Risk in Supply Chain Management

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Feb 28, 2009 - Ruefli, T.W., Collins, J.M., Lacugna, J.R., 1999. Risk measures in strategic management: auld lang syne? Strategic Management Journal 26 (2), ...
Proceedings of National Conference on Advances in Mechanical Engineering (NCAME 2009) th st February 28 and March 1 2009 Department of Mechanical Engineering Moradabad Institute of Technology, Moradabad

Risk in Supply Chain Management a,b

A. R. Singha, R. Jainb and P. K. Mishrac Research Scholar in Mechanical Engineering Department, MNNIT, Allahabad c Professor in Mechanical Engineering Department, MNNIT Allahabad E-mail addresses: [email protected] , [email protected] ABSTRACT

Current business trends are leading to complex and dynamic supply chains. Increasing product/service complexity, out-sourcing and globalization are the reasons that have enhanced the risk, changed its location and nature in supply chains. In this present work a review of risk definition, its classification and holistic approach of risk assessment and management have been made. An approach has been developed that help to identify, assess and manage the risks. Keywords: Supply Networks; Risk; Risk assessment; Risk management 1. INTRODUCTION Risk and uncertainty have been studied in numerous business settings and have warranted significant investigation in corporate functions, such as managerial decision making (March and Shapira, 1987), strategy (Ruefli et al., 1999; Sitkin and Pablo, 1992; Wiseman and Bromiley, 1991), operations (Newman et al., 1993; Pagell and Krause, 1999), accounting (Ashton, 1998; Baucus et al., 1993), finance (Chow and Denning, 1994; Ho and Pike, 1992) and distribution (Celly and Frazier, 1996; Lassar and Kerr, 1996). Current business trends are leading to complex, dynamic supply networks. One consequence is that risk is increasing, and shifting around supply networks. Managers need to identify and manage risks from a more diverse range of sources and contexts. In the past, when firms manufactured in-house, sourced locally and sold direct to the customer, risk was less diffused and was easier to manage. With the advent of increased product/service complexity, and outsourcing of supply networks across international borders, risk is increasing and the location of risk has shifted through complex changing supply networks. There have been numerous researches about the risk in purchasing and supply, but little is reported for complex supply networks. This research describes identification, assessment and management of the risk. 2. INCREASING COMPLEXITY IN SUPPLY CHAINS Supply networks are becoming more complex, dynamically changing webs of relationships. Whilst this complexity arises from many sources, some key drivers are increasing product/service complexity, e-business, outsourcing, and globalization.

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2.1. Product/service complexity Increasing demand for product/service performance and variety, combined with more complex product/ service and process technologies, has led to increasingly complex products and services. Various dimensions of complexity impacting on supply chains have been identified, including: scale, technological novelty, quantity of sub-systems components, degree of customization of components in the final product/service, quantity of alternative design and delivery paths, number of feedback loops in the production and delivery system, variety of distinct knowledge bases, skills and competencies incorporated in the product/service package, intensity and extent of end user involvement, uncertainty and change of end user requirements, extent of supplier involvement in the innovation and transformation process, regulatory involvement, number of actors in the chain, web of financial arrangements supporting the product/service, and extent of political and stakeholder intervention. One of the effects of increasing product/service complexity is the recognition that single firms cannot be excellent at everything; this gives rise to outsourcing 2.2. Outsourcing Outsourcing involves the use of specialists to provide competence, technologies and resources to provide parts of the whole (Gomes-Casseres, 1994; Lonsdale, 1999). Outsourcing not only impacts on the organization and its immediate relationships, but also changes supply network structure and processes. Aggregating these changes, outsourcing changes industry structures, shifting the ‘balance’ of supply markets. Increased outsourcing allows access to global markets, and may cause organizations to seek international sources for perceived ‘best in class’ performance. This has contributed to supply chains becoming globalised. 2.3. Globalization Outsourcing is only one driver of globalization. The transnational mobility of capital, information, people, products and services is increasing, leading to ‘global entanglements’ Strategic intent, global brands, economies of scale and scope, management of the value chain, comparative advantage, market access, the growth of free trade and facilitating information technologies, most recently e-business, have all been cited by various authors as contributory reasons for globalization. 2.4. e-business e-business, or ‘doing business electronically’, has increased opportunities to reach new customers and suppliers (Erridge et al., 1998) and respond to rapidly changing markets.The new market and commercial opportunities afforded by the Internet increase the speed of change and complexity in supply networks, and consequently increase risk. The combined, messy, intertwined effects of increasing product/service complexity, outsourcing globalization and e-business have caused supply networks to become increasingly complex and dynamic (Croom, 2000). The previous, relatively simple business-to-business relationships involving product/service and payment exchanges conducted at arms length are now embedded in complex inter-organization network flows of intangible and tangible features; the intangible features in networks are difficult to examine as they are ‘tangled up’ with many other features and their accrual is highly context specific. A significant intangible feature in these chains is risk.

