The O-Ring in Your Supply Chain

Whether political perils arise far afield or close to home, the consequences for your supply chain can be catastrophic. Here's how finance executives can manage the risk.

Could a labor dispute on U.S. shores be considered a “political risk” — and a threat to supply chains in the United States? Surely political risk is the province of Asia, or the Middle East, or Latin America, the consequence of civil unrest that threatens the inflow of raw materials to stateside production lines.

But the West Coast port shutdown of 2002 had some of the earmarks of supply-chain political risk. It did, after all, involve politics of a sort: By invoking the Taft-Hartley Act, President Bush took flak and garnered praise for forcing workers to return to their jobs. And the shutdown certainly threatened companies’ ability to fill their production pipelines with raw materials.

During the 10-day lockout of dockworkers at Pacific Coast ports, 200 ships were reportedly stranded. The effect, according to The Economist (a sister publication of CFO.com) was that “manufacturers were missing parts, retailers could not plan their Christmas shelves and farmers could not sell food to Asia.” At least five auto plants had to close up shop — their just-in-time supply chains were running on empty.

Can such disruptions be prevented? Experts in managing political risk believe that planning for contingencies along the entire supply chain — whether far afield or close to home — can at least mitigate the losses associated with these supply breakdowns. For instance, had companies affected by the port shutdown plotted out alternative supply routes — say, through the East Coast or the Canadian border — at least some parts of their operations might have stayed up and running, according to Gene Long, president of UPS Consulting.

Planning for alternative transportation — Why not air cargo? asks Long — might have also helped. But supply chains that are more geographically complex and more time-sensitive bring another demand. Senior executives need to think harder, say risk experts, about how to minimize the effects of arbitrary government actions, trade wars, military conflicts, and other aspects of political risk.

Sitting on Too Much Risk

For their part, many CFOs acknowledge that their companies can’t respond quickly to problems with overseas suppliers. In a September 2003 survey conducted by CFO Research Services and funded by UPS Consulting, just 32 percent of 247 top financial executives said their companies were able to make major changes to their supply chains when such moves were needed. Fully 38 percent said their corporations were sitting on “too much unmanaged supplier risk.”

One reason all that risk has gone unmitigated may be that until recently, insurers have focused on protecting companies that don’t get paid for their exports rather than on companies that don’t receive their imports. That said, underwriters do seem to be paying more attention to coverage that addresses import problems.

Another reason is that companies themselves have focused on increasing the benefits of their supply chains rather than on controlling the risks. After all, just-in-time and build-to-order systems are designed to raise efficiency and lower the costs of carrying inventory. But thinking only about the advantages can have a downside. “If you haven’t considered what can make your supply chain break,” says Long, “you haven’t done the whole job.”

Not that it’s easy to scope out global trouble spots; even for the experts, determining country risk is something of a crapshoot. Take Brazil, which — by at least one measurement — is about 10 percent less risky for foreign investment than a year ago, when the election of a Leftist president spawned anxieties. (See “Country Risk,” at the end of this article.) Although Brazil has recently “behaved well,” says Keith Dunford, worldwide political-risk underwriting manager for Chubb and Sons, “we’re always wary” of the country because trade barriers could be erected at any time. China, on the other hand, looms too large in the U.S. trade picture for trade wars to arise, says Dunford — disputing what he sees as the conventional wisdom about the country.

Moreover, to manage day-to-day risks, a company shouldn’t merely analyze the political situation in its suppliers’ home countries, say insurance brokers; the company should extend that assessment to the supplier’s own foreign political risks. For instance, if a U.S. automaker relies on a Latin American manufacturer for auto parts, says Long, it should be alert to the supplier’s vulnerability to disruptions in its fuel imports.

Another concern, especially since September 11, is that the logos of prominent U.S. companies abroad amount to incitements to violence, according to some insurance underwriters and brokers. “If your company is associated with the U.S., your risk goes up significantly” compared with “XYZ Widget Co.,” says Ken Horne, a managing director in the political risk insurance practice of Marsh. By that reasoning, foreign-based subsidiaries that supply raw materials to companies headquartered here would do well to fly the company flag low, if at all.

A weak dollar, though it makes domestic goods less pricey than imports, adds another note of uncertainty for U.S.-based supply chains, says Michel Léonard, the chief economist of political-risk insurance broker Aon Trade Credit. “Any drastic instability that alters costs in your supply chain” — for example, the notion that the dollar might fall precipitously — is “obviously not positive,” he notes.

Indeed, the mix of terrorism and an unsteady dollar could pack a heady wallop. The weakness of the dollar makes it more susceptible to devaluations as a result of terrorism against U.S. domestic and foreign interests, according to Léonard. Continuing terrorist attacks on U.S. interests, he reasons, would lead to even greater increases in military spending, to be followed by rising deficits and whopping currency downgrades. Those events, in turn, could create economic instabilities abroad that might disrupt shipments to U.S. companies.

As for more-objective measurements, Aon broker Bryan Squibb suggests that executives use a metric like value-at-risk to calculate the impact that a given hazard in a given country might produce on a company’s finances over a specific period of time. Aon’s Léonard notes, however, that such analyses are a better fit for “number-driven exposures” like a stock market crash than for a political risk like terrorism.

