The primary reason for businesses to exist is to make profits. In a perfect world, having a good product that caters to a specific need for a growing base of customers would ensure profits. Unfortunately, we do not operate in such a perfect world. Many variables drive business success. The last two years have shown, yet again, that these variables are influenced by all kinds of events—pandemics, geopolitical instability and wars, blockages on cargo routes (e.g., the Ever Given’s accident in the Suez Canal), natural disasters, political unrest, regulatory announcements, leadership changes, production shortages, shipping container shortages, supply gluts, etc.
Sometimes, these variables flip from positive to negative overnight, but mostly, the change is gradual. Sudden flips cause some risks to skyrocket instantly while creating a ripple effect on others. It is especially true for manufacturers of goods since these are increasingly a part of complex global supply chains. Therefore, managing, controlling, and mitigating the financial risks of various participants in the supply chain is an absolutely critical activity.
Types of Financial Risk in a Supply Chain
Any risk that threatens the financial health of any business, which is a part of a manufacturing supply chain, constitutes a financial risk to the entire supply chain. There are different types of financial risks, and the exposure to these risks needs to be measured, assessed and controlled at all points in time.
Some of these risks include:
1. Non-payment of dues by the customer/ distributor/ dealer, i.e., bad debts
2. Non-delivery of the promised goods or delivery of inferior-quality goods by the supplier
3. Delayed deliveries of raw materials, components, etc. that cause cascading delays in the manufacture and supply of the finished product; these delays adversely impact the working capital cycle and result in higher interest and financing costs
4. Volatility in commodity prices; if commodity prices are not properly hedged, they can cause huge financial risks to businesses
5. Unhedged foreign exchange exposure
6. Labour shortages in the supply chain result in delays and higher costs; for example, in the US, labour markets are extremely tight at present, causing wage inflation and worker shortages, leading to knock-on effects on all parts of the supply chain.
7. Shipping delays caused by shortages in the availability of shipping containers or vessels; this happened during the COVID-19 pandemic, causing freight costs to skyrocket and impacting the viability of various businesses
8. Problems caused by improper legal contracting between buyers and sellers, especially in international transactions; this causes delays in goods getting cleared from ports and results in very high demurrage costs
9. Geopolitical issues such as war and conflict can result in trade sanctions; these have a long-term financial impact on supply chains.
Need for Management of Financial Risks in the Supply Chain
The Federal Reserve Bank of New York has devised a new indicator called the Global Supply Chain Pressure Index (GSCPI) to measure supply chain conditions. This measure, back-dated to 1997, showed relatively small fluctuations till 2020. Since the pandemic, supply chain pressures have gone through the roof, and the index has climbed to unprecedented levels.
Not surprisingly, the clamour for more effective supply chain management has also reached a crescendo because of the lessons learned from the pandemic. Due to supply-chain disruptions, companies are considering the development of alternative sources of supply closer to home, especially for critical items, such as pharmaceuticals, silicon chips, etc. Having said that, geographically diverse and complex supply networks are here to stay for most products, given cost and productivity arbitrage between countries.
CFOs, Chief Risk Officers, and Supply Chain Heads of companies must collaborate to create a risk management plan that safeguards the company against the financial impact of the risks mentioned earlier in this article. Risk Management in the Supply Chain domain has several objectives:
- To stem losses and avoid profit erosion
- To avoid disruption and delays across the supply chain
- To sustain a long-term competitive advantage
- To prevent single points of failure in the supply chain, as the chain is only as strong as its weakest link
- To protect corporate reputation
- To ensure optimisation of working capital management across the entire supply chain
- To facilitate accurate financial forecasting and budgeting
- An essential element of a supply-chain risk management exercise is dealing with supplier risk. Without suppliers, there can be no supply chain, and any problems they face or create can throw the entire value chain into a tizzy. Various external and internal factors (lack of credit, labour problems, internal fraud, external fraud, economic downturns, compliance issues, management and ownership changes, etc.) can create financial problems for suppliers and interfere with their ability to fulfil contracts. As mentioned earlier, a single delayed or violated contract can have a domino effect on the entire supply chain. Therefore, companies must constantly monitor their suppliers’ financial stability.
Steps in Managing Risks in the Supply Chain
A comprehensive supply-chain risk management process can be approached through 4 steps.
- Developing a supply-chain risk management plan: This step entails determining the acceptable levels of supply chain risk and formulating a comprehensive mitigation plan for all identified risks.
- Data gathering: The right kind of structured and unstructured data pertaining to various risk variables has to be obtained continuously for all participants in the supply chain.
- Data analysis and risk assessment/monitoring: Identifying patterns from the data and deploying analytics-based risk scoring tools to assess and monitor the financial risk of suppliers.
- Monitoring the execution of the plan: Finally, the outcomes of the risk management plan need to be measured continuously to ensure that the plan is effective in keeping risk at acceptable levels.
Stages of Supplier Risk Management
A good risk management plan must include measures to identify, manage, control, and mitigate risks at every stage of a business relationship. Let us look at it from the point of view of three stages in a transaction lifecycle.
- Onboarding: This includes identity validation, conducting KYC checks, and all basic hygiene practices before starting a business relationship. This process is required to ensure that potential suppliers have the wherewithal to cater to your needs, enable them to become familiar with your internal systems and processes, and help agree on standard operating practices in your business dealings. A robust onboarding process will streamline procurement processes and improve efficiency, lay the foundation for strong supplier relationships, minimise risks to your reputation and profitability, and reduce costs.
- Risk decisioning and supplier risk assessment: In this stage, risk assessments are conducted on prospective counterparties in the supply chain before appointing them. Suppliers are assessed from a financial strength perspective and also for statutory compliance. Besides financial strength, some of the data points include management background, legal checks, Politically Exposed Persons (PEP) checks, Anti Money Laundering (AML) checks, anti-bribery compliance (FCPA, UK Bribery Act), and Sanction violations. The goal of supplier risk assessment is to identify, assess, and quantify the risks involved in transacting with a particular supplier. The exercise should consider potential risks as well as the probability that the adverse risk event may happen. One of the approaches for this is to create a risk scoring system that uses algorithms to automatically assign a numerical score to each supplier based on its level of risk. A low-risk score assigned to a supplier indicates a higher risk level; therefore, a more cautious approach is required in such cases.
- Risk monitoring: A business entity’s risk profile can change rapidly and needs constant monitoring. Therefore, in the risk monitoring stage, you need to track changes in your suppliers’ risk and continuously monitor the key developments impacting it. For this, you need to deploy an Early Warning System (EWS) that collates key risk indicators on a near real-time basis from various data sources, including statutory compliance and financial filings, news, and media to get a dynamic view of a company’s risk profile. The EWS system automatically updates risk scores when variables fluctuate and hence helps identify weak suppliers that need support.
Leveraging Technology and Analytics for Supplier Risk Assessment:
Data science and technology-backed platforms have delivered promising results in the area of Supplier Risk Management. Today, at every stage of the supplier risk-assessment lifecycle, there are tools and platforms to aggregate data from internal and external sources, systematically generate automated risk scores using scoring engines, and monitor these risk scores based on new data. It helps speed up the risk management process and also reduces the scope for human error and bias in supplier selection. The algorithms in these risk management platforms are easily customisable to meet the needs of different sectors. The platform can also provide updated risk scores and intelligence as frequently as the risk management team desires. If the platform detects higher levels of risk at a supplier due to some negative information, risk mitigation actions can be quickly implemented by the risk management and supply chain teams.
In conclusion, having a well-designed, technology and analytics-based risk management system is imperative for today’s complex and interconnected supply chains.