Reducing the cost of disruptions
AUTHOR
Deana Claessen
Content Manager
This article deep dives into the true cost of procurement and supply chain risk for your company.
We hope to show the cost of risk is larger than the procurement spend itself due to downstream dependencies, therefore risk management becomes essential to protecting your P&L and balance sheets.
Summary
Snowballing Costs: Procurement disruptions initiate a downstream snowball of escalating costs, underlining the principle that every change in the supply chain has a cost. Some costs are immediate and obvious like expedite fees, while others may surface months later like cash flow impact, and some remain hidden disguised under the veil of fire fighting.
Liquidated Damages: These are fines imposed by customers due to late delivery. These damages can take various forms including per diem charges, fixed or tiered penalties, and recovery of additional costs incurred due to the delay. They represent a direct financial repercussion of operational lapses, due to failing to meet customer delivery obligations
Expedite Fees: Expedite fees are additional charges incurred to accelerate deliveries, often through airfreight, to mitigate procurement disruptions. In tight-margin industries like garment manufacturing, these fees can be detrimental, potentially wiping out a season’s profits. If companies have modelled their business on sea freight without accounting for additional unplanned airfreight costs, such unplanned expenses could severely hurt their financial stability
Alternative Supplier Costs: In the event of disruptions, resorting to alternative suppliers becomes essential. Companies are forced to pay a premium for higher-cost suppliers at short notice. The associated costs of using alternative suppliers can include premium pricing, expedited shipping fees, and potential re-tooling expenses
Cash Flow Impact: Procurement disruptions, wreak havoc on planned cash flow. Such disruptions misalign the procurement and financial forecasts, causing late customer payments, incomplete customer orders, and delayed customer receivables. This ripple effect strains cash flow especially for those operating with tight margins. More details CLICK HERE
Inventory Costs: In the event of procurement disruptions, a knee-jerk reaction often entails increasing inventory buffers, which ties up working capital and demands additional space. Ordering early, can lead to deterioration costs or storage may outlast manufacturers’ warranty periods, potentially leading to you incurring extra replacement costs for your customers.
Loss Revenue: Disruptions can lead to lost revenue, lost customers and marketing share by causing brand and reputational damage. A BDO study revealed that 38% of CFOs identify brand and reputational damage as a lasting impact of procurement disruptions. The wider risk is customers switching to alterantive providers and may never return. The stickiness of customers in the event of disruptions often hinges on the niche nature of the product or service provided, and the availability of alternative suppliers capable of fulfilling the same need
Hidden Costs Disguised As Firefighting: Hidden costs often emerge disguised as firefighting measures during procurement disruptions. Reworking production plans, incurring opportunity costs from lost productivity during resolution efforts, and reallocating resources like overtime or temporary labor are common repercussions.
Supply Chain Costs
- Expedite Fees
- Alternative Supplier
Your Operations
- Opportunity Cost of Lost: Productivity
- Cost of Reworking Production
- Idle Labour/Machinery
- Cash Flow Impact
- Inventory
Customers & Market
- Lost market share
- Lost revenue
- Brand & reputation
- Liquidated damages
The Problem: Not All Costs Are Immediate & Obvious
Not all costs stemming from procurement disruptions are immediate and obvious; some manifest over time, revealing a deeper financial impact than initially perceived.
Companies often conduct post-mortem cost assessments to pass on the costs to suppliers. However these only address obvious surface level costs
The table delineates how different costs of procurement risk are realised over varying time frames, and how they reflect on a company’s Profit & Loss statement or Balance Sheet
Immediate: These costs are realised almost immediately post-disruption.
Short-term: These costs are realised in the near term, typically within the same fiscal quarter.
Long-term: These costs have a lingering effect and may impact the financials over multiple periods, potentially spanning years.
