New Article Preview: “A Quantitative Approach for Valuing and Managing Procurement Cost of Risk”

I have a new article on calculating the Cost of Risk in procurement that will be out soon.


If anyone is interested in reading this piece ahead of publication contact me, and I will be glad to send you an advance copy.

Here is a preview:

Executive Summary

One of the most debated topics today in procurement is the issue of risk, which takes many forms ranging from concerns about supplier financial viability to commodity volatility to conflict minerals content in purchased components. The vast majority of the articles and guidance given to Chief Procurement Officers (CPOs) on this topic focus on trying to “avoid future risk costs” that would be generated by, say, shutting down production because a critical supplier went out of business or being fined for using a banned substance.

Disruptions and regulatory risks are all legitimate concerns, and every CPO should have some method in place to identify, understand, and hopefully mitigate costs that would arise from unplanned events. However, to focus solely on these types of issues and costs, is to miss the much greater risk costs that are present in every supply chain every day and that most Procurement organizations do not formally track or manage. This article will provide an introduction into the concepts of supply chain and procurement Cost of Risk (CoR), illustrate them with real-world examples, and provide a framework that CPOs can use to go beyond planning for contingency costs to a fully working CoR-based procurement risk management methodology and organization.

Conclusions for CPOs

There is hardly a CPO today, in companies of all sizes, who does not think procurement risk is a major concern. They are correct, in many cases for more reasons than may at first appear. It is important to minimize or even avoid supply disruptions and regulatory violations, but this is not the whole story. CPOs need to push for the creation of dedicated procurement risk teams whose primary mission is to calculate, monitor and efficiently manage the CoR across all Direct and Indirect spend. The benefits of this approach are many. Separating RC from PC, for example, may indicate that the buyer is in the best position to hold RC, which immediately results in a reduction of TC. Indeed, when one considers that many companies have a total RC across all Direct and Indirect spend in the billions of dollars, it raises the intriguing possibility that a very sophisticated procurement organization would try to zero-out RC in its contracts, “repatriate” that CoR, and manage it as a kind of internal captive procurement hedge fund. Such an idea is not only possible today but would have the benefits of making all CoR visible to organization and would allow for more efficient procurement risk-transfer pricing. This last point is critical since if, as is the case at most large companies today, CoR payments are allocated across tens of thousands of supplier and contracts, it stands to reason that the procurement organization is over-paying for risk. A pooled CoR investment pool, managed and hedged optimally with the help of third parties, is a novel idea but one that might become real in the not too distant future. In the meantime, as the RC percentage of spend has dramatically increased over the last decade because of globalization, political risk, financial market instability, etc., the time has come for CPOs and their teams to: (a) move beyond passive procurement risk management, (b) adopt the quantitative CoR approach presented above, and (c) become as good at valuing and negotiating risk as they typically are with the other important aspects of the most complex operational function today.



Carlos Alvarenga

Founder and CEO at KatalystNet and Adjunct Professor in the Logistics, Business and Public Policy Department at the University of Maryland’s Robert E. Smith School of Business.

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