Financial Risk Management

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Value Chain Risk Management
William Grey and Dailun Shi
IBM T.J. Watson Research Center
November, 2001
Key Business Trends
• The pace of business is accelerating, and there has
been a dramatic increase in uncertainty
• A difficult business climate is exacerbated by
heightened competition
• Supply chains are not only more efficient – but also
riskier
• Customers (and the equity markets) are becoming
increasingly unforgiving
Enterprise Risk Management is an integrated
approach for managing risk across the firm
Enterprise Risk Factors
Market Risks
Foreign exchange
Interest rates
Equity prices
Commodity prices
Operational Risks
People
Processes
Systems
Procedures
Policies
Supply Chain
Business Risks
Enterprise
Risks
Credit Risks
Accounts receivable
Vendor financing
Notes receivable
Liquidity
Economic
Reputational
Supply Chain
Technological
Legal risk
Regulatory risk
Environmental risk
Value Chain Risk Management Applies this
Approach to the Extended Supply Chain
customers
design
service / support
store
point of sale
suppliers
local delivery
outbound
inbound
manufacturing
distribution
Three key value chain flows are subject to risk
Design
Buy
Build
Sell
Ship
Support
Financial Flows
Customers
Suppliers
Information Flows
Physical Flows
SCM
Enterprise Risk Taxonomy
Enterprise Risks
Core Business Risk
Value Chain Risk
Non-core Business Risk
Operational Risk
Event Risk
quality
systems
legal
quantity
policies
regulatory
price
procedures
political
complexity
serviceability
timing
processes
people
Recurring Risk
Credit risk
Market risk
liqudity risk
interest rate
vendor financing
commodity prices
debt risk
equity prices
covenant violation
foreign exchange
hazard
economic
natural
account receivable
reputational
account payable
Tax Risk
Studies in Risk
•
•
•
•
•
•
•
Nokia / Ericsson (Supply risk)
Cisco Systems (Supply-demand management risk)
Lucent Technologies (Credit risk)
IBM (Supply risk)
Micron Technologies (Price risk)
Nike / i2 (Technology risk)
Firestone / Ford (Quality, reputational risk)
Value Chain Risk Management Process
Risk Management
Strategy
Implementation
Strategic Changes
Planning/Execution
Changes
Risk
Identification
Risk
Characterization
Risk
Management
Strategy
Formulation
Organizational
Changes
Financial Risk
Management
Insurance
Risk Identification
• Techniques
– Scenario Analysis
– Historical Analysis
– Process Mapping
• Basis for consistent framework to uniformly identify,
assess and manage risks
• Dynamic process - requires periodic reviews
• Standard categories for identifying risks
• Common language for communicating risks
Risk Characterization
• Assess the nature, impact and importance of risks
• Balance quantitative vs. qualitative analysis
• Measurement Metrics
–
–
–
–
–
Probability of occurrence
Severity of the potential impacts
Loss distribution function
Value at Risk
Stress Test / Simulation outputs
Risk Categorization
Severity of Impact
Establish mitigation measures and
contingency plans; insure
Too expensive to insure: Take steps to
reduce frequency or severity. Consider
divesting if returns don’t justify risk.
High Severity
Low Likelihood
High Severity
High Likelihood
I
II
Low Severity
Low Likelihood
Low Severity
High Likelihood
III
IV
Probability of Occurrence
Monitor periodically for change in
status
Deploy operational changes and
controls to reduce frequency of
occurrence
Interactions between risks and value chain
processes (examples)
Sourcing
Manufacturing
Marketing and
Sales
Distribution and
Logistics
Support
Quantity
- Component
shortfalls impact
production, hurting
sales, and potentially
damaging reputation
for service and
reliability.
- Poor capacity
planning constrains
production output.
- Poor demand
- Poor supply chain
forecasts result in
design and execution
either missed
leads to excess
revenue
inventory.
- Poor production
opportunities, or
planning result in
excess inventory
- Poor inventory
production
throughout the supply positioning prevents
constraints or excess chain.
products from
inventory.
reaching customers,
hurting revenue.
- Poor warranty
forecasting leads to
under stocking spare
parts. This causes
poor customer
satisfaction and loss
of market share.
Price
- Unexpected price
volatility in procured
components
increases revenue
and profit variability.
- Excess capacity
- Poor pricing
increases production decisions hurt market
costs.
share, resulting in
foregone profit
margins, or excess
inventory.
- Poor support
network design and
execution increase
expediting, causing
higher logistics costs.
Quality and
- Low-quality
- Low yields can
Serviceability purchased parts
constrain production
impact manufacturing output, reducing
yields, hurting sales. revenue.
Also affects customer
satisfaction and
-Poor quality affects
reputation, and
customer satisfaction
increase warranty
and reputation, and
and support costs.
increases warranty
-Selecting suppliers and support costs.
with poor or erratic
service affects
- Poor quality affects
production, reducing obsolescence, and
revenue and
creates obstacles for
damaging reputation. marketing and sales
- Poor supply chain
design and execution
increase the need for
expediting, thus
increasing logistics
costs.
-Certain sales
- Poor supply chain
processes work well design or execution
for certain customer results in poor
segments, but are too serviceabiliy,
costly to address
reducing customer
other segments.
satisfaction, and
Revenue and profit
limiting ability to fulfill
decline.
service models such
as VMI and JIT.
- Poor quality of
support execution
affects customer
satisfaction,
damaging firm’s
reputation.
Risk Propagation in the Supply Chain
Example 1: Price risk is comparatively well-behaved as it
propagates through the supply chain
Component 1
Computer Chip
price +$1
Circuit Board
Cost: +$(1+/-є)
Component N
Assemble
BOM
High-end Computer
Cost: +$(1+/-є)
Risk Propagation in the Supply Chain
Example 2: Quantity risk is amplified at the point of Bill of Material
assembly
Component 1
Cost: excess
inventory
Computer
Chip
shortage
–100 units
Circuit Board
Shortage
–100 units
Component N
Cost: excess
inventory
Assemble
BOM
High-end Computer
Opportunity cost:
-100 units of lost
sales, customer illwill
Risk Propagation in the Supply Chain
Example 3: Quality risk is amplified as it propagates through the
supply chain
Component 1
Computer Chip
defect
Circuit Board
Cost: Rework
Component N
Assemble
BOM
High-end Computer
Cost: field failure,
damage to
brand/reputation
Value Chain Risk Management Process
Risk Management
Strategy
Implementation
Strategic Changes
Planning/Execution
Changes
Risk
Identification
Risk
Characterization
Risk
Management
Strategy
Formulation
Organizational
Changes
Financial Risk
Management
Insurance
Financial Risk Management
• Use of financial instruments
–
–
–
–
Forward contracts
Futures
Options
Swaps, caps and floors
• Use of supply chain contracts (embedded options)
• Use of spot markets and new derivatives markets
Insurance
Probability of
loss
Controllable Loss
Losses Managed
by Strategic,
Operational, and
Financial Means
Catastrophic Loss Leading to Default
Default
Losses Covered
By Insurance
Size of loss
Strategic Risk Management
• Application of financial management analogues to the
value chain
• Value chain restructuring
• Risk-based modeling and analysis
• Improved visualization
Relationship between the Value Chain and
Shareholder Value
Cost Drivers
Revenue
Drivers
Operating Performance and
Profit
Value Creation
Value Allocation
Capital Structure
(Debt-equity mix)
Shareholder Profit
Cost of Capital
(Required equity return)
Shareholder Value
Linkages between Strategic Risk Levers and
Shareholder Value
Cost Drivers
Revenue
Drivers
Operational
Leverage
Operating Performance and
Profit
Value Creation
Value Allocation
Capital Structure
(Debt-equity mix)
Operational
Diversification
& Hedging
Shareholder Profit
Cost of Capital
(Required equity return)
Shareholder Value
Financial
Leverage
Financial
Diversification
& Hedging
Linkages between Supply Chain Decisions and
Shareholder Value
•Revenue Management
•Transportation &
Logistics
•Inventory Policies
•Sourcing
•Supplier Management
Cost Drivers
Revenue
Drivers
Operating Performance and
Profit
Value Creation
Value Allocation
Capital Structure
(Debt-equity mix)
•Outsourcing
•Strategic Alliances
•Supply Chain Design
•New product introduction
Shareholder Profit
Cost of Capital
(Required equity return)
Shareholder Value
Examples of Strategic Risk Management
Supply Chain
Design
Strategic
Sourcing Strategy
Leverage

