William Grey and Dailun Shi IBM T.J. Watson Research Center November, 2001 Value Chain Risk Management

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 Risks Market Risks  Foreign exchange  Interest rates  Equity prices  Commodity prices Business Risks  Economic  Reputational  Supply Chain  Technological  Legal risk  Regulatory risk  Environmental risk Operational Risks  People  Processes  Systems  Procedures  Policies  Supply Chain Credit Risks  Accounts receivable  Vendor financing  Notes receivable  Liquidity Enterprise Risk Factors

Value Chain Risk Management Applies this Approach to the Extended Supply Chain

Three key value chain flows are subject to risk DesignBuyBuildSupportShipSell Financial Flows Suppliers Customers Information Flows SCM Physical Flows

Enterprise Risk Taxonomy

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 Formulation Risk Identification Risk Characterization Strategic Changes Planning/Execution Changes Financial Risk Management Insurance Organizational Changes Risk Management Strategy Implementation

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 High Severity Low Likelihood I High Severity High Likelihood II Low Severity Low Likelihood III Low Severity High Likelihood IV Severity of Impact Probability of Occurrence Too expensive to insure: Take steps to reduce frequency or severity. Consider divesting if returns don’t justify risk. Establish mitigation measures and contingency plans; insure Deploy operational changes and controls to reduce frequency of occurrence Monitor periodically for change in status

Interactions between risks and value chain processes (examples)

Risk Propagation in the Supply Chain Example 1: Price risk is comparatively well-behaved as it propagates through the supply chain Computer Chip price +$1 Circuit Board Cost: +$(1+/-є) High-end Computer Cost: +$(1+/-є) Component 1 Component N Assemble BOM

Risk Propagation in the Supply Chain Example 2: Quantity risk is amplified at the point of Bill of Material assembly Computer Chip shortage –100 units Circuit Board Shortage –100 units High-end Computer Opportunity cost: -100 units of lost sales, customer ill- will Component 1 Cost: excess inventory Component N Cost: excess inventory Assemble BOM

Risk Propagation in the Supply Chain Example 3: Quality risk is amplified as it propagates through the supply chain Computer Chip defect Circuit Board Cost: Rework High-end Computer Cost: field failure, damage to brand/reputation Component 1 Component N Assemble BOM

Value Chain Risk Management Process Risk Management Strategy Formulation Risk Identification Risk Characterization Strategic Changes Planning/Execution Changes Financial Risk Management Insurance Organizational Changes Risk Management Strategy Implementation

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 Size of loss Catastrophic Loss Leading to Default Losses Managed by Strategic, Operational, and Financial Means Losses Covered By Insurance Default

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 Value Creation Value Allocation Cost of Capital (Required equity return) Shareholder Profit Shareholder Value Capital Structure (Debt-equity mix) Cost Drivers Operating Performance and Profit Revenue Drivers

Linkages between Strategic Risk Levers and Shareholder Value Financial Leverage Financial Diversification & Hedging Shareholder Profit Cost of Capital (Required equity return) Shareholder Value Capital Structure (Debt-equity mix) Cost Drivers Operating Performance and Profit Revenue Drivers Value Creation Value Allocation Operational Leverage Operational Diversification & Hedging

Linkages between Supply Chain Decisions and Shareholder Value Value Creation Value Allocation Cost of Capital (Required equity return) Shareholder Profit Shareholder Value Capital Structure (Debt-equity mix) Cost Drivers Operating Performance and Profit Revenue Drivers Outsourcing Strategic Alliances Supply Chain Design New product introduction Revenue Management Transportation & Logistics Inventory Policies Sourcing Supplier Management

Examples of Strategic Risk Management

Strategic Risk Management Analytics Low UncertaintyHigh Uncertainty Discounted Cash Flow Analysis Sensitivity Analysis Scenario Analysis Decision Trees Real Options Valuation Monte-Carlo Simulation Visualization Techniques

Example of Improved Visualization EPS Probability Target Investment 1 EPS Probability Target Investment 2

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 Data Integration ERP SCM PLM Real-time Risk Management Integrated Risk Management Standalone Risk Analytics Real-time Risk Monitoring Risk Extensions CRM Analytic Intensity