Quick. What’s the biggest threat to your business? If you said terrorists or natural disasters, you’re probably wrong. Those concerns get prime time coverage, but what can really bring a business to its knees are its suppliers.

Allied-Signal and Honeywell know that firsthand. Both companies made flat screen displays for military aircraft, using glass from its only U.S. manufacturer. When they got last-minute word that the glass supplier was going out of business, they had to scramble to find and qualify another supplier. The challenge was complicated by the fact that the offshore supplier had to be vetted by both the Department of Defense and the Commerce Department. Ultimately, the process took about a year. To keep their production lines humming, Allied-Signal and Honeywell formed a consortium that propped up the supplier while they sought alternatives.

Forming a consortium to keep the company running was a solution of last resort, but these are hardly the only manufacturers who’ve done it. Land Rover actually bought its sole source chassis supplier, UPF-Thompson, for £16 million (sixteen million pounds) after that supplier went bankrupt in 2002.

In the face of such supply chain disruptions, companies—Allied-Signal among them—have determined to find a way to identify at-risk suppliers earlier to buy necessary lead time to prevent similar situations from occurring.

Part of the problem is that, with outsourcing, specific supply chain risks are less visible to manufacturers. As the supply chain stretches beyond one’s nation and around the world, visibility does not improve. Consequently, many companies are beginning to understand that they are vulnerable to supply chain failures and are beginning to do something about it.

That something, often, involves getting closer to their suppliers. “It’s not just a question of having more inventory,” notes Donald B. Rosenfield, director, leaders for manufacturing program, MIT Sloan School of Management. It’s a matter of understanding the business climate your suppliers face and knowing enough about them to take action early enough to prevent problems from occurring whenever possible. It’s about having a backup plan.

Managing supply chain risk really focuses on the science of supply chains, says Jim Lawton, who ran operations and procurement for Hewlett Packard before joining Open Ratings as VP of marketing.

In the 1990s the focus was on running lean, with just-in-time deliveries and fewer suppliers. “But, there’s a major downside,” says Jim Lawton, who ran the operations and procurement for Hewlett Packard before becoming vice president of marketing for Open Rating. “You cut costs, but increase risks.”

That risk was amply illustrated when Hurricane Katrina hit the Gulf Coast this time last year. Nothing moved through the Port of New Orleans or other Gulf of Mexico ports for quite some time, making businesses that relied on the port scramble for other options. In 1995, the Kobe, Japan earthquake closed Japan’s largest port for two months and destroyed 100,000 buildings. “Toyota was unable to produce 20,000 cars on schedule because damage to plants left it short of critical components,” according to Ruud Bosman executive VP, FM Global.

Natural disasters, though, aren’t usually the problem. More often than not, supply chain risk comes from a series of smaller events that domino.

Mark Hillman, senior analyst, supply chain management for AMR Research in Boston, says the main supply chain risks are commodity cost increases, supply failures and logistics failures. It may be as simple as a key person removed from the picture, a labor strike, political turmoil, a bad production run, or even a transportation slowdown. (The government of Ontario, for example, notes that delays at the U.S.-Ontario border alone cost Canada more than $6 billion dollars in trade opportunity).

Basically, risk management is an exercise in answering, “What if…?” As Gary Lynch at Marsh says, a risk-based approach to supply chain management looks at such things as:

• The risk of moving manufacturing abroad or of having substantial international suppliers.
  
  
• The risk of not fulfilling spikes in product demand.
  
  
• The risk of not having real-time inventory information from vendors or customers.
  
  
• The risk of managing all customers as if they were the equal.
  
  
• The risk to the brand if an incident occurs at one of your suppliers or distributors.

To get a better handle on your exposure to risk and its seriousness, Hillman advocates mapping the supply base to understand the risk, “at least for the first tier suppliers.” It’s better, though, he says, to look at the entire relationship among the first and second tier suppliers because issues faced by the second tier suppliers may be passed on to the first tier. For example, if your supplier has one major customer and a few small customers, losing the major customer may put the other customers at risk.

But risk management goes beyond that. At Allied-Signal, the supply chain analysis started with a close look at the product, recalls Dennis Lemon, now president of Blue River Consulting, who was Allied Signal’s director of supplier quality at the time. Questions, he says, included: “How critical is the component? Is the product a commodity, high tech, low tech, etc.? Is there a long qualifying time? Do the suppliers also supply our competitors? Does manufacturing require highly trained people with unique skills? What is the likelihood of things going wrong and how difficult will it be to remediate?”

At the end of that exercise, “Surprisingly, we found that about 40 percent of our strategic suppliers were at risk!” Lemon says. That doesn’t mean suppliers were having problems. It does mean that, however, that a problem with one of those suppliers could have dire consequences for the company.

