Value Chain Risk Management

1. Value Chain Risk Management William Grey and Dailun Shi IBM T.J. Watson Research Center November, 2001

2. Key Business Trends • The pace of business is accelerating, and there has been a dramatic increase in uncertainty • A difficult business climate is exacerbated by heightened competition • Supply chains are not only more efficient – but also riskier • Customers (and the equity markets) are becoming increasingly unforgiving

3. Enterprise Risk Factors Market Risks • Foreign exchange • Interest rates • Equity prices • Commodity prices Operational Risks • People • Processes • Systems • Procedures • Policies • Supply Chain Business Risks • Economic • Reputational • Supply Chain • Technological • Legal risk • Regulatory risk • Environmental risk Enterprise Risks Credit Risks • Accounts receivable • Vendor financing • Notes receivable • Liquidity Enterprise Risk Management is an integrated approach for managing risk across the firm

4. customers service / support design store point of sale suppliers local delivery outbound inbound manufacturing distribution Value Chain Risk Management Applies this Approach to the Extended Supply Chain

5. Design Buy Build Sell Ship Support Three key value chain flows are subject to risk Suppliers Customers Financial Flows Information Flows Physical Flows SCM

6. Enterprise Risks Core Business Risk Non-core Business Risk Value Chain Risk Operational Risk Event Risk Recurring Risk quality systems legal Credit risk Market risk quantity policies regulatory liqudity risk interest rate price procedures political vendor financing commodity prices complexity processes hazard debt risk equity prices serviceability people economic covenant violation foreign exchange timing natural account receivable reputational account payable Tax Risk Enterprise Risk Taxonomy

7. Studies in Risk • Nokia / Ericsson (Supply risk) • Cisco Systems (Supply-demand management risk) • Lucent Technologies (Credit risk) • IBM (Supply risk) • Micron Technologies (Price risk) • Nike / i2 (Technology risk) • Firestone / Ford (Quality, reputational risk)

8. Risk Management Strategy Implementation Organizational Changes Risk Identification Risk Characterization Strategic Changes Risk Management Strategy Formulation Planning/Execution Changes Financial Risk Management Insurance Value Chain Risk Management Process

9. Risk Identification • Techniques • Scenario Analysis • Historical Analysis • Process Mapping • Basis for consistent framework to uniformly identify, assess and manage risks • Dynamic process - requires periodic reviews • Standard categories for identifying risks • Common language for communicating risks

10. Risk Characterization • Assess the nature, impact and importance of risks • Balance quantitative vs. qualitative analysis • Measurement Metrics • Probability of occurrence • Severity of the potential impacts • Loss distribution function • Value at Risk • Stress Test / Simulation outputs

11. Risk Categorization Too expensive to insure: Take steps to reduce frequency or severity. Consider divesting if returns don’t justify risk. Establish mitigation measures and contingency plans; insure High Severity Low Likelihood I High Severity High Likelihood II Severity of Impact Low Severity Low Likelihood III Low Severity High Likelihood IV Probability of Occurrence Deploy operational changes and controls to reduce frequency of occurrence Monitor periodically for change in status

12. Interactions between risks and value chain processes (examples)

13. Risk Propagation in the Supply Chain Example 1: Price risk is comparatively well-behaved as it propagates through the supply chain Component 1 Computer Chip price +$1 High-end Computer Cost: +$(1+/-є) Circuit Board Cost: +$(1+/-є) Assemble BOM Component N

14. Risk Propagation in the Supply Chain Example 2: Quantity risk is amplified at the point of Bill of Material assembly Component 1 Cost: excess inventory High-end Computer Opportunity cost: -100 units of lost sales, customer ill-will Computer Chip shortage –100 units Circuit Board Shortage –100 units Assemble BOM Component N Cost: excess inventory

15. Risk Propagation in the Supply Chain Example 3: Quality risk is amplified as it propagates through the supply chain Component 1 High-end Computer Cost: field failure, damage to brand/reputation Computer Chip defect Circuit Board Cost: Rework Assemble BOM Component N

16. Risk Management Strategy Implementation Organizational Changes Risk Identification Risk Characterization Strategic Changes Risk Management Strategy Formulation Planning/Execution Changes Financial Risk Management Insurance Value Chain Risk Management Process

17. Financial Risk Management • Use of financial instruments • Forward contracts • Futures • Options • Swaps, caps and floors • Use of supply chain contracts (embedded options) • Use of spot markets and new derivatives markets

18. Probability of loss Controllable Loss Catastrophic Loss Leading to Default Losses Managed by Strategic, Operational, and Financial Means Default Losses Covered By Insurance Size of loss Insurance

19. Strategic Risk Management • Application of financial management analogues to the value chain • Value chain restructuring • Risk-based modeling and analysis • Improved visualization

20. Capital Structure (Debt-equity mix) Cost Drivers Operating Performance and Profit Cost of Capital (Required equity return) Shareholder Value Revenue Drivers Shareholder Profit Relationship between the Value Chain and Shareholder Value ValueCreation Value Allocation

21. Cost of Capital (Required equity return) Capital Structure (Debt-equity mix) Cost Drivers Operating Performance and Profit Revenue Drivers Operational Diversification & Hedging Shareholder Profit Linkages between Strategic Risk Levers and Shareholder Value Operational Leverage ValueCreation Value Allocation Financial Leverage Financial Diversification & Hedging Shareholder Value

22. Revenue Management Transportation & Logistics Inventory Policies Sourcing Supplier Management Cost of Capital (Required equity return) Capital Structure (Debt-equity mix) Cost Drivers Operating Performance and Profit ValueCreation Value Allocation Shareholder Value Revenue Drivers Outsourcing Strategic Alliances Supply Chain Design New product introduction Shareholder Profit Linkages between Supply Chain Decisions and Shareholder Value

23. Examples of Strategic Risk Management

24. Strategic Risk Management Analytics

25. Target Example of Improved Visualization Investment 1 Probability EPS Probability Investment 2 EPS Target

26. Risk-enabled Planning and Execution • More accurate specification of decision objectives, deeper analytics • Richer, more complete information • Extensive usage of uncertainty data • Leveraging financial data in supply chain decisions • Leveraging supply chain data in financial decisions • Risk-based measurements and metrics • More timely and effective response to risk events • Extend financial risk management concepts and tools: leverage, diversification and hedging

27. Integrated Risk Management Risk Extensions Standalone Risk Analytics Analytic Intensity SCM CRM Real-time Risk Management ERP PLM Real-time Risk Monitoring Data Integration Evolution of Value Chain Risk Analytics