Introduction
Supplier risk management is in flux. While supply chain leaders have readjusted to business as usual following the Covid-19 pandemic, there is no doubt that it exposed global supply chains’ fragility. In addition to seismic disruptions and production delays, demand for some products soared, leaving suppliers struggling to keep pace. The immediate steps taken to mitigate these risks were not only chaotic for supply chain leaders but also costly, as stockpiling inventory or scrambling for alternative suppliers became an all-too-familiar approach.
It is no wonder, now with the dust firmly settled, that many firms are rethinking and rebuilding their approach to supplier risk management so it not only advances
resilience but is also more cost-conscious. And time is certainly of the essence. Evidence points to similar disruptions only becoming more common and severe, as recently seen following the rising geopolitical tensions and wars in the Middle East and Ukraine. It is paramount that supply chain teams are able to respond to disruption while protecting revenue and controlling costs.
THIS EBOOK WILL EXPLORE
→ The concept of VaR, how it is measured, and how it can be applied to supply chain management
→ The importance of enterprise data and predictive analytics to inform reliable VaR calculations
→ Real-world examples detailing how VaR can be applied in practice
From data to decisions: why using value at risk calculations can bolster supply chain management 1
SUPPLY CHAIN RISKS:
AN OVERVIEW
In short, the pandemic produced a real- life lesson that proactive supply chain risk
management can be less costly than reactive approaches. The question then becomes what can be done?
Against this complex backdrop, Moody’s believes there are levers at the supply chain team’s disposal that can help. Among them is the application of value at risk (VaR).
While more commonly used in financial modeling, VaR is not necessarily new to supplier risk management. It provides a more objective measurement of how risk mitigation strategies protect revenue — enabling supplier risk professionals to make more targeted, data- and outcome-led supply chain decisions according to the outcome or value a risk mitigation response can achieve.
But there’s no doubt that VaR among supply chain professionals is resurfacing, and the reason why is clear: The greater quality and availability of enterprise data today means that VaR calculations are more reliable and
can therefore become the cornerstone of a corporate’s supplier risk strategy.
It has the potential to empower supply chain professionals to better communicate their actions, decisions, and outcomes to senior management. VaR can certainly play a fundamental role in this respect: Supply chain teams can apply it to more confidently communicate risk mitigation strategies to boards during times of crisis.
Central to VaR’s efficacy is the availability of sophisticated enterprise-level data.
Thankfully, supply chain leaders today have access to an abundance of resources and analytics that ensure they shift from reactive and after-the-fact mitigation strategies to forward-looking and proactive approaches.
With the non-targeted approach to supply chain risk management now a thing of the past, this paper will explain the critical role VaR can play in helping supply chain
leaders understand the efficacy of their risk mitigation strategies. It will also provide real- world examples of how VaR can be practically applied to help maintain supply chain performance and resilience.
The key questions
that value at risk answers:
→ What is the supply chain team protecting as its key objective — revenue, the guaranteed supply of goods, timely delivery?
→ In the event of disruption, what could be lost?
→ Based on how much it would cost the company to avoid these losses, is the cost of the mitigation a sound investment?
At its core, value at risk is an expression of the number of days a firm can continue to supply a
generate revenue — before a disruption could lead to tangible losses due to the nonfulfilment of an order.
Value is not always revenue
To give an example, we can look at value at risk being applied to two scenarios at a fictitious company:
SCENARIO 1
Company A supplies an electronic component that generates daily revenue of $100,000. The company currently has 10 days of inventory based on existing orders and projected sales and a recovery time of 20 days.
The risk exposure index for this product can be calculated as follows:
$100,000 x (20 – 10) = $1 million
The probability of disruption can be based on historical data, expert judgment, or scenario analysis. For simplicity, let’s assume that
the supply chain leader uses historical data and predictive analytics to estimate the probability of disruption to be 10%. The value at risk for this product is:
$1 million x 10% = $100,000
This means if a disruption occurs, Company A has $100,000 in revenue at risk for this
product. By comparing the value at risk across different products, the supply chain leader can prioritize the most critical products to protect by using mitigation strategies accordingly.
SCENARIO 2
Company A supplies a second component that also generates daily revenue of $100,000. It only has five days of inventory and a recovery time of 20 days.
