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While this approach adds some complexity to the already challenging world of supply chain management, therein lies the opportunity. What Do You Say?   Send Feedback Click Here to See Reader Feedback

Though the worst of the global recession is clearly behind us, and many hope a more robust recovery lies not too far down the road, companies still face much supply chain and bottom line risk from suppliers struggling to keep out of bankruptcy court or failing all together.

So say Hans-Kristian Bryn and Michael Denton, both consultants at Oliver Wyman, who argue a new approach needs to be taken to address and predict potential supplier financial  and operational failure.

In a new report, Bryn and Denton note that the lukewarm recovery means there are many firms across the globe still in dangerous financial territory. US bankruptcies are up 126% since the start of the recession in 2008. That's no surprise, but Mariarosa Verde, an analyst at credit rating company Fitch Ratings, says while low lending rates have kept many companies afloat for now, if US economic growth does not get above 2% soon many more companies are likely to go under.

In fact, Fitch downgraded the credit ratings of 23.2% of the companies it followed during 2009 while only upgrading the credit ratings of 6.6% of industrials. Those were primarily large companies. The financial condition of smaller suppliers could be even more dicey.

As a result, "supply chain risks have moved from the province of engineers into the realm of chief financial officers and treasurers," Bryn and Denton write in a recent report on the topic.

What are the Real Costs of a Financially Week or Failed Supplier?

Bryn and Denton argue that the true cost of a supplier in weak financial condition or one that ultimately fails is often larger than most companies realize or measure.

That's in part because, they say, "the metrics companies use to evaluate the impact of a supplier failure are often too simplistic. Companies often fail to take into account that the more they push out to potentially less secure suppliers, the more they are often obliged to use their own balance sheets to support suppliers," and that there are a variety of other costs that companies incur when they are forced to replace a failed vendor.

There are also changes going on in the credit ratings industry that may make their numbers less useful than in the past for assesssing supplier risk, Bryn and Denton say. They also note that the increased reliance on offshore suppliers makes use of US credit ratings agencies and other tools often less practical than for domestic suppliers.

(Sourcing and Procurement Article - Continued Below)

Instead, companies need to starting "acting like their own credit ratings agencies," using a variety of metrics across financial, operational, and "experience" or judgmental factors to predict when a supplier is starting to have financial or operational/supply chain troubles earlier than existing tools are likely to achieve, Bryn and Denton say.

The type of model they recommend is shown in the graphic below.

Source: Oliver Wyman

Bryn and Denton note, however, that the specifics of such a model need to be tweaked for a given company and maybe even each supplier to come up with a predictor that is most accurate for each situation.

"Applying statistical methods to determine the combination of operational, financial and more subjective factors will do more than explain past disruptions," Bryn and Denton say. "As new data becomes available, a model can be rerun to assess whether particular risks are increasing, and corrective management action can be taken before the problem materializes."

While this approach adds some complexity to the already challenging world of supply chain management, therein lies the opportunity, Bryn and Denton argue.

"There are nearly limitless places for problems to spring up in supply chains. Companies that identify the full range of default factors — essentially becoming their own credit rating agency—will have a competitive advantage over rivals who lack this level of sophistication," they conclude.

Do companies often underestimate the true costs of supplier financial or operational failure? What is your reaction to developing a multi-factored predictive model such as the one proposed here? Let un know your thoughts at the Feedback button below.