I once knew of a guy who was unrealistically terrified of the Year 2000. Certain that the Y2K computer glitch would bring commerce to a halt and turn the city into a post-apocolyptic Waterworld, he bought a safehouse in the mountains, stocked it with food, and converted most of his wealth into gold bullion bricks.

True Story.

Now most Supply Excellence readers would characterize this person as a paranoid crackpot. (I know I did.) You might argue that he wasted his money and time planning for the most unlikely of events. And you’d be right.

Yet, this is exactly what most supply management organizations do when planning for supply chain risks. (This, or nothing at all.)

“Most companies spend too much time trying to predict and protect against unlikely risk events,” said Venu Nagali, head of Hewlett-Packard’s Procurement Risk Management (PRM) program. Speaking at AMR Research’s Supply Chain Executive Conference earlier this month, Nagali stated plainly: “The geopolitical risk and natural disasters we hear about in the news are low probability events.”

Nagali’s recommendations were echoed by AMR’s own supply risk management guru Mark Hillman who said, “The greatest risks are the day to day operational risks that can detract from shareholder value and performance. You need to focus on high probability risks that you can control, such as supplier failure or market risks, and take steps to mitigate these.”

HP tracks three areas or uncertainty:

1. Demand uncertainty of its own products
2. Uncertainty of future commodity cost and components
3. Supply availability

As part of its PRM program, HP has embraced new processes, supplier engagement approaches, and systems to better predict, mitigate, and balance risk across the supply chain.

“Risk has traditionally been put on the weakest players in the supply chain — the suppliers,” said Nagali. “Even today most companies don’t set a forecast. They don’t commit [volume] and just expect suppliers to take on all the risk.”

Nagali says HP’s PRM approach is a generic framework designed to answer three basic questions: How much should I buy? At what price? And for how long?

To answer these questions HP assesses the probability of its demand forecasts and of the cost or availability of supply required to support it. Based on this assessment, HP determines high, base, and low scenarios for its demand forecasts and the probability that each will occur.

The high-tech giant uses this probability analysis to define supplier agreements that share both risk and reward. Depending upon the probability and risk of a particular product or supply market, agreement terms range from a fixed quantity with a market-based discount to a fixed quantity, fixed price contract. HP may also use price caps and floors to protect parties even further.

(Click graphic to enlarge.)

Nagali states simply, “The company that bears the risk, gets paid for it.”

HP first applied this PRM approach to its direct material spend, both for commodity and custom parts and assemblies. The company has since used it to mitigate risk for key and volatile indirect spend categories, such as energy and advertising. In fact, Nagali reported that $7 billion of HP’s spending last year was based on such PRM contracts.

All told, HP has generated more than $445 million in cost savings from implementing its PRM approach. “We help HP take on more risk and save more money,” said Nagali. “But cost savings is not the key objective. Our key goal is to always be certain that we can get the material we need.”

In short, by sharing risk and reward with suppliers, HP has been able to ensure that it is the Customer of Choice when supply markets get tight. And this has helped the company not only to cut costs, but more importantly to gain a leg up on competitors using outdated approaches that require suppliers to take on all the risks of an uncertain market.