carrying more inventory to avoid possible shutdowns and stockouts. That costs a company money and reduces the benefits gained by the consolidation.

Responsiveness helps achieve flexibility and provides a mechanism for companies to be more customer-focused. These strategies must be supported by addressing inventories, capacities, transportation and other issues.

Companies need to focus on what they need to support customer demand. A company can use inventory as a hedge and add redundant suppliers to the supply chain network.

Redundant Suppliers and Excess Inventory

Buying components and raw materials from a variety of suppliers avoids building and carrying inventory. A purchasing plan should be a prominent aspect of any company’s global sourcing policy to achieve appropriate economies of scale with its suppliers.

Ordering from a second supplier only when the first supplier does not perform as required won’t produce the appropriate pricing structures or the urgency to provide a product quickly. However, flexibility while attempting to mitigate supply uncertainty is beneficial to the supply chain.  Incorporating a variety of suppliers into a sourcing plan enables a company to respond to events and changes as they occur rather than having to operate reactively.

Redundancy in the supply chain can be effectively added as the need arises or as changes occur. Of course, supply chain costs will increase, but these increases may be warranted given the benefits to be gained.

Analyzing cost trade-offs will enable appropriate decision-making. For example, using facilities or suppliers closer to the customer provides a more responsive supply chain.

Zara, a Spain-based home furnishings and clothing company, uses production facilities in Europe to produce trendy items that have a limited life cycle. The company uses production facilities in Asia for its staples and basic items. Designing a supply chain to accommodate different requirements leads to better planning, increased responsiveness and more successful results overall.

Having both inventory and redundant suppliers can alleviate supply-side risks. While every company should have a risk mitigation plan, having a core of redundant suppliers will help maintain a company’s ability to compete. A hedging strategy might be appropriate when a company faces high supply-side risks and wants to minimize certain operational risks. A hedging strategy can be an expensive proposition, but it is certainly preferable to having dissatisfied customers or losing them to a competitor.

About the Author

Dr. Karen Pentz, CPIM, CSCP, CLTD, is a faculty member for the School of Business at American Public University. Her research interests include supply chains, logistics, transportation and business operations. Karen holds a B.S. in information systems and operations management and an M.B.A. in business administration from the University of North Carolina at Greensboro, as well as a D.B.A. in business from the University of Phoenix.