Managing and Addressing Troubled Suppliers. Kimberly Davis Rodriguez, Managing Director Stout Risius Ross ,

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1 Managing and Addressing Troubled Suppliers Kimberly Davis Rodriguez, Managing Director Stout Risius Ross , Peter Stenger, Director Stout Risius Ross , 91 st Annual International Supply Management Conference, May 2006 Summary. All businesses have critical supplier relationships that could impact their ability to deliver quality products/services in a competitive manner. Interruptions can cause significant damage to both financial results (e.g., lost sales, idle facilities, consequential damages, etc.) and to your company image. Suppliers are also sources of innovation and features for the goods and services that your customers want, so maintaining the right suppliers is essential. In this article, we will address techniques for identifying and avoiding supplier based risk, and strategies for dealing with those that may eventually turn into troubled supplier situations. Prevention. The initial step in prevention is to avoid allowing potentially risky suppliers into your base in the first place. As most of us already have an existing supply base, we cannot start from scratch, and therefore we must manage this risk in our current base. But over time, as we introduce new suppliers and eliminate others, we can effectively clean-up the base so that it grows stronger. To accomplish this you need a road map that defines the positive attributes required from a supplier of a given commodity, part or service. A structured strategic commodity planning process identifies critical performance areas and directs organizational sourcing to meet long-term requirements. The result establishes a baseline profile to benchmark suppliers against. By aligning your organization and your supplier base, you improve return on investment within the entire supply chain. Your desired profile will vary depending on the type of item or service being purchased, but generally product types can be grouped together based upon common characteristics. If you effectively communicate your requirements to your suppliers, they will be able to maintain and develop those competencies you value most. Suppliers can focus investment resources where you need them to maintain proper capacity and optimal capital structure. Ideally, your baseline profile should include performance targets or covenants that address capital structure and financial reporting from your suppliers, particularly if you are a significant customer. The following diagram illustrates a balanced model, one that considers many dimensions of performance for presenting and organizing your desired commodity profile and comparing it to your current suppliers.

2 Technology Desired Role of research and Com modi ty Profile development Technology 30 Patents Product or process innovation Financial Capital expenditure requirements Material price volatility Industry condition Geography Transport cost Local market regulations Tariffs Multi-platform sourcing Performance Quality Geography Financial Performance Product launch complexity Frequent design change Actual Commodi ty Pro f ile Quality Safety related Potential warranty cost Narrow loss function profile Manufacturing complexity The actual process for determining your desired commodity profile involves first determining the factors that most impact that dimension and then determining how important those items are within your supply base. The actual factors for any of the five dimensions will vary depending on the nature of the item being purchased. The following table is a simple illustration of possible factors that might be used for two completely different commodities (computer hardware supplier vs. electric motor manufacturer). Computer Hardware Electric Motor Factor Relative Weight Factor Relative Weight On-site 24 hour response time 15 Produces linear and rotary motors 30 Supports Unix and NT server platforms 20 Variable speed capability 25 Customize hardware configuration 5 Waterproof enclosures 15 Provides lifecycle management 10 Advanced light weigh design Hour Help Desk support 10 Highly energy efficient 20 Web-base ordering system 30 Provides internet diagnostic services 10 Total Points 100 Total Points 100 In both cases, the relative weight of the factors total 100, but the individual factors and their respective weightings are completely different. You would perform a similar process to identify relevant factors for each dimension. The determination of the factors and relative weightings should be conducted with a cross-functional team so that current and future requirements are properly reflected. Once your baseline is complete, you can assess your current supply base

3 and new suppliers in order to measure your fit and work to close gaps. One supplier does not need to complete your entire profile; instead, two or more complimentary suppliers may be the best solution. Performance and Measurement Now that we have reviewed the mechanism for preparing a long-term commodity plan and the alignment process, let s look at on going performance measurement. The purpose of the measurement process is to identify suppliers that may be experiencing operational or financial issues that could threaten the stability of your organization. Supplier scoring is a systematic approach to continually assess and monitor supplier performance on critical metrics. It needs to be a consistent and repeatable process based on numerous financial and operational metrics. The primary benefits and characteristics of a supplier scoring process include: Supports a structured response protocol to address supplier performance in a scalable manner Integrated into sourcing and supplier management programs Formulated to consider quality, delivery and financial data The following flow chart illustrates the major phases involved in developing a supplier performance scoring process designed for early identification of troubled suppliers: Initiation Phase I Data mining Initial data set selection Phase II a. Establish business rules Validate metrics effectiveness Go No Go Phase III Configure data engine Establish reporting requirements Testing Phase IV On-going Maintenance Implementation Phase II b. Commonize supplier metrics Phase I involves working with all constituents within your company that may have supplier data you want to use in the scoring system (accounting, engineering, quality, logistics, purchasing and manufacturing) and understanding what that data is and how it is collected. At the end of Phase I, the team will select what it believes are the most reliable and useful data sets for evaluating cross-functional supplier performance. Phase IIa and IIb, which can be done concurrently, involve reviewing the data to begin development of business rules on how the data will be scored and also working with selected sources of data to commonize the scoring and data collection process. Depending on current levels of standardization within the data selected in Phase I, Phase IIb may or may not be required. During Phase III you will build the model and establish the reporting format for supplier results. Depending on the organization size you may need to use a relational database. If the supply base is small enough a spreadsheet may be sufficient. However, in our experience the data analyzed can easily involve millions of records.

