From SCDigest's On-Target e-Magazine

April 27, 2011

Supply Chain News: Dr. David Simchi-Levi on Managing Supply Risk

Companies Too Often Focus on Financial Drivers, not Other Considerations He Says; Low Cost, High Risk Items often Overlooked?

SCDigest Editorial Staff

The recent earthquake-related disruptions in Japan have again heightened the focus of procurement managers on supply risk, but many lack the right frameworks for how to adjust their supply management strategies.

That according to Dr. David Simchi-Levi of MIT, during a recent Videocast on the Supply Chain Television Channel. That broadcast was part 3 of a series based on Simchi-Levi's best selling new book, Operations Rules: Delivering Customer Value Through Flexible Operations. The full broadcast can see viewed here: Operations Rules Videocast Part 3: Mitigating Supply Chain Risk from the Known-Unknown to the Unknown-Unknown.

First, Simchi-Levi says that for most companies the most important driver of procurement strategy is naturally enough the financial impact of their decisions. But, he says, companies need to explicitly understand other drivers of procurement strategy, such as supply risk, price risk, forecast accuracy, and innovation speed.

"Depending on these drivers, your procurement strategy may be completely different," Simchi-Levi said.

To illustrate that, Simchi-Levi uses a simple two by two matrix, with commodity or component price on one axis, and "financial impact" on the other. He defines financial impact as the impact on overall business performance if there is a disruption in the supply chain for that item.

Source:  Dr. David Simchi-Levi

When both commodity price and financial impact are low, companies should generally focus on reducing inventories and establishing long term contracts, Simchi-Levi said.

But the situation is "much more complex," he added, when you have components that have a low price but a high financial impact from a disruption.

(Sourcing and Procurement Article Continues Below)

"Most companies don't pay a lot of attention to this, but this box represents where a lot of the real challenges are," Simchi-Levi added.  For these products, companies need to pursue one or more of the following strategies, he says: using inventory buffers, pursuing dual or multi-sourcing arrangements, or embracing any of several "flexibility" strategies (system, process or product design strategies).

"For these items, if you do not invest in at least one of these three strategies, you will face huge problems in your business, " Simchi-Levi said.

In the top right quadrant, where both commodity price and financial impact are high, is the area that generally gets the most procurement attention, Simchi-Levi says, and the strategies, such as partnerships, risk or gain sharing contracts, and other mechanisms are quite common.

Because it is unlikely to have a procured item that has a high cost but a low financial impact, the upper left quadrant is empty.

In the broadcast, Simchi-Levi detailed two case studies illustrating these principles. He noted that when a fire disrupted production at a major cell phone chip manufacturer in March of 2000, the fates of Nokia and Ericsson were dramatically impacted.

Nokia's fast response and flexible product design enabled it in part to use alternative chips and as a result, saw almost no disruption to its production levels. Ericsson, on the other hand, was slow to respond, and combined with its single source strategy had huge production problems. The eventual impact was that Ericsson ultimately left the cell phone business.

In another example, Simchi-Levi noted how a another fire in 1997 destroyed the only plant that made a type of valve for many Toyota cars. Though the valves themselves were cheap, lack of them would shut down the lines - and Toyota's Lean culture meant that buffer inventories were low.

But Toyota's collaborative culture with its suppliers meant it could respond quickly through a flexible system. In just  a few days, existing Toyota suppliers in other areas were able to begin producing  parts of the valves, which were then assembled by the damaged supplier into the final product, resulting in almost no production impact.

These and other risk management strategies are discussed in the full broadcast.

Do you agree low value, high financial impact items are too often under scrutinized from a supply management perspective? Let us know your thoughts at the Feedback button below.