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Are Global Supply Chains Too Risky? A Practitioner's Perspective
[July 03, 2006]

Are Global Supply Chains Too Risky? A Practitioner's Perspective

(Supply Chain Management Review Via Thomson Dialog NewsEdge) In the classic story of the Trojan War, the Greeks offer the Trojans a gift that is too tempting to refuse. As the story goes, the infamous wooden horse is taken behind the city's walls only to have Greek soldiers emerge from its interior and conquer the city. The Trojans' mistake, of course, was failing to see the risks associated with what appeared to be a benefit. Much like the Trojans, you may have unwittingly let risk infiltrate your supply chain. And, much like the soldiers emerging from the wooden horse, the risk that could be unleashed may do considerable harm to your business.

Why is risk management in the supply chain so important now? You've spent years streamlining operations, reengineering processes, integrating with partners, implementing enterprise systems, andthe final stroke of masterymoving production to low-cost, offshore locations. You've done all of this in an attempt to improve the service you provide customers at a more competitive cost. Congratulations, you now have a global supply chain. It all seemed so simple, like taking candy from a baby.

But now you learn the rest of the story. Creation of the global supply chain has also brought new risks that you may not have encountered before.

The simple fact is that in today's longer, more global supply chains, product moves over greater distances and across more borders than in the more localized supply chains of the past. The coordination and execution required for international shipments has always been a challenge. But now we find that market conditions, security considerations, and regulatory pressures are converging in such a way that makes the task even more daunting.

Much has been written about the tactical responses to these evolving challenges. Diversifying port usage, avoiding peak import periods, and using more air freight and dedicated carriage are all possible responses. However, these largely short-term fixes are not sufficient to address the longer-term challenges, which require more in-depth structural responses. I recently discussed this with Larry Lapide, the director of MIT's Supply Chain 2020 research program. Lapide commented that "the real issue is differentiating between the long- and short-term issues. If it's a long-term issue, you can no longer assume your current practices are appropriate." (For more on the MIT research, see "The Essence of Supply Chain Excellence," Supply Chain Management Review

, March 2006.) So how should supply chain practices change to reflect the new global realities?

This article endeavors to explore the longer-term implications and possible strategic responses to these new challenges from a practitioner's perspective. In my current position at Limited Brands, I am responsible for overall supply chain process improvements across the enterprise. Prior to this, I was vice president of supply chain operations at AVEBE America, a European-based manufacturer of food ingredients. I have also been a consultant at Accenture where I worked on various global projects in the firm's Supply Chain Strategy Practice. I'm hopeful that this set of experiences brings a useful perspective on the topic.

The New Global RealityFirst, let's level-set on some of the transportation-related forces affecting the flow of global commerce today. Specifically, there are a number of well-documented challenges facing both the international and domestic transportation markets. Some, like the domestic driver shortage, represent cyclical phenomena that we have seen in the past. Others are more evolutionary, resulting from a new global economic structure that involves a massive shift of production abroad. Still others reflect the new political realities of our modern world; the threat of terrorism being a case in point. Together, these challenges force us to take a hard look at our existing supply chains practices and provide a strong impetus to rethink them.

Ocean Port Congestion.
Containerized cargo volume from Asia is forecasted to increase roughly 10 percent per year for the foreseeable future. This translates to a doubling of annual container throughput in the next seven years. Most agree that the U.S. port, rail, and drayage industries are ill-equipped to keep up with this demand. Compounding the problem is the steamship lines' drive for asset productivity by using new massive ships. While these 5,000+ TEU (twenty-foot equivalent units) ships may lower per container costs for the lines, they represent a challenge for the ports and supporting infrastructure. In fact, the Panama Canal can't even handle these mega-ships. Barring dramatic improvements in productivity and/or an investment in infrastructure, the combined effects of these trends could be catastrophic for supply chains that are reliant on imports. As 50 percent of all product sold at retail in the United States is sourced overseas, the potential for serious port congestion puts a significant amount of economic activity at risk.

Inadequate Surface-Transportation Infrastructure.
Our rails, roads, and bridges are in woeful condition. Railroads are not investing at the level required to develop new capacity to meet demand. Many highways and bridges are in need of repair as bottlenecks worsen in major metropolitan areas. The I-95 corridor in and around New York City is one major pinch point. The highways surrounding the Port of L.A./Long Beach are simply chock full of trucks. It is logical to assume that the velocity of commerce will be adversely affected as the volume of highway traffic increases.