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3. RISK In this section we provided an overview of theories with in risk with special focus on organization. 3.1 Risk definitions Risk is an ambiguous construct – the meaning varies depending on context and user. The origin of the word risk is uncertain, but it may have come to us from the Arabic word risq or from classical Greek via the Latin word risicum. A number of common meanings of the word can be distinguished: • a threat or a danger (”There is a risk of flooding”); • a probability (”Driving a car without safety belts means an increased risk of injury”); • the total appraisal of probability and size of the consequence; and • a measure of dispersion (“Taking out an insurance means a reduction of the risk”) The Royal Society in Britain describes risk in the following way: “These definitions begin with risk as the probability that a particularly adverse event occurs during a stated period of time, or results from a particular challenge. As a probability in the sense of statistical theory risk obeys all the formal laws of combining probabilities. Explicitly or implicitly, it must always relate to the ‘risk of (a specific event or set of events)’ and where appropriate must refer to an exposure to hazard specified in terms of its amount or intensity, time of starting or duration.” Deloach, 2000 described the definition of risk based on firm performance is “The distribution of possible outcomes in a firm’s performance over a given time horizon due to changes in key underlying variables. The greater the dispersion of possible outcomes, the higher the firm’s level of exposure to uncertain returns. These uncertain returns can have either positive or negative consequences. The organization’s sensitivity to risk is a function of (1) the significance of its exposures to changes and events, (2) the likelihood of those different changes and events occurring and (3) its ability to manage the business implications of those different possible future changes and events, if they occur.” Risk definition by Kaplan & Garrick The risk definition that will be used as a starting point in this study, when looking specifically at supply chain disruption risks, is the one presented by Kaplan & Garrick (1981) and which was further developed by Kaplan (1997). The motivations for choosing this specific definition are that it is a commonly used (but not by all disciplines accepted) operational definition of risk and that it explicitly splits up the concept of risk in different elements/parts, which facilitates adaptation of the general definition to more specific risk areas. Presented below is a condensation of the discussions on the risk concept in the two articles mentioned above. The terms used are those presented in the articles. “In analyzing risk we are attempting to envision how the future will turn out if we undertake a certain course of action (or inaction). Fundamentally, therefore, a risk analysis consists of an answer to the following three questions: (i) What can happen? (i.e., what can go wrong?) (ii) How likely is it that that will happen? (iii) If it does happen, what are the consequences?”

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An answer to those three questions is called “a triplet”. There might be many triplets/answers to those questions, and each answer can be described by the help of the following formula: [3.1] where • Si is a scenario identification and description; • Li is the probability of that scenario; and • Xi is the consequence or evaluation measure of that scenario, i.e. he measure of “damage.” A “set of triplets” could then be described as: {< Si, Li, Xi >} where i = 1, 2,…., N. [3.2] Baird and Thomas (1990) have defined risk from eight different perspectives. Their arguments incorporate views from finance, marketing, management, strategy, and psychology. The first three definitions—variability of returns, variance, and market risk—focus on the organization’s financial return. The last two definitions of risk as disaster and as accounting risk measures relate to the risk of a company going bankrupt. These definitions of risk provide evidence that risk is a multidimensional construct and differs according to business function. Shapira (1995) Shapira (1995) found that very few managers define risk in those terms. Instead, managers identify (1) the downside of risk, (2) its magnitude of possible losses, (3) the act of risk taking involving the use of skills, judgment and control, and (4) risk as a concept that cannot be captured with a single numb. These findings also suggest that the term ‘‘risk’’ can be perceived in different ways, and no single definition of risk may be appropriate in all circumstances. Yates and Stone (1992) Yates and Stone (1992) note that risk entails (1) the elements of loss, (2) the significance of loss, and (3) the uncertainty associated with loss. Within the elements of loss are three additional factors. First, risk is not limited to one specific loss that can occur. This is similar to the variance of outcomes discussed by March and Shapira (1987), with the exception that it focuses only on losses. For example, a fire that destroys a supplier’s plant can affect production for 1, 2 days, or even months. The incident can result in various degrees of loss (outcomes) for the supplier as well as the supplier’s customers. Losses are also experienced in reference to an outcome. What is important is not the loss itself, but the actual outcome in comparison to an expected outcome. Another facet of loss is multiplicity, in which losses can transcend multiple categories such as financial, performance, and time loss. 3.2 Static and dynamic risks Dynamic risks are risks that can have either a positive or a negative outcome, e.g. market reactions. Static risks are risks that can only have a negative outcome, i.e. the outcome does not bring an economic advantage. An example of a static risk is a fire. Dynamic risks are often more interesting for companies, as they can bring in a profit as well as a loss. But the better a company is grasping its static risks, the bigger dynamic risks it can take. By taking bigger risks, bigger profits can in many cases become possible.

