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Supplier Risk Management

By Ashok Santhanam

In this macroeconomic climate, when the demand for products and services has been falling at an alarming rate, companies are focused on reducing inventory within the supply chain to lower costs and reduce the risk of write-offs. In addition, they are reducing the number of suppliers they do business with, so they can consolidate purchases with remaining suppliers to gain additional volume discounts and further reduce costs. However, as a result of these efforts, one of the biggest risks to a company's supply chain comes from its unhealthy suppliers.

In the current environment, when suppliers are booking lower revenues and credit to finance their working capital is harder to secure, the number of supplier bankruptcies are on the rise. For example, according to Motor & Equipment Manufacturers Association (MEMA), a third of auto suppliers are in financial distress, and another third say they will be by the end of this quarter. Operating in such an environment, when there is a significant risk from the supply base, the business operations of any company can be disrupted unexpectedly by the failure of one supplier and can cause it significant harm. As a result, procurement organizations, which have historically focused on securing products and services of the best quality at the lowest possible cost for their operations, are also being tasked with evaluating, monitoring and managing the risk from the supply base.

To ensure that they are able to consistently evaluate and manage supplier risk, procurement executives need very clear visibility into their spend with each of their suppliers at various levels of detail: how much are they spending with each supplier, what commodities or components are they buying from which supplier, what is the split of a commodity or component purchase across its suppliers, what regions is each supplier shipping from, what is the trend line of various operational, financial and legal risk metrics for each supplier, who are their suppliers, how are the various suppliers linked at different tiers, which components are critical to their supply chain in order to prioritize which suppliers one needs to focus on, etc. Spend analysis provides procurement executives clear visibility into answers to such questions.

Spend analysis is the process of determining what is being spent, with whom, and for what. Such an insight is typically used to identify opportunities for cost reduction such as rationalizing supply base, increasing contract compliance and reducing maverick spending. However, spend visibility is also critical in determining the risk to supply chain from the supply base. It provides critical information to categorize suppliers by spend, commodity, industry and geography and enables procurement executives to use that information to create a short list of key suppliers. It allows the procurement organization to enrich the supplier information with data from external sources and internal supplier performance metrics, so a clear risk assessment of the short list of suppliers can be done and programs be put in place. Hence, investment in spend analysis is the starting point to a comprehensive supply risk management initiative.

Obstacles to Good Spend Analysis
While the benefits from spend analysis are clearly huge, organizations need to address one key issue: ensuring that systems are in place to provide accurate spend visibility. Even after implementing ERP systems, most organizations do not have accurate and complete spend data because:

  • Spend data sits within multiple systems within the company, such as ERP, procurement systems, data from p-card vendors, and travel and entertainment expense data from credit card companies. In addition, large companies have multiple ERP systems within their companies due to acquisitions and mergers done over time. Finally, large companies may run multiple instances of their ERP system. Hence, spend data is situated in multiple systems, that needs to be aggregated to get visibility into overall spend
  • Different codes are used to describe the same supplier or commodity across various systems. For example, HP may be 'coded' as HP in one system at one division and as Hewlett Packard in another. As a result, spend aggregation information from multiple systems may not be accurate, leading to inefficient leverage over suppliers.
  • Same component may be represented by different codes (item code) in different systems, making it hard to get an aggregate view into how much is spent on that item.
  • Item codes used by systems do not relate an item to an industry standard classification. Consequently, it becomes difficult to aggregate similar and equivalent data. For example, two different suppliers may be providing equivalent pumps at different prices, but they are likely to be represented by different item codes. Without being able to correlate this information because codes for them have different values and item descriptions may not be sufficiently revealing, it is difficult to identify opportunities to save money by combining spend across commodities, locations, suppliers and programs.
  • Relationships between suppliers are rarely identified within various systems. For example, your system may not tell you that Lab Safety, Inc. is a subsidiary of WW Grainger. If it did, you would realize that you are spending a lot more money with WW Grainger than you thought, and you could use that information to gain negotiating leverage.
  • Other related information such as minority status of suppliers, shipment performance and quality data from last 12 months or even D&B credit rating usually does not exist within these systems. Such information is critical to taking advantage of tax breaks, to meet regulatory compliance requirements or to assess risk. Without such information, supplier rationalization initiatives can fall short of expectations.

Due to the data accuracy and completeness issues listed above, it is not possible to do an accurate and comprehensive analysis of spend by simply bringing data from various systems into a spreadsheet or a business intelligence system and performing the analysis. The data has to cleansed to remove errors, normalized to ensure suppliers are represented in a consistent manner and finally enriched with commodity classification data, subsidiary relationships, supplier performance data, etc. Only then the analysis can be done on the data to yield an accurate picture of the overall spend. As a result, spend analysis is typically a two-phase process: phase 1, where the data is prepared for spend analysis using specific technologies, and phase 2, where the spend-ready data is analyzed. Let us look at the two phases in more details.