Although companies are beginning to audit their critical suppliers, it takes a large number of people—larger, in fact, than most companies can field. (Wal-Mart, according to Lawton, has 15,000 annual, onsite supplier visits in China alone.) Open Rating developed an automated methodology that looks beyond financials to predict the suppliers most likely to have problems.

Such predictive indicators are at the heart of Open Rating’s automated supplier analysis system. Using a process developed at Massachusetts Institute of Technology (MIT), the software accurately predicted 92 percent of all bankruptcies six months in advance. That’s enough time for manufacturers to take action either to help the supplier or to find other sources.

Open Ratings has taken that predictive system and augmented it with manufacturers’ own knowledge and experience with specific suppliers and about those suppliers’ suppliers. As Lawton explains, we take a manufacturer’s master list of vendors and match it against our system, looking for overlaps and for potential issues. A list is compiled that lists the company, the risks and whether they’re major risks. From there, Open Ratings built a framework to help clients analyze that risk, which includes such issues as the number of products that company supplies, where they fall in the product lifecycle and how much money is spent with that supplier.

One of Open Rating’s automotive clients—“a $15 billion company”—used the software to identify a potential problem with a sole source supplier of transmissions. The Brazilian company was unionized, and the manufacturer knew “a strike could sink the company,” Lawton says. About six months before union contract negotiations were to begin, the manufacturer began ordering additional inventory, communicated with union leaders about their issues and concerns and then followed negotiations carefully. The manufacturer had a backup plan in case a strike was called.

Lemon, an Open Rating client, says accuracy is quite good. “We found that on-time delivery and quality were greater indicators than financial data in finding problems.”

Lean manufacturing and just-in-time delivery were the buzzwords of the ‘90s, and companies took the message to heart. It’s not unusual today to have several sole-source suppliers. That amplifies any supply disruptions. And, as companies source globally, they increase their lead-time and their vulnerability for supply chain failures. So, Lemon says, “If you understand the risks, you may want multiple suppliers.”

Alternate suppliers, however, shouldn’t be subject to the same risks. A computer manufacturer, Hillman elaborates, wouldn’t want its both primary and secondary chip suppliers to be from Taiwan (a leading chip producer) because disruptions like natural disasters, blockades, political upheaval or even power outages that affect the primary supplier may also affect the secondary supplier.

Another strategy Lemon advocates is to increase your involvement with the supplier, lending management expertise or resources as needed.

In Mexico, Lemon says, a reliable machine shop owner who supplied a substantial number of parts for Honeywell engines decided to quite the business. Financials were good, deliveries were on time and quality was high, but the owner was ready to retire. Lemon and Honeywell, after many discussions, persuaded the owner to develop a succession plan that would allow him to retire while allowing the business to continue operating.

A similar nudge was needed in Malaysia, Lemon says, for a circuit card manufacturer. The company was responsive, wanted the business and had well-trained employees. The problem was that competing start-ups were hiring away the already-trained workers. “They’d literally show up at the factory with a car and an offer of 10 or 15 cents more per hour and say ‘hop in,’” Lemon says. His team worked closely with the supplier to develop a retention strategy to keep its highly trained workers.

Hedging has, so far, worked well for Southwest Airlines as a bulwark against rising fuel costs. Locking in a then-premium price for jet fuel that would be delivered a few years later enabled the airlines to turn a profit for 2005, Hillman says. It bet that fuel costs would rise above the price it set and won. The strategy worked for Apple Computer, too, when it forward bought its NAND-flash memory cards in 2005 in preparation for launching the iPod Nano line of digital music players. “But,” he says, “hedging is a double-edged sword.”

Risk pooling is another strategy Hillman advocates, and one used frequently by industry. Boeing, for example, makes the fuselage of its planes and puts them in storage. Later, when orders come in, the plane is finished according to the customer’s specifications, giving Boeing the flexibility of using the fuselage for cargo or passenger planes and adjusting the electronics package and other components as needed.

Whatever strategies are used, to be truly successful, risk management must be embraced at the most senior levels within the company. In the past 10 years, boards of directors have become more aware of risk and generally maintain they are well prepared. Digging deeper, however, reveals that corporate directors tend to approach risk on a case-by-case basis so that risk is linked to a specific issue, according to a study released in June by The Conference Board. Many companies, it says, lack a robust, systematic, enterprise-wide approach to risk management.

Disruptions, however, are system wide, and have significant repercussions. Those disruptions aren’t short-term, either. The repercussions of a supply chain failure reverberate throughout the company for at least two years, according to FM Global, citing work by Professor Vinod Singhal at the Georgia Institute of Technology and Associate Professor Kevin Hendricks at the University of Western Ontario. Companies experiencing a supply chain disruption—regardless of the cause of the disruption—had stock returns that were 33 to 40 percent lower than their industry average and their stock was 3.5 percent more volatile.

Another figure, cited by Lawton, said that each time an aerospace supplier filed for Chapter 11 bankruptcy protection, the aerospace industry spent $5 million internally to fix the problem.