Modify using
changes in
production
technology

Modify by
outsourcing
production
Diversification

Geographical
diversification
to reduce
hazard risk

Political unit
diversification
to reduce
political risk
and tax risk

Geographical
diversification
to reduce
labor price
risk
Hedging

Natural
hedging of
foreign
exchange risk

Matching
inbound and
outbound
supply chain
capacity and
flexibility

Matching
supply chain
capacity to
marketing
capability
Execution

Value Chain
Restructuring

Alternative
supply chain
interactions

Supply chain
designed to
reduce cycle
time and
inventory

Supply chain
simplification
to reduce
complexity
risk





Increase by
selecting
vendors
requiring
capacity
commitments
Reduce by
consolidating
spend to
improve
flexibility
terms

Vendor
diversification
to reduce
supply, price
and quality
risk
Vendor
diversification
to reduce
hazard risk

Hedge
demand
volatility with
supplydemand
matching
Natural
hedging of
foreign
exchange risk

Single source
selected
components to
reduce
complexity
Increase
information
sharing with
core suppliers
Strategic Risk Management Analytics
Low Uncertainty
• Discounted Cash Flow
Analysis
• Sensitivity Analysis
High Uncertainty
• Scenario Analysis
• Decision Trees
• Real Options Valuation
• Monte-Carlo Simulation
• Visualization Techniques
Investment 1
Target
Probability
Probability
Example of Improved Visualization
EPS
Investment 2
Target
EPS
Risk-enabled Planning and Execution
• More accurate specification of decision
objectives, deeper analytics
• Richer, more complete information
– Extensive usage of uncertainty data
– Leveraging financial data in supply chain decisions
– Leveraging supply chain data in financial decisions
• Risk-based measurements and metrics
• More timely and effective response to risk events
• Extend financial risk management concepts and
tools: leverage, diversification and hedging
Evolution of Value Chain Risk Analytics
Risk Extensions
Analytic Intensity
Standalone
Risk Analytics
SCM
Integrated
Risk
Management
CRM
Real-time Risk
Management
ERP
PLM
Data Integration
Real-time Risk
Monitoring
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