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Deconstructing the Supply Chain

Link by link, country by country, global supply chains are today under increased scrutiny as more companies advance new approaches for monitoring and managing global risk.
eRic kRell is a contributing editor for Business Finance.

By eRic kRell

Corporate finance executives perform a supplychain-management balancing act that grows more unsettling by the day. If inventories swell, costs rise and profit plummets. If inventories get too thin, stock-outs add cost and also reduce profits. Managing an increasingly global supply chain is akin to walking a never-ending balance beam while wearing a blindfold. Indications of growing supply chain risk have become increasingly visible over the past two years as days inventory outstanding (DIO) continued to grow among the 1,000 largest U.S. companies, a trend intricately linked with the growing use of offshore manufacturers, according to an annual working capital study published by REL Consultancy Group (see chart, page 19). Add product-quality problems, logistical bottlenecks, Intellectual Property (IP) concerns, and numerous other disruptions to the mix, and its no wonder that so many U.S. companies are poised for a major tumble thanks to inadequate supply chain risk management capabilities. Strengthening those capabilities requires not only global sourcing expertise, but also financial and risk management savvy as well as a clear view of how an increasingly global and complex supply chain links to high-level strategy and the bottom line. This perspective, of course, resides in the finance function, which has an opportunity to sharpen the entire organizations visibility into suppliers processes so that risks linked to global supplier relationships can be monitored and managed. The approaches finance executives employ to manage global supply chain risk resonate beyond the manufacturing sector. For example, the supplier quality report card that $13.6 billion Arrow Electronics uses to manage vendors of electric components in Asia, the distributors fastest growing region, can also help companies to qualify and manage

offshore finance and accounting outsourcing (FAO) relationships. Whether its the supplier quality report card or a customer service level agreement, says Arrow Electronics president, global alliance and supply chain, Brian McNally, you need a document that clearly defines and specifies all of the key process steps and the given tolerances involved in providing the specified deliverables. This holds true whether deliverables are manufacturing components or accounts payable services.

Remote Risk is eveRywheRe

The global supply chain poses a set of unique risks tied to the physical movement of goods across great distances; however, two of the key methods of addressing this risk establishing greater visibility into suppliers processes and stronger communication links between suppliers and buyers can also reduce risks associated with services outsourcing. Boston Consulting Group senior vice president George Stalk uses the term supply chain gymnastics to describe the increasingly thorny problem of managing your supply chain when it includes suppliers or partners in Asia, especially China, and how it affects your strategy in his forthcoming book Five Future Strategies You Need Right Now (Harvard Business School Press Memo to the CEO Series, March 2008). Stalk, one of the consulting professions foremost experts on manufacturing (and manufacturing in Asia, in particular), cites shipping and freight-related snafus on the West Coast as a problem that will soon confront numerous U.S. companies, many of which now source more than half of their goods from Asia. While this qualifies as a major strategic risk for a broad swath of industries, individual com-

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As supply ChAins Grow, So Too Does Inventory on Hand

inventory trend
50 50
49 US 1000 Leading CompanieS

Dio Days inventory on hand

48 47 46 45 44 43 42 41 40 40
Q3 2005 Q4 2005 Q1 2006 Q2 2006 Q3 2006 Q4 2006

Linear (US 1000)

Q1 2007 Q2 2007 Q3 2007

Source: reL conSuLtancy Group, annuaL WorkinG capitaL Study

panies face more immediate, day-to-day supply chain risks including IP theft, counterfeit parts, defective products, poor information sharing, and much more. One of the best ways to avoid these disruptions is by, quite literally, shedding the blindfold and scrutinizing internal needs and supplier processes with greater depth and candor. One of the five efficiency actions Stalk lays out in his forthcoming book confirms this point: Conduct in-depth examinations of buying practices and the management of supplier relationships at all levels of the supply chain in order to identify areas where hidden costs arise and prevent their occurrence. While greater visibility into suppliers operations and better communications with suppliers will hardly mitigate all supply chain risks, it marks a sensible starting point. Most problems associated with global supply chains disruptions, quality assurance, hidden costs, and IP protection, to name the most common issues boil down to what McNally describes as remote risk. Its much easier for a product engineer to solve a product issue by walking out to the factory, talking to the workers, and meeting with the factory engineers, he explains. Its much more challenging when youre trying to hold those

conversations where there is a 12-hour time zone difference and when the factory workers and engineers speak a different language. For these reasons, a structured process serves as a common language that can bridge potentially problematic gaps.

eaRning an a in supplieR management

McNally points to the recent experience of a very large North American manufacturer to illustrate the magnitude of problems that distance between supplier and buyer can cause.

