Beyond the Physical World in Procurement Risk Management

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It is unusual to scan across a magazine or web site dedicated to supply chain and not find at least one article focused on risk management. However, the great majority of these articles deals with only one of the two aspects of supply chain risk, namely physical risk -the risk of something going wrong with physical (i.e., “real”) elements of the supply chain, e.g., supply disruption, piracy of goods, destruction due to natural disasters, etc.   While this is a vital and important topic, most of these pieces  fail to discuss  non-physical risk — e.g., demand risk, financial risk, trade risk, opportunity cost risk — which in many cases are more important issues to understand in supply management decisions.

THE PROBLEM – Three Scenarios

A common procurement scenario: A category manager at a manufacturing company must renegotiate a transportation contract in an emerging market. No doubt the buyer will look at cost and rate escalations as well as performance metrics and contractual terms. In these discussions the buyer will be on solid ground as she has benchmarks from the past or outside studies to guide her analysis, and she understands the supplier landscape. But then  comes  a discussion about termination terms wherein the carrier demands that if the global price of oil increases beyond X percentage, it has the right to a significant increase in rates or even to cancel the entire rate schedule unilaterally. Our buyer will of course negotiate to limit both potential increases and cancelation parameters. If she is a buyer at one of a small set of industrial companies, she may even have at her disposal a risk management team which focuses on hedging commodities and similar items, so she has them develop a fuel hedging strategy that would attempt to put into place a risk management mechanism to hedge the risks she is acquiring in the new contract. However, if her firm is not a major transportation buyer (such as an airline for example), she will find that the risk team lacks the expertise to solve her buying problem. Even though she is better off than most transportation buyers — since most manufacturing firms do not have such a team in house — without advanced help she may conclude incorrectly that there are no strategic options available.

A more complex example:  A buyer at a high tech company is negotiating to buy contract engineering hours in support of a new cell phone model.  He knows from past experience that when a model launch is successful, the limit to capturing immediate demand is not physical supply but engineering time configuring the device’s software to work with carrier networks. Thinking ahead, he sits down to negotiate hours but is confronted with a dilemma:  the option to buy is binary — he can either buy hours or not and there is a high minimum from the vendor. Does he accept the offer, commit to the hours, and then hope for the best? Or is there another strategy at his disposal?

An “exotic” scenario:  A buyer for an energy company must acquire a raw material that is a by-product of rice. He would love to lock down a price for this critical production input but can’t since the price and availability of the by-product needed is driven by the demand for rice itself. The price and availability of his most critical production input then are functions of a demand-supply curve that is wholly independent of his business.  How does he protect his company’s production ability and cost structure?

Assume all these buyers turn to typical supply chain risk specialists who, for the most part, are focusing on physical risk and have very little to offer our three buyers  who need something different.   They need strategies, techniques and specialized risk products that focus on the non-physical risks described above. Fortunately for our buyers, such techniques and products are quietly emerging and are at the forefront of a coming revolution in how the best procurement organizations manage non-physical risks.

THE SOLUTIONS

The first step our buyers must take is to understand the types of non-physical risks and existing techniques to mitigate potential losses. This non-physical supply chain risk can be segmented into the following several classes, the most common of which are the following:

  • Demand risk —  some element of expected demand will not act within expected parameters, e.g., demand for a new product far outruns planned supply
  • Supply risk —  some element of a supply market will not act within expected parameters, e.g., a vital production input is no longer available
  • Financial risk — a financial variable will not act within expected parameters, e.g., interest rates for supply financing suddenly  rise dramatically
  • Trade risk — one part of an agreement will not fulfill its end obligations, e.g., a supplier goes bankrupt and does not deliver critical product

Each of these non-physical risk classes has different characteristics and different solutions, though clearly they are often inter-related and inter-dependent. Turning to the solution set our buyers have at their disposal today, we can segment those as well (in order of increasing complexity):

  • Insurance (and insurance-like) products include contracts wherein risk is transferred to a external agent, with the expectation that loss is an improbable outcome, e.g., trade credit insurance
  • Finite risk products include contracts wherein risk is transferred to an external agent, with the expectation that loss is an possible outcome, e.g., performance bonds
  • Counterparty agreements are dual or multi-party risk transfer agreements, e.g., interest rate swap agreements or “real” options (i.e., the option to acquire or not acquire something tangible, such as engineering hours)
  • Hedging instruments are standard or custom built unilateral risk mitigation/transfer instruments, e.g., foreign exchange put (“right to sell”) and call (“right to buy”) contracts

Returning to our three buyers, we can classify the first example as a case that combines supply risk with financial risk (transport being a critical component of the manufacturing process + oil prices which are an independent financial variable). Our buyer could combine both a “real option” on transportation from the same or another transport provider at a known price (i.e., counter-party agreement) with oil price futures contracts (i.e., hedging instrument) to remove much, most or all of the risk of  oil prices increases disrupting transportation of supply to her factories.

In the second example, the buyer could develop a real option agreement with one or more engineering services providers to have the right to buy engineering time at a set price, which would cost a fraction of actually committing to the minimum buy initially demanded.

In the last example, the most difficult of the three, the buyer develops a strategy using commodity derivatives to mimic the price movement of rice, hedges against price increases, and then uses payouts from the hedging to fund price increases in times of short supply.

All of the solutions described above are real and in use by sophisticated procurement specialists today. Indeed, the rate of innovation in this field is dramatic and within a few years knowledge and use of these sophisticated techniques and products will expand beyond a handful of leading edge procurement teams and into a broader set of industries and organizations. They will change and evolve how supply chain risk is understood and my advice is to start understanding and experimenting with these ideas today. Some can be put into place with a few months of work. Some will require a year or more of complex analysis and modeling to fully implement. All require a mind-shift change which will help move procurement closer to the finance function and introduces a new set of skills and expertise the best procurement organizations will soon consider vital to being at the forefront of this dynamic and complex discipline.

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