A Short Guide to Procurement Risk

Richard Russill

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351961608
• Edition: 1
• Topic: Business
• Subtopic: Management
• Index: Business

Increasingly, top executives view supply markets as sources of competitive advantage and as means of achieving strategic objectives. Procurement is the management activity that makes this happen, and this process depends on a superior risk management capability if it is be effective. Yet, despite its importance, Procurement Risk Management is surprisingly under-developed. Recent Global Risk surveys have pinpointed Supply Chain Vulnerability as one of the four key global risks for the next decade. What is less well known is that this is only half of the story... risk exposures also exist inside the company and can be just as damaging. No company is an island; it needs suppliers as well as customers. Conventional wisdom puts great emphasis on managing certain aspects of business such as customers; operations; strategy and finances. Typically, however, much less regard is paid to external suppliers and the risks present in dealing with them. As a minimum, suppliers are the sources of materials, services and expert attention which enable the company to feed its business model. When done well, a risk-aware procurement process provides the bonus of competitive advantage, with the ability to capitalise, on the occurrence of unexpected events. This short guide explains just how to do it. Each chapter explores the topic in hand, outlines the risks and the remedies available and offers guidance on the principles and risk prevention.

1
Procurement and Risk – The Big Picture

Procurement’s Place in the Business … and the Need to Get it Right

Every business enterprise uses suppliers in one form or another. It is inherent in the business model. One enlightened CEO described her company’s business in this way: ‘we buy, we transform and we sell.’ She added: ‘… and we need to be equally good at all of that if our business is to be as successful as possible.’ In other cases it might be more accurate to say ‘this is what we do and what we sell to our customers, and we use external sources (of whatever) to make it possible to do that.’ In the public sector, the equation could be expressed as ‘we buy, we add value and we deliver.’ The point is that no company or public sector organisation is an island. Resources are needed at one end of the business just as customers are required at the other.

Traditional procurement is no stranger to risk management, witness any good company’s approach to contract terms and conditions and supply planning. But things move on. Public and private sector organisations have outsourced activities previously conducted in-house; what were domestic supply chains now span the globe in search of low cost sources; and communications technologies have dramatically increased the possibility and appetite for rapid, constant change … whilst also rendering a company’s activities more transparent and open to public scrutiny.

Despite this, most companies are so focused on managing the people and assets employed in the business and on satisfying their customers that they fail realise what is going on behind them in their supply markets. And it is not all good news:

• Vulnerabilities in physical supply chains are poorly understood and managed. This has been identified as one of four emerging risk issues likely to impact in the years to come.¹ The recent capture by Somali pirates of a cargo ship serves as a stark lesson that this is no theoretical forecast and that the ‘unimaginable’ does happen. Increasing supplier bankruptcies coming in the train of the economic crisis only add to supply chain woes.
• High growth in the Chinese economy in 2007–08 drove huge price increases in commodity raw materials along with additional concerns about shortages of supplies for Western economies. Freak weather conditions in Brazil and India caused wholesale prices of sugar to hit a near 28-year high, up 80 per cent in 2009 alone. An expected knock-on effect will be a global shortage of sweeteners as big importers of sugar switch into them as a substitute.
• Although its supplier had breached a contract, a customer company had to accept a court ruling in favour of the supplier because the buyer had not exercised the contract’s termination clause in a timely manner.²
• The value of procurement fraud in the UK increased by 347 per cent during 2008.³
• And truth continues to be stranger than fiction. Workers at a recently bankrupted French company supplying the car industry threatened to blow it up if their redundancy compensation claims were not satisfied. ‘The gas bottles are in the factory. Everything is ready to blow it up,’ said a union representative.⁴

Another company knew exactly what it was doing in its supply market but was caught for manipulating supplier behaviour.⁵ The computer chip manufacturer was found guilty of engaging in illegal practices, one being to make payments to suppliers to halt or delay the launch of products containing competitors’ components.

The view that supply chain vulnerability is an ongoing concern is confirmed by the fact that Aon’s 2009 Global Risk Management Survey⁶ includes supply chain failure in its Top Ten most pressing risks around the world. Interestingly at least half of the risks in the Top Ten can be directly related to procurement activity, and hence would fall within the remit of Procurement Risk Management (PRM).⁷ One consequence of this is that procurement risk has emerged as a comprehensive topic in its own right rather than being a facet of specific but fragmented procurement tasks. The benefit of this ‘promotion’ up management’s agenda is the requirement for more clarity about what is ‘procurement risk’ and greater awareness that risks can lurk in areas where traditionally they have not been sought.