Phase 1: Accurate and Complete Spend Data
A very technology and resource intensive process, this phase consists of two steps:

  1. Extracting information from source systems: Spend data often exists as individual transactions in various source databases such as ERP systems; eProcurement applications; travel and expense reports etc. This information must be extracted from the various sources and aggregated into a common location such as a separate database.
  2. Cleansing, normalization and enrichment: Extracting spend transaction data into a common location isn't enough. The data must then be normalized and enriched.
    • Cleansing to remove typos and spelling errors in supplier names, item descriptions, etc.
    • Normalization to ensure that similar supplier names, such as HP or Hewlett Packard or HP Systems, are recognized and converted to a common supplier name.
    • In addition, each product should be mapped to popular standards-based classification taxonomies such as United Nations Standard Products and Services Classification (UNSPSC) and eClass. This mapping allows users to aggregate spend information for the same commodity type, such as 5 HP motors from two different suppliers (identified as different item codes in the ERP system) or even roll-up that information for product family; i.e., spend on all motors under 10 HP).
    • Finally, enrichment of additional supplier-related information such as parent company name, revenues, financial risks, legal risks, operational risks, supply chain operational metrics and performance metrics, Standard Industry Code, diversity status etc. are added during this step. This type of data enrichment provides additional information needed for risk assessment and for supply base rationalization.

Phase 2: Spend Analysis and Supplier Risk Identification
Once data has been cleaned, normalized and enriched, it can be analyzed to not only identify low hanging opportunities for cost savings such as supply-base consolidation, or identifying sources of price variance or contract non-compliance and addressing them, but also to identify risk to a company from its supply base and putting a plan in action to manage this risk.

For example, one scenario can have the first step to be to classify suppliers by categories such as total spend, commodity, industry, and geography. Ability to classify suppliers along these dimensions allows a procurement executive to identify all those suppliers where they are either buying large volumes or those suppliers where they are sole-sourcing or those suppliers providing critical components and commodities. This analysis allows them to prepare a shortlist of suppliers that need to be evaluated and monitored for risk. The classification also provides immediate visibility into those suppliers who are associated with either an industry or a commodity group that increases their exposure from issues such as quality; commodity and labor shortages; price fluctuations; environmental and safety issues; and supply/demand imbalances. It also quickly clusters suppliers by their geographical risks such as political issues, infrastructure difficulties and currency fluctuations. By analyzing data along these dimensions, procurement executives are able to create a short list of suppliers that need to be closely monitored.

Due to a lack of spend analysis tools, many procurement organizations end up sorting their suppliers only based on spend and focus their attention on the top 20% of suppliers that make up 80% of the spend. But low spend suppliers can be a source of significant risk as well. A cheap part in an expensive engine can cause the engine to fail. Data theft enabled by poor security practices of a small IT provider can cause irreparable damage to a retailer's brand, and lead to lawsuits. Using spend analysis, procurement organizations can do a comprehensive analysis of their supply base to identify suppliers than pose risk.

There is no measurable return from a supplier risk management initiative until the risk materializes and you can quantify the avoided loss. Until then, it's only possible to estimate the impact using a metric that takes the probability of the risk and the expected magnitude of the loss. In addition, it is important to remember that even the most successful risk management programs only reduce the impact of a risk, they do not eliminate it.

Ongoing Risk Management Process Steps
Once the spend analysis is done and supplier risk is evaluated, the procurement organization can identify at-risk suppliers and incorporate that information into their supplier risk mitigation and sourcing strategies. This analysis needs to be repeated every six months to have the finger on the pulse of the supply chain. However, spend analysis, though a critical step, is one of the many steps that an organization must take to manage supplier risk. Here is a list of top 10 activities to reduce supplier risk, based on best practices in the industry today.

  1. Build risk assessment into the sourcing process. Seek a weighted balance between cost, risk, flexibility and performance based on the commodity or component type, as well as other suppliers already in your portfolio. This ensures that suppliers that fall outside your risk profile are eliminated during the supplier selection process in sourcing.
  2. Develop a close relationship with your suppliers so you can sense that something is amiss before it is announced. Also, read between the lines of what they are telling you. This is key to identifying potential issues before they occur.
  3. For categories that are deemed strategic, develop an alternative list of suppliers as a contingency. Continuously evaluate suppliers on this list, as if you were initiating a new sourcing relationship and prioritize them. As a result, you always have a 'Plan B", when something goes wrong.
  4. Create a detailed plan for switching to an alternate supplier (existing supplier or one on your list above) at a rapid pace than a regular changeover and ramp-up period. This ensures you can successfully switch over to a different supplier in a rush.
  5. For commodities and components where supplier risk is high, explore increasing inventory to give you more runway. Treat the cost of higher inventory as insurance premium.
  6. Aggressively monitor the performance of your suppliers by tracking metrics such as quality, on-time delivery, request for early payment, etc. These signals are often leading indicators that a supplier is in trouble.
  7. Invest in ongoing spend analysis to give you continuous visibility into all your suppliers. Accurate and complete information into all your spend is the best starting point for risk assessment and enables better decision-making.
  8. Perform on-site supplier visits with little notice. Speak with people at various levels, not just your account manager. Observe. You can pick up a lot of early signs.
  9. If you can not eliminate an at-risk supplier, renegotiate terms with them to give you better prices and discounts in exchange for faster payments. This will be a win-win for both parties.
  10. Consider multi-sourcing for most components and commodities. It not only reduces your risk and gives you more flexibility; it creates a healthy competition for your business, resulting in better quality and service.

These steps, in conjunction with initial supplier risk evaluation based on data from spend analysis initiatives will help you reduce the risk within your supply chain from weak suppliers in this economic environment.

About the Author
Ashok Santhanam is President and CEO of Bristlecone, a supply chain strategy consulting firm headquartered in Mountain View, California.

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