In this scenario, the company identifies that there is a 70% chance that its supplier is at risk of not fulfilling its commitments. In the event of disruption, for each day that orders are not fulfilled, the company will miss out on
$100,000 in revenue each day for 15 days (or
$1.5 million total). Since the probability is 70%, the value at risk is $1.05 million, if calculated at that particular confidence level.
Faced with these two scenarios simultaneously, the supply chain leader can reasonably approach the board and request resources to intervene in order to protect a larger proportion of the revenue that could be lost. As such, the keys to effective supply chain management are understanding which
risks must be mitigated as a priority, what the cost of inaction is, and, most importantly, a crystal-clear view on the true value of what risk mitigation strategies are attempting
to protect.
Value at risk:
the key benefits
REVENUE-BASED DECISION-MAKING
VaR calculations can help justify risk mitigation strategies by clearly outlining the costs as well as the anticipated revenue that can be protected, aiding supply chain leaders to make better decisions according to their risk profiles.
EASING BOARD ENGAGEMENT
VaR introduces a more transparent measure of anticipated return of investment, not only easing conversations around the cost-benefits
of near-term risk mitigation strategies but also in demonstrating the longer-term value of investment in the supplier risk management function.
RISK PRIORITIZATION
Using a VaR calculation, the suppliers that expose a firm to heightened revenue risk can be identified and assessed more easily. By thinking about supply chain risks with a revenue-first mindset, supply chain leaders can make better decisions that avoid mitigating risks that do not pose the greatest threat to revenues.
IMPROVED RESILIENCE
Supply chain resilience is the capacity to absorb, mitigate, and avoid shocks to the supply chain. By calculating VaR, supply chain professionals
can ensure that the largest and most severe anticipated shocks to the supply are prioritized, absorbed, and lessened.
COMMUNICATING IMPACT
In recent years, the supply chain function has transitioned from being a reactive cost center to one that is expected to proactively maximize revenue.
VaR enables supply chain professionals to clearly demonstrate the value the function brings to a company’s bottom line.
The concept can also help alleviate a secondary issue in the supply chain field: professional attrition and high turnover rates. In recent years, we’ve noted higher levels of employee
dissatisfaction among supply chain professionals. In a 2023 Gartner survey, 93% of respondents said burnout-related turnover had increased at
their organization1.
We see VaR as a possible antidote to help these professionals better demonstrate value to employers, which in turn can lead to greater employee engagement and satisfaction.
1 https://www.gartner.com/peer-community/
oneminuteinsights/managing-burnout-during-supply- chain-crisis-k4e
VaR in practice:
Leveraging advanced data and analytics to anticipate supplier risk
Methodology:
value at risk (VaR) approach
To quantify the potential revenue impact, Alpha Manufacturing employs the VaR methodology. In this case, the company uses it to estimate the revenue at risk due to supplier-related disruptions.
From data to decisions: why using value at risk calculations can bolster supply chain management 10
Conclusion
VaR is enabling supply chain teams to reliably assess
and prioritize risks, and to demonstrate financial value to their organization.
Value at risk has been a mainstay of financial analysis for decades and even permeated supply risk management for the best part of 20 years. However, what has changed
is threefold.
First, supply chain teams are increasingly considered a commercial arm of a business. Intrinsically, they are being asked to show their financial value to their management teams to secure budgets and resources.
Second, as global risks become more interconnected, supply chain issues become harder to anticipate. The resulting web means supply chain leaders must be clear on what risk types they’re protecting their supply chains from by employing mitigation strategies, which risk types to prioritize, and which to simply accept as unmitigated risks.
The third — and most crucial — value at risk has become more reliable thanks to the vast swaths of entity data at the supply chain team’s disposal.
At Moody’s, we believe the value at risk can empower supply chain leaders to communicate more effectively and transparently with board members
around supply chain decision-making. By incorporating VaR and making reliable calculations, we believe the VaR concept represents an effective and proven method that can be the North Star of any supply chain function, helping organizations build resilience and make better supply
chain decisions.
If you would like more information about incorporating value at risk into your functions or how Moody’s can support your journey toward supply chain resilience, please contact us.
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