Managing Supply Chain Risk in Lean Times

Managing Supply Chain Risk in Lean Times

Track 1 Session 8

2 0 0 6 M A T E R I A L H A N D L I N G & L O G I S T I C S C O N F E R E N C E S P O N S O R E D B Y H K S Y S T E M S

Mark CotteleerAssistant ProfessorMarquette University

[email protected]

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AbstractThe business benefits of operating lean are well established. However, as lean principles continue to take hold through our supply chains, it is also important to consider the risks they introduce. This session takes a look at balancing the risks and rewards of lean as it applies to sourcing. Attendees will take away an understanding of how to define and maintain "optimal leanness" in their firms.


AgendaTradeoffs in Lean Procurement– Financial Example

How Much Risk?– How Realistic is the Threat?

Risk Mitigation Strategies– Proactive– Reactive

The Risk in Lean Procurement

Mark J. CotteleerMarquette University


Lean Practice in SourcingFewer suppliersLong term relationships– Selection based on past relationships and

performanceSingle-sourcing of components “Tiering” of the supply base– Assignment of whole components to supplier– Design and production become responsibility of

supplier“Just in Time” Delivery


Leanness

Benefits

Leanness Benefit

Leanness is expected to improve operations, profitability, and firm value.

Benefits of “Leanness” increase as policies are implemented– Supplier reduction– Supplier integration– Vendor-managed inventories

Tradeoffs in Lean Procurement


A (hopefully) clarifying example from Finance

Consider a simple business that purchases a single commodity from two suppliers. An analysis of the business yields the following forecast:

Net Profit (est. cash flow) = $1,000Total Years of Life = 20Cost of Capital = 8%

Then the value of the firm is estimated to be: NPV = $9818.15

∑= +

=N

nn

n

rCFNPV

1 )1(


A (hopefully) clarifying example from FinanceAssume the owner decides to increase supply chain “Leanness” by partnering with a single supplier:

Net Profit (est. cash flow) = $1000 $1,100Total Years of Life = 20Cost of Capital = 8%

As a result of the increased cash flow estimate, the revised estimate of firm value is:

NPV = $10,799.96 (vs. $9,818.15)

And it looks like “going lean” was a good decision.

XXX

∑= +

=N

nn

n

rCFNPV

1 )1(


Leanness Benefit

Leanness

Benefits

Stability BenefitStability Losses Due To

GovernanceMismanagement

Life Cycle“Natural” Disruption

Hold Up

However, as the firm increases its “Leanness”, new kinds of risk arise from dependence on fewer, more critical suppliers– In short, becoming more “Lean” in procurement can lead to

reduced supply chain stability

Tradeoffs in Lean Procurement


A (hopefully) clarifying example from FinanceNeither supplier is well run. Therefore, although costs were reduced (improving expected profitability), uncertainty also increased, (thus increasing cost of capital). The newforecast changes as follows:

Net Profit (est. cash flow) = $1,100Total Years of Life = 20Cost of Capital = 8% 10%

As a result of the increased cash flow estimate, the revised estimate of firm value is:

NPV = $9,364.92

XX


A (hopefully) clarifying example from FinanceAn increase in “Leanness”:

– Increases cash flow (Leanness Benefit)– Increases firm risk (Decrease in “Stability Benefit”)

Pre-Lean Firm Value = $9,818.15Lean Firm Value = $9,364.92

The shift to “Lean” actually cost the firm $453.23 (4.6%) of its value!!!


How much risk can Lean Procurement add?A “Sole Sourcing” example…

Three firms producing identical products– Each purchases 50 essential components from 50 different suppliers– Each supplier has 99% chance of avoiding disruption in the next year– If a component is dual sourced and disruption of one supplier occurs, the other

supplier can meet demand

Only difference between firms is percentage of components they have sole vs. dual sourced– Firm 1 = 0% (100% dual sourced)– Firm 2 = 50%– Firm 3 = 100% (100% sole sourced)

What is the probability of supply (and therefore production) disruption for each of these firms?


How much risk can Lean Procurement add?

What is the probability of supply (and therefore production) disruption for each of these firms?

Firm 1 (100% dual sourced) probability of supply disruption during year– 0.50%

Firm 2 (50% sole sourced) probability of supply disruption during year– 22.41%

Firm 3 (100% sole sourced) probability of supply disruption during year– 39.50%

Probability of disruption is 79 times greater for the 100% sole source firm!!