Similarly on the rails, we've seen average speeds remain steady at best and actually decline during some peak periods. The recently approved highway bill is only a drop in the bucket relative to what's required to shore up the country's sagging transportation infrastructure.

Escalating Transportation Costs.
We have just lived through a period of $70-per-barrel oil. While there appears to be some short-term relief in sight, some have predicted that the price will hit $100 a barrel. Still others, looking out 1520 years, are predicting $300 oil. What's clear is that a severe oil shortage is likely to occur as production approaches its maximum and demand peaks near that same level. Not only will prices increase, they will become much more volatile as swings in demand lead to shortages. These issues affect all modes of transport. Compounding the cost problem domestically is a truck-driver shortage. While this shortage may be alleviated in the near term as market conditions change and more potential drivers become available, it is a cyclical situation that is likely to reoccur. All of these factors are contributing to an escalation in transportation costs as a percent of total landed costs.

Supply Chain Security Considerations.
The impact of a terrorist attack via containerized cargo or any other mode of transport would be devastating. The required response would dramatically slow the flow of commerce. New initiatives, such as the Container Security Initiative (CSI) and Customs-Trade Partnership Against Terrorism (C-TPAT), are aimed at improving security and protecting the flow of commerce. Ironically, these measures may themselves slow the flow of commerce while increasing shipper cost. Increased inspections from Customs, the Environmental Protection Agency, and the Food and Drug Administration are obvious examples.

Another concern are hazardous materials moving by truck. Because of the new requirement of extensive background checks to obtain a hazardous-material (hazmat) endorsement, many drivers either are failing the checks or choosing not to apply. Railroads also have begun to restrict their hazmat freight, choosing not to deal with the administrative burden of proving they can safely transport what has become a potential terrorist target.

Add to the above list, potential problems like natural disasters, SARS, bird flu, and political instability and you have a long list of potential risks to the movement of product. Most would agree that these risks, in aggregate, are certainly substantial.

A Changing EquationSo what do these developments mean for supply chains? What new factors and responses must be considered? First, we need to recognize that the most far-reaching supply chain change centers on where companies now source product. In this regard, the three drivers of sourcing strategycost, quality, and servicenow have a new important sibling: risk. (See Exhibit 1). Accordingly, we need to begin to thinking of risk as a key attribute driving our supply chain decisions.

Supply chain managers have long recognized the concept of risk. Yet the focus has traditionally been on demand riskthat is, how to respond to variability in actual demand. With the advent of more global supply chains, supply-side risks have become a greater concernparticularly those that affect lead time and/or cost.

Lead-time risk
increases in the global supply chain because there are more potential constraints that could slow a shipment at any point in its journey. Throughput at the origin or destination port may decrease, rails may back up, or cargo inspections may increase because of an increased terrorist-threat level.

Cost risk
increases for several reasons. First, the inputs to transportation (for example, fuel) might spike at any moment, resulting in higher freight rates. A sourcing decision that was once appealing may become less so as fuel costs increase and total landed costs rise. In addition, costs may increase due to forced mode shifting. That is, you may be forced to use a more expensive mode to reduce lead-time risk or to secure transportation capacity during certain peak periods.

The practical implications of these potential risks are that supply chains become much harder to manage. Managing inventory becomes more difficult under more risky conditions. Companies find that they need to hold more inventory to account for lead-time variability or reduced service levels. Many companies have already backed off the "leanness" that once characterized their operations. One big reason: the transportation reliability required to support such practices no longer exists. Similarly, rapid replenishment strategies will become less common. And just-in-time practices will take a hard hit, especially in cross-border commerce.

Recent research supports these observations. The 2005 State of Logistics Report
by the Council of Supply Chain Management Professionals (CSCMP) showed that aggregate inventory levels, which had been greatly reduced during the 1990s, have started to rise again. A recent survey by the Warehouse Education and Research Council (WERC) found that 30 percent of the surveyed companies have already increased their inventory levels. These research findings are confirmed by many front-line observations as well. Bill Sampson an executive of LMD Logistics, a third-party provider in Long Beach, Calif., that specializes in imports, comments that "more and more companies are asking us to hold backup stock. They are not running as lean as they once did."

