The Supply Chain Balancing Act

Lori Widmer


April 1, 2012

In 2009, 137 workers were injured in a China-based Apple supplier location when they were exposed to poisonous chemicals used to clean iPhone screens. Over the next two years, two separate explosions at Apple iPad factories in China killed four and injured 77. Despite the human toll and the obvious public relations nightmare, Apple faced yet another issue after each incident: how to get products manufactured and shipped when safety issues were getting in the way. With critics already questioning Apple’s reliance on Japanese suppliers and how the 2011 earthquake would affect sales, investors were understandably nervous.

Naturally, supply chain interruptions are not unique to Apple, and they come in many forms. In April 2010, for example, a giant volcanic ash cloud blanketed Europe and halted air transportation for six days—the longest such disruption since World War II. When the euro took a dive on the heels of Greece’s economic crisis, the ripple effect soon exacerbated the crisis throughout Europe and led to social  unrest at home. Even worse was the political turmoil that swept Egypt, Tunisia, Thailand, Syria and China. Pile on an unprecedented natural disaster year in 2011—the earthquake in Japan, flooding in Thailand and Australia, and  tornadoes throughout the Midwest United States—and it seems there is no safe place on the globe to do business.

For companies that have been doing international business for decades, few of these risks are altogether new. Nor are they surprising. What is now staggering, however, is the increasingly complex domino effect these disruptions create in a world where supply chains are so intertwined.

The Greatest Risk

A recent study conducted by the World Economic Forum showed that more than 90% of industry experts surveyed believe that supply chain and transport risk management is a greater priority in their companies today than it was five years ago. According to that same study, natural disasters were the cause of 59% of uncontrollable supply chain disruptions. Yet surprisingly, 46% of disruptions that are considered to be influenced by outside forces came from conflict and political unrest.

The conclusion made by the 2012 World Economic Forum report is that it is time for new models to address supply chain and transport risk. The problem is serious enough to garner the attention and cooperation of the U.S. Department of Homeland Security, whose secretary, Janet Napolitano, has called for international participation in building “a more secure and resilient supply chain.”

That may have been what prompted President Barack Obama to direct the Departments of State and Homeland Security to develop a plan protecting the $14.6 trillion U.S. economy from supply chain interruptions. Issued January 23, the president’s “National Strategy for Global Supply Chain Security” directs the departments to develop recommendations within six months on how to identify risks and create a more resilient commercial infrastructure (see page 42).

Let’s just hope that happens before any crisis hits China. A recent study conducted by insurer FM Global examined the impact of a crisis the size and scope of the 2011 Japanese earthquake occurring in China. The findings were telling: the overwhelming majority of companies surveyed (86%) say they are more reliant on China as part of their supply chain for key product lines than they are on Japan (a country on which only 43% rely).

Considering the loss amounts from the Japan earthquake and subsequent tsunami, that is a frightening prospect. The reported damages totalled $210 billion, according to the Centre for Research on the Epidemiology of Disasters and the UN International Strategy for Disaster Reduction. Actual insured losses are still unknown, but estimates from AIR Worldwide, a catastrophe modeling firm, are as high as $30 billion.

Insurers have taken notice. A recent Marsh analysis shows that rates are going up for buyers in regions where supply chain risks or natural catastrophes are a larger exposure. According to the report, companies operating in Europe, the Middle East and Africa are going to see higher premiums. Availability in China and Thailand is decreasing, along with limits, perils and territories covered. Insurers are also expecting more information before writing coverage. The Marsh paper says buyers can expect more of the same from the natural catastrophes insurance market.

Availability in supply chain coverage could be the emerging issue of 2012 if the latest survey of brokers is any indication. In the survey, conducted by The Independent, a global coalition of privately owned insurance brokerages and risk management service firms, 96% of brokers stated that their insurance buyers are most concerned with availability and cost of coverage.

With both brokers and insurers recognizing the tightening market, it makes the risk manager’s job that much more difficult. For risk management and top executives trying to wrap arms and controls around it, the supply chain can become an unwieldy snarl of risks that can upend revenue and topple business operations. What will become of your company’s supply chain should a revolution, financial crisis or natural disaster occur in a country where your major suppliers reside? What is the backup plan?

Beyond the Back Door

Planning starts with looking beyond the immediate corporate environment. Companies tend to think inside their own silos, which means threats are overlooked and outsourcing decisions are made in a vacuum. Al Niederfringer, second vice president of the risk control division at Travelers insurance company, says the new landscape requires a more evolved view of global business. So far, however, companies are slow to respond.

Too often, companies tend to think only one layer deep when it comes to supply chain risk. But there are plenty of risks that lie beyond the immediate suppliers. “It’s not enough to make sure you’re in good stead,” he said. “You need to do that with your key suppliers.”

Some companies, he says, take the deeper risks seriously enough to send investigators halfway around the globe for a firsthand look at the risks and a face-to-face talk with management. This can help ensure that a supplier actually has a plan in place to mitigate interruptions. An on-site visit may also uncover hazardous conditions, shoddy operations or unknown exposures.

Though the cost of sending an employee overseas is probably worth the peace of mind, a visit is not always possible. In that case, Niederfringer suggests that companies build into their supplier contracts the requirements that they prove they have completed a business continuity assessment and that they provide a business continuity plan.

