How does one incorporate risk analysis into the S&OP process?
In my blog entry earlier this week, we asked the question “Are key decisions made in the context of risk adjusted scenarios?” and pondered whether actuarial techniques can be applied to the fundamental questions that often arise out of the sales and operations planning process (S&OP).
In today’s discussion we will begin to delve into approaches that the Steelwedge Center of Excellence will be studying to elevate S&OP to the next level. As a starting point, let’s consider the fundamental definitions of effective risk analysis. In their recent article in “Disaster Recovery Journal” risk analysis authorities Geoffrey H. Wold and Robert F. Shriver outline three key tenets of risk analysis:
1. Risk analysis involves identifying the most probable threats to an organization and analyzing the related vulnerabilities of the organization to these threats.
2. Risk assessment involves evaluating existing physical and environmental security and controls, and assessing their adequacy relative to the potential threats of the organization.
3. Business impact analysis involves identifying the critical business functions within the organization and determining the impact of not performing the business function beyond the maximum acceptable outage. Types of criteria that can be used to evaluate the impact include: customer service, internal operations, legal/statutory and financial.
A casual observer will note that Shriver and Wold’s approach to risk analysis is not entirely different from Economic Order Quantity (EOQ) approach to inventory optimization. That is, establishing acceptable service levels, estimating the volatility around bounder conditions (in the case of inventory it is the variability of supply and demand), and then applying simple mathematics to determine the optimal investment (or hedge) against outlier events.
In the context of S&OP, incorporating risk management concepts involves assessing possible disruption events, attaching fact-based but otherwise arbitrary probabilities associated with these events, quantifying the financial impact of such an event, and estimating the cost to mitigating the event.
As one example, in the course of a Sales and Operations Planning process, a concern is raised about the potential impact of supply disruption for key parts sourced from Switzerland. This concern may be associated with any type of event whether it be a volcano causing a disruption in air cargo, a terrorist event, or a disruption in global maritime shipping lanes. In any case, one can estimate a probability range or better yet – a probability distribution for this event based on various parameters – and then estimate the cost of hedging by bringing alternative suppliers online.
In this example, the alternative supplier would need to be from a different geographic region unlikely to be impacted by any kind of regional disruption. The cost of establishing a small alternative, but scalable source as a hedge against risk can then be weighed against the benefits related to risk mitigation.
An example of a simple framework for the creation and measurement of S&OP scenarios would be to create a matrix of impact and the costs associated with each possible occurrence and likewise a matrix of mitigation benefits. For example, the range of impacts may be established as:
0= no impact or disruption
Severity 1 = a disruption of supply of up to 12 hours
Severity 2 = 12 to 24 hours disruption
Severity 3 = 1 to 3 days of disruption
And so on.
Likewise, one would need to then quantify the cost of the supply disruption, the frequency of each type of supply disruption based on a one hundred year analysis of historic equivalent events, the degree of predictability of each disruption, the speed of onset of each disaster, and so on. Then, using standard risk assessment methodologies, one needs to estimate the potential cost impact of these events including lost production, lost business new opportunities, lost assets, lost customer goodwill, lost market share, negative publicity and so on.
As a practical issue, how does one incorporate this approach into monthly S&OP? How does one apply a technology like Steelwedge to automate the evaluation and solution of alternate cost-benefit scenarios? What is the relationship between monthly supply-demand conversations and these much more prosaic but all too real discussions of supply chain risk? What are your observations?