Cost risk forces companies to think about their supply chain decisions and become more flexible in how they source and route products to market. Financial practitioners are masters at managing risk and have long understood that flexible global manufacturing capacity can be used to overcome shifting exchange rates. If the dollar depreciates relative to the Korean won, shift production to China. If the dollar depreciates relative to the Chinese yuan, move manufacturing to Malaysia. The goal becomes to develop flexible production and logistics systems capable of chasing the least-cost production source on short notice. Supply chain managers would do well to adopt a similarly nimble approach in terms of their ability to move product effectively from source to destination.

How can we incorporate risk more formally into our supply chain thinking? Risk can be thought of as variation relative to the mean ("variance" or "standard deviation" in statistical terms). So, for lead time, a planned transit time from Hong Kong to Chicago may be 20 days. However, you might discover that actual lead times range from 18 to 27 days. That's a significant variation skewed towards late arrivals that will certainly influence customer service. An appropriate response would be to increase buffer stocks at the destination or risk lower service levels to customers.

Cost risk can be estimated in a similar fashion. You likely have a planned freight rate in place with a preferred carrier across a lane, and you may use that rate as a factor in determining product profitability. However, because of capacity constraints you may find yourself using alternative higher-cost carriers or modes (such as air freight) more often. This increases your effective transportation cost per unit and reduces profitability. The potential variation should be considered in your forward-looking product-profitability analysis. Think in terms of actual effective cost based on historical levels of variance rather than nominal quoted prices. Your preferred carrier's rate is meaningless in any profitability calculation if you are not actually using it.

When the risks of the new global realities are fully considered, the traditional inventory/transportation cost trade-off may shift. Historically, transportation has often been used as a trade-off for inventory. The idea is to minimize stocking points in order to reduce working capital and storage/processing costs. When products are required, move them to the point of need.

Going forward, however, this equation may shift. As transportation becomes more expensive and risky, it may cross the point at which it carries a relatively larger weight than inventory and storage costs. (This is depicted in Exhibit 2.) This has significant implications for the structure of the distribution network. A preferred approach might now be to increase stocking locations in order to be closer to the point of manufacture and/or use inventory to reduce the need for product movement.

Time to Rethink Your StrategyAs risks increase and the equation changes, companies will need to modify their strategies so that they manage their supply chain assets more intelligently. During my time as both a practitioner and a consultant, I've seen three ways to better manage assets by reducing supply chain risk and lowering attendant costs. These approaches focus on reducing transportation content, using transportation more efficiently, and rethinking the global sourcing strategy.

Reduce Transport Content.
Think about your supply chain as a map with sources, distribution points, and destinations all connected. The length of those connections indicates of the amount of transport "content" in your supply chain. Think about how to make the cumulative length of these lines shorter. Rethinking your distribution network is an obvious place to start. A single national distribution center (DC) requiring long-haul transportation might not make the most sense in today's environment. Instead, regional distribution facilities close to the production sources, to the ports, and to the demand points may be wiser.

For importers, using facilities near ports to perform a value-added service that would otherwise be done at far inland DCs can help minimize inland transportation while lowering costs. Bill Sampson of LMD Logistics spoke to this point: "We are being asked to do more activities near the port. It reduces reliance on the rails and speeds the product to market." Direct-to-destination delivery from overseas factories may be an option as well. By increasing order size, building consolidated multi-product containers, pallets, or cartons, product can flow directly to the destination with fewer "touches."

Another technique for reducing transport content is through greater use of cross-dock facilities and dynamic planning. By building dynamic routes into your system, you may be able to maximize consolidation opportunities and bypass distribution centers and other consolidation points as product moves from source to destination.

The bottom line: Less transportation content translates into less risk and lower costs.

Use Transportation More Efficiently.
Each time you ship a load you are occupying and paying for a fixed asset for a short period. How do you increase utilization of that fixed asset? In the past, you may have tried to minimize inventory through the use of small, frequent deliveries. A better approach may now be to seek larger, more-efficient consolidated shipments. High-volume businesses will, of course, have an advantage in doing this. But companies without the big volumes might consider altering their shipping patterns to consolidate more product or seeking out a third-party provider to leverage their volume with that of others. Better planning pays dividends here, regardless of the volume in play. In particular, smoothing demand and longer lead times will normally help to secure capacity at lower prices.

Still another way to use transportation more efficiently is to increase distribution points so as to reduce excess product movement. "In market" distribution points will allow you to move product in large consolidated loads far into the market before breaking them into smaller customer deliveries.

