Beyond Risk Management – Agility is the Key: Part I
June 25, 2012
The second half of 2010 and early 2011 saw exponential increases in market prices of rare earth elements (REEs), the 17 chemical elements with unusual properties that make them valuable in metal alloys, magnets and catalysts. Meanwhile, disruptions in global auto production following Japan’s nuclear disaster led to huge, unexpected drops in the prices of platinum-group metals (PGMs).
Why were these trends news, even for people who weren’t traders in specialized substances? They were particularly newsworthy because of their effects on so many global supply chains. The volatility in these once-obscure markets rippled into profound impacts on the bottom lines of any number of companies. REEs and PGMs are examples of low-volume but high-value supply chain components. They play small but irreplaceable roles in the automotive, high tech, clean energy and chemical industries. And their price fluctuations do more than inflate the cost of various manufacturing inputs; they can also force manufacturers to tie up large amounts of capital in inventory.
Traditional risk management strategies are not sufficient to proactively manage these challenges, because those strategies generally look only upstream, rather than at a holistic operational picture. Thus, executives of global companies are increasingly embracing “agility.” By adopting an agile supply chain, companies can make decisions more quickly, adapting to market conditions to minimize the impact of volatility. Indeed, one global manufacturing company implemented an agile supply chain and achieved an immediate 17 percent reduction in annual controllable operating expenses, with bigger benefits still to come.
In this article we will first explain why increasing prices and market volatility in high-value input materials aren’t going away. We’ll then look at how an agile supply chain can manage that volatility more successfully than traditional risk management approaches. We’ll conclude with a summary of what a company needs to do to set up an agile supply chain.
The Problem is Permanent
The management of high-value raw materials will remain a strategic issue for executives for three reasons:
1. Prices will continue to rise: Global demand will continue to rise while the supply market tries to catch up. In the case of REEs, users are not dealing with a completely liquid supply and demand market. China’s decision to regulate and limit their production and export has significantly constrained global supply. Yet few alternatives are available, because decades of low Chinese prices have inhibited investments, meaning that alternative sources are four to eight years from being available. Several REE projects are coming on stream in 2012 and 2013 (e.g. Molycorp Inc. in Mountain Pass, CA and Lynas Corporation in Australia / Malaysia). However, their capacity will have little impact on the global supply and demand balance.
Meanwhile, PGM prices will rise due to ever-increasing automotive industry demand. Expected increases in diesel engine production, a rebound in the North American truck market, and tightening of global emission standards will require more PGM materials in catalytic converters. And again, alternatives—in the form of substitutes or new capacity—are far from ready.
2. Market volatility will increase: Prices will swing up and down as investor activities increase. New exchange traded funds (ETFs) make it easy for institutions and average investors to trade PGMs and REEs, among other commodities. Many ETFs are physically backed, meaning that physical inventories are purchased and held by a custodian, making them unavailable for manufacturing use. Thus these investment trends will likely increase market volatility, with physical backing exaggerating price swings. Meanwhile, external events (earthquakes, hurricanes, floods and who-knows-what’s-next) are becoming increasingly frequent and devastating in a variety of markets. They too will increase volatility.
3. Geopolitical issues will continue to drive risk: For both PGMs and REEs, geopolitical risks will continue to be an “X” factor. For example, the REE crisis has resulted from policy changes in China. Will China continue on the same path, accelerate or decelerate?
Likewise, South African PGM production has been constrained by struggles with safety performance and labor disputes, both of which are ongoing and difficult to predict. Meanwhile, nobody knows how much PGM material is stockpiled in Russia, or what political factors could accelerate or decelerate its sell-off of those stockpiles.
Beyond Traditional Risk Management
What’s wrong with using traditional risk management for these issues? The traditional approach normally includes supply and demand analysis; price and demand forecasting; and strategies to transfer, mitigate, avoid and respond to risk. In other words, it seeks to address the financial implications of upstream price fluctuations. This approach can be effective for low-value commodities, but high-value commodities require a greater financial commitment.
With an extreme risk aversion mentality, many companies have developed slow-moving, inventory-heavy value chains. (These tendencies are often exacerbated by a focus on security and precision requirements that have built excess redundancies and inflexibility into many manufacturing processes.) Yet those high inventory levels result in significant working capital requirements, high lease costs (metals are sometimes leased, rather than purchased, in the open market) and losses from shrinkage and potentially recyclable wastes. And although traditional risk management can smooth exposure to fluctuating input prices, it doesn’t address these core operations.
The best response to volatility is to not just mitigate it, but to be able to adapt to it. Optimizing inventory levels based on current and expected market conditions can provide competitive advantages. Quickly changing processes to alter use of expensive inputs can help reduce risks. And minimizing material loss and maximizing waste capture can bring additional value. To accomplish these steps, manufacturers need an agile supply chain.
Agile Supply Chains
When we speak of agility, we refer to two key elements. The first is decision making: the wisdom to know when to make a deep course change (vs. when to maintain the current plan)—a wisdom backed by accurate, timely information. The second is flexibility: the ability to implement those decisions quickly, because you have removed rigidity from your business processes. In volatile, fast-changing markets, agility is a new element of competition. You can use agility—in addition to value, service, quality, etc.—to expand your market share.
Agility focuses on improving the core operations in a value chain. It makes them faster, more flexible and more able to adapt. Though it improves performance of individual processes, more importantly, agility aims to enhance the cohesiveness of a company’s entire value chain as an integrated process. When fully executed, agility enables company executives to promptly adapt to external market conditions and address internal operating needs simultaneously.
You can think of applying agility across three timeframes:
• Operative Agility is an effort to become faster and more reactive in the short term. For example, you can integrate sales & operations planning (S&OP) processes with cross-functional core operation processes. By quickly sharing accurate demand, supply and pricing information, these enhanced processes promote timely decision-making and increase flexibility.
• Tactical Agility aims to increase flexibility across the entire value chain in the medium term by developing internal capabilities or leveraging external capabilities. For example, you may seek to shorten lead times through vendor collaboration. You may apply advanced supplier relationship management and supply risk management approaches to gain deeper supplier leverage, more flexible deal structures, and other methods of effective risk response.
• Strategic agility focuses on building flexibility and speed into the value chain for the long term. You may align with key customers and suppliers for end-to-end value chain optimization. You may optimize your product portfolio, supply footprint, degree of customization or innovation strategy to maximize flexibility and speed requirements in core operations.
Applying agility in this three-pronged approach provides benefits in the short term (such as improved processes and compliance and better price quality), medium term (optimized balance between production scale and flexibility and better pass-through of volatility) and long term (stronger market recognition, more targeted innovation and top- and bottom-line optimization).
Agility is especially valuable in managing REEs and PGMs because it can reduce inventories, thus freeing working capital. It also allows companies to take advantage of temporary external price volatilities by quickly adjusting internal processes. In short, it helps ensure that all decisions across your company are made with full knowledge of ever-fluctuating market conditions.
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