Four Signs of Vulnerability

Rather than fixate overseas, however, U.S.-based managers might do well to start their analyses at home. The risk assessments should begin with an examination of their companies’ entire sourcing strategy to uncover those areas where political woes can hurt the most. “You look at your chokepoints, you look at your weaknesses,” says Diane Labrador, assistant treasurer for risk and insurance at Intel. “What would be the O-ring that would cause you problems?” she continues, alluding to the infamous cause of the Challenger shuttle disaster.

Here are four signs that a company’s supply chains are vulnerable to political risks, according to an August 2003 white paper by Aon:

  • Tight timeframes. While just-in-time manufacturing has enabled companies like Dell Computer to extract costs from their processes, it also leaves less room to maneuver when a supplier doesn’t come through. Not only might alternative suppliers bargain harder on costs, but the timeliness of the company’s product delivery might also be threatened.

When timeframes were stretched even more by border delays after September 11, some companies sought certification by the voluntary Customs-Trade Partnership Against Terrorism (C-TPAT). The certification, which requires a rigorous self-assessment of a company’s supply-chain security, provides company imports with a fast lane through Customs if they measure up.

Overall, it seems that the longer the time between securing raw materials and shipping finished products, or the larger the buffer of materials on hand, the less political risk in the supply chain. Too long a cycle time or too big a buffer, of course, and just-in-time goes out the window.

  • Custom designs. The more exacting the product specification, the less wiggle room for the manufacturer that must find a new supplier. To take an extreme case, a one-off product blueprint might require an alternative supplier to retool its own operations — a process that could result in months of delay and a drain on the manufacturer’s revenues.
  • One supplier. Like low-inventory strategies, the currently fashionable single-source doctrine increases political risk even as it adds to efficiency. But on occasion — say, when it’s harvest time for one particular fruit — it can’t be helped.
  • No geographic diversification. Relying on suppliers from just one country could result in devastating delays if, for example, war were to break out in the region. Penciling in alternative suppliers in different countries, but in the same region, might do no good; as the authors of the Aon study suggest, “a full-scale Korean conflict would likely disrupt production in much of Asia, at least for a time.”

Heading Off Shortages

After analyzing their exposures, companies can take a number of measures to head off supply shortages. A first, obvious step is simply to line up alternative suppliers. But companies aren’t out of luck even if only one supplier is possible, says Lisa Hauser, a supply-chain risk consultant for Marsh. A company should negotiate the terms of its supplier agreement so that if the pipeline is clogged, the company will receive priority treatment before other buyers.

Another step is to make custom-tailored designs a tad less tailored. In a previous job, Hauser worked for a large food company that found itself locked in to a single supplier because of the company’s own rigid specifications for a key ingredient. But by working with other suppliers, she found that a slight change in specs afforded her company a few different ingredients to choose from.

Still another step, according to insurance industry experts, is to pay close attention to contracts with suppliers. One clause to insist on, says Dunford of Chubb and Sons, is a force majeure provision that enables the company to void a supplier contract in the event of war or civil strife. Dispute-resolution clauses are also a good idea, he adds, to enable the parties to settle differences out of court. The “must-avoid” clause: any sovereign-immunity provision that would allow government-owned suppliers to assert that companies have no legal standing to make claims.

More broadly, finance executives should know which legal system holds sway in their supply-chain contracts. “Is it the state of New York or the federal government of Ghana?” says Dunford. “There’s a big difference.”

When All Else Fails…

A company’s best efforts notwithstanding, sometimes the goods arrive too late or not at all. To protect themselves against the ensuing loss of revenue, U.S. manufacturers can buy a form of political risk insurance called “trade disruption” or “contract frustration” insurance. Policies, which cover specific trade arrangements, typically last three to five years but can run as long as a decade, according to Dunford. Coverage usually includes reimbursement for supply-chain losses associated with embargoes, import and export curbs, and other government actions that bar the free flow of goods.

Terrorism coverage can be included, but rarely is. “It would be hard for me to imagine a terrorist attack interrupting trade flows in any way,” says the underwriter. “Terrorists are usually looking for headlines, and they usually go after people rather than things.”

Then there are individually tailored policies, generally called “supply-disruption insurance.” Usually underwritten by Lloyd’s of London syndicates, the coverage aims to fill the gaps in standard property-casualty policies. According to the Aon white paper, supply-disruption policies can cover such perils as non-arrival or late arrival of just-in time deliveries; shipment delays or non-arrivals; and ship reroutings.

Now isn’t a terribly bad time to think about buying political risk coverage. Unlike property-and-casualty coverage, which most big companies can’t really do without, political risk insurance is a discretionary buy, maintains Harry Palumbo, a vice president with AIG WorldSource. Underwriters know this, too, and so political risk insurance tends to be cheaper.

Indeed, in the softening market for commercial insurance, buyers of political risk coverage are enjoying small premium increases — and sometimes, no increase at all. What’s more, insurance is in fairly abundant supply: Under Chubb’s contract-frustration policy, for instance, companies can secure up to $37.5 million in coverage for each trade arrangement.

Insurance can provide only limited, monetary solace for a broken supply chain, however. That’s why Intel focuses on planning for contingencies with its overseas suppliers rather than buying insurance, according to Labrador. The company’s risk-management goal isn’t to receive compensation for a supply chain gone awry, “it’s getting us back to market as quickly as possible.”

Country Risk: Brazil “Behaving Well”

The country-risk ratings of the Economist Intelligence Unit (a sister firm of CFO.com) take account of 77 indicators of political stability and other measures of credit quality. The EIU’s ratings show that Brazil has become less risky in the past year, thanks in part to better-than-expected economic policies.

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