Re-examine Your Sourcing Strategy.
A more far-reaching option may be to rethink the wisdom of global sourcing entirely. This is an extreme method of reducing transport risk. But the reality is that from a total profitability perspective, sourcing certain items overseas may be less appealing once all costs and risks are considered. Lead-time risk is an especially big concern for importers, especially those with seasonal or fashion products. As a security-conscious infrastructure becomes ever more constrained, reliable lead times are an increasingly dicey proposition.

Ultimately the sourcing decision can only be made by a thorough cost/benefit analysis. Of course, the benefits of sourcing overseas can be substantial. However, much like financial investments are measured according to the marginal risk associated with some marginal return, sourcing decisions should consider the transport cost and lead-time risks associated with chasing the cost benefits. A recent Bain & Co study showed that sourcing from low-cost countries (LCCs) offers product cost savings of 1035 percenta very attractive alternative. However, a 20 percent reduction in purchase price, for example, may start to lose its appeal once you consider the total costs and significant market risk you assume due to lead-time variability. Can you afford the potential lost margin resulting from a late shipment? The results of a cost/benefit analysis may help you determine how to answer this question and alter your strategy.

One interesting approach could be to source low-margin products reliant on inexpensive production from overseas suppliers. Higher-margin products with significant demand volatility may require shorter, less variable lead times and could be sourced closer to the ultimate point of use. Finding the right mix between these two sourcing strategies will yield your optimal solution.

Solutions Companies Are PursuingLet's now look at some real-life examples of how companies are adopting these types of solutions to minimize supply chain risk. My company, Limited Brands, is looking into various options to reduce the level of transportation content in the supply chain while improving speed. For instance, we are building the capability to "switch on" node bypass opportunities when volumes warrant. So rather than flowing product across a fixed path regardless of volume, we want to be able to alter paths dynamically in order to maximize transportation efficiencies. This, of course, is no small task as a variety of logistics services still need to be performed in connection with any given move. But now multiple locations must be able to perform them.

The dynamic bypass approach is being pursued in concert with a proposal to open regional distribution centers. These regional DCs will allow product to move in full truckloads as far as possible into a market prior to breaking bulk. As a result, product produced in region will be used to satisfy regional demand without excess movement. While this approach will add expense in terms of inventory investment, it will reduce the overall cost of getting product to market. In addition, our company is exploring the possibility of shifting production between manufacturing locations to reduce the expense of moving product from certain regions of the country. Lastly, Limited Brands is implementing planning improvements to smooth demand for truckload capacity. By avoiding large unplanned spikes in demand, we believe that we will be able to utilize low-cost carriers more often.

Garden Ridge, a chain of home dcor stores in the Southeast, is taking similar steps to reduce transportation content. It has recently implemented a direct-to-store shipping program during peak seasons. Rather than bring product into their Houston DC, only to reship it to the stores, Garden Ridge has begun to build consolidated loads in Asia. These loads, comprised primarily of large bulky items, now move directly to stores upon import. The company pays a bit extra for the overseas consolidation service. But the cost is more than offset by the reduction in transportation content.

Some apparel manufacturers have rethought their global supply chains in more fundamental ways in order to support rapid replenishment of certain items. Specifically, they are sourcing certain products far overseas and others more locally. One U.S.-based apparel retailer that I studied sources first-run product with long lead times in Asia. Harder-to-predict replenishment product, on the other hand, is manufactured closer to market. While the retailer incurs higher production costs on these items, it is able to capture additional margin through a more rapid response than if it had sourced everything in Asia.

According to the Harvard Center for Textile and Apparel Research, this type of strategy reflects a trend that has actually been in the making over the last 20 years. The researchers point out that from 19842000, the percentage of apparel imports into the United States from the "Big 4" Asian countries (China, Taiwan, Korea, and Hong Kong) dropped dramaticallyfrom 64 percent to 19 percent of total apparel imports. The primary beneficiaries of this shift have been Mexico and the Caribbean countries. These countries have seen their share jump from 7 percent to 39 percent during this period. One driver behind this shift is time. Simply put, these countries are closer to the U.S. market. And the closer you are to the end market, the faster you can respond to changes in demand and the lower your risk to variable transit times and costs. Arguably, these countries (especially Mexico) also benefit from more favorable transportation interfaces with the United States and face less onerous administrative burdens crossing the border.

