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Risk Pooling, A Technique to manage Risk in Supply Chain Management

Conference Paper · May 2016

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Simon Peter Nadeem

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 Simon Peter Nadeem
PhD Candidate
University of Derby,
England
United Kingdom

RISK POOLING, A TECHNIQUE TO MANAGE RISK IN SUPPLY

CHAIN MANAGEMENT

To cite this paper:

Nadeem, S. P. (2016). "Risk Pooling, A Technique to Manage Risk in Supply Chain
Management", LSCM Regional Conference and International Seminar 2016. Logistics
and Supply Chain Management Publication (pp. 86-93). Bishkek: Kyrgyz Russian Slavic
University.

1
Introduction
In the world of Global competitiveness, every company strive to optimize its
operations/ services in order to expand its impact. Doing so, is expected to
result in desired outcomes but often times can lead to unexpected and negative
outcomes. This often happens due to the over-estimation of reliability on
system, design, and strategy, as well as under-estimation of Risk.

This paper is a brief description of what Risk is, and how it can be managed by
utilizing the “Risk Pooling” methods to optimize the efficiency and
effectiveness of operations and/or service, specifically in relations to Logistics
and Supply Chain Management.

The challenge for managers is to compete and outweigh the competitors by

having maximum service level in most cost effective manner. Moreover other
constraints such as physical space limitations, transportation cost, overhead
cost, handling cost, etc. are some of the significant factors requiring strategic
decisions by managers to survive and thrive in market. Inventory Management
plays an important role to achieve higher service level but if not managed well,
it can lead to exceedingly high costs and at the same time other constrains
mentioned above, add to further limitations.

The paper aims to help its reader understand the actual nature of Risk and how
it can be identified. Further it leads to the strategies that can be adopted to
mitigate the risk and optimize company’s performance through utilizing one of
the best tool ‘Risk Pooling’.

Key Words: Risk Pooling, Inventory, Standard Deviation, Bullwhip effect,

Coefficient of Variation, Aggregate demand, safety stock.

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What is Risk? And its categorization

Risk, as generally understood, is associated with some negativity, or unwanted

occasion to take place. Often the terms Risk and uncertainty are assumed to be
same and are used as synonyms for each other. While they might superficially
look the same, fundamentally they are different. One must keep the difference
between two very clear, especially if to talk about risk management. Donald
Waters defines these terms in following way: (Waters, 2007)

 Uncertainty means that we can list the events that might happen in the
future, but have no idea about which will actually happen or their
relative likelihoods.
 Risk means that we can list the events that might happen in the future,
and can give each a probability.
To make it simpler, uncertainty is something negative or unwanted, we can
think of that might happen but there is no concrete base that it would happen or
not. Risk on the other hand is similar but with an additional piece of
information attached to it and that is the probability that we are able to assign to
it for its likelihood to happen.

An example for this would be that a food-store might have frozen foods with an
expiry date of 2 months. When the food store is not sure whether the products
will be sold or not – this is uncertainty. When the food store is sure that there
are 96% chances of product being sold within 8 weeks, then there is 4% risk of
products not being sold.

Dr. David Simchi-Levi expands the categorization of sources risk as

“Unknown-Unknown and Known-Unknown” (Simchi-Levi, 2009). The former
is uncertainty and the latter is Risk.

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Types of Risks in Supply Chain: “There are risks in the supply chain when
unexpected events might disrupt the flow of materials on their journey from
initial suppliers through to final customers.” (Waters, 2007)

Sarbanes-Oxley Act also acknowledges that Supply chain are inherently risky
(Waters, 2007). These risks can be caused by changes in exchange rates,
customs control causing delay in delivery, breakdown of machinery, changes in
market conditions, natural disaster, longer lead time due to traffic conditions,
shortage of capital due to high inventory, increased cost due to holding cost,
storage capacity, etc. These risk are often seems to be, but are not limited to,

External Risk involves different elements such as weather conditions, natural

disasters, different cultures and way of operations of different companies,
different road conditions and customs policies in different localities, etc. These
externals factors are uncontrollable and can make significant impact.

Internal Risks are mostly manageable as they can be predicted and the
intensity/effect can be pre-measured as well. These are the risks such as
delayed deliveries by suppliers, internal process break down, standard deviation
in lead time, contamination/ quality issues due to handling of the materials, and
strike by workers, etc.

Figure 1: Risk Sources and their characteristics (Simchi-Levi, 2009)

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In the movements of goods from point A to point B, C or Z, the process is
completely exposed to the above mentioned categorizations of risk and these
can be originated both by internal and external factors.

Tools to identify (& nail) the risk:

It is easier to recognize or acknowledge the disruption but most often we only

recognize and acknowledge the effect and do not nail down the actual cause of
disruption at first occurrence. This makes the element of risk a bit shady and
many a times only after repetitive occurrences, companies start to dig out the
actual root cause.