However, a comprehensive commercially aware approach to procurement is not the norm. In its absence, organisations experience one or more of the harming events listed in Box 1 and will under-perform, maybe not survive, as a consequence. The impact of supply chain disruption on business performance has seldom been better described than in Hendricks and Singhal’s comprehensive, and sobering, study of its effect on long-term shareholder value. To quote from their concluding summary:⁸

The evidence presented in this report makes a compelling case that ignoring the risk of supply chain disruptions can have serious negative economic consequences. Based on a sample of more than 800 supply chain disruption announcements, the evidence indicates that firms that suffer supply chain disruptions experience 33 to 40 per cent lower stock returns relative to their benchmarks, 13.5 per cent increase in share price volatility, 107 per cent drop in operating income, 7 per cent lower sales growth, and 11 per cent increase in costs. By any yardstick these are very significant economic losses. More importantly, firms do not quickly recover from these losses. The evidence indicates that firms continue to operate for at least two years at a lower performance level after experiencing disruptions. Given the significant economic losses, firms cannot afford such disruptions even if they occur infrequently.

BOX 1
WHAT ARE THE RISKS OF NO
PROCUREMENT RISK MANAGEMENT?

• Profit, budgets, and cash flow are all hurt:
  1. – substantial reductions in shareholder value occur
  2. – need to maintain a far higher than necessary level of risk capital
• Customers kept waiting or turned down.
• Helplessness in dealing with supplier price increases.
• Output prices forced up with loss of competitiveness.
• Poor supplier performance or, worse, allocation or loss of supply.
• Fragmentation and loss of procurement negotiating leverage.
• Legally unsound contracts heavily biased in suppliers’ favour.
• Unproductive use of human resources.
• Insufficient 'internal challenge’ of specifications and decision-making.
• Decision-makers prey to the tactics of salespeople.
• Political embarrassment or damage to company image and reputation.
• Vulnerable to internal and external fraud.
• Exploited and manipulated by monopolies, cartels and hostile contractors.
• Supplier innovations passed to competitors.
• Beaten to the market by competitors with new products or services.
• Too quick or too late to market with own new offerings.
• Damage to brand and company reputation by unethical behaviour or incompetence.
• Organisation is penalised for non-compliance with regulatory requirements.
• Organisation’s activities become subject of public scrutiny and investigation.

The ultimate goal of risk management is to protect and enhance what the enterprise is primarily there to do. In the private sector the aim is profitable survival. The public sector equivalent is to deliver maximum service and organisational effectiveness within the constraints of the resources provided to do it. This includes money. But is the risk-catching net being cast wide enough? Focusing on risks external to the company tells only half the story. What is less well known is that risk exposures also exist inside the company and can be just as damaging.

Whilst excellent articles are written about PRM, the balance of content trends in the direction of risk evaluation and mitigation rather than something which is arguably even more important, namely identifying risks at the outset. As one Chief Procurement Officer (CPO) observed: ‘we are good at reacting to issues when they arise but not good at populating our risk register in the first place.’

‘Playing with Fire’: The Elements of Procurement Risk Management

Procurement Risk exists for an organisation ‘when supply market behaviour, and the organisation’s dealings with suppliers, create outcomes which harm company reputation, capability, operational integrity and financial viability.’

The key word in this definition is ‘harm’. This requires judgement, criteria, and maybe calculation, to decide if an event is potentially harmless or harmful. It is also necessary to distinguish between what is ‘at risk’ (that is, ‘exposed’) and the possible event that does the damage. For example, the company’s ability to meet delivery commitments is exposed to the possibility of supply disruption or if a key supplier becomes bankrupt. Recessions mean that suppliers shut down production capacity to save overhead costs, which eventually lead to shortages when the upturn comes. Suppliers use price increases to ration supplies. Thus, financial performance and the ability to meet budgets is now exposed to the significant price increases that suppliers can impose when it is a seller’s market.

I...

Table of contents

• Cover Page
• A Short Guide to Procurement Risk
• Copyright Page
• Contents
• List of Figures
• Introduction
• 1 Procurement and Risk – The Big Picture
• 2 External Dependencies
• 3 Market Conditions and Behaviours
• 4 Procurement Process
• 5 Management Controls
• 6 Handling the Unexpected
• 7 Procurement Risk Management – An Integrated Approach
• Index