Electronics Production | December 10, 2009

Risk Management in Purchasing

Insolvencies of small and medium-sized suppliers will shape the environment in the automotive and equipment industry during 2010, management consultants Oliver Wyman states. (The charts are in German.)
In two of Germany’s key industry sectors – the automotive and the equipment industry – we will see a massive wave of insolvencies during 2010, mainly affecting smaller and medium-sized suppliers. Short-work measures, a certain order backlog and a financial cushion have helped these suppliers over recent months to stay afloat. However, a few of these companies are now running out of funds.

This brings a considerable risk potential for those sectors in its wake, which – so far – has only been partially addressed. Oliver Wyman has interviewed 150 decision makers in Europe and North America – from various industries – for a new study Risikomanagement im Einkauf (Risk Management for Purchasing Department).The results show that many companies are not adequately prepared for procurement risks. It will be even more important over the next few years (as it has been in 2009) to protect oneself against adverse effects – with an intact supplier risk management.

In addition, companies can gain competitive advantage for the coming economic upturn – through the right risk management. Over the past 12 months, the German automotive industry reported new insolvencies almost every week. Some 50 automotive suppliers went bankrupt (with a combined turnover of more than €8 billion and over 50 000 employees). Purchasing managers are now pondering the question of what affect this might have on their own production.

The graph has a zoom function.

So far, limited or interrupted supply of some individual parts and components can be easily compensated by most automobile manufacturers. Joint actions at times of restricted production can create sufficient breathing space.

The equipment manufacturers have also experienced a doubling of insolvencies in recent months (compared to 2008) to an average of 30 insolvencies per month.

The Oliver Wyman study predicts a worsening situation for 2010. The consulting firm expects some 70 to 100 insolvencies of automotive suppliers in Germany alone for 2010. “Many automotive suppliers have exhausted their financial reserves. The slight upturn – predicted for 2010 – will not be sufficient for them to survive”, says Christian Heiss, purchasing expert and partner at Oliver Wyman.

"We are dealing here with a typical problem, almost always occurring at the end of a crisis", Christian Heiss explains further. While large companies already have begun to look forward again, many smaller and weaker companies have to close their businesses. When demand regains its strength and starts to pick up again, supplier insolvencies become particularly critical.

While the wave of insolvencies will hit the automotive industry very hard, the German equipment manufacturers will be off much worse. Here, single-sourcing (from just one supplier) is quite common. In addition, the sector has been hit especially hard by the economic downturn in 2009 – with a massive 50% dip in order intake.

Oliver Wyman forecasts that the machinery and equipment sector will have to deal with more than 500 insolvencies in 2010 (especially from smaller and more specialised companies). Like a domino effect, business failures could jeopardise whole industry segments – segments that are otherwise quite healthy. Sales are expected to increase again in 2010 – the risk of failure however too. This can put a big question mark on the recovery of some companies.

Purchasing risks have been insufficiently addressed
The ability of companies to deal with growing supplier risks vary greatly, the new Oliver Wyman study shows. "In many companies, the risk profile of suppliers has very little transparency", said Marc-Oliver Schell, Project Manager at Oliver Wyman. "This is why many only react when risks occur, rather than to be proactive and to establish a systematic risk management when it comes to procurement".

The graph has a zoom function.

Sometimes counterproductive changes in suppliers in recent years have even compounded the risk situation. In search of lower prices (in the short run), companies have replaced suppliers – without taking all the resulting risks and changes into account.

New suppliers – mostly from the Far East – do not always guarantee a certain quality and quite often evade the assessment of their financial situation and their reliability. Due to the high risk and long lead times when changing suppliers, mistakes cannot be corrected on short notice.

Purchasing managers have professionalized their dealings with suppliers so that they can optimise their cost quite intensively; they are informed about new technological developments and master increasingly complex supply chains. The question: "What happens if a supplier drops out?" has not been ranked very highly (if at all) on the 2008 priority list.