It is noteworthy that there can be two approaches to identify the risk – reactive
and proactive. Reactive approaches are such as Fish Bone Diagram, Whys
approach, and others that look at the problem and try to identify the causes of
those problems. The proactive approach is like ‘what if’ approach, where one
try to forecast the possible negative scenarios and try to make system as risk
averse as possible.

Here are few tools described briefly to help identify and nail down the risks.
The list provided is not exhaustive but is just to lead the reader to think in the
direction to nail the actual cause and deal with that. Detailed description of
these can be found in many books and online available sources such as
www.mindtools.com

Fish Bone Diagram: Here the analysts start with undesired effect being
faced and try to nail down the main causes and sub-causes. This is also
known as ‘causes and effects diagram’. (Thomas Goldsby, 2005). This
helps the analyst to understand the actual factors/variables contributing to
the negative effect faced and a strategy can be developed to handle the
problem by manipulating specific variables. An example of fish bone
diagram is below.

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 Figure 2: Fish Bone Diagram – a tool to nail down causes of disruption.

Whys?: Also known as 5 whys. Here,

Why?
basically, one keep asking the question
why something occurred, until you get to Why?

the core cause of the unwanted effect Why?

being experienced.

Figure 3: WHY Diagram

“What if” Analysis (Mind Tools Ltd., 2016). This is more of a proactive
approach. In this, one basically assumes certain possible scenarios that
can or might occur. Upon identification, a proactive approach for the
minimization of the probability for the occurrence of such negative
possibilities can be formulated.

Approaches to Manage Risk:

Once the elements of risk have been identified, the next step is to prioritize
them. One of the best tools to prioritize this risk is Pareto Analysis.

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 Pareto Analysis: “also known as the "80/20 Rule" – which is the idea
that 20 percent of causes generate 80 percent of results. With this tool,
we're trying to find the 20 percent of work that will generate 80 percent
of the results that doing all of the work would deliver.” (Mind Tools Ltd.,
2016)

Once the prioritization is done, the usual method to manage or handle any risk
and to develop counter and/or proactive strategy is Top-Down approach. In
this approach the top management examine and analyse the situation, and
develops the strategy to manage/ handle the risk and challenge being faced.

However the top-down approach has its limitations as there is big gap between
top management and people at bottom actually faced with risk. This gap
outcasts a lot of details and potential solutions which the people directly faced
with risky situation observe and have better ideas for handling it. Therefore an
alternative approach to supply chain risk strategy is Bottom-up approach
(Waters, 2007) where people lower down the organization identify risks in their
normal work and provide their input as to how it can be dealt with, in effective
and efficient manner. So the role of upper management is to analyse the
proposed solutions/ methods and chose the best by either picking one or
combining few together for optimized results.

Out of many ways that companies can attempt to manage the risk, one of the
most popular one for Risk Management in Inventory & Supply Chain is called
Risk Pooling, for which a computerized version of game has been developed by
MIT (Massachusetts Institute of Technology) to simulate the effect of Risk
pooling.
It is important to remind that the focal point of any business is ‘Customer’. It is
crucially important for any business to provide the customer right thing, at right
time, at right price, and in right quantity.

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And if a business fails to do so, it can result in loss of customers. The demand
from customer is variable and is something out of the control of the company.
This variability leads the business to maintain higher safety stock to avoid
shortage and that leads to higher cost of holding. To manage this risk, the
concept of risk pooling was introduced.

Risk Pooling:

“Risk Pooling suggests that demand variability is reduced if one aggregates

demand across locations. …. It becomes more likely that high demand from one
customer will be offset by low demand from another …allowing a decrease in
safety stock and therefore reduced average inventory” (Simchi-Levi, 2009).

In order attract and retain customers, a business needs to provide higher service
level of demand fulfilment. In-order to do so, businesses hold inventory and
consequently, a lot of their capital gets tied up in three types of inventories: raw
material, work in process, and finished goods. The capital stuck in inventory
can lead to shortage of capital, opportunity cost, higher cost of product due to
holding cost, and any change in market conditions/ demand might result in
those inventories losing their values completely or partially. Such a scenario
did occur in the Kyrgyz Republic in late 2012 (The Times of Central Asia,
2012), where Kazakhstan temporarily banned the import of milk and dairy
products from Kyrgyzstan and that resulted in overabundance of finished goods
– resulting in milk sold at half price for 6 months by Wimm-Bill-Dan alone.

Reduction in inventory is ultimate goal to optimize the company’s efficiency

with effectiveness which is to either maintain the same service level or achieve
even higher. The capital engaged in inventory is sitting idle and/ or losing its
value every second if not utilized properly.

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Demand forecasting for individual market/ product is always questioned for
accuracy. However aggregation of demand forecast is more accurate than the
other way around. Therefore the risk pooling method can be utilized to do so.

To understand Risk pooling, one needs to understand the following two

principles in relations to demand (Simchi-Levi, 2009):

 Standard Deviation (SD) – a measure of how much demand tends to vary

around average.
 Coefficient of Variation (CV) – the ratio of standard deviation to average
demand
Coefficient of variation = SD / Average Demand

While both the SD and CV provide the measure of variability, the difference
between two is that SD measures absolute variability of demand and CV
measuring variability relative to average demand.

