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Global Sourcing and Risk Management

Article · December 2012

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Bernardo Nicoletti
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 Global Sourcing and Risk Management 1

Introduction

Global sourcing is becoming more and more relevant in today globalisation environment. Many companies that were laggards in using

this opportunity are now rushing into low-cost country strategies. Not always they take into proper consideration the potential risks that

are connected with global sourcing. Even more often they do not try to mitigate these risks.

Recently the price of hard disks on the market almost doubled.2 The reason is very simple. A flood has discontinued for a period of time

hard disk factories in Thailand. This is globalization. It represents an enormous opportunity but also a situation that may create

significant risks. There are many reasons why firms choose a strategy of global sourcing. Lower production costs are perhaps the

primary factor, but not without risks. The question is how to assess the risks of such a strategy as completely as possible and how to

mitigate them.

Taxonomy of costs connected with Global Sourcing

Few models provide an overall assessment of the risks and costs to guide managerial decision making in global sourcing. A recent work

attempts to describe its risks and opportunities3. It starts by defining three classes of costs in a sourcing strategy:

 Static;

 Dynamic;

 Hidden.

This paper uses this approach to assess the costs of risks inherent in global sourcing scenarios. It analyse them further and make some

modifications to take into account the real world situation.

The static costs are the most obvious factors. They include works unit costs, as transport and customs clearance, if any, insurance and

handling. In more details, they include:

 Purchase price ex-factory;

 Transportation costs per unit, assuming that there are no unexpected delays or quality problems;

 Customs and related taxes for the shipment for export;

 Insurance and transaction costs;

 Cost of quality control and compliance with local environmental and safety standards than those in the country of the supplier;

 Search costs and agency fees to identify and interact with local suppliers.

1
Bernardo Nicoletti - Business Consultant, www.bernardonicoletti.com
2 Randewich, N. (2011)Thai floods boos PC hard disk prices, http://www.reuters.com/article/2011/10/28/us-thai-floods-drives-
idUSTRE79R66220111028, accessed on Mrch 6th, 2012.
3 Holweg, M., Reichhart, A. and Hong, E. (2010). On risk and cost in global sourcing. International Journal of Production Economics,
131(1), 333-341.

1
Then there are the dynamic costs of acquisition. The static evaluation omits the dynamic dimension of such sourcing decisions, namely

the fact that supply and demand can vary widely, and are not always controlled by the buyer:

 The need to increase the pipeline and safety stocks, since they are amplified by demand volatility and the variety of products.

 The possible obsolescence of stocks because of logistics with long times of re-supply in case, for example, of problems with the

quality of the supply;

 Cost of lost sales and broken light, with the supply chain that does not respond promptly to changes in demand;

 The possible need for expedited shipping, for example by air;

The hidden costs are not directly related to the operation of the supply chain. They impact on the broader economic context of the

organization. They can be organized in three buckets:

 Environmental:

 Supplier connected;

 Logistical

The environmental hidden costs are:

 Fluctuations in exchange rates;

 Inflation of labour costs in countries that start from very low levels;

 The need to manage cultural differences and languages;

 The risk of political instability and changes in economic or political systems;

 The regulations which can change over time-

The hidden costs can be also supplier connected:

 The lead times for investments or developments are often relatively long;

 Overhead associated with managing an international supply chain;

 The possible loss of intellectual property with unstable suppliers;

 The technology of the supplier could not always be up to date and reliable;

 Wuality problems that if not well managed can damage the company’s brands..

There might be also hidden logistics costs:

 The increase in transportation costs;

 Elements such as input/ingredient/equipment lead time, technology development lead times, staffing, consumer/customer

testing, capacity start up, quality issues and other factors can all impact the time equation.

Types of Risks

2
In evaluating the risks it is possible to take four possible data views4:

 Aggregate commitments;

 Competing Commitments if there are there activities or more with parallel commitments that could delay each other:

 Sequential commitments: Is there a next-generation activity that will make the current commitments obsolete before they are

paid out;

 Supplier aggregation: how many activities does a single supplier have and what does that do to the supplier and your risk

profile if you have multiple failures and successes?

A Model for Risks and Opportunities in Global Sourcing

The static and dynamic costs are important. It is also important to evaluate the hidden costs. There are several key factors that have a

significant impact on dynamic costs (cost and partly hidden). They are important to evaluate the total risk associated with the economic

viability and success of global sourcing decisions:

1. The time difference between the supply of domestic and international deliveries;

2. The need for flexibility;

3. The importance of service levels;

4. The logistical costs;

5. The objective quality and / or complexity of the product;

6. The stability of the country /region/currency of the foreign suppliers.

To compare these factors, it is possible to develop a simplified decision framework for a first assessment of the risk associated with

global sourcing decisions. It ranks each factor on a five-point Likert scale (where one indicates low importance / value / cost and five

high importance /value /cost). The best way to represent it is with a spider diagram like the one shown in the

Figure 1. In this way, you can compare different scenarios of supply and the risks associated with each one of them. The result is a

decision support more quantitative than one based on a qualitative judgment.