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Another aspect of risk is risk relativity, i.e. risk compared with your competitors, meaning that even though a certain event, e.g. a hurricane, leads to negative consequences it can give you a competitive edge if you can ensure to be less affected than your competitors by that same event 3.3 The circle of risks Traditionally the main focus within risk management has been insurable risks, but in a wider perspective commercial risks have been separated from non-commercial risks. Commercial risks include decisions that can lead to profit but also to a negative outcome, as opposed to noncommercial risks that can only lead to losses. Another classification of risks is into dynamic risks and static risks, where dynamic risks more or less correspond to commercial risks and static risks correspond to non- commercial risks. Hamilton presents the “circle of risks” as a comprehensive view of all risks that can threaten an organization The circle of risks is divided into two natural halves. The right half includes operational, static risks within production where the risk with most impact is disruption in the production flow. Most of the work the risk manager is conducting is represented on this half. The left half includes dynamic risks found outside the production such as inflation, new laws and terrorism. This half is included in the circle of risks to offer a comprehensive view of the risk situation of the organization 3.4 Risks within the production Employee risks include such things as working injuries, problems related to stress and drugs and bullying among colleagues. A company with an inferior working environment produces discomfort and working injuries that result in increased absence and unwanted employee turnover. This creates disruptions in production, which can result in poor quality. In the long run this is a major threat to the organization. Property risks represent damages to property such as can be caused by fire, water, storms and inadequate maintenance. For a long time fire has been the most dreaded risk. Lately though, new technological advances have released new forces that may be difficult to control. Hence fire is no longer as feared as before. Still, however, the damage from fire is a big problem. Environmental risks include pollution and leakages. The environmental problems are gaining more and more attention. Criminal acts include sabotage, industrial espionage, theft and fraud. During the last decade there has been a significant shift from outside criminal acts to inside operations. Today the employees in a company are responsible for most of the economic crimes in the organization. Some ways to prevent this are clear routines and running of internal records. 3.5 Risks outside of production Market risks cover inflation, trade agreements, changed terms of competition, currency risks and so forth. Financial transactions have become a considerable risk lately. Speculations in stocks, foreign currencies and other financial means have led to most big companies now having some form of finance policy to limit the associated risks. Liability risks include among other things responsibility for the environment and product and also risks involving contracts. Product liability means that a company is liable to pay for the damage when their product has caused injury to a person or a property. The risks of damage claims are by far most substantial in the USA, since the amounts demanded for compensation are generally very high. To avoid risks associated with product liability, it is important to have a quality assurance system in the company that results in products and services fulfilling the quality expected by the customer. Political risks involve new laws, terrorism, nationalization, social revolution etc. Countries with political instability are more affected by alterations that can change the conditions of economic life overnight. Hence there are

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great political risks in owning companies situated in such countries. The most obvious political risk is considered to be confiscation or nationalization of property. 3.6 Closing comments It is important to put operational and dynamic risks in relation to each other to get a meaningful judgment of the company’s risk environment and to be able to act rationally. But the risk manager often lacks the requisite knowledge about risks associated with the market. It is essential for every company to chart their own circle of risks to fully grasp the risk environment that is specific for each organization. There are some risks that are not represented in the circle of risks, such as the human factor and loss of trust.

Figure 1: The circle of risk (Hamilton, 1996, p.16)

