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Last summer, the RC2 Corp., maker of Thomas the Tank Engine toys, had to recall 1.5 million products it imported from Chinese suppliers. It was discovered that the toys contained lead paint. In 2005, Hurricane Katrina disrupted the ocean-borne supply of polyethylene foam used in furniture and mattresses, causing polyethylene prices to jump 67 percent the day after hurricane landfall. The West Coast port strike in 2003 slowed computer manufacturers that were waiting for electronic parts to arrive from Asia. Following the introduction of the Nintendo Wii game console in late 2006, Nintendo wasn't able to keep up with demand. The result was widespread stock-outs.

Today's global supply chains generally operate smoothly. But as these cautionary tales prove, when something goes wrong, it can go wrong very quickly.

Supply chains are also stretching across wider geographies and additional borders, making them more vulnerable to transportation disruptions, customs delays and geopolitical events. Many end customers are also becoming more demanding, requiring that goods be packaged and delivered to their exact specifications, ready for sale.

Virtually every business venture involves some amount of risk, and supply chains are certainly no exception. In fact, a recent survey of top supply-chain executives by AMR Research revealed the risks that most concern supply-chain managers. Supplier failure tops the list, followed by strategic risk, natural disasters, geopolitical events, regulatory risk, logistics failure and intellectual-property infringement.

Managing global supply chains today, in short, is risky business. As supply chains become more central to corporate strategy, how companies manage their supply-chain risks often determines how well they succeed in the marketplace.

Managing supply-chain risks essentially comes down to managing the balance of effectiveness and efficiency. Supply chains are like balloons: Squeeze them at one end, and problems will pop up at the other end.

Supply-chain operators can always choose to expedite deliveries, for example, by using air freight rather than ocean transport, but this accelerates cost. Retailers can guard against stock-outs by storing more inventory, but this increases carrying costs and the risk of product obsolescence.

Focusing exclusively on minimizing costs, on the other hand, can make supply chains highly vulnerable to the variability caused by unplanned events such as natural disasters, changing demand and regulatory requirements.

Studies show that leading supply-chain operators have total distribution costs that are about half those of other companies in their peer group. They achieve these results by viewing their entire supply chain as an integrated network and looking at the "total cost of ownership." The most successful supply-chain operators have three things in common:

-- Leaders align their supply chains with overall corporate strategy, which often requires attention to order speed, accuracy, service levels and customer satisfaction.

-- Leaders optimize the total supply chain "cost of ownership" rather than managing costs piecemeal by transportation segment, product or geographic division.

-- Leaders manage risks as part of total distribution costs. These risks, if realized, can have significant impacts on cost, revenue and brand image.

The first two characteristics are topics for another day. This article will explore the third characteristic of supply-chain leaders: managing risks as part of total distribution costs.

Before companies take steps to manage risk, they need to first identify and assess them. Let's look closer at the top five areas of supply-chain risk that many companies face.

NO. 1: SUPPLY DISRUPTIONS

A 2006 Accenture study revealed that three out of four supply-chain executives at major U.S. enterprises have experienced a disruption in the past five years. The study also found that it took at least a week--and sometimes several months--for the companies to recover. Another study by the Georgia Institute of Technology found that supply-chain disruptions caused companies to suffer 33 percent to 40 percent lower stock-market returns in the three-year period following the disruption.

What kinds of events can disrupt physically the supply of goods? For starters, natural disasters such as hurricanes, floods, ice storms and blizzards can shut down supply lanes for days, weeks or even months. Roads, airports, power supplies and communications can go down in severe weather. Even short-term weather conditions like fog can delay shipments.

Another source of physical disruption is transportation infrastructure congestion. Around the world, shipping ports, airports, railways and roadways are having trouble keeping up with increased global trade and higher traffic volumes. Here in the United States, our transportation infrastructure is headed for gridlock.

The U.S. Department of Transportation reports that congestion on our nation's highways, seaports, airports and railways costs the country $200 billion a year. When shipments are backed up at ports, waiting to berth, or trucks are caught up in highway traffic jams, or bad weather causes airports to delay incoming air freight shipments, just-in-time fulfillment can turn into just-sit-and-wait.

The failure of suppliers to fulfill commitments is another potentially troublesome source of supply disruption. There's been an incredible rise of global sourcing: cross-border transactions have more than tripled between 1990 and 2007 to $10 trillion and are expected to grow to $70 trillion by 2025, according to McKinsey.

This means that suppliers are becoming more geographically dispersed and harder to manage. The risks of product shipments that are inaccurate, of poor quality or not up to regulatory standards are higher than ever. What's more, smaller suppliers in developing countries might not have the resources to cope with sudden changes in demand. It's no wonder executives point to supplier management as a top supply-chain worry.

NO. 2: CHANGES IN DEMAND

Changing demand can result from a number of factors, including a poor economy, new products by competitors or changing consumer tastes. When demand doesn't equal supply, your supply chain can suffer from one of two problems: stock-outs in the face of unexpectedly high demand; or excess inventory when sales aren't as strong as anticipated. Both impose risks in the form of extra costs.

Stock-outs are the bane of retailers in particular, because customers will just go to a competitor to get what they need. Stock-outs--especially those involving trendy or hot-selling products--represent not only lost sales but potentially lost customers over time. This kind of poor planning can irritate customers and damage a company's brand image.

