By K. Dunlop Scott

The entire issue of this magazine is devoted to understanding the business risks with a focus on the supply chain. This article addresses one of the most common sets of risks that enterprises face: Operational and financial risk.

Every enterprise – private sector, government or non-profit – depends on a number of suppliers who can be deemed “critical” to the enterprise mission – if these suppliers do not provide the components or services which the enterprise depends upon, then the enterprise cannot fulfill its mission to its own customers.

Because supply chains have become lean and dependent upon just in time or continuous delivery, major enterprises need to understand where their risks lie, and then they must understand any changes in the risk profile which could potentially interrupt the expected flow of components and services from their critical suppliers.

Operational and financial risk are just as real as other major risks such as earthquakes and transportation disruptions – and unlike those types of risk, we believe operational and financial risks are largely predictable. Further, operational and financial risks generally develop over a period of time, so that the enterprise customer, if it pays attention, can see these problems as they develop. Tracking developments in the critical supplier base allows for some forward planning, to reduce or eliminate the threat to continuous supply of the critical components or services.

Virtually every major enterprise is aware of serious operational and financial problems in several of its critical suppliers. In many cases, senior supply chain executives in these enterprises recognize that there are likely many other critical suppliers suffering similar challenges – but because there is no structured program for tracking and measuring risk in the critical supplier base, the enterprise customer is not yet cognizant of the problems.

Operational and financial risk boil down to this: Do the enterprise’s critical suppliers have the management and financial resources available to meet the changing demands of the enterprise for products and services? In other words, can the suppliers actually do what the enterprise expects them to do?

In many cases, the enterprise customer may not be aware of the capabilities of the critical supplier – the supplier simply can’t meet demand, because it is operationally or financially strapped. This leads to some of the most common issues in the enterprise supply chain.

In simplest terms, operational and financial problems at the supplier level manifest themselves in several ways:

• Lack of cash flow to fund current operations
• Inability to adapt to change because of inexperienced or inflexible management
• Inability to grow because of capital constraints
• Turnover in key personnel may have a profound impact on the supplier’s ability to meet even current enterprise demand
• Lack of scale may mean that profitability of the supplier is too low, resulting in low reinvestment and a downward spiral over time

Each of these manifestations of trouble can grow – if left unchecked – into eventual bankruptcy or the demise of the supplier. But many of these issues are rarely crises of the moment – rather, they build over time – and an enterprise can carefully watch its critical supplier base and gain considerable time to plan for mitigating the risk.

In assessing the supplier base, one of the most important questions an enterprise must ask itself is “Is there something we are doing which is making it difficult for our suppliers to thrive?” After all, the health of the supplier base becomes essential, as the enterprise becomes more dependent upon fewer, but more important critical suppliers.

Large enterprises often act in ways which seem logical to a large entity, but which run counter to the health of the supply chain. Several examples spring to mind:

• A large government customer places huge orders for components, but only sporadically. Critical suppliers are faced with scrambling to meet these orders, and then protracted periods of no orders at all. Not a recipe for supplier health, clearly. In fact, several large government customers have seen their supplier bases wither – there are no producers of certain components at any price.
• A major OEM is rolling out a new technology developed by a small entrepreneurial company. The OEM is expecting that volumes go from hundreds of units to hundreds of thousands. Both OEM and supplier now have a challenge – how is the supplier going to get the management and capital resources required to meet demand? Is there a credible path to success for both OEM and supplier?
• A non-profit customer asks one if its key services suppliers to take on a new outsourcing opportunity, requiring the supplier to dramatically increase staffing. Both enterprise and supplier need to assess the impact on working capital – if it represents a strain on the supplier’s resources, then the enterprise must be aware of this, and find some way to assist. Using the enterprise’s normal payment terms may not be adequate for the supplier, leading to potential failure of the new effort.

Each of these problems can be foreseen and even solved. But each requires that the enterprise be keenly aware of its supplier base.

Developing a Critical Supplier Risk Map

We advocate that an enterprise undertake a four step process to determine where its supply chain risk lies and what the nature of that risk is:

1. AUDIT: Analyze current risk management practices and status within a particular program or supply chain; benchmark existing process versus best practices; perform a gap analysis versus best practice; develop a plan to implement a complete risk assessment process
2. ASSESS: Determine what factors and supply chain elements are considered critical for the enterprise mission, and identify all the suppliers in the supply chain; develop metrics for monitoring risk, using best practices and program specific metrics, if appropriate; then categorize suppliers into criticality and risk quadrants, identify high risk critical suppliers and evaluate overall risk
3. MEASURE: Perform detailed risk analysis on high risk critical suppliers; ascertain the sources and nature of risk; develop closed loop feedback mechanism for monitoring risk; develop strategies for mitigating each risk, including replacement of suppliers
4. MITIGATE: Where appropriate, seek to remediate supplier risks

What can an enterprise do to reduce risk on a forward-looking basis? Once developing problems are identified, senior enterprise executives have several paths for dealing with operationally and financially troubled suppliers:

• Figure out how to stop doing business with that supplier. This may require time, but with enough planning, it may be possible.
• If not, perhaps the supplier can be encouraged to combine with another stronger supplier, providing comfort to the enterprise customer.
• In some cases, an operational fix may be appropriate. Several of the largest enterprises have operational skills which they provide to suppliers to assist them in improving their capabilities. Or the supplier can be encouraged to get operational assistance from a third party.
• The enterprise can also determine if the issues could be solved if more capital were available. In some cases, particularly where enterprise demand for the product or service is growing, more capital may be the solution to assist the supplier fund working capital and investment needs. Most enterprises don’t think using their own capital to fund suppliers is a good use of funds – so a third party should be encouraged to provide that capital.

Once an enterprise understands where the operational and financial risks lie in its critical supplier base, then actions can be taken to reduce those risks. The cost of developing a process for measuring and monitoring operational and financial risk is minimal – the cost of an interruption caused by not knowing about a developing weakness can be devastating.

Dun Scott is President and Chief Operating Officer of Columbia Partners, LLC, Investment Management. Columbia Partners manages over $2.1 billion in capital from institutional and individual clients and is interested in assisting enterprises determine where their supply chain risk lies and in providing capital to help solve enterprise supply chain challenges where appropriate.

[1] Disclaimer- we are not recommending ANYTHING, just educating our readers. Thanks to the GR for their continued contributions.

©2004 ChainLink Research, Inc.