Greek Crisis Underlines the Importance of Risk Management

How can companies shelter their supply chains from market storms?

No one knows for sure how Greece’s financial crisis will impact the global economy over the long-haul. However, what companies can expect is instability in some form or other, such as volatile prices and fluctuating currency values within the Eurozone and beyond.

Companies have developed financial hedging tools such as long-term, fixed-price contracts with suppliers denominated in their currency of choice. More sophisticated financial hedging includes put and call options, that allow a company to shield itself from large fluctuations in currencies or shifts in commodity prices and even profit from them.

Yossi Sheffi

Yossi Sheffi

Other financial instrument separate the volatile and stable part of a quote. For example, transportation companies may quote a price plus a fuel surcharge that is tied to a government index of fuel price, thus taking the volatile component out of the negotiations. (Of course, this raises many other issues between suppliers and customers, such as the percentage of the commodity in the supplier’s offering, the difference between retail and wholesale prices, the timing of surcharges, and many others.)

But not all hedging strategies are financial. There is another risk mitigation toolbox, operational hedging, that companies can use to shelter their supply chains from market storms.

[Also on Longitudes: Supply Chain Risk Series]

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Exchange rate fluctuations are constantly redrawing the competitive map across the globe.

These tools are described in the volatility chapter in my forthcoming book, which will be published by MIT Press in September 2015.

The volatility of the Euro, which became apparent as a result of Greece’s fiscal tragedy, is an example of the economic upheavals that companies must now expect, and the increasing importance of risk management strategies such as operational hedging. Here are some examples:

Localize production. Exchange rate fluctuations are constantly redrawing the competitive map across the globe. For example, if the US dollar soars on the back of the crisis in the Eurozone, US producers become less competitive in European markets, causing their products to be expensive in Europe.

Other changes such as rising wages in certain parts of the world have a similar knock-on effect. One way to offset these risks it to locate manufacturing closer to demand. This is what the Japanese automotive manufacturers have done in moving operations to the US and Europe.

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Efficiency, substitution, and recycling displace primary resource consumption and reduce pressure on primary supplies.

Now, with a weak Euro and both a strong Dollar and Yen, they can increase production in Europe and not only sell their products there but export from Europe to the US and elsewhere. Such a strategy negates much of the effects of the currency exchanges – and takes advantage of them.

Integrate vertically. In 2012 Delta Airlines bought an oil refinery in the state of Delaware, US, for $150 million and spent $100 million upgrading the facility to increase jet fuel production. Why did an airline get into the oil refining business?

The move enabled Delta to protect itself against large increases in the spread between the cost of oil and the cost of jet fuel. A cautionary note: As with many other risk mitigation strategies, vertical integration can swap one supply chain risk for another and incur unexpected costs.

[Also from Yossi Sheffi: It Takes More Than an “Uber” Prefix to Reinvent a Business]

In this example, Hurricane Sandy delayed the start of the acquired refinery, and a gasoline production outage created early losses from the project.

Cut consumption. Large or long-term scarcity or price disruption requires larger or long-term supply chain changes.

Three strategies – efficiency, substitution, and recycling – displace primary resource consumption and reduce pressure on primary supplies. In the late 1990s palladium prices spiked, so catalytic converter manufacturers found ways to consume less of the precious metal by, for example, using thinner coatings in their products.

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Companies should maintain a historical perspective when assessing the implications of economic disruptions.

This is a typical example of an efficiency response. Substitution involves using cheaper materials in lieu of expensive ones. For instance, makers of wind turbine generators are developing designs that are less reliant on magnets made of pricey rare-earth metals.

Recycling is a well-known response to material scarcity and price increases. Up to 80 to 90 percent of the lead used by Johnson Controls to manufacture batteries is recycled content, which provides a significant price advantage and protection from availability problems.

In addition to deploying risk management mechanisms like these, companies should strive to maintain a historical perspective when assessing the long-term implications of economic disruptions.

Today, the prospects for Greece look grim, but the country will not disappear, and years hence when the dust has settled new opportunities will almost certainly come to light. Who knows, perhaps a restructured Greek economy will become a highly competitive location for manufacturing and distribution hubs. goldbrown2

This article first appeared on LinkedIn

Yossi Sheffi is the Elisha Gray II Prof. of Engineering Systems at MIT, where he serves as Director of the Center for Transportation and Logistics.

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