Given volatile supply chains, commodity prices and currency rates, how are CFOs protecting revenues and profits?
On Christmas Eve 2008, Zavvi, Britain’s largest independent music retailer, went bust. But this wasn’t a failure of falling sales and missing profits, indeed revenue was up 10% earlier in the year despite the recession. No, Zavvi went into administration due to a lack of supply. In the previous year the company had negotiated a single source of supply for CD’s and DVD’s from Entertainment UK, no doubt securing excellent terms and prices in the process. But Entertainment UK was part of the Woolworth group of companies, and once that organisation closed down, Zavvi simply couldn’t get product to put on their shelves. They went bust having suffered the reality of supplier risk.
Given volatile supply chains, commodity prices and currency rates, how are CFOs protecting revenues and profits? How do they monitor the biggest risks and opportunities facing their organisations? What steps are they taking to balance prudent risk management with their companies’ growth ambitions? Business is all about risk: in competitive industries, companies win by understanding the risks better than their competitors; business school theory is full of measures of overall business risk. Managers spend a lot of time managing demand risks, have departments to manage legal risks and spend a large amount on insurance to compensate for some risks. However, in our experience while most businesses are good at managing many risks they often fail to manage supply risk.
For most organisations more than 50% of their costs originate from other companies delivered via various types of contract. Many of these represent risk to the company’s performance and there are many risks that arise with suppliers in the normal course of trading.
We categorise them into three general areas:
• Price risk:
Most organisations are unable to pass price increases onto their customer base. Therefore understanding the price risk that you face is critical.
• Supply risk:
Within every organisation’s spend there are business critical suppliers whose failure could cause serious impact. Globalisation is stretching supply chains and exposing companies to risks many thousands of miles away. It is impossible to predict an earthquake in Japan or the impact of volcanic ash clouds for example.
• Reputation risk:
How your suppliers behave regarding business ethics and corporate social responsibility is now as important as how you behave, and significantly less predictable.
As is suggested above, it is not always possible to predict events that impact supply. It is possible to have contingency plans in place however. We have developed and use a framework for measuring supply risk and modelling the impact it has on your organisation. Once risks are understood and quantified, the best approach to risk management is to implement sound processes that are applied, implemented and followed.
Our experience from a number of clients is that they will usually have a relatively soundly (over) engineered process which is designed primarily to avoid specific risks. However, because the processes are complex and sometimes burdensome, organisations don’t follow their own processes properly (or at least they bend them significantly). They are therefore not delivering what they set out to achieve but still incur the costs of the process and increasing bureaucracy. However, with a risk modelling approach the processes can be optimised to address the actual risks. Moving from good to outstanding on how you manage these risks can result in significant margin improvement and protection.
We are in a period of high price volatility (See chart below). A roller-coaster ride for prices in 2011 resulted in several commodities reaching record levels in the early part of the year before dropping sharply in the latter half. The Economist dollar all-items index, which excludes oil and precious metals, ended the year at its lowest level since September 2010 and 23% off its peak in February 2011. Bumper harvests in cereals, sugars and oils, coupled with falling demand, led to a drop in food prices (the food-price index fell by around 15% from its 2011 high). The prices of industrial raw materials, meanwhile, suffered because of concerns about the debt crisis in the euro area.
Understanding your exposure to commodity variation relative to your competitors is critical. Even in the same industry different players can be hit by changes in commodity prices in different ways; this depends on their strategy for buying, efficiency of use of volatile commodities as well as short term factors such as hedging. Furthermore we have noted that organisations vary in their ability to flex costs down. Companies are more likely to end up the high cost player in an environment when prices have fallen and they have failed to respond than in an environment where prices have risen.
Clearly this is more of an issue where the commodity cost is a more significant proportion of the product cost, for example food. Some players try to avoid fluctuations by integrating up the supply chain, for example GSK controlled blackcurrant farms to ensure product supply for Ribena. However, even for services industries that don’t buy commodities, supply prices have been volatile. Most companies are impacted in some way by energy prices.
These prices have fluctuated over the past year with changes of up to 30% (source UK Dept. of Energy and Climate Change). The chart above shows that changes in energy costs impact different organisations in different ways. All sizes of organisation have been hit by rises in heavy fuel oil (HFO), however, electricity prices rises have been more than 5% for large users. Small gas users have not seen any increase in gas costs; however large gas users have seen price increases of more than 30%. As with commodities some organisations are better able to mitigate the risk from changing prices due to their business model.
For example, we recently carried out a cross industry study on the impact on fuel prices on logistics networks. We found that the worst networks’ costs actually increased by more than the increase in fuel costs, whereas the most robust networks costs only increased by a third of the fuel cost rise.
Supply chains are now not linear, they can be complex global networks, reducing supplier visibility and increasing hidden risks. Equally as important as price risk is supply risk: these risks include breakdown of supply chains, supplier failure and poor supplier relationship management. There are many examples of companies being caught out by an unexpected risk; some of these get reported whilst others are kept out of the limelight.
Some of the causes can be mundane. Often they can be caused by a freak fire or weather event. One of our clients was hit by a fire at their major packaging supplier, which caused a percentage-point drop in EBITDA and revenue and resulted in key management being deflected away from driving the business forward to managing a shortage of packaging.
