Supply Chain Risk – A 5-step Method for Calculating the Costs

What are the top three risk factors in the area of the world you do business with? According to the IHS Global Risk Service, 2014-Q3 Forecast the three biggest risk factors are (1):

1) Enforceability of Private Contracts

2) Losses due to corruption

3) Losses due to Crime

In other parts of the world, you may also want to add transportation disruption due to weather events.

John Mothersole, of Supply & Demand Executive magazine (2), outlined the following method to analyze internationally sourced materials or commodities (i.e. sheet and tube steel, or chemical feedstock

Here are five basic steps for a method of risk analysis:

1) Quantify

A risk profile for a particular material or service would need to be quantified by whether its a simple transaction of money for goods, or if there were other aspects such as service contract, replacement parts, or differing levels of quality. Simple materials such as tube and sheet steel can be profiled more quickly than say the purchase of electronic components.

2) Assign

Mothersole started his own analysis of sheet steel by using a global risk report from the consulting / analytic firm IHS. This broad-based report looks at a country in terms of its government stability, regulatory climate, wage pressure, labor pool, and infrastructure. These aspects impact the scale of the risks listed above. For each major risk assign a number to the country on a scale of 1 to 50, or 1 to 100, with the higher number meaning the risk is more of an issue / more prevalent in that country.

3) Weight for Probability of Occurrence

After the key risks are identified, weight each risk for its probability of occurrence (i.e. contract issues are more likely to be frequent occurrences than losses to corruption or crime.)

4) Create Risk Score

The next step is to multiply the Weighting factor by the Country’s Risk profile (See chart.) This results in a Risk Score for each country.

Chart 1 Risk Ranking

5) Create Complete Cost Picture

The final step is to combine pricing information with risk information for a complete cost picture. Acquire pricing for the materials or services you are analyzing, and re-rank your suppliers based on this result. In Mothersoles’ example China had been the most cost-competitive at the out-set, but its higher risk profile offset that and pushed it to the bottom of the list along with Brazil and Mexico. The U.S. and Japan rose from mid-level price competitiveness to top of the list due to low risk of contract-enforceability issues and low-levels of corruption.

Chart 2 Risk Cost Summary Context

This is what I call the “Hassle Factor”, that intangible amount of stress created when something unexpected goes wrong. For example if someone steals a large quantity of material that you had previously thought was on its way to you, that’s going to ripple through your production process that effect everybody from top management down to the floor workers. What is the cost to the organization? How many hours of work will it take to recover from that theft?

Perhaps your company has already experienced such an event. For example a supplier sends only 40 tons of stainless steel despite receiving payment for 100 tons @ $3,000 / ton. The supplier fails to return attempted correspondence and communication. Local authorities and government agencies will not intervene. The purchasing company can only manufacture 40% of the products it had planned in its schedule as a result. They miss sales targets, anger their customers, and lose an account.

Is the cost of this incident simply the $180,000 (60 tons * $3,000)? I think not.

Could you historical records as a metric or “add-to” factor in your risk-pricing structure?

(1) IHS Global

(2) John Mothersole, Supply & Demand-Chain Executive, Nov 2014, p12.

How have you quantified supply chain risk?

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