Mitigating the High Risk of Low-Cost Items

Mitigating the High Risk of Low-Cost Items

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When suppliers’ priorities change, the availability of critical items can be put at risk.

How important are you to your suppliers? It’s a question that companies need to ask when evaluating risk in their procurement strategies. And it is especially important in today’s fast-changing commercial environment where suppliers’ priorities can change very quickly.

Of particular interest are items that are low cost and low volume but essential to the business. When thinking about procurement risk, it’s tempting to immediately associate high-spend, strategic items with the highest level of risk. But critical, low-spend items are often the riskiest, partly because they might not be a high priority for suppliers that prefer buyers of higher volume products.

As described in my book The Power of Resilience: How the Best Companies Manage the Unexpected (MIT Press, October 2015), people have defined four categories of procurement conditions.

  • Tactical buys. This category refers to common items with low volume and ready availability. Because the volume is low, transaction costs as a percentage of spend are high.
  • Leveraged buys. These are high-spend commodities. Minimizing total landed cost is important to keep spend under control.
  • Strategic buys. Items or services that provide a competitive advantage typically appear in this category. Companies frequently enter into long-term, deep partnerships with suppliers of these key items.
  • Critical buys. This category covers essential, low-spend, hard-to-procure items. An obvious risk mitigation strategy here is to maintain high inventory levels.

As mentioned, the latter category is often the riskiest. Buyers of these items can be relatively low in the pecking order from a supplier’s perspective. Also, dual sourcing may not be viable as a result of the lack of alternatives and the high cost involved relative to spend.

Procurers of electronics are subject to this type of risk. For example, both GM and Verifone depend on a variety of electronic industry suppliers. But, many of those suppliers pay more attention to cell phone and computer makers who tend to use the latest products. In many cases these suppliers stop manufacturing and supporting the parts that GM or Verifone rely on. The problem is that makers of cars, commercial systems, and many industrial systems prefer not to use the latest electronic chip but rather “tried and true” components. For example, BASF, the giant German chemical company has a policy of “three generations behind” in its IT implementation policy. When a chemical plant relies on digital controls, reliability and safety are more important than small performance improvements.

Moreover, in the extremely dynamic electronics industry, suppliers’ are constantly shifting their gaze to other market opportunities.

One can think about several risk mitigation strategies for this category of purchased items. The obvious one is to keep relatively high inventory. Inventory carrying costs are, by definition, low for low-spend materials, and the strategy does not require supplier cooperation. Furthermore, as the risk varies over time, companies can adjust inventories in sync with the level of risk.

Medical equipment-maker Medtronics uses such adjustments to shield the company from adverse weather. During the hurricane period in South America the company applies a “hurricane factor” in its safety stock levels to ensure that it has sufficient stocks in the region to cover operations during this high-risk period. Extra inventory of both finished products and parts can be utilized immediately after a disruption. Even if the inventory is not sufficient to cover the entire time-to-recovery, it allows crisis managers to “catch their breath” and organize a response – continuing operations and not affecting customers’ orders, while collecting data from suppliers, consulting with customers, and launching various recovery efforts.

Changing engineering specifications to avoid uniqueness is an important mitigation measure for low-cost, essential items. This reduces the complexity of the material and moves it into the “tactical buy” category described above.

Another approach to mitigation is to consolidate procurement. Companies can consolidate buying of the critical parts by all product divisions across the company to the same supplier, and also combine the procurement efforts with other companies, creating a buying consortium – thus increasing the spend and the attention paid by the supplier to the company. Another option is to direct the procurement of other, non-critical parts and materials to the critical supplier, thus making the company a more important customer.

Companies should not automatically attach a low level of risk to low-spend items without considering the criticality of the items in question. For items that are indeed critical, they should ascertain whether suppliers value their business sufficiently to go the extra mile when a crisis hits.

This post is based on an article by Yossi Sheffi, Elisha Gray II Professor of Engineering Systems at MIT, and Director of the MIT Center for Transportation & Logistics, published in the August 2016 issue of Inside Supply Management magazine. Yossi Sheffi’s book The Power of Resilience: How the Best Companies Manage the Unexpected (MIT Press, October 2015), is available from Amazon.com, and from MIT Press.

 

 

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