In just-in-time fulfillment systems where safety stock is minimal, stock-outs are more likely than excess inventory. Over the past 20 years, U.S. companies slowly but surely removed slack in the form of inventory from their supply chains. In 2003, logistics costs as a percentage of U.S. gross domestic product reached its historic low of 8.6 percent.

However, in the past three years--as global sourcing has taken hold and security regulations, labor disputes and bad weather have disrupted supplies--companies have begun adding more safety stock. In 2006 alone, wholesale inventories were up 10 percent, and inventory carrying costs jumped 13.5 percent, according to the 18th annual State of Logistics Report. Author Rosalyn Wilson identifies a key source of this increasing inventory: retailers pushing responsibility for holding inventory down to their suppliers.

Storing more inventory might reduce the impact of supply disruptions, but it also increases carrying costs. It can lead to price reductions that can hurt margins. And for trendy products like computers, apparel and high-tech items, items gathering dust in warehouses can lose much of their value very quickly.

NO. 3: FINANCIAL RISKS

With more supply chains extending globally, companies face higher financial risks than they do with purely domestic networks. For starters, it can take sellers longer to get paid. Rather than 30-day or 60-day payment terms, settlement of international transactions can stretch up to 120 days or more. Cash flow can become an issue.

Getting loans for operations and global trade expansion is also more difficult. Traditional lenders often cannot or will not include international inventory when assessing the amount a company may borrow. Financing global trade, with its higher risks, requires greater persistence with lenders.

Currency fluctuations also can make it trickier to price products, manage costs and maintain margins in global supply chains.

In addition, rapidly rising fuel prices in recent months have significantly raised transportation costs for supply chains that stretch across oceans and borders. Transportation costs remain the largest component of overall logistics costs--around 60 percent--so rising fuel costs impose a particularly harsh burden on global supply chains.

NO. 4: LEGAL, SECURITY

Unlike many of the other supply-chain risks, which hinge on events that might or might not happen, legal and security requirements can be fully anticipated. Failure to comply with these regulations can result in delays and fines that can far outweigh the value of the shipments.

Security measures in the wake of Sept. 11, 2001, have required that shippers electronically transmit advanced, detailed information about the contents of shipments, often hours before the shipment arrives at U.S. ports, airports and highway border crossings.

To avoid security delays through customs, many companies volunteer to adhere to security best practices outlined in programs like the Customs-Trade Partnership Against Terrorism and Free and Secure Trade. In exchange for becoming accredited as a trusted shipper, these companies are able to move into customs "fast lanes." Those who aren't certified as trusted shippers are more likely to have their cross-border shipments held up for customs inspections.

Importers must wade through thick books of harmonized tariff codes to pay the correct duties that apply to their class of imported products. Inadvertent misclassifications can result in steep fines. One producer of latex-coated paper, for example, misclassified its imported product as another kind of paper. The Colombian government fined the shipper $200,000.

Newer regulations like Sarbanes-Oxley that hold corporate officers legally responsible for financial control over sensitive corporate and customer data also impose regulatory risks.

There are also the increased environmental regulations around the world that affect partners throughout the supply chain, including manufacturers, wholesalers, distributors and retailers. In environmentally conscious locations like Europe, California and elsewhere, products found in landfills that violate environmental restrictions can be traced all the way back to manufacturers and result in stiff fines.

Other regulations impose restrictions on carbon emissions or prescribe recycling requirements. Key green regulations that global supply-chain operators have to consider include: Reduction of Hazardous Waste; Waste Electrical and Electronic Equipment Directive; Greenhouse Gas Emission Trading Scheme; Registration, Evaluation and Authorization of Chemicals Directive; and End of Life Vehicle Directive.

NO. 5: REPUTATION, BRAND

One area of supply-chain risks that might be overlooked is the potential damage of corporate reputation and brand image caused by supply-chain failures. We've already mentioned the effect of stock-outs on customer loyalty and the company's brand image. Besides these distribution risks, there are other kinds of supply problems that can harm the company's image.

One involves distant manufacturers that might not follow prescribed quality standards or take quality shortcuts to maximize their margins, unbeknownst to their corporate customers.

Recent cases of dog-food poisoning, for example, stem from a few Asian suppliers adding a toxic protein booster to wheat gluten. The suppliers fattened their profits while reputable dog-food companies suffered serious damage to their brand images.

Another kind of supplier risk involves shady manufacturers in developing countries that might divert a portion of their production to the black market. High-fashion products like designer handbags might be sold at cut-rate prices, weakening a company's carefully cultivated, exclusive brand image.

Companies whose supply chains run afoul of green regulations can also take hits to corporate reputation. A growing number of consumers are tying their purchase preferences to companies that are socially responsible.

A global survey of consumers by Tandberg found, for instance, that 53 percent of respondents say they prefer to purchase products and services from a company with a strong environmental reputation.

There's a reason that people use the term "business venture." Business--and the business of supply-chain management-- all about managing risks and maximizing rewards. There is no way to avoid supply-chain risks altogether, but the smartest companies learn to manage them effectively.

BOB STOFFEL is senior vice president of engineering, strategy and supply chain at UPS.

April 15, 2008

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