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By LOWELL YARUSSO, a senior vice president with The Mpower Group in Oak Brook, Ill. With more than 30 years experience in the delivery of professional education, especially in the areas of supply chain, strategic sourcing and change management

The recent economic challenges have led many companies to revisit their view of risk management. Among other areas of risk, many had to rethink their approach to low-cost country sourcing. By the end of 2008, many executives and their sourcing organizations were chagrined to discover that the lowest-cost country was no longer Mexico, Poland or the Philippines. It was actually the United States. As 2009 progressed, there were strong indications that even China, the 800-pound gorilla of outsourcing, was considerably less attractive than it had been 18 months before.

Bearing in mind the need to broaden our risk focus, there were three major contributing factors that redefined the global economy in general and that have and will continue to critically impact risk management in the future. They are speculation, faulty regulation and "me-tooism."

From the perspective of sourcing and supply chain organizations, the message here is that risk management are even more critical to survival today than they have been in the past. That is not to say that identifying and minimizing risk was not important in the past.

Yet looking at risk as a commodity-, country- or industry-specific issue is out of date. Risk must be continually and systematically assessed across industries and on a global basis. The potential impact of speculation, faulty regulation, and me-tooism on individual sourcing decisions should be a critical factor in any risk management program.

SPECULATION

It is easy to see how speculation impacts commodity prices. All that is necessary is to study the roller coaster ride of oil prices for the 12 months from Sept. 1, 2007, to Sept. 1, 2008. At no time in that period was there a substantial shortage of oil in the world. And most of the rise from $50 a barrel to $140 a barrel was fueled by speculation.

What does this tell us about risk management? Most savvy supply chain professionals are well aware that betting on commodity prices is risky business. What is missing is a strategy to ensure that sourcing decisions look at the impact of commodity prices on overall risk to the organization.

Usually, organizations begin to look for ways to mitigate their exposure to commodity fluctuations in response to a major rise (or fall) in commodity prices. Many may argue that today's supply chain professionals know better than that. Our experience suggests that, if they do, they have not found ways to incorporate that knowledge across their organizations.

FAULTY REGULATION

There can be little doubt that a major contributor to the meltdown in, for example, the housing industry, had its roots in the failure of regulatory mechanisms to successfully oversee the operation of the market.

While governmental agencies clearly played a role, of concern here is the internal regulation (or lack thereof) exercised by many of the key players in, especially, the secondary mortgage market. The underlying economic weaknesses of the subprime mortgage concept were scary enough that, in hindsight, it is hard to understand how they were allowed to dominate so many mortgage portfolios. One answer lies in the failure of financial institutions to establish and maintain internal controls that would keep risk at a manageable level. Similar issues impact many of the companies that we have observed over the years.

Many supply chain and sourcing efforts fail because of the inability to establish and enforce internal controls that regulate the way the organization goes to market on a day-to-day basis. In one example, a large multisited organization put a robust strategic sourcing process in place and, over the course of 18 months, vigorously applied the process to its 10 most strategic and costly spends.

The result, on paper, was significant cost savings across the enterprise. Absent internal policies to regulate how individual locations conducted their local purchasing operations, however, the result was chaos. As sites began to implement the central agreements, several chose to "cherry pick" them, buying only under those that gave them the most savings and continuing to use their old suppliers for the other categories.

The net result was that the global suppliers complained that the volumes on which they had based their pricing and other cost parameters were not available and, therefore, they demanded retroactive price adjustments to compensate for the reduced volume. The organization actually increased its costs as a result of the unregulated implementation of the strategic sourcing results and also gained a negative reputation in those strategic supply bases.

ME-TOOISM

The final factor to consider in addressing risk management is me-tooism. In the broader financial markets, it represents a compensation system that drives the people and institutions to seek average performance. Creativity and risk-taking have a higher upside for the investors, in the long run, than following the crowd, but that upside is not sufficient to overcome the negative downside potential to the investment advisor. The outrageous success of those few contrarian fund managers is ample evidence of how many "follow the crowd."

At the enterprise level, me-tooism is manifested in two ways:

First, is the "safety first" approach of making the choices that everyone else is making. If competitors are moving to China, move to China with them. If it's a bad decision, everyone will suffer; if it's a good decision, you won't be left behind.

Less obvious, is the impact on sourcing decisions of a reward system: e.g., bonuses based on average purchase price variance (PPV), which rewards and encourages short-term rather than long-term thinking. In one organization with which we worked, sourcing managers actually asked suppliers to increase their price in the first year of a long-term agreement so that the PPV in out years would support maximum bonuses.

In many organizations, risk assessment receives scant attention when it can do the most good and is called on to perform miracles long after it has the ability to impact results. Successful, world-class organizations have processes and procedures in place to control these three key factors.

In addition, those organizations have created organizational cultures that take supply chain risks seriously. They have made risk management a way of thinking about the business of the business and insist that everyone in the organization understands their role in the process. Any organization that does not do so must, like the global economy in the last 18 months, accept the possibility that a predictable and manageable set of circumstances will arise that expose the organization's key weaknesses with catastrophic effect.

Certainly, risk management is not an absolute guarantee against potential dangers. What can be said is that, like fire insurance, these key tools in the strategic sourcing process will help minimize the impact and will speed recovery when the worst happens.

June 1, 2010

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