How much risk can Lean Procurement add?Probability of supply chain induced disruption is a function of:– Number of critical components– Percent sole sourcing– Individual supplier stability

0%

25%

50%

75%

100%

100.00% 97.50% 95.00% 92.50% 90.00%

Individual Supplier Stability(% chance of non-disruption)

Ove

rall

Supp

ly C

hain

Sta

bilit

y

20 Components 40 Components 60 Components

Stability Probabilities for 50% Sole Sourced Firm


How realistic is this scenario?

Supply chain disruptions are associated with diminished operating performance (Hendricks & Sighal, 2005a)

– Operating Income– Return on Assets– Return on Investment

Supply chain disruptions are associated with diminished market performance (Hendricks & Sighal, 2005b)

– Stock Market Performance

Supply chain disruptions are associated with increased stock market risk premium (Hendricks & Sighal, 2005b)

– Beta


Leanness BenefitStability Benefit

Leanness

Benefits

L*

Supply ChainManagement Benefit

Stability Losses Due ToGovernance

MismanagementLife Cycle

“Natural” DisruptionHold Up

The Lean/Stability tradeoff


Managerial Take AwayLean Procurement is subject to diminishing returns– Firms need to seek “optimal” leanness


Leanness BenefitStability Benefit

L*Leanness

Benefits

Supply ChainManagement Benefit




Influencing the Lean/Stability tradeoff


Leanness Benefit

L*Leanness

Benefits

Stability Benefit**

L**

Supply ChainManagement Benefit**




Influencing the Lean/Stability tradeoff


Lean Procurement is subject to diminishing returns– Firms need to seek “optimal” leanness

“Optimal Leanness” can be increased through supply chain risk management

Lean discourages diversification as a supply chain risk management strategy– Managers must, therefore, focus on mitigation

Managerial Take Away


Lean-induced risk requires proactive and reactive management

ProactiveReciprocal Trust

IP ControlActive Assessment

ReactiveTit for Tat

Response Capability


Proactive Risk Mitigation: Reciprocal Trust

Loss of “Trust” in the supplier relationship leads to costly behaviors (Rossetti & Choi, 2005)

– Suppliers as competitors– Parts, repairs, accessories

– Dispersion of Intellectual Property

Key trust issue from a stability perspective is supplier willingness/opportunity for “Hold Up”– Monopoly sources– Increased switching costs– Loss of flexibility

The only way to have a friend is to be one (R.W. Emerson)


Proactive Risk Mitigation: IP Control

Retained ownership of design and associated intellectual property

Retained ownership of manufacturing process

Retained ownership of tooling


Active, comprehensive assessment is critical– Financials may be a trailing indicator

– Governance continuity– Capital Investment– Percentage of business (not too high OR too low)

Proactive Risk Mitigation: Active Assessment

PreliminaryEvaluation

Model

RiskRanking Selected?

DeepDive

Model

Supply BaseData

MarketData

ActionRequired?

DevelopAction Plan

No No

Internal

Private Equity

Turnaround

“Surprise”

Consulting

Disseminateto Response

Network

Network


Theoretically “best” strategy for achieving cooperative behavior among self-interested parties– Partners engage in repeated, long-term relationship– Always cooperate unless provoked – Always retaliate if provoked – Forgive quickly

Reactive Risk Mitigation: Tit for Tat

Repeated punishment and forgiveness eventually generate a payoff higher than any initial loss from rebuffed cooperation

Partner’s incentive to cheat rises as soon as they predict an end to the association– Must move quickly/decisively to end relationships


Build reactive capacity– Process for intervening in troubled suppliers

– Internal– Response network

– Repeatable & Regularly Exercised Process

Reactive Risk Mitigation: Response Capability

When a friend is in trouble, don’t annoy him by asking if there is anything you can do. Think up something appropriate and do it. (E.W. Howe)


If You Cannot Manage It, You Must Diversify It

Sole source on components, not capabilities– Harley-Davidson locks in long-term commitments

with suppliers but retains redundant capabilities in supply chain (i.e., only you make castings for the FatBoy but someone else makes castings for the Road King).


Key TakeawaysLean Procurement is subject to diminishing returns– Firms need to seek “optimal” leanness

“Optimal Leanness” can be increased through supply chain risk management

Lean discourages diversification as a supply chain risk management strategy– Managers must, therefore, focus on mitigation

Proactive and reactive risk mitigation represents a critical element of lean management

Questions?

Documents

Managing Supply Chain Risk in Lean Times