On-site visits don’t always uncover the truth, however. Gary Lynch, head of the supply chain risk management group for insurance broker Marsh’s risk consulting practice, says it is not uncommon to find that the company operations that you have vetted aren’t their actual operations at all. Some of the suppliers in various countries, he says, will set up temporary warehouses and distribution centers that pose as the primary business facilities. They exist solely to pass the corporate vetting. “Those were just set up during the audit process,” said Lynch. “The goods were moved in there for the day and then moved somewhere else.”

That is why it is critical to have more guarantees around supply chain transparency. Risk management has to go beyond that first layer and look both deeper and farther out. “Who participates in the supply chain after that first year?” asked Lynch. “It seems like such a tough question for organizations to ask. Either they don’t want to know or don’t want to put the energy into knowing.”

But there is a shift in thinking taking place. The hedge funds caught on early. “The first call I got after the Japanese earthquake was from a hedge fund,” said Lynch. “They were looking for business partners to help them understand the details of these complex supply chains—who is going to win and who is going to lose with regard to capacity that is needed in every point in the supply chain?”

There is also a return to measuring the decision to outsource. “Many of the threats haven’t changed,” said Lynch. “That shouldn’t necessarily change an organization’s strategy, but there are a number of issues they need to think about with more precision.”

One recent situation illustrates his point. The primary supplier organization was approached by the client to respond to a cost reduction by another supplier. The organization examined the other supplier and realized the cost savings came from that supplier moving operations to Mexico. Lynch’s group was able to show the long-term loaded cost of managing the extra risk. Over time, the supplier’s outsourcing was going to result in a 10% increase in costs thanks to the added risks.

Losing Sight of the Big Picture

Direct costs are not the only exposures brought on by a complex supply chain. Companies too often get caught up in making outsourcing decisions based solely on material prices. Lisa Anderson, president of LMA Consulting Group, Inc. believes companies should be looking at the impact on customer service. “The post-recession is the new normal,” said Anderson “It’s not an environment of huge sales. People are looking for more for less, and customer service is elevating in importance.”

She says that even the smallest of efforts are netting large results in terms of customer satisfaction. And that is where many companies drop the ball. There are a lot of factors that can relate to customer service—from natural disasters to financial instability—and the further away a supply chain goes, the more risks will emerge. With each new port, nation and region you enter, the likelihood of disruption rises. Her suggestion is to avoid outsourcing business functions directly related to customer service, such as invoicing and other administrative duties.

Companies also tend to overlook country risks, according to Stephen Kay, U.S. leader of Marsh’s political risk and structured credit practice. Companies often mistake a current, docile political environment for long-term stability. “If you go to a country with unstable regimes or immature legal environments, people get a perceptional bias,” he said. “They think if a country has been stable for, say, the last 10 years that that will continue indefinitely. That bias feeds into the short-term thinking.”

As a result, executives need to make sure that supplier and that country are relevant to the company’s operations. Too often, says Lynch, companies view the global community through demand only, though he is seeing a seismic shift in how companies are approaching outsourcing risks.

Over the last three years, he has seen organizations much more willing to look beyond the first year and see where they are really sourcing their goods from and where their contractors are actually operating. The surprise comes when companies realize their suppliers are no longer operating in China. “That’s where the contract operator claims to be, but in reality they’re sourcing from Cambodia, Vietnam, Bangladesh,” said Lynch. “They’ve extended their supply chain without the knowledge of those organizations that are running their supply chains.”

Niederfringer has seen similar surprises from companies unwilling to follow the supply chain. “Go beyond the first supplier,” he said. “Have them do a risk assessment themselves to provide a level of understanding of the risks and contingency plans, and what needs to be done to protect your supply chain.”

The Backup Plan

Those contingency plans are essential. Experts agree that the best backup plan includes a secondary supplier. Yet as Anderson points out, just aligning the supplier for future use and not utilizing their services now won’t work. She suggests channeling a portion of your business through that supplier to maintain a strong connection. “If you just identify someone and do not have a working relationship with them, it’s not going to work,” she said.

Also, don’t outsource your most critical functions if you can avoid it. Instead, outsource those business functions that won’t directly affect customer service and satisfaction. Anderson advocates setting up the entire supply chain and mitigation process with the focus on the customer.

For Anderson, a good backup plan starts with brainstorming and prioritizing risks. However, clients are frequently better at brainstorming than implementing. Written plans are often ignored, and employees either do not know about them or do not agree with them. The solution: prioritize according to impact. Which is most likely to cause the biggest or most urgent problem? Which one will create the biggest customer service issue?

Companies must ensure that backup plans are in place for core suppliers, distribution partners and other critical components of the supply chain. Sourcing a backup alone will not work. Risk management must integrate the backup into yearly plans so all parties are comfortable doing business when an issue occurs. Also, she says, have a collaborative partnership with your supplier to make sure the end customer has the best service. Partner with them in identifying and mitigating the risks with customer service as the primary motivation.

She also believes suppliers should be made aware of the company’s main areas of concern. “If customer service is important, it should be a key topic with your suppliers.”

Niederfringer sees part of the solution resting in a mind-set shift on the part of the business. The current atmosphere of, “It’s never happened to me” fuels inertia. “It’s a bit of human nature to look around your locale, your region, your state, your country and not think globally,” he said. “Yet so much of their goods and services are outsourced, and there’s something that can happen halfway around the globe that can impact them.”

This complacency is a risk that all humans can fall victim to. The key is to be aware of and vigilant against it. Supply chains are fluid and constantly moving. So, too, must you be.

“Businesses are rarely static,” he said. “They’re dynamic, and as a result, you need to be certain your business continuity keeps up.”
Lori Widmer is a Philadelphia-based freelance writer and editor who specializes in risk management and insurance.