Procurement, early warning systems, and the next disruption

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For procurement leaders at industrial companies, the past 18 months have been difficult. Resurgent economic activity has collided with supply disrup-tions that have seemingly come one after another. Procurement executives know they need to respond but are unsure how. Most of them have not had a chance to anticipate the next set of problems—let alone to quantify them.

What procurement departments need is a comprehensive view of their supply chain vulnerabilities, organized around their companies’ product lines. With this view in hand, they can secure the products that are most at risk. This article describes a holistic approach that companies can use to safeguard their sources of supply and make their organizations resilient. The approach focuses on three potential problems that every industrial company now faces in one way or another: absolute-shortage risk, supplier risk, and inflation risk (Exhibit 1).

Procurement leaders face three sources of risk.

First risk scenario: Absolute shortage

The first supply chain risk is the unavailability of products that are essential for a business to operate. While a mid- and long-term view of commodities—copper, steel, and cement—is usually relatively straightforward, analysis becomes more complex for more processed products with longer supply chains. Those products use a combination of intermediate and raw materials. A greater number of inputs means more chances for structural shortages that could affect availability.

Procurement departments should consider performing a classic supply-and-demand analysis. How much of a product will the company need in a specific year in the future, and how much of that product will be available to all vendors globally? This seemingly simple question rarely has a simple answer. It requires a bottom-up assessment of market reports, conversations with internal and external resource experts, and a study of the steps being taken by others who are also trying to secure the product. The resulting supply-and-demand calculations should become part of a regularly updated briefing report—a library of category shortages, so to speak—that companies can use to inform decision making.

The goal of the analysis is to position a company’s procurement categories on a continuum, with “continuity risk” (the highest level of concern) on one end and “no immediate danger” on the other.

For example, after doing just such an analysis, one European energy company identified continuity risks in approximately one-third of its procurement categories. Only a small fraction of the risks arose from directly sourced materials; the majority of the continuity risks were related to indirectly sourced products that were further upstream in the supply chain. Those at-risk categories of supplies—where supply-and-demand deficits were evident—became the targets of mitigation actions. Where it could, the company entered into long-term, high-volume contracts for the supplies.

Second risk scenario: Supplier defaults

Over the course of five or ten years, it’s almost inevitable that at least one of a company’s suppliers will go out of business. If the failed supplier is in a peripheral area, the failure may not be much more than a temporary inconvenience. But if the supplier furnishes an essential material or product along a path that leads to a major source of revenue, the consequences of supplier failure can be devastating.

Part of the challenge lies in what’s unseen. Companies are often aware of problems at their tier-one suppliers—either because there’s a delay in delivery or because the supplier communicates about the problem to get ahead of market rumors. The invisible part—the part that companies almost never know—is what’s happening with the suppliers that the tier-one supplier itself depends on. The only way to be sure of a tier-one supplier’s health is to have a view of what’s happening in tiers two, three, and sometimes even four.

The only way to be sure of a tier-one supplier’s health is to have a view of what’s happening in tiers two, three, and sometimes even four.

The risks that companies need to look at for their direct suppliers—and often for their indirect suppliers as well—fall into seven dimensions:

  • Operational. This dimension involves understanding how suppliers have set up their sourcing networks. Crucial questions include whether the supplier has visibility into its own suppliers, how concentrated the different supply sources are, and how well the supplier performs in areas such as lead time and on-time, in-full (OTIF) delivery, a metric of effectiveness in fulfilling orders.
  • Structural. A supplier’s tier-two or -three suppliers may face external or internal shocks in the form of trade divergence, climate events, or local challenges, including epidemics or conflicts with neighboring countries. The existence of such shocks doesn’t necessarily prevent a company from getting what it needs from a supplier. But it might be a reason not to depend solely on one supplier.
  • Financial. Suppliers of every size and in every sector can face challenges related to corporate liquidity, credit ratings, and revenue concentration. One way or another, effective procurement executives should ensure that the financial risks of an individual supplier don’t lead to product shortfalls at their manufacturing plants.
  • Regulatory. Procurement executives need to understand whether their suppliers have the oversight in place to meet regulations. This could become trickier in the future as downstream companies are increasingly held to account for activities in their upstream supply chains, including activities related to CO2 emissions.
  • Data security. Security breaches can hurt seemingly stable suppliers in many ways, such as by leaving their systems inaccessible, by causing them to lose customer data, or by allowing misinformation to be sent out in their names. Such breaches can also interfere with delivery schedules and affect downstream customers. The due diligence that is required revolves around tier-two and tier-three suppliers’ cybersecurity standards and intellectual-property policies.
  • Reputational. Companies sometimes make news because of questionable activities. When this happens to a supplier, a downstream manufacturer may be forced to sever its relationship with that supplier to protect its own environmental, social, and governance (ESG) reputation.
  • Organizational maturity. Suppliers vary in their tenure and in their risk management capabilities and culture. What we’re calling “organizational maturity” determines how deftly a supplier can recover from the inevitable problems that arise in business and how well it can handle future contingencies. This trait allows companies to minimize the negative effects of the other six sources of risk.

After performing these assessments, a company should have a central view of the risk associated with each of its key suppliers.