Suppliers in the automotive industry – which were at risk if imminent insolvency – were ‘rescued’ by a concerted effort by manufacturers (with higher prices) in the past. However, this method – given the different structure, a very diverse supplier base (as a consequence of that) and the high number of possible insolvencies – this approach is no option for the equipment sector. Even within the automotive industry, such ‘rescue operations’ will be a very seldom sight in 2010 (due to the currently rather restraint financial situation of most).

Although the Oliver Wyman study clearly shows that – at leadership level – these companies show a very good risk perception, only a few of them know how to deal with these threats and risks. More than half state that operational risks are the most important at the moment. Financial risks (25%) and strategic risks (17%) also show a high importance level.

External and personnel risks however were assigned a rather low B-priority. About half of the respondents expect that the (important) operational risks will clearly increase over the next five years. Almost 70% of all respondents believe the same if it comes to financial risks.

Risk management in procurement as a competitive advantage
Companies can protect themselves against the risk of supplier insolvency by providing the purchasing department with a risk management system. At the same time, a successful risk management can be an important competitive advantage. A proactive risk management within the purchasing department can lead to increased market shares (for example). This is most likely to happen, if the competitor is affected by supplier insolvencies and can – as a consequence – not deliver on time.

In addition, companies with an effective risk management can easily transfer knowledge and responsibility along their supply chain – without a sudden stop in supplies due to abrupt supplier insolvencies. Through these strategic partnerships, companies can improve their cost base and secure a competitive advantage through shared innovation.

A successful risk management is based on clearly defined processes. These business processes are used to prepare should clearly defined risks occur. The development of a comprehensive risk management system represents a unique cross-functional task; it is necessary to combine the right content and information.

Here it is important that appropriate systems are established within the company and all responsibilities are clarified and properly assigned. In daily business, the "extra" burden is relatively low. Often, the costs caused by sudden supplier insolvencies are much higher than the cost of building and operating an effective risk management system.

Oliver Wyman classified the companies – while assessing the risk management system within the purchasing department – within five levels. In order to asses the individual actions for each company, the risk management was evaluated on strategy, processes, organisation, resources and systems.

Companies with an ‘unstructured’ risk management only respond ad-hoc to occurring risks – without a defined structure. "Reactive" companies will have defined structures for their risk management, but only react when risks occur. More advanced companies will address risks in a more "proactive" or even "cross-functional" way, with clearly defined processes, systems and resources.

The graph has a zoom function.

"Productive" companies, however, will use their risk management in order to systematically seize opportunities in a risky supplier market and to secure competitive advantages.

More than 70% of those companies interviewed by Oliver Wyman have either an "unstructured" (18%) or "reactive" (55%) risk management system in place. Another 24% of companies address their sourcing risks in a "proactive" way, but not "cross-functional" (3%) or even "value-creating" (0%).

Through a professional risk management system, companies can successfully differentiate themselves from their competitors and secure a competitive advantage for the coming recovery. The current crisis offers the opportunity to make the necessary changes in the management of procurement risks. Companies that act quickly and decisively in this area will emerge stronger from the crisis.

Recommendations for successful risk management

1. Identify risks and prioritise
Companies must identify potential risks at an early stage (e.g. perform audits, quantify financial risks and the probability of occurrence). Specific risks that could arise from a supplier's insolvency must be prioritised.

2. Prepare emergency plans
Prepare contingency plans for the most important risks and develop avoidance strategies. For example, an early alternative supplier can be set up to respond quickly if this should become necessary.

3. Establish early warning indicators
Risks must be audited through a simple and effective risk metrics and a close and regular communication with the suppliers. This is the only way companies are safe from nasty surprises when it comes to their supplier base.

4. Establish clear responsibilities
A successful risk management requires a clear definition of responsibilities.

5. Risk premia must be taken into account
In awarding contracts to suppliers, risk profiles should be included in the decision making process. For critical suppliers, a risk premium should be considered.

Source: Oliver Wyman.
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