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Analyzing Risk

December 6, 2011

Last week, I commented on the weaknesses created by a focus on low-cost sourcing and the apparent absence of analysis related to the resulting supply chain risks and their cost to the business. Among the observations in my blog was: “It can be hard to get the right balance between cost and risk. But a start would be through an understanding of the ‘costs of vulnerability’ – that is, the actual cost to a business that occurs as a result of selecting low price supply. This would of course be a cumulative number over a specified period of time and would capture the costs associated with supply disruptions, crisis management etc. that were a direct result of deciding to take the risk of going with a low-cost supply option.”

In his Friday blog, Jason Busch raised similar concerns when he suggested that ‘spend analysis is broken‘.

The common strand to both of these is that contracts and commercial staff need to focus on business and market intelligence that will help steer the business towards improved decision making. This is a  point that Professor Rob Handfield has made on many occasions in the past and of course, by fulfilling this role, those in the commercial contracts group would place themselves into a far more strategic business position. To do this, we need to be far more thoughtful about the nature of the data needed for analysis and how to combine this with forecasts based on likely market trends and directions.  Through this combination, the quality of risk management would improve and result in increased bottom-line contribution.

  1. “But a start would be through an understanding of the ‘costs of vulnerability’ – that is, the actual cost to a business that occurs as a result of selecting low price supply.”

    I think this is the wrong perspective too. There is no additional cost to a business as a result of selecting a low cost supplier…unless something goes wrong. Choosing any supplier (high cost or low cost) entails certain risks and you have to chose a supplier. For example, the high priced one might have the same natural disaster risk as the low cost one. \

    Trying to put a cost on risks can also lead to flawed analysis. There’s always an urge to stick with current suppliers just out of familiarity. Trying to put a cost on risk enables a lot of fudge factors that too often lead to sticking with the current supplier.

    It’s better to look at pure total (landed or life cycle) cost estimates from various suppliers and then see how much has to go wrong before the lowest cost supplier is no longer lowest. That’s the definition of the wrong decision in supplier selection.

    The key part of that exercise is to cause people to plan for what they will do if any of the negative events do actually happen. What will we do if the low cost supplier’s currency strengthens? What if we need premium freight? Bottom line: How can we take steps that enable us to use this low cost supplier with confidence that we have plans to keep the cost of problems at a level where we did not make the wrong sourcing decision?

    And of course remember that the higher cost supplier is not risk free either.

  2. Dick – I agree completly that low cost will be the right choice for as long as we have no idea about the potential consequences. But the point I am making is that we should seekt o improve our understanding of what is likely to go wrong and the best way to reduce its probability / consequence. At present, most businesses ‘self-insure’ against the consequence sof their procurement actions; but they do not appear to analyze the cost of that self-insurance, to determien whether it was a good idea.

    By capturing actual performance data, rather than just claiming savings, there is a chance that decisions would, over time, become more sophisticated and that recurrent issues would be anticipated and avoided.

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