Yet, most companies fail to look beyond their immediate experience or, for that matter, beyond their immediate walls. Gary Lynch, national practice leader for Marsh’s Risk Consulting Practice, notes that manufactures tend to look at efficiency and costs, but don’t look at source-to-destination issues and what’s needed to support them.

In analyzing risk, Lynch says, the goal is to look at risk not as a separate and discreet category but to determine what contributes to our business success now and in the future. “Without that, it’s very difficult to look at risk properly. Look at source to destination issues and then at interdependencies,” he says. That involves interdependencies among people (cross-training and succession planning, for example), software and physical attributes (such as available cash, vital records and facilities) and relationships within the supply chain (who your supplier is reliant upon and who their biggest customers are).

“One company, for example looked at the programs it supports and found that 1,600 were funded by the DOD,” Lynch says. Applying a threat assessment to the whole range of programs was impossible. They focused on the most valuable projects and in mapping the process from materials to delivery of the final products, they found that 80 percent of suppliers were sole source. Sometimes, the lead time was very long,” The looked at location, logistics, and financial viability and found that “many were questionable.” The manufacturer, Lynch says, chose to work with its critical suppliers to solve their problems. During Hurricane Katrina, for example, they sent teams to help suppliers get up and running fast.

The specific threat doesn’t matter. In supply chain risk management, assume the break is substantial and begin to understand how it affects business. Then, Lynch says, you can begin to develop a contingency plan.

The best advice, from CBIZ Risk Management, is to work closely with suppliers and vendors. Ask what plans they have in place for various contingencies. If their plans are inadequate, work with them to develop better plans or look elsewhere, and realize that “you’ll never think of everything!” says Michael A. Mayers, senior vice president.

“Risk management is dedicated process and it’s never over,” he adds. “Have a “Plan B.”

Sidebar:
How a U.S. Optics Manufacturer Monitors Its Asian Suppliers

Price, availability of supplies and the desire to enter Pacific Rim markets were the driving forces behind optic manufacturer Leupold & Steven’s expansion into Asia. The optical glass used in Leupold’s rifle scopes and binoculars is available mainly in Asia, with a few manufacturers in Germany and some extremely high quality (and expensive) manufacturers in the U.S.

The challenge, for Leupold & Stevens, was to become competitive in its line of ancillary products, like covers and lens filters. They began working with some Asian suppliers about five years ago “in a limited way,” says Peter Lemon, materials manager. That gave the company affordable optical glass for its award-winning products and access to local markets. Then, when Wal-Mart because a customer in 2003, “we dramatically increased the amount of goods we procured overseas,” and built upon that, adding a new, more affordable line of binoculars to its product mix, expanding relationships with existing suppliers and courting new ones. The result is an increase of 300 percent on gross revenues from the ancillary products Leupold sources overseas.

The optics market, Lemon explains, is a small niche industry with many companies vying for the same resources. Maintaining a wining mix of reliable suppliers goes beyond commercial interests to what the Chinese call guanxi—the mix of friendships and connections that is the very fabric of business throughout Asia.

“Our relationships with suppliers go beyond commercial relationships,” he says. That means flying there when a supplier opens a new facility, and getting to know suppliers’ likes, dislikes, families and even the pet canary. When associates visit the U.S., it means entertaining on a personal level with, perhaps, a fishing trip thrown in for fun. That level of personal interaction builds strong relationships based on more than mere commercial interests that, in turn, give Leupold the greatest potential for keeping its intellectual property safe and for expanding its business with reliable, reputable suppliers. The result is a win-win situation for both parties.

That said, there have been some bumps along the way. Generally speaking, “Asian suppliers tend to over-commit themselves,” Lemon says, with the extent of the over-commitment varying by country. To dissuade such over-enthusiasm, Leupold & Stevens has developed “aggressive agreements with penalties for failure to perform,” but, Lemon says, “they are balanced against the risk of souring an otherwise good relationship.”

The preferred solution, he says, is to offer management help. When launching a new series of range-finder scopes manufactured overseas, for example, the designs weren’t finished on time, he recalls. Leupold’s solution was to put a man on the ground for about three months, living and working alongside the supplier’s staff. The project got back on track.

Protecting intellectual property is another key issue that can be particularly frustrating in emerging economies because many don’t really understand how anyone can own an idea or a process and intellectual property protection sometimes only applies to certain categories of items and not others.

Like many companies with vital patents, Leupold & Stevens keeps its most valuable intellectual property in its own facilities. The result is that only portions of some new products are outsourced. Such care is only partial protection, however. In China, another company is using the Leupold name. The situation is being resolved in the Chinese courts, but the concepts of intellectual property and trade names are still evolving, and sometimes differ from those of Western nations. His understanding, Lemon says, is that, “Whoever files for the name first gets it. It’s a very difficult situation.”

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