A more dramatic response was taken by AVEBE, a well-known European food ingredients manufacturer where I formerly worked. The company recently exited the U.S. market in large part due to escalating inbound transport costs. Those costs approximated 20 percent of revenue by 2004, an intolerable level in a commodity market full of domestically produced substitutes. However, this disappointing outcome was not due to a lack of attention to the issue. Indeed the company's approaches to the challenge are instructive for anyone seeking to take risk and costs out of their supply chains.

AVEBE over the years had explored and implemented a number of innovative solutions. An example was using the Port of Montreal rather than the more congested and expensive East Coast ports. While this switch cost the company time, it saved them precious dollars. AVEBE also implemented an "overweight" container program. By positioning their distribution centers close enough to the port of entry (typically just a few miles away), they were able to avoid over-the-road weight limits. They could stuff roughly 60,000 pounds of product into a container rather than the typical 44,000 pounds. AVEBE even went so far as to explore domestic production of some products. (An idea that was ultimately abandoned due to a local scarcity of specialized raw materials.) However, despite these efforts, the challenge of moving a low value-to-weight ratio product over vast distances proved uneconomical in the end. The company chose to retreat and focus on local European markets.

Implementing the SolutionsAs the case examples suggest, implementing the good ideas is the hard part. As you go about the process of rethinking your supply chain strategy and implementing the desired solutions to manage risk, it's helpful to keep the following thoughts in mind.

Educate Your Peers and Customers.
Helping your partners understand the new environment is critical to driving any sort of change that effectively addresses risk. When peers and customers understand the realities of the new marketplace, they will be far more likely to buy into any change initiative. In fact, they may already be hearing the same message from other suppliers or observing the same thing in their own operations. Remember, though, this message is not necessarily intuitive, especially to the non-supply chain professional. This is where your interpersonal communications skills come into play.

Get out of Your Silo.
Virtually every firm suffers from the silo effect. Even the most savvy supply chain professionals will make suboptimal decisions if their organization has created incentives for functional optimization. Work hard to get out of your silo and force the organization to reach supply chain risk decisions that are optimal for the entire enterprise. Customer-facing issues, in particular, are notoriously difficult to address. Sales will want to maintain service, and logistics will want to reduce it. This emanates from their traditional revenue and cost focuses respectively. However, the ultimate goal should be to maximize the profitability of a customer relationship within a supply chain strategy that prudently considers risk.

Walk Before You Run.
Start with the simple, obvious opportunities. A broad stroke "Excel-based" analysis may help uncover significant consolidation and node-bypass opportunities to increase efficiency and minimize risk. In the long term, opportunities might be uncovered via sophisticated systems enablement. But don't wait. You can achieve much through a basic exploration of your existing supply chain.

Follow the Money.
Risk is an amorphous concept. It's hard to justify new practices based on things that may or may not happen. But supply chain change will not take place without economic justification. So think about looking at historical data and creating several "what if" scenarios. Estimate the likelihood and financial impact of each. While it may be difficult to attach a probability to each scenario, you will get a sense of the magnitude of the problem. Also, think about applying lessons learned from other companies that have suffered from unmanaged supply chain risk. What was the financial impact on them?

Leverage Third Parties.
Tremendous expertise and leverage resides outside of your organization. In particular, look for third-party partners that have implemented the processes before and specialize in providing the services you're looking for. You will benefit from their asset leverage and process expertise. For instance, some third parties specialize in overseas consolidation, which will support a direct-to-store shipment model either at the container or carton level. Third parties also provide services at the destination ports allowing for the quick release of product to the market.

There is no shortage of new risks in any global supply chain. While these risks do not alter any of the fundamental principles of supply chain management, they do alter the practices you might want to employ. Moreover, the potential permanent nature of these risks force us to think about more than just simple workarounds.

This is the new reality facing companies engaged in global commerce today. In some ways, the heightened risk may be considered a threat. But a more insightful perspective is that it presents an opportunityan opportunity for supply chain professionals to fundamentally rethink their operations. This article has discussed aspects of the new environment, offered some options for dealing with it, and recounted real-world examples of solutions pursued. Does it contain all of the answers to supply chain risk? No, but we hope it at least will keep the Trojan Horse from rolling up on your shores.

Mark Crone is Director, Supply Chain Planning and Analysis at Limited Brands Inc.

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