Jun 09, 2022

Supplier Risk Assessment: How to Understand and Reduce Risk

by Arielle Kushner

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In an ideal world, you can always rely on your suppliers to deliver the goods and services you need. However, this isn’t always the case, making supplier risk management a genuine concern for companies.

Suppliers can pose a risk to businesses since they are companies themselves. This means that they are susceptible to the same risks as any other enterprise, including financial risks, political risks, and natural disasters. As a result, businesses need to identify and mitigate these risks as much as possible.

In this article, we’ll discuss the most common types of supplier risks and how you can protect your business from them. Let’s get started!

What Is Supplier Risk Assessment?

Supplier risk assessment consists of the many methods businesses can employ in order to pinpoint and address the threats associated with working with a particular supplier.

Many potential threats are associated with working with suppliers, like quality issues, delivery issues, financial instability, and more. By identifying and assessing these risks upfront, businesses can avoid or minimize potential problems down the road.

Supplier risk management aims to identify and assess the risks associated with working with a particular supplier. It should account for both potential risks and the likelihood of those risks occurring.

There are many different approaches to supplier risk assessment. One common method is to use a scoring system. Here, you would assign a numerical score to each supplier based on their risk. The higher the score, the more risk involved.

Another approach is to create a list of criteria that you use to assess each supplier. This list might include things like financial stability, performance history, quality control, and delivery times, among others. You would then rate each supplier on each criterion and come up with an overall risk score.

Other companies use a combination of different approaches. Regardless, supplier risk assessment is an integral part of doing business, no matter what method you use. It can help you avoid potential problems in the long run and ensure that you’re getting the best possible products and services from your procurement process.

Challenges of Supplier Risk Assessment

Performing an accurate and comprehensive supplier risk assessments can be challenging for several reasons:

Large supplier base: The number of suppliers a company has can vary significantly depending on its industry and size. For example, companies in the technology sector may have upwards of 10,000 vendors, while smaller businesses may only have a handful. Regardless of the size of your company, performing an accurate and comprehensive risk assessment for all your suppliers can be challenging.

Different Issues per Organisation: There is no one-size-fits-all strategy for supplier risk assessment. Every organization is unique and has different risks associated with its suppliers. What works for your rival company might not work for your organization.

Lack of Resources: Organizations often lack the internal expertise to assess supplier risk effectively. They may not have the right tools or processes to conduct a comprehensive assessment. Additionally, conducting a supplier risk assessment can be time-consuming and resource-intensive. 

Too Complex: Today’s supply chains typically involve thousands of stakeholders to produce a single product. Often, they span across multiple countries, with each link in the chain introducing new risks. As such, they won’t even bother with a vendor risk management program or supply chain transparency because there are too many entities involved.

Data Restrictions: To evaluate supplier risk, organizations need access to various data, including financial information, performance indicators, quality control metrics, and more. However, many suppliers are reluctant to share this information with their customers for fear of competitive advantage or simply because they don’t have the resources to compile it.

Risk is Inherent: There’s some level of risk involved in any business relationship. This is especially true when working with suppliers. Since there’s no chance of eliminating inherent risks, some companies forgo it altogether, not knowing that they’re putting their organization even more at risk.

Why Is Supplier Risk Assessment Important?

Today, organizations are more aware of the need to manage supply chain risks consistently and proactively. A supply chain disruption at any point in the process can significantly impact business operations, including disruptions to production, delivery of goods and services, and ultimately, revenue and profit.

While supplier risk assessment is not a new concept, the current global business environment has made it a top priority for many organizations. The COVID-19 pandemic has shown us how vulnerable global supply chains can be to disruptions and how quickly those disruptions can escalate into major problems.

Vendor risk is significant and can include financial, operational, and reputational damage to your business. Thus, a comprehensive supplier risk assessment program is crucial for an organization’s ability to mitigate supplier risk even before onboarding a supplier.

Supply chain risk management is a continuous process. To protect your business, you need to be proactive and clearly understand the risk factors that come with working with different suppliers. By conducting supplier risk assessments, you can identify which suppliers pose the biggest threat to your business and take steps for risk mitigation.

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Types of Supplier Risk

There are different types of risks that suppliers can bring to your business. Here are the major ones:

Strategic Risk

Strategic risk is the possibility that a supplier won’t be able to meet your needs due to incompatibility in strategic objectives. For example, they may be making business decisions contrary to supporting your growth, such as allocating resources to a new product line unrelated to your company.

Strategic risks can come in the form of mergers, new product development, or management changes. All of these could lead to the supplier no longer being able to provide the same products or services that they currently do.

Operational Risk

Operational risk is the possibility of loss due to errors or omissions in the planning and execution of business activities. This type of risk can be caused by inadequate training, systems, or processes. Staffing issues can also prevent vendors from accomplishing their tasks as expected.

A major example of operational risk is when the supplier fails to solve internal and external issues right away. This can disrupt your company’s production or service levels and cause customer satisfaction to decline. 

Understanding your vendor’s capabilities and procedures is vital to avoiding these risks. You should also have contingency plans in place in case of supplier disruptions.

Business Continuity Risk

Business continuity risk is the possibility that a supplier will not be able to meet its contractual obligations due to an unforeseeable event. This type of risk is often mitigated by having contingency plans, such as alternate suppliers or manufacturing locations.

It’s often considered a subcategory of operational risk in that it represents the potential for disruptions to business operations. However, it’s also unique because it specifically relates to the supplier relationships and contracts that a company has in place.

Natural disasters and accidents, such as fires or power outages, can cause business continuity risks. So can financial difficulties, such as bankruptcy.