4 Despite your best efforts to avoid troubled suppliers, the cyclical nature of markets and economies and the effects of natural and man-made disasters will likely still result in critical supply situations. When a critical supply situation is identified, either through performance monitoring or supplier admission, there are several actions that can be taken to minimize the effect on the supply chain and the cost to the customer. The issues facing troubled suppliers are numerous and the methods and processes to correct those issues are just as numerous. Typically, a customer s primary concerns are continuity of operations/supply and preparing for a potential resourcing. Below we address the primary issues in quickly stabilizing production and the mechanics of an inventory bank build. Insuring Continuity of Operations Continuity of operations is dependent on stabilizing production. Often times, the material pipeline has been depleted as a result of growing trade indebtedness, leading to a tightening of terms and a further deterioration in liquidity. The time and cost of filling the pipeline depends largely on the cooperation level of trade vendors and the accuracy of the material management system. In other words, the better the system, the tighter inventory levels can be maintained. If, however, the system is highly inaccurate, more inventory may be required for stabilization. The length of the value chain also needs to be taken into consideration when determining the costs to fill the material pipeline. The two most significant factors that impact cost and timing are high demand raw material (lack of availability) and distance from source, particularly for material coming from low cost countries. As a sufficient flow of inventory is secured, the supplier s production capability needs to be assessed. Even experienced personnel who have not previously been through a distressed supply situation tend not to be well trained at the finer points of capacity maximization, inventory bank builds, resourcing and the related logistics. Utilizing individuals that understand process control, launch, inventory systems and logistics are critical to maximizing performance. Distressed suppliers are often times very inefficient and are capable of substantially more production than is represented. Retaining key employees that can keep production flowing is critical and should be considered early in the restructuring process. Communication is usually the key element in employee stabilization and may or may not require extensive retention bonuses and plans. Also, changes in the new bankruptcy code may affect the ability to pay retention bonuses. Obviously, vendor management is also critical to the continuity of operations. The fair treatment of vendors in terms of communication and appropriate representations can significantly improve the situation. Effective and timely vendor negotiations, reconciliations and prospective tracking require a substantial effort but can ultimately minimize the cost to all stakeholders. Frequently, vendors have lost trust in the existing management, and intervention from a third party may be necessary. Inventory Bank Build Protection As production stabilization is addressed, a situation analysis needs to take place to determine whether the distressed situation can be resolved. Whether the solution is a restructuring that will eventually correct the situation, or if ultimately the determination is made to exit the supplier, inventory bank builds can often be a solution. Inventory bank builds provide

5 protection/cushion during a restructuring and are often critical in an exit. Bank builds give customers a level of protection that allows them to give the supplier room to effectuate its turnaround plan. It is difficult to otherwise provide flexibility when dealing with production coverage levels of as little as a few days or a few hours resulting from either single sourcing or just in time delivery issues. The bank build process also tends to be a positive net cash flow and revenue gain to the supplier. While bank builds may include additional expenses for dunnage, labor and other variable costs, the additional revenue generated results in greater overhead absorption. In other words, adding volume typically costs less than the average marginal piece price, especially since most distressed suppliers have substantial excess capacity. Note that should the bank build be for protection purposes only and the supplier regains stabilization, the bank build will need to be bled off and at that time the cash flow and revenue effects will reverse. For example, note the following profit gain when utilizing the bank build process: Standard Pricing Model Bank Build Additional Parts Price $100 Price $100 a Material (40) Material (40) b Labor (20) Labor (30) c Variable (10) Variable O/H (15) d O/H Fixed O/H (20) Fixed O/H e Profit 10 Profit 15 a) Assume pricing on bank build parts is a constant. b) Material cost is assumed a constant (depending on situation, there could be expedite costs here). c) Labor assumed increased due to over-time requirement to build bank. d) Variable overhead assumed to increase due to management oversight, equipment maintenance, etc. e) Fixed overhead is considered to be fully absorbed under standard volume assumptions and therefore no further costs are incurred to run additional production. By definition, since inventory bank builds offer protection to the customer, they present risk to the supplier (i.e., providing vehicle to exit). As a result, monitoring programs should be put into place to assure bank build schedules are being met.