Ignoring the True Cost of Risk: The Lessons of Rana Plaza

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The FT has an interesting graphic out that shows the evolution of the garment export trade:

http://www.ft.com/intl/cms/s/0/5448bc70-c460-11e2-9ac0-00144feab7de.html#axzz2UJXFZ5ym

The graph shows that it was only in 2010 that Bangladesh entered the Top 10 exporters list, and that as of 2011 it ranked number 4, with $23+B worth of exports. This is interesting, but what is more interesting is the Deutsche Bank graphic, also from the same article:

Fashion-Costs

This graphic is interesting not for what it shows but what it fails to show, for absent from this distribution of costs (duty, freight, labor, etc) is the cost of risk of this supply chain, a cost that would vary significantly with the location of production.

I have written before about this topic (https://reconnomics.com/?s=cost+of+risk&submit=), and how it is one of the most mis-understood topics in supply chain risk management, but the Bangladesh disaster is a timely moment to discuss the idea again.

Too many SC risk people think of risk costs as only those items associated with a major disaster. They fail to grasp that, following the logic of finance, risk is a cost that is present wherever there is uncertainty. To illustrate this point with students, I offer them an envelope in which I guarantee there is a E100 note and then ask them what they would be willing pay for the envelope (E100, of course). Then I tell them that the envelope either contains a E100 note or it contains nothing. I then repeat my question. The answer (E50) neatly illustrated how introducing volatility to the envelope cut it’s present value by half.

Now, returning to the garment trade, let’s assume you are a fashion brand deciding between locating production in Western Europe or Bangladesh. If you only look at the Deutsche Bank you either assume there is no such thing as risk cost (hard to imagine today) or that it is zero or that it is “impossible to define” (which some intelligent people would argue). Thus, working only on traditional SCM costs, and treating risk cost as zero, you locate your production in Bangladesh. You don’t sleep well at night, though, since you know that the cost of risk is NOT zero. One morning you wake up to read about the Rana plaza disaster, and suddenly the cost of risk that you hoped you would never have to calculate becomes all too real.

This is exactly what has happened to firms like Wal-Mart, Benetton, H&M, etc., and the reason they can’t agree on what to do has as much to do with their perceptions of the cost of risk as any other factor.

I was recently in Sri Lanka, co-leading a series of supply chain risk and strategy workshops sponsored by the NEXT business school in Colombo. While there, I met several leaders of the Sri Lanka fashion exporting business. These executives, many of them trained at Harvard and Wharton, understood this concept immediately. We discussed how a nation like Sri Lanka, where the cost of risk of garment production is much lower than at places like Bangladesh (due to much higher emphasis on proper working conditions), needed to make the fashion brands and consumers aware of this fact. This same strategy applies in other industries where the true cost of risk is very high but where, for whatever reason, people either assume it is zero or impossible to measure (food is the best example…).

Until  executives and SC risk strategists begin to treat SC risk as a present cost, measure it, and treat it with the same importance as they do other factors such as labor and transport, we will, unfortunately, have more Rana Plazas. This omission is not an academic point. It can be, as we have just seen, a matter of life and death.

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