Compliance and Regulatory Risk

Compliance and regulatory risk arise when a supplier does not comply with applicable laws, regulations, or industry standards. This type of supplier risk can result in financial penalties, damage to reputation, or other negative consequences.

Non-compliance can lead to regulatory action against the company, including fines, suspension of operations, or even revocation of licenses. In some cases, non-compliance can also lead to criminal charges against the company or its executives.

Compliance and regulatory risk are significant concerns for companies doing business in highly regulated industries such as healthcare, finance, and energy. In these industries, the consequences of non-compliance can be severe, and companies must take steps to ensure their suppliers comply with all applicable laws and regulations.

Information Security Risk

An information security risk is any type of risk that could potentially compromise the confidentiality, integrity, or availability of an organization’s data or systems. This could include risks posed by malicious cyberattacks, human error, or system vulnerabilities.

Cyberattacks and data breaches are the most common information security risks that you can get from suppliers. These risks come from various sources, such as malicious insiders working for the supplier, poorly protected data storage systems, and previously hacked systems.

To protect your organization from these types of risks, not only do you need to have strong information security controls in place, but you should also consider the measures taken by your suppliers to protect your data. These include things like data encryption, access control measures, and security monitoring.

Financial and Credit Risk

There is also the risk that a supplier will not be able to meet its financial obligations to you or that it will default on its debt. This can happen if the third-party provider is having financial difficulties, or if it’s unable to get financing from lenders.

There are several ways to assess financial and credit risk. One way is to look at the supplier’s financial statements, which will give you an idea of the supplier’s overall financial health. Another way to assess financial and credit risk is to contact the supplier’s lender(s) and ask about the supplier’s creditworthiness.

Reputation Risk

Your company may also suffer damage to its reputation due to the actions or products of your supplier. This is a critical consideration, as your company’s reputation is crucial to its success.

Lawsuits and data breaches that your supplier is involved in can indirectly affect your company’s reputation as well. If your supplier is caught up in a scandal, it may reflect poorly on your company by association. You don’t want to be known as the company that does business with an unethical or illegal supplier.

How to Perform a Supplier Risk Assessment

Performing a supplier risk assessment is an important step for businesses to understand the threats posed by their suppliers. By following these steps, you can conduct your own assessment:

Prioritize Critical Supplier Risks

It can be daunting to think of assessing and monitoring all types of supplier risks for your company. To start, you can focus on the crucial risks to your operations. For instance, you should evaluate the operational risk third-party providers bring to your business, especially if you’re just starting in the industry. You don’t want to start on the wrong foot with your customers due to delayed orders and damaged goods.

Create Supplier Risk Assessment Questions

Once you’ve determined the critical supplier risks you want to evaluate first, you can then create a list of questions that will help you identify potential risks associated with working with a particular supplier. Here are some example questions you might ask:

  • What is the financial stability of the supplier?
  • Does the supplier have a good reputation?
  • What is the supplier’s history of quality or delivery issues?
  • What is the supplier’s customer satisfaction rating?
  • Is the supplier compliant with all relevant regulations?
  • What is the supplier’s environmental record?
  • Does the supplier have a good safety record?
  • What are the supplier’s labor practices?
  • What is the supplier’s capacity to meet your demand?
  • What is the supplier’s contingency plan in case of disruptions?
  • What is the supplier’s insurance coverage?
  • What are the terms of the contract with the supplier?

These are just some of the questions to help you get started with supplier risk assessment for your company. You can modify them or ask more specific questions to get the answers you need.

Understand the Supplier Risk Assessment Matrix

A supplier risk assessment matrix is a tool organizations use to evaluate and manage supplier risks. The matrix can be used to rate suppliers on various factors, such as financial stability, quality of products or services, delivery reliability, and customer satisfaction. This allows you to evaluate third-party threats according to probability and impact.

There are five risk levels listed below:

  • Negligible Risk: This means there is no or minimal risk associated with the supplier. As such, you don’t need to take any action yet for supplier risks with this risk level.
  • Low Risk: Low risk scores would also mean that the third-party threat won’t significantly impact your business operations. You can simply monitor it and take action when it becomes a medium or high risk.
  • Medium Risk: Medium risk means you will have to mitigate the risk by adjusting policies and processes involving the supplier. Make sure to review supplier performance regularly. 
  • High Risk: Similar to medium risk, you have to take steps to minimize high-level risks. Some actions would also depend on whether the supplier delivers enough value or critical service to justify continuing vendor relationships with your business regardless of the high risks involved.
  • Extreme: As much as possible, you should avoid suppliers who bring extreme threats to your organization in any type of supplier risk. Although this is rare, it’s best to find another vendor if you encounter this level of risk with any of your third-party providers.

Plan Your Course of Action

Going into a supplier risk assessment blindly can lead to negative consequences. You need to have a plan to ensure the best possible outcome.

The plan should include:

  • A description of the supplier risk assessment process
  • The objectives of the supplier risk assessment
  • The criteria for assessing supplier risk
  • The steps in the supplier risk assessment process
  • The resources needed for the supplier risk assessment process

Once you have the assessment results and have evaluated them based on the supplier risk assessment matrix, you should have a clear understanding of which suppliers pose the greatest risk to your organization. The data you gathered should help you make intelligent decisions about which suppliers to work with and how to mitigate the risk they pose. 

Risk management is an essential part of doing business, and supplier risk management plays an important role. By assessing and mitigating the risks associated with your suppliers, you can protect your business from potential losses and ensure that your supply chain remains strong.

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