Supply Chain Risk: How to Effectively Evaluate Sourcing Risks and Opportunities

An in-depth look at a framework organizations can use to accurately evaluate risk and purchasing opportunities

By John Mothersole

Supply Chains Expand in Risky Geographies

When it comes to identifying supply chain risk and effectively tapping into global business opportunities, many organizations overlook the fundamentals and wind up making wrong and costly decisions. Earlier this year, when IHS and Supply & Demand Chain Executive magazine surveyed supply chain executives, they learned that 50 percent of executives view China as one of the most likely sources of volatility within their supply chains. Curiously enough, 25 percent of the respondents pinpoint China as an area where they were likely to expand their supply chains in the future. 

This brings up a pressing question: Why would firms knowingly expand their supply chains in countries that they know pose the most risk and potential for volatility? “We believe the answer lies in a fundamental mispricing of risk,” says John Mothersole, IHS economist. “This situation can be avoided by joining country risk analysis and price forecasting analysis.”

Take commodity grade steel sheet, for example. Used to make everything from automobiles to air conditioners, steel sheet is produced in several countries around the world. “Because of this international scope,” says Mothersole, “companies can take a step back, and look at the price and risk profiles in many different regions.” 

The process starts with a thorough country risk analysis through which organizations can develop unique risk profiles for specific source decisions based on the sourcing relationships themselves. A steel purchase, for instance, is transactional in nature. There’s no servicing contract associated with the buy, no replacement parts to worry about and very little quality differences between countries. “As a result,” says Mothersole, “the risk profile for steel is fairly simple.” 

Establishing Risk Probabilities 

Next, says Mothersole, establish subjective probabilities for these three key risks: enforceability of private contracts, losses due to corruption and losses due to crime. Enforceability of private contracts carries much of the weight, he notes, because the buyer’s goal is to get his or her hands on the steel—and because most producers possess histories of low crime and corruption.

Steel Sheet Country Risk Scores

The risks laid out in the Country Risk Scores table illustrate the probability of the triggering of a defined event. In this case, such an event would either be a worsening of contract enforceability, or an increase in losses from corruption or crime. Not surprisingly, the U.S., Japan and Germany lead from a risk perspective. “What may come as a surprise,” says Mothersole, “is China’s position as a high-risk country due in large part to problems with contract enforcement.”

In assessing price forecasts for steel, the key factors to consider include raw material prices, wage rates, productivity, profitability, and supply and demand for each country. This information can then be used to build forecasts for those countries. As you can see from the chart above, the Latin American producers (Brazil and Mexico) are notable outliers on the high side, whereas the Asian producers (China and Japan) are on the lower end of the pricing picture. 

Identify Supply Chain Risk and Opportunities 

After developing a forecast for risk and price, you need a framework to combine the two together. Because risk scores vary from country to country, it’s important to reduce that dispersion and ensure the risk section doesn’t do all of the heavy lifting in the final calculation. “Take the natural log of each of these scores to compress them down,” says Mothersole. “In the end, you still have relative differences, but they are slightly smaller than they were previously.”

The final step in effectively identifying supply chain risk and purchasing opportunities is to multiply the scores by the price forecasts to get single-sourcing risk scores for each country. The results for the steel example reveal that, even though China’s position as the low-cost producer is expected to hold over the next five years, its higher profile doles out enough punishment to push China towards the bottom of the risk-adjusted sourcing score list. “

Japan and the U.S., on the other hand, which were in the middle of the pack of our price discussion,” says Mothersole, “move to the top of the sourcing score list reflecting their superior risk profiles.”

When it comes to identifying supply chain risk and effectively tapping into global business opportunities, many organizations overlook the fundamentals and wind up making wrong and costly decisions. Equipped with market insight, accurate price histories and information about target countries, organizations can effectively price risk and tap into potential opportunities with the knowledge that sourcing decisions are made taking into account both price and risk.