Others are caused by industrial unrest at the supplier. British Airways lost millions of pounds in revenue and sustained damage to its reputation when Gate Gourmet staff went on a prolonged strike and the company was unable to source food for its customers. The reality is that all companies are exposed to these kinds of risks, they cannot be eliminated but they can be managed and mitigated. However, if they are managed they actually stop being a risk and can even be turned into an opportunity. One of the best examples was documented by Yossi Sheffi in his book ‘The Resilient Enterprise’.
In 2002, a lightning strike caused a minor fire at a Philips Semiconductor fabrication plant in Albuquerque, New Mexico. Automatic sprinklers put the fire out within 10 minutes and nobody was hurt. Except LM Ericsson. A few months later, the company blamed huge quarterly losses on its inability to source key mobile phone components from Philips, which had initially underestimated the impact of smoke, water and firemen’s boots on its clean-rooms. Unfortunately for Ericsson’s management, the company’s biggest rival, Nokia, had a different story to tell of the Albuquerque fire. During the same financial period, it posted record sales – despite the fact that it sourced the same parts from the same Philips plant.
The difference was Nokia had processes in place to track just such an ‘event’ and it was quick to respond when it realised the loss of production could potentially prevent it making up to four million new phones. Nokia had established a collaborative planning process which closely involved key suppliers. This process instilled in Nokia’s supply chain a keen awareness of fluctuations in both supply and demand. When disaster struck, this awareness helped Nokia look elsewhere for its essential parts, and to come out of the ordeal relatively unscathed.
It scoured the world for alternative sources for five vital chip types, and forced Philips to retool other facilities to manufacture some of the components. By the company’s own admission, Ericsson did not have a ‘plan B’ and had few processes in place for escalating its response once it had realised the seriousness of the situation.
It’s not just acts of nature that can impact supply chains; competitors may lock up key parts of the supply chain through vertical integration. For example, the players in the payments processing industry are buying upstream technology companies to try to lock in key suppliers. But this kind of risk can also become an opportunity. If companies can identify the critical influence points in a supply chain and focus on managing those points, then they can change the economics of their business: owning or influencing a critical node in your key supply chain can lead to improved profits. A company might initially get into this supply chain analysis as a way to reduce risk but in addressing the risk they may gain a competitive advantage.
For example, in the car windscreen replacement industry, the first company which was able to source strong, quick-drying glue suitable for windscreen replacement was able to offer rapid roadside windscreen replacement, giving it a significant cost and value advantage over its competitors. A final major supplier risk is supplier liquidation. In Europe this downturn has produced a lower rate of business failure than previous downturns; however it is still a major risk.
Most large companies have robust procedures in place for managing their own reputation, including areas like:
• Corporate and social responsibility
• Use of child and forced labour
• Environmental compliance
However how many can be sure about their suppliers, or their suppliers’ suppliers? Many companies’ recent reputation problems arise from supplier performance rather than issues within the company itself, for example:
• BP’s Gulf of Mexico oil spill was caused by outsourced suppliers. Initially, BP tried using this as a defence before taking full responsibility.
• Nestlé buying chocolate in Africa farmed by child labourers
• Pressure of production schedules being blamed for suicides amongst workers in Chinese factories making products for Apple.
Like any other supply risk, reputation risk can be managed. Supplier surveys can identify suppliers where the reputation risk is high and these can be followed up with a supplier management programme.
Protecting your company from supply risk
The best companies are able to actively manage price, supply and reputation risk. They have it as an ongoing process that is incorporated into their strategy and planning, supplier management and sourcing processes. In our experience best practice companies proactively manage these risks through developing a risk modelling approach that identifies and quantifies:
1. Their exposure to commodity price fluctuations (up and down) and relative to the competition. Then develop a robust strategy to minimise the impact.
a. The key commodity price fluctuations that they (or their supply chain) are exposed to? Energy, data storage, telecoms, steel, wheat?
b. The impact on their cost base if these costs change
2. Who their critical suppliers are, what is the risk of failure, what is the contingency plan for failure. Note that this analysis should include service suppliers; many companies critical suppliers are IT, telecoms or other service suppliers. The best-protected companies start with a critical, process-oriented view of their organisation. What are the vital processes in the organisation and how can they best be protected from risk?
3. Identification of the single point of failure in their supply chain that could hit their reputation. Which suppliers are more likely to have environmental or labour risks, which supplies need careful management?
Most companies now know (through their ERP system) who their suppliers are and how much they spend with them and on what. Intelligent analysis of this data, combined with the risk modelling approach above, to minimise supply risk
Most companies invest heavily in controlling risks that might arise from within or have an immediate impact on their staff, building or assets. But many do not consider the equally important risks that may come from their suppliers and the associated supply chains. Risk cannot be managed out of the relationship and it is not possible to move that risk to the suppliers. However, companies can take practical steps towards minimising risk and have contingency plans in place to address those risks that become a reality. Companies that do this not only protect their company and its stakeholders, they may well be creating a latent competitive advantage that can cause a complete shift in the markets in which they operate.