Every business faces risks – the probability of events occurring – that can or will present challenges to their operations. Risk management is the practice of using processes, methods and tools to identify the level of probability, and then manage the ensuing risks.
In practice, this means identifying in advance what can go wrong in relationships between buyer and supplier. Failing to do this means you will be under-prepared and get some unwelcome surprises. A risk management strategy in procurement allows you to anticipate what may go wrong, thereby preventing disasters or serious financial losses.
Insuring is one way of mitigating risk. The question is who pays for this, the buyer or the supplier? Asks Elaine Porteous, in this month’s SmartProcurement.
Types of contractual risk
1. Strategic and operational Strategic risks are those risks associated with operating in a particular industry. Your strategic risk in procurement may be a reliance on one or more key suppliers that may fail to fulfil their commitments, which, at best, can cause loss of sales and embarrassment. At worst, strategic supplier failure may be critical or even fatal to a business. This type of risk can be managed through having a Plan B or using back-up suppliers. Who carries the cost of your contingency plans?
2. Compliance/ Legal Compliance risk includes the need for suppliers to conform to the law and other industry regulations, including environmental, health and safety requirements. There is a cost attached to this and you may have to support your supplier to allow him to reach your required level of corporate governance.
3. Finance and credit Financial risks in procurement are associated with the transactions your business makes and the financial systems you have in place. Identifying financial risk involves examining your daily procure-to-pay and accounts payable operations, including controlling exposure to interest rates and foreign exchange rates.
How to evaluate risks
Performing an overall risk evaluation within procurement allows you to determine the significance of certain supplier risks to the business. A decision on whether to accept the specific risk (carry the cost) or take action to prevent or minimise it depends on the organisation’s appetite for the risk. The cost of insuring the risk may be so high that it does not make financial sense.
Is the risk high, medium or low? Effort and time must be focused on the most important risks. This could involve defining a decision process and escalation procedure, which your company would follow if an event occurred. You can put systems and controls in place to deal with the consequences of an event.
Ways of managing contract risk
There are really only four ways of managing a risk: accept it, transfer it, reduce it or eliminate it. If we accept it, we can insure it (in some cases this is compulsory anyway). However, some costs are uninsurable, such as the damage to a company’s reputation. In the contract:
• ensure there are clear definitions of deliverables and dependencies;
• ensure there is a clear division of responsibilities for all parties;
• accept only those terms that can be reasonably performed and managed;
• set clear measurement criteria and monitoring processes; and
• ensure any warranties are tied to what can be reasonably managed.
How suppliers avoid risk
At contracting time, suppliers may refuse to accept a transfer of the cost, risk or potential liability by simply striking out a clause in your draft. They may also accept a limited transfer of the cost or risk by including qualifying language to water down their commitment and their potential liability. A favourite ploy is to transfer some of the risk and cost back to the buying organisation or propose other terms to where the parties agree to share in the cost.
What can go wrong?
The consequences of not managing procurement risk effectively can include:
• discontinuity in the supply of essential goods or services;
• avoidable cost increases in raw materials, services and project costs;
• loss of influence in relationships with essential suppliers;
• loss of market share or revenue through an inability to meet customer demand; and
• financial exposure and cash flow problems.
Risks in the transportation of goods across borders are managed by the use of Incoterms that define which party bears each of the risks that the supplier, the transporter or the buyer carry during the delivery. This is a specialised field that requires clear agreement between buyer and seller prior to contracting. In this area, as with other contracting terminology, clear communication between the parties is vital.
Elaine Porteous is a business writer and commentator on supply chain issues. Contact her on firstname.lastname@example.org.