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Global TradinG risks Many Flavors
supply chain disruption is the most prominent risk linked to global sourcing. when the flow of goods stops, inventories dry up and customers turn to competitors. as recent toy recalls and other quality assurance problems illustrate, disruption is far from the only risk companies trading with overseas partners need to monitor. other global supply chain risks, in addition to disruptions and quality, include the following: The company moved significant manufacturing operations to an external supplier based in a low-cost region. The corporation followed a methodical transfer process, complete with detailed process control diagrams and specific performance metrics, to ensure that the suppliers quality assurance capabilities were up to snuff. Only 12 months after the suppliers operations were up and running did the company realize that no one had taken responsibility for overseeing the implementation of corrective actions. The metrics were all there and they were appropriate, but the feedback loop wasnt tied, McNally explains. That factory came to a standstill and the company lost tens of millions of dollars in value. It brought the company to its knees. To help ensure that a troubleshooting process is in place and working as intended, Arrow uses a supplier report card. The document, and the actions that it stipulates, serves as a key tool in governing global supplier relationships at Arrow and also among the companys customer base. The report card is the product of a step-by-step process designed to ensure that a company is managing its supplier relationships by focusing on the most important relationships (from a financial and/or risk perspective) and also focusing on the elements of performance within those relationships most highly correlated with success (i.e., the right metrics). Arrow reviews all of its critical suppliers on a quarterly basis. In those meetings, all of the performance metrics are reviewed and all corrective actions from prior meetings are resolved and also reviewed. McNally points out that the suppliers performance records should influence subsequent decision-making. So, if a supplier subject to quarterly performance review meetings performs at an exemplary level over a period of time, it can be rewarded with more business. Best-in-class OEMs [original equipment manufacturers] find a way to attach a dollar amount to higher-performing suppliers, he notes. For example, suppose Supplier As widgets cost 10 cents apiece while Supplier Bs widgets run 11 cents a pop. A savvy OEM can quantify the value of performance differences. As a result, the OEM may give much more business to Supplier B because it has determined that Supplier Bs performance reduces quality assurance processes that equate to a 1.5-cent discount premium. Last, McNally emphasizes the importance of continuous benchmarking. What was acceptable 6 to 12 months ago may not cut it today, so companies should tap the databases of industry associations and consulting firms, where possible, or conduct their own research. You need to continue to benchmark to ensure that youve got the most appropriate set of measurements, tools, systems, and processes necessary to keep your products and your quality where they need to be, McNally says.

hidden costs
Most companies that use overseas suppliers focus too much on the initial acquisition costs and wind up underestimating the cost of managing those relationships moving forward (e.g., technology infrastructure, staff, site visits, opportunity costs due to troubleshooting). Many companies also underestimate acquisition costs, reports Archstone Consulting principal John Kamauff. Its the hidden costs of a long supply chain that are the real killers, reports Boston Consulting Group senior vice president George Stalk, who points to the gross margin a company loses when it does not have a product (one that is selling) in stock. On the other hand, having too much inventory also represents a significant hidden cost. The write-down costs of excess inventory average 10 to 20 percent of retail shelf space, Stalk notes.

intellectual property (ip) theft

IP theft looms large in certain manufacturing sectors such as high-tech. OEMs at all levels are spending more money, time, and energy in trying to protect and ensure their supply chain and their intellectual property, says Arrow Electronics president, global alliance and supply chain, Brian McNally. These are multimillion-dollar efforts.

corporate social Responsibility problems

As high-profile companies in almost every manufacturing sector have discovered, there are high costs associated with failing to spot and address corporate social responsibility (CSR) issues that crop up in their suppliers factories. It is not possible to outsource the responsibility for all that occurs upstream, Kamauff says. CSR risk can become a huge liability.

port capacity
Heres a troubling statistic with long-term implications: U.S. West Coast ports will reach their combined capacity in 2010. Stalk, who has researched this phenomenon (and describes it as The China Riptide) warns that this infrastructure challenge will seriously affect the way U.S. companies do business with overseas trading partners.

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Long-Distance Quality Assurance

How to Better Manage Global Risk

ast falls news footage of defective toys being yanked from the shelves of U.S. retail outlets raised troubling questions about supply chain risk management and, more specifically, the quality of quality assurance as more U.S. supply chains stretch into Asia. It comes down to making sure that you have the right suppliers, and having an inspection process in place at the source to make sure that suppliers are making what theyve contractually agreed to make to the specifications youve agreed to, says Steve Payne, president, REL Consultancy. If somebody is manufacturing something of poor quality, when sourcing is local you can pick up on it and you can fix the issue. But when youre sourcing from so far away and the inventory is on the water for 10, 12, or 16 weeks, and you find that youve got a problem once the product reaches the U.S., your ability to impact the flow of inventory is hindered enormously. So it goes back to where youre doing your inspections. To help minimize the risk of faulty products, General Motors has 200 employees in Shanghai to work with suppliers. You need more oversight [when sourcing in China], you need to communicate clearly what your values are because of the real cultural differences about whats important, says Marjorie Doyle, of LRN Consulting Services in New York. The Chinese have gotten so much business due to extreme lower costs, and this has led Chinese vendors to think that cost is the only important factor. There has to be education that while cost is important, the other values are just as important. And when theyre evaluated at year-end, the only metric shouldnt be cost, says Doyle, the former executive vice president and chief compliance officer at DuPont. Progressive companies are building supply chain risk frameworks around type two risks the kinds of risks that you dont know about and tying them to board level. We talk about revenue at risk, which is a metric that the executive committee reviews every week thats very comprehensive, to get senior management familiar with all of the risks in the supply chain, says Pierre Mitchell, senior business advisor at The Hackett Group. And the companies that have clear governance and strong performance measurements, looking at the total cost of the supply chain and trading off risks vs. costs, are more transparent around communications to shareholders. The laggards are going to be holding things closer to their vests.