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4. RISK ASSESSMENT Risk assessment is the general term used to describe the study of decisions subject to uncertain consequences. It can be sub-divided into risk estimation and risk evaluation. If we consider the information on which the assessment has to be based, risks can fall into at least three different classes: • Risks for which statistics of identified casualties are available; • Risks for which there may be some evidence, but where the connection between suspected cause and injury to any one individual cannot be traced; and • Expert’s best estimate of probabilities of events that have not yet happened. Risk assessment includes deciding values for different risks. However, it might not be possible to collect all the information necessary to do a solid risk calculation because the information is not there or it takes too much time or is too costly to get. We are then faced with a choice. Either we choose to only assess those risks that we have enough information about to be able to do calculations based on “hard”, objective facts like statistics. Or we choose to say that it is better to consider all risks, although some of those risk assessments have to be based on “soft” data like subjective judgments by individual experts within the relevant area. Risk assessment is what we as private persons do every day, e.g. when we decide to take the car instead of the train for a certain trip or when we choose to cross the street outside instead of inside the pedestrian crossing. Those decisions are partly based on objective information and partly based on our subjective judgments. Professionals would probably have taken other decisions in some of the situations because they have access to more knowledge, especially within their own special area, e.g. traffic safety. But although they are the experts, they cannot avoid subjectivity – but the degree of subjectivity ought to be lower than for a layman. Generally, From the definitions of risk provided earlier, it appears that in order to assess risk there are two main questions to be answered: 1. How likely (probable) is it that an event will occur? 2. What is the significance of the consequences and losses? The first question can be divided further. The likelihood of an event occurring depends partly on the extent of the exposure to risk and partly on the likelihood of a trigger that will realise the risk. The realisation of risk may be partly influenced by an organisation and individuals within it and partly by things beyond their influence; this relates to categorization of direct and indirect risks. Clearly, however, this categorisation is not universal— some very powerful organisations and individuals will be in a position to influence regulation, politics and markets. Others will only be able to cope and react to these business environmental influences. The second question can also be divided. Some of the significance of the consequences can be estimated reasonably accurately if there are regulations or laws in existence that you must comply with; non-compliance often carries known penalties. Some of the significance of the consequences depends on different circumstances; a local figure of repute is more likely to have their court case publicised in the local press than someone who is less known. Aspects of risk such as exposure to risk, consequences, non-compliance, business impacts and the magnitude of losses are illustrate an example (Table 1) of a taxi company, and the risks it faces in the broader environment it operates in, compared to the customer of the taxi company.

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Benefit Example1. driver Income for taxi firm and driver

Example 2customer CEO can work in transit and low stress

Table1. Illustrative example of different aspects of risk Exposure Event Consequence Business Impairment Parking Parking ticket Fine Increase Cost illegally Vehicle towed Fine and time to Increase Cost collect vehicle & Time Speeding Caught by Fine Increase costs Running a police or Points (possible Possibly cease camera red light loss of licence) trading Drink Caught by Fine Increase costs driving police Fails MOT Vehicle off road Temporarily Faulty while remedial cease products action trading fitted to vehicle CEO misses Business lost Company Taxi involved in Crash meeting uses taxi to get CEO to important meeting

Magnitude of loss Can range from minor to major

Can range from minor to major

5. RISK MANAGEMENT Risk management was defined as “The process whereby decisions are made to accept a known or assessed risk and/or the implementation of actions to reduce the consequences or probability of occurrence” No human activity can be considered to be risk free. Therefore risk management is of relevance and interest to everyone. In today’s society, many of the traditional risks have been eliminated or substantially reduced. At the same time, new risks have emerged that are difficult to explore and interpret – risks that often have very severe consequences. Borge, 2001 was defined as, “Risk management means taking deliberate action to shift the odds in your favour – increasing the odds of good outcomes and reducing the odds of bad outcomes.” That is why risk management is of interest to all of us. Since there normally is a cost linked to a risk handling action, and also the possibility that other risks might be spun off by that action, it is probably not optimal to try to cover all risks. Expected result impacts have to be balanced against risk handling costs. What are the elements of the risk management process? There are many different definitions depending on what academic field is addressed. The basic objective of all risk management processes is after all the same, i.e. to prevent undesirable and detrimental events from taking place and, if they do take place, to mitigate the consequences, thereby saving lives, property, environment, financial resources or something else considered “valuable”. It includes all types of risks – from the risk of loss of competence when key employees leave the company to the risk of a harmful discharge into the external environment from production facilities or processes. Figure2 presents a detailed description of the process. This process is proactive, i.e. preventive, compared to what is usually called crisis management. Crisis management, although a

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crisis group might have been established and resources and routines decided upon in advance, is primarily reactive, that is events or incidents that develop into something critical to the organization are addressed ad hoc, i.e. separately and in each specific situation. The risk management process identifies the existing risks and their possible consequences. By quantifying them in economic terms, you acquire an effective instrument by means of which you can communicate with management. The International Electrotechnical Commission (IEC) has developed the following model of the risk management process and its different parts.