The global sourcing may be less beneficial than you think. From the perspective of lean (lean thinking), any transport or escort should

be seen as a possible waste5. Before accepting them as necessary waste the risks should be carefully evaluated and if necessary

remediated.

A certain number of initiatives of global sourcing lead to fewer benefits than expected - or actually are not economically sustainable -

because of hidden costs and dynamic than had not been budgeted in the original calculation. Each case must be examined and global

sourcing, according to specific situations, is a decision one way or another. The model examined can help. In other words, often the

best solution is a mix of local and global sourcing.

4
SCDigest Editorial Staff. Understanding the Risks in Global Sourcing. http://www.scdigest.com/assets/newsviews/08-06-04-
2.pdf. Accessed Mar 6th, 2012.
5
Nicoletti, B. (2010). La Metodologia del Lean and Digitize. FrancoAngeli, Milano, Italy.

3
An Example of Balanced Sourcing

A relevant example of the suggested approach is represented by Zara, the Spanish producer and distributor of fashion goods.

Someone has said that "Zara is a fashion company, It is a logistic company carrying fashion." 6 It completely redesigned logistics.

In a certain number of cases, it has passed to insourcing from outsourcing. In these cases, it has obtained a very short and under

control supply chain.

The advantages that Zara obtained from having a short supply chain for a certain number of products and components are:

 Speed of response to new trends and cost containment;

 Reduction of safety stocks;

 Cycle constant supply throughout the year, from various internal and external suppliers. Can vary only tissues and imodelli,

with an update twice a week (6-12 months against competitors who then have time to re-supply much higher).

In the fashion market, it fits the rationalization of the production cycle, but the competitive advantage you get in the arena of time (quick

response) and style.

The supply chain must be efficient with features such as:

 Agility;

 Reducing time to market;

 Ability to change quickly according to new applications.

Therefore maintains production capacity in Europe and Asia, despite the costs are significantly lower. In this way, Zara allocates the

production of products with uncertain demand for European producers, leaving the production of items with predictable demand from

Asian producers. The result is that approximately 60% of production in Europe (Spain).

The "Living Collections " in Zara are manufactured, distributed and sold with the same speed with which change attitudes and

behaviours of customers. With local production, Zara is able to supply even twice a week their stores compared to once a week or less

of its competitors. The offer is completed, planned daily. It takes less than two weeks for an item designed by the design team of La

Coruna arrivals in any of the shops around the world, Zara is thus able to be 12 times faster than the competition. Customers know that

Zara renews the offering every week and often visit its stores (11 times per year compared to 4 of the competition).

The phenomenon is not related only to Zara. GE has recently organized a survey of UK manufacturing companies. 27% had increased

domestic purchases compared with 13% who had reduced them. How extreme situation, the Group Rhodes had increased purchases of

iron castings from national companies from 40% to 90%. These are extreme situations. We will continue to buy on a global basis, but at

a more mature and careful.

Tools for Buyers to Remediate Risks in Global Sourcing

6
Bevilacqua. M. (2011). Corso di Progettazione e Gestione della Catena Logistica. Università Politecnica delle Marche – C.d.L.
Ingegneria Gestionale, http://www.univpm.it/Entra/Engine/RAServeFile.php/f/P002133/allegati_ins/format_tesina.pdf,
Accessed on March 5th, 2012.

4
Given the complexity, uncertainty and cross-functional interactions required in these risk management scenarios, a structured

remediation process for managing the risks is important. This kind of processes includes a series of focus areas and several tools that

help reinforce those focus areas.

First of all it is important to conduct a failure modes and effects analysis (FMEA) .The Fmea is a procedure for the analysis of potential

failure modes within a system for classification by the severity and likelihood of the failures.

The first step is to be realized in the decomposition process, product or system under test in elementary subsystems. It is necessary to

penetrate and understand thinking through the six types of risks, their probability, impact and potential interdependence.

At this point, the analysis of failures of each subsystem, you must list all:

 Possible failure modes, and for each:

 Possible causes

 Possible effects

 The controls in place (in the prevention or detection of a fault)

For all combinations of failure so - because you must consider three factors:

 Probability of occurrence (P)

 Impact of the occurrence (I)

 Possibility of detection by controls (D)

To the extent possible, it is necessary to quantify these factors for the different risk scenarios.

For each of the three factors one should assign a quantitative score (for instance from 1 to 10, in which (for the items "P" and "I") 1

represents the condition of minimum risk and maximum risk to 10 (for the "D" is lower the score - for example, 1 - the greater the chance

of detection of the failure mode.

Once identified the risks several actions are possible7:

 Own the risk

 Portfolio management: Risk is viewed in two ways: in individual projects and across multiple projects – a portfolio view.

 Cancel the use of foreign suppliers:

 Reduce the probability of occurrence of the risks:

 Reduce the impact of such occurrences to take place;

 Improve the monitoring system for early warning of risks taking place;

 Share the risk, for instance with insurance-*

7 SCDigest Editorial Staff. Understanding the Risks in Global Sourcing. http://www.scdigest.com/assets/newsviews/08-06-04-

2.pdf. Accessed Mar 6th, 2012.

5
 Figure 1 The Procurement Risk Diagram

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