After performing these assessments, a company should have a central view of the risk associated with each of its key suppliers. Those risks can be plotted against a “dependency” or business criticality score. Exhibit 2 shows an actual company’s supplier risk dashboard with the supplier names removed. The company has used white bubbles to plot its suppliers, with the size of the bubble showing the relative amount it spends with each supplier. On the dual-axis chart, the company has overlaid three recommended actions: “actively mitigate” (for the suppliers that represent the biggest risk), “develop mitigation plan” (for suppliers whose risk may necessitate a plan in the future), and “continue to monitor” (for the suppliers that pose no current risk). In a dashboard like this, the red zone tells companies which suppliers they should immediately look at.

Procurement leaders can set mitigation plans by plotting suppliers’ risk against their importance.

During the height of the COVID-19 crisis, a materials conglomerate used this methodology to determine that more than 100 of its tier-one suppliers were high risk. In ten of those cases, the supplier’s risk was caused by an issue at one of its own suppliers. The materials conglomerate would never have known about those risks had it not looked deeper into its supply chain and investigated its tier-two suppliers. The analysis also allowed the conglomerate to undertake mitigation steps.

Third risk scenario: Out-of-control inflation

Shortages aren’t always absolute. A relative shortage—that is, when supply exists but is insufficient—can also lead to price volatility.

For instance, the price of many metals has gone up, often dramatically, during the past few years. Nickel is a case in point: the price of this metal, widely used in electric-vehicle batteries, has soared. There have also been other shortages amid the upheaval of the past few years. For instance, high demand has driven up the price of basic materials such as sawlogs and timber. Many industries—including packaging and paper goods—have felt the effects of these price increases.

It isn’t only the difference between materials supply and demand that is raising costs. There has also been an imbalance in labor supply and demand. Together, base-materials inflation and services inflation have handed corporate-procurement departments a problem that seems to be growing exponentially.

To identify the places where inflation can hurt them the most—and to minimize wasted effort—companies need a clear methodology, such as the following three-step process: In step one, a company takes a cleansheet approach and uses comparative values or bills of materials to determine the share of a product’s price that comes from raw materials versus from services. These calculations help create a baseline for understanding how the price might develop over time.

In step two, the company models the expected price changes for all the raw materials and service types that are involved. Typically, they do so by tri-angulating a variety of sources, including forecasts, market models, and expert assessments.

In step three, the company ranks the risk of inflation in its top supply categories. The accuracy of this ranking is largely dependent on the analysis done up to this point. But it is also crucial to calculate how long an increase in a raw material’s price would take to drive up costs for a company buying it. In the chemicals industry, for instance, many contracts call for index-based pricing with monthly adjustments. Where these contracts exist, as they do for some commodities, the price realization is typically close to 100 percent. There are also industrial sectors where contracts call for prices to be fixed for two years. The realization of those price increases is much slower.

In practice, the inflation forecast can usually be accelerated through analytics. This automates part of the process and allows for an earlier discussion of inflation and volatility risk.

One company that used the three-step approach was able to fully analyze its spending baseline within three weeks. By the end of that period, the company realized that a significant portion of the materials it relied on were going to be affected by inflation. This realization allowed the company to do some renegotiation and repricing. Had it not done this, several significant projects would have ended up in the red.

The end goal: A business continuity heat map

Even a company facing risks in every single one of its procurement categories would have to weigh the risks against one another and make distinctions. Some risks are simply bigger and more existential than others. Taking a systematic approach yields a clear picture of which supply category risks need attention immediately and which can wait (Exhibit 3).

A heat map can help companies prioritize risks in their procurement categories.

For each procurement category that a company is concerned about, the heat map helps capture the degree of risk, prioritized from highest to lowest. There are three priority levels:

  • Priority one: Immediate action is needed. These are the most at-risk procurement categories. Priority one categories usually involve a major source of revenue hanging in the balance. The problem is typically an absolute supply shortage or the imminent disappearance of a sole supply source for which there is no current alternative.
  • Priority two: Action is needed in the medium term. A disruption in these procurement categories could create inefficiencies and hurt profitability. Disruption would not, however, threaten the company’s ability to generate revenue altogether, nor would it threaten the company’s survival. Priority two calls for some initial strategy work, but companies don’t have to implement the strategies developed at this priority level in the near term.
  • Priority three: No immediate action is needed. This priority indicates that a procurement category has little to no significant scarcity risk and that there is no inflation on the horizon.

A European energy company was under the impression that about 15 percent of its procurement spending was in categories that carried a continuity risk. A heat map helped the company discover that in fact, twice that amount of spending (30 percent) was in areas that were at high risk. This realization allowed the company to take steps to secure its most critical supplies, including adding a local second source of supply for a crucial product.

Many procurement leaders have turned to this methodology amid the disruptions of the past 18 months to understand which supply categories are at risk of shortages. But there is no reason to treat the work as a one-time effort. The methodology should be used continuously and more broadly by organizations—including buyers with day-to-day responsibilities for specific categories.

Furthermore, the insights should not stay within the procurement department. If procurement’s analysis shows that inflation is about to hit a key supply category, that should start a conversation between procurement and sales so that the sales team can pass the higher cost through to customers if necessary. Similarly, if an analysis shows that a sole supplier is in danger of going out of business, that should prompt a conversation with the R&D or manufacturing team about finding alternative suppliers.

In other words, the methodology’s most powerful application is to provide an end-to-end tool for cross-functional collaboration and problem solving.

To expand the methodology’s value in this way will require a holistic setup and the development of certain processes, tools, and capabilities. Procurement departments that make the investment will be building early warning systems and contributing to their organizations’ resilience.

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