One of the most debated topics today in procurement is the issue of risk. The 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.

These articles present the reader with many examples of how risk manifests itself, but few, if any, definitions of what exactly risk is, but defining a problem is a good first step to solving it. At its most basic form risk is the possibility of more than one outcome (of unequal value) to a given scenario. Risk exists whenever multiple outcomes are possible. This seems straightforward enough, but the follow-on conclusion is a little bit harder to grasp: Wherever risk is present, there exists also a cost, in the present, created by that risk. Thus, rather than think of risk as a potential cost that materializes only when a disruption of some kind arrives, supply chain and procurement managers should also think of risk as a cost born in the present – with or without disruptions. Furthermore, these costs can take two forms: financial and economic. The former refers to costs that are present and recorded and the latter refers to costs that are not recorded but exist nonetheless. Figure 1 below provides examples of both of these classes of risk costs.

Financial Risk Cost Examples Economic Risk Cost Examples
•       Safety stock

•       Secondary and tertiary supplier costs

•       Business Continuity insurance cost

•       Maritime and property insurance costs

•       Forecast error costs that result in write-downs

•       Excess and obsolescence material costs

•       Cost of risk management programs/activities

•       Political disruptions

•       Supplier errors/crimes

•       Weather volatility

•       Resources scarcity

•       Social media

•       Regulatory uncertainty

•       Competitor moves

•       Technology cycles

•       Commodity cycles

Figure 1: Supply Chain Cost of Risk Elements

If one accepts the idea that risk (i.e., uncertainty) about the future creates cost in the present, the logical conclusion in the context of Procurement is that wherever there is uncertainty in a sourced value chain there will also be a risk-driven cost in the sourced item that value chain produces. This risk-driven cost percentage is the Cost of Risk (“CoR”). In other words, if a Buyer is sourcing from a non-zero-risk value chain, then the contract price is based on two distinct cost components: the physical cost of the item plus the cost of risk of the value chain. The following two examples illustrate this point.

Procurement CoR, Example 1: Demand Risk in Consumer Products

There is a high degree of uncertainty in cosmetics products forecasts that filter down from brands to suppliers. However, when a new product is launched, packaging suppliers are asked to bid on what is typically a generally optimistic demand scenario, which creates a serious risk dilemma for them. If they price on a low-volume/higher-probability scenario, they will probably be undercut by the competition. If they price on a high-demand/low-probability scenario, they may be stuck with a lot of excess material. This demand uncertainty/risk forces suppliers to “hedge” their bets by charging a hybrid price to the brands that contains two costs: the material cost + risk cost. Just how high is the CoR component? In this one category, packaging, it can be as high as 20-30%, which means that if a box costs a brand $4, then only $3 is the actual box cost. The other $1 is the cost the supplier places on hedging the brand’s demand risk. If one extrapolates that idea across, say, a $100M new product launch, of which something like $60M might be direct material costs, then the conclusion would be that in launching that product the brand’s direct material costs were $45M and their direct risk cost was $15M.

Procurement CoR, Example 2: Solvency Risk in Tires

One of the more interesting aspects of CoR is that if any one agent in a value chain lowers its CoR, it necessarily produces an increase in CoR elsewhere in the industry. An interesting example of this phenomenon can be found in the tire industry and the steel cord suppliers that service it. When the economy turned for the worst in 2008, the tire producers for the most part selected a small group of steel cord suppliers and guaranteed a specific demand in return for price reductions. The reduced price, of course, was simply the CoR reduction that the steel cord suppliers would enjoy as a result of the contractual guarantees. One tire manufacturer, for example, guaranteed demand for about 80% of its required steel cord and received price reductions in return.

One would think that spot prices for the remaining 20% of demand would be higher than the guaranteed price.  Yet the reverse actually happened, and in many cases spot prices for steel cord were lower than the guaranteed prices. While this may seem prima facie to undercut the CoR arguments in this article, a deeper analysis shows that there was serious overcapacity in the steel cord industry pre-recession, and it was this overcapacity that prevented key suppliers from raising prices in the spot market. The result was that these suppliers had a double hit: first, the CoR of the suppliers with guaranteed demand was passed onto them and, second, financial asset pressure led them on a race to capture any remaining demand from the tire manufacturers.

 

What’s interesting is that so much effort is made in many Procurement organizations to quantify and negotiate physical cost elements such as material, logistics, or tooling costs, though individually these costs are often smaller percentages of total cost than the risk cost. For example, in the high-tech industry a lot of effort is put into negotiating the manufacturing cost of an outsourced item, which is typically 6-8% for simpler items and 8-10% for more complex equipment. Yet the risk cost of the same items, which is typically much higher, most often goes uncalculated.

Conclusions for CPOs

The benefits of the CoR 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 TPC. 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 possible today and would have the benefits of making all CoR visible to the Procurement organization and would allow for more efficient Procurement risk-transfer pricing.

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 what is probably the most complex supply chain function today.

 

Read more:

For more on this topic, see my article entitled “The Operations-Centered CFO:  Reinventing the Role of Finance in Supply Chain Management,” Corporate Finance Review, 2013.

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Posted by Carlos Alvarenga

Carlos Alvarenga is the Executive Director of World 50 ThinkLabs and an Adjunct Professor at the University of Maryland's Smith School of Business.

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