Companies that want to be successful in China, and around the world, also need to make quality a top priority in order to avoid any potential pitfalls in sourcing product from this region, notes William E. Mitchell, chairman, president, and chief executive officer of Arrow Electronics Inc., a U.S.based distributor of electronic components with more than 20 locations in China. In 2006, Arrow sold nearly $2.5 billion of products in Asia. The 10 steps Mitchell identifies here are culled from Arrows internal quality-control practices, which help the company manage significant counterfeiting, intellectual property theft, and supply chain disruption risks in Asia and beyond: 1. source from reputable, well-established companies with tight internal controls. 2. conduct comprehensive background checks, including checking trade references and past business history, of supply chain partners before conducting business with them. 3. implement site inspections of supply chain partners and find out what systems have been put in place to track quality. 4. conduct ongoing performance reviews of supply chain partners and engage in ongoing communications with them to benchmark against preset goals and define improvement plans. 5. source only from companies that are willing to provide a written guarantee for products. 6. Be cautious of buying from companies that do not have franchised relationships with distribution partners to avoid a greater potential risk of counterfeit product. 7. Beware of unusually low pricing. While pricing is certainly important, it should not be the only determining factor in business relationships. 8. look for international organization for standardization (iso) or other equivalent, globally recognized certifications in a supply chain partners operations (e.g., Arrows distribution centers in Asia are certified to ISO9001:2000). 9. establish relationships with third-party organizations. Arrow often works with Restriction Learn more testing centers for the of Hazardous Substances (RoHS) in China to have products tested for compliance to meet customer requirements. 10. translate quality into measurable and clearly defined targets with supply chain partners and ensure that these metrics are communicated regularly with employees.

Laurie Brannen contributed to this article. Learn more

22 business finance january 2008

BReaking BReaD with new supplieRs

Extending the supply chain into new geographies and selecting new vendors in those areas should begin with some soul-searching closer to home. It starts with a cross-organizational understanding of the corporate and operations strategies that you would adopt when pursuing an extended supply chain, says John Kamauff, a principal with Archstone Consulting, who specializes in supply chain management and strategic sourcing. Subsequently, the ramp-up must entail thorough due diligence. This scrutiny, Kamauff says, can be strengthened by objective, third-party involvement to develop and validate the supply chain and ensure that the appropriate controls, checks, and balances are in place, initially. Finally, the ongoing supplier relationship requires the sort of systematic monitoring, troubleshooting, and review that Arrows supplier report card processes identify. Kamauff, who leads Archstones global sourcing and procurement practice, offers a refreshing step in the supplier screening process. My litmus test for overseas suppliers remains the same as I would use for any potential partner upon whose core competencies I am depending: Would I invite him or her to Thanksgiving dinner? he explains. At the end of the day, the key to a successful overseas partnership is the level of information-sharing both formal and informal between partners. A robust information exchange starts the relationship off on the right foot and helps both parties to keep their balance as they confront risks that will continually threaten the health of their respective balance sheets.

reporT Card
three steps: Define, communicate, and manage
Step 1: Define Metrics and Establish Benchmarks

Establish which supplier-performance measures are most important to your company. Metrics may include on-time delivery, incoming discrepancies, labeling and packaging requirements, corrective-action performances, number of stock-outs and/or cycle-time reduction. Once relevant metrics have been identified, benchmarks should be established.

Step 2: Communicate Expectations and Establish a Mechanism for Exchanging Information

Equipped with those benchmarks, a company should communicate those expectations directly to suppliers. Start with suppliers who comprise 80 percent of total procurement spending or 80 percent of the risk. Next, develop a structure and, where possible, a highly automated process for evaluating supplier performance against benchmarks, noting and reporting performance gaps and documenting corrective actions.

Step 3: Monitor and Manage

Ensure that the internal auditor and, if necessary, external auditors understand the performance metrics and overall risk criteria that suppliers adhere to so that they can weave reviews of those supplier relationships into their quarterly (for key suppliers and those that are not ISO-registered, where such registration is applicable) and annual (for all suppliers) reviews.

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