Risk Analysis •System border •Hazard Identification •Risk Estimation Risk Assessment

Risk Evaluation •Acceptable risk •Analysis of alternatives

Risk Management

Risk Reduction/Control •Decision making •Implementation •Monitoring Figure 2. A risk Management Model by IEC

Risk analysis is the initial phase in the risk management process. First the system border of the project/study is set. Then the hazards are identified and estimated. The second phase is risk evaluation i.e. to evaluate those risks compared to a defined acceptable risk level. Risks under this level are sorted out and not further considered. The third and final phase in the risk management process is risk reduction and risk control. This includes decision making, implementation and the following up of the action plan. These are important activities. Without an effective change exertion with continuous feedback, the time and resources spent on risk analysis and risk evaluation can be wasted.

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6. SUPPLY NETWORK RISK TOOL A tool for helping to identify, assess and manage risk is provided in Figure 3. The tool is divided into boxes, commencing with the first box involving mapping the supply network. Here the supply network to be mapped would be defined by the problem or concern. For example, the network might be the product supply network for a particular product where it is felt there is some exposure to risk. In this stage a diagrammatical representation of the supply network enriched with appropriate data is created. Mapping this supply network is likely to involve understanding who owns what, and what are the key measures currently in place, i.e. clarity of role and responsibility within the network Map supply network - structure ofactors - key measures hi 1

Identify risk and its current location - type t ti l l 2

Implement supply network risk strategy 6

Form collaborative supply network risk strategy 5

Assess risk - likelihood of occurrence - stage in life cycle - exposure lik l t i Manage risk - develop risk position d l

i

Figure 3. Supply Network Risk Tool In the second box the map is enriched with information concerning the type of risk and its location. A prompt list can be provided from those compiled from the literature review, i.e. Strategic Risk, Operations Risk, Supply Risk, Customer Risk, Asset Impairment Risk, Competitive Risk, Reputation Risk, Financial Risk, Fiscal Risk, Regulatory Risk, Legal Risk. The specific risks that will be considered for the particular problem/product should be identified, through brainstorming with other actors in the supply network. At this stage only those with a significant potential loss to any actor in the network should be considered.

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In the third box the chosen types of risk are assessed for the likelihood of their occurrence, exposure in the network, potential triggers of the risk, at what stage in the life cycle the risk is likely to be realised, and what likely potential losses to whom might occur. Risk management occurs in box 4, where the assessment information is analysed and alternative interventions are proposed. Here the risk position is determined—whether, for this particular problem/product and the particular actors involved, the position will be reactive, defensive, prospective or analytical. Alternatively, some organisations might feel more comfortable using such terms as ‘cautious’ or ‘risk averse’. Depending upon the risk position, scenarios of alternative network structures and relationship strategies can be developed to realign risk, exposure to it, likely losses and location of those losses. In boxes 5 and 6the chosen redesign of the network and relationships within it are effected through a reformulated collaborative supply network risk strategy. This strategy is implemented and gives rise to a remapping of the network, i.e. back to box 1. It is intended that this tool is used in collaboration with other key network actors. Individual focal firms can use this tool independently. However, their own view of how to deal with risk in the network may not coincide with other actors and is likely to give rise to destabilizing of the network at some point. 7. CONCLUSION Risk exists in virtually all firms, and has been extensively studied in various business contexts. The current business trends of increasing product/ service complexity, outsourcing, globalisation and e-business that have lead to more complex, dynamic supply networks have resulted in risks shifting around supply networks. Managers need to identify, analyse and manage risks, as well as potential opportunities, from a more diverse range of sources and contexts. Supply networks are undoubtedly becoming significantly more messy units of analysis to deal with. The tangled up changes that cause the dynamics of supply networks to be complicated to understand, also impact on risk. Whilst there has been substantial research attention to date on risk and on supply networks, there has only been limited empirical research on risk in supply networks. This paper provided a brief review of risk, its assessment and management. It summarized a tool of risk in supply network REFERENCES 1. Ashton, D., 1998. Systematic risk and empirical research. Journal of Business Finance and Accounting 25 (9/10), 1325–1356. 2. Baird, I.S., Thomas, H., 1990. What is risk anyway? In: Bettis, R.A., Thomas, H. (Eds.), Risk, Strategy, and Management. JAI Press, Greenwich, CT, pp. 21–52. 3. Baucus, D.A., Golec, J.H., Cooper, J.R., 1993. Estimating risk-return relationships: an analysis of measures. Strategic Management Journal 14(5), 387–396. 4. Borge, Dan (2001) The book of risk. John Wiley & Sons Inc. New York. 5. Celly, K.S., Frazier, G.L., 1996. Outcome-based and behavior-based coordination efforts in channel relationships. Journal of Marketing Research 33 (2), 200–210. 6. Chow, K.V., Denning, K.C., 1994. On variance and lower partial movement betas: the equivalence of systematic risk measures. Journal of Business Finance and Accounting 21 (2), 231–241.

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