It is best to describe that with an example:

Market A Market B Market C

Demand Week 1 150 200 500
Demand Week 2 180 185 450
Demand Week 3 145 145 575
Demand Week 4 160 210 480
Demand Week 5 175 190 510
Mean (Average) 162 186 503
Standard deviation 15.25 24.85 46.31
CV 9.41 13.36 9.21
Table 1: Sample Demand Structure and Coefficient of Variation

Comparing 3 markets (shown in Table 1) and their demand structure for 5

weeks, gives results of dramatic difference in standard deviation among all 3
markets with Market A at 15.25 and Market B and C at 24.85 and 46.31
respectively. This shows the higher spread of data and may lead to the thinking
of higher inventory level. However if we look at the coefficient of variation, the
variation for Market C is actually slightly lower than Market A.

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Method of Risk Pooling

Risk pooling, is also referred as centralized and the opposite as decentralised

system. The figures 4 and 5 below present both the decentralized and
centralized system of supply chain.

It is often assumed that the having decentralized system will increase the
efficiency of demand fulfilment and reduce the possibility of stock out.
Moreover locating the warehouse closer to market would result in shorter lead
time.
Warehouse Market A

Supplier Warehouse Market B

Warehouse Market C
Figure 4: De-centralized system of Supply Chain

While this is true, that having more warehouses and being closer to market
definitely brings shorter lead time and better demand fulfilment but at the same
time it also means that the more safety stock is being kept and any dramatic
demand variability will result in either stock out or over stock of products –
with former resulting in increasing the demand from supplier and will most
likely cause bullwhip effect or the latter resulting in higher cost of holding.
Bullwhip effect occurs when a slight seasonal increase in demand at the
consumers’ end, increases the demand variability throughout the whole supply
chain (Mitch Kirby, 2015), shown in figure 5 below.

Figure 5: Bullwhip Effect diagram

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Instead the Risk Pooling method of having a centralized or few centralized
stores to serve different nearby markets is more efficient – as the demand
variability from one store/market can be balanced by the demand variability in
the other. The same is applied to the demand variability of products. The
demand for Product A being high and resulting in profit can offset the poor
performance of product B in a certain market. This will lead to reduced safety

Market A
Market B
Supplier Warehouse
Market C
Market D
Figure 6: Centralised System of Supply Chain

stock while managing the same and/or higher service level. Refer to our
example above with Markets A, B, and C. If to manage warehouses for three of
them separately, then the cost for holding safety stock at each warehouse, as
well as the capital stuck in inventory will be quiet high. Whereas with risk
pooling, aggregation of demand will reduce the need for safety stock and thus
the cost. And any demand variability in one market would be offset by the
variability of the other – unless if all the markets present demand variability in
positive at the same time.

Impact/ Limitations of Risk Pooling:

Aggregated demand of different markets/stores, and products can result in

having less safety stock, reduced overhead cost, lower transportation and
handling cost, and with same or often time higher service level (Simchi-Levi,
2009).

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 Positive Impact
•Increased Service Level
•Decreased overhaul cost
•Increased Service Level
•Decreased Safety Stock - less holdign cost

Negative Imapct
•Longer Lead time (but manageable)
•Possibilty of inceased transportation cost

Figure 7: Positive and Negative impacts of Risk Pooling

While Risk pooling brings many advantages and does help to optimize service
level with reduced cost, it also has its own limitations like any other tool/
method. Few likely negative impacts could be as follows;

 The likely possibility of increased cost due to increased distance between

different markets would result in higher transportation cost.
 The increased distance may/ can also cause longer lead time.
 Any force majeure can lead to shortage of alternative options.

Conclusion:

Given the pros and cons, scholars do agree that the weight of gains is more than
the negative possibilities, therefore the impact of Risk Pooling overall results in
positive. However the implementation of such strategy needs in-depth analysis
before any decision to be made in its favour or against.

The purpose of this whole process is to create win-win situation for both the
client and the companies in the world of perfect volatility in demand, and
competition. With smart decisions and optimized resource allocations a
company can gain competitive advantage over its competitors and boost the
company’s progress.

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 Bibliography

Mind Tools Ltd. (2016, Mar 22). MindTools. Retrieved from

https://www.mindtools.com/pages/article/newTED_01.htm

Mitch Kirby. (2015, June 8). A Brief Overview Of Operations Management. Retrieved from Musing on
Science, Health Care, and Business: http://mitchkirby.com/2015/06/08/overview-of-
operations-management/

Simchi-Levi, K. (2009). Designing and Managing the Supply Chain. New York: McGraw-Hill Education.

The Times of Central Asia. (2012, October). The Times of Central Asia. Retrieved from
http://www.timesca.com/news/12017-kazakhstan-restricts-dairy-imports-from-kyrgyzstan

Thomas Goldsby, R. M. (2005). Lean Six Sigma Logistics. USA: J. Ross Publishing.

Waters, D. (2007). Supply Chain Risk Management. London: Kogan Page Ltd.

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