Cost of Risk | Timing of When Costs are Realised | Appearance on Financial Statements |
Expedited Shipping Costs | Immediate | P&L: Increase Freight Expense |
Liquidated Damages | Immediate to Short Term | P&L: Penalty Expenses |
Over Time Labour Costs | Immediate | P&L: Increased Wage Expense |
Alternative Supplier Costs | Immediate | Increase Cost of Goods Sold |
Brand & Reputational Damage | Long Term | P&L: Potential Decreased Revenue |
Lost Revenue | Immediate to Long Term | P&L: Decreased Revenue |
Inventory Carrying Costs | Short Term to Long Term | Balance Sheet: Increased Inventory |
Administrative Overhead | Immediate to Short Term | P&L: Increased Administrative Expense |
Costs from Reworking Production | Immediate | P&L: Increased Production Costs |
Inventory Costs | Short Term to Long Term | Balance Sheet: Increased Inventory Costs |
Cash Flow Impact | Short Term to Long Term | P&L: Varied Cash Flow Implications |
Cost of Procurement Risk > Procurement Spend
The cost of risk surpasses the procurement spend due to the intricate web of downstream dependencies that are affected by procurement disruptions.
Every dollar of procurement spend carries a multiple in cost of risk
When a procurement hiccup occurs, it not only incurs immediate additional costs but also triggers a cascade of financial repercussions throughout the supply chain, significantly amplifying the total cost impact beyond the initial procurement expenditure.
Calculating Procurement Value at Risk (VaR)
Value at Risk (VaR) is traditionally used in finance to estimate the probability of portfolio losses based on the statistical analysis of historical price trends and volatilities.
However, in the context of procurement, VaR can be adapted to measure the potential financial impact of procurement disruptions over a certain time period.
The Value at Risk due to Procurement Disruption could be calculated by aggregating all potential additional costs that might be incurred due to disruptions, beyond the initial procurement spend.
Case Study: Value at Risk is 127x Procurement Spend
Simpsons Manufacturing Ltd is an automotive parts manufacturer for large OEMs. Their annual procurement spend is $180m of which $144m is spent with 60 key suppliers.
Bradley & Hamilton Components Co. is a key supplier. Simpsons procures $1,000,000 of rubber components per year from Bradley & Hamilton, with an average order value of $80,0000 per month.
The rubber components are a relatively small spend but a critical material for nearly all of Simpsons products.
Calculating Value at Risk for $80,000 Order
Cost of Disruption Risk
Expedite Fees:
The supplier is in Taiwan and seafreight is the normal logistics mode. In the event of production delays, airfreight costs from Taiwan to UK would cost roughly $5 per kilo. Estimated costs $40,000
Liquidated Damages
In the event of disruptions leading to delays, customer contracts stipulate liquidated damages of 1% of customer order value per day for a $2,000,000 order. Estimated costs for 7 day delay $70,000
Alternative Supplier Costs
In the event of needed European suppliers on short notice, the cost for the order would be 40% more expensive. Estimated cost for short lead time local supplier $112,000
Lost Revenue & Reputational Damage
Simpsons manufacturer a commoditised car components. The customer therefore has multiple alternative suppliers with the same capabilities. Total orders from this customer per year amount to $10,000,000. Estimated cost of 1 year lost revenue $10,000,000 should the customer use alternative suppliers. Moreover, there is a big risk the customer never returns.
Other Costs:
These include; idle labour and machinery, Costs from Reworking Production, administrative overhead, cash flow impact from low revenue etc.
Order Value: $80,000
Value at Risk: Minimum $10,222,0000
We can see the value at risk is significantly higher than the order value.
The highest cost is by far is the brand and reputational damage leading to loss customers. This is the biggest risk procurement carries and echoed in a recent survey of Chief Finance Officers.
Benefits: How Kavida Reduces The Cost of Disruptions
Kavida specializes in preventing delays and disruptions in procurement, ensuring smooth and reliable inbound order flows as our core business focus.
Early Warning Alerts: Kavida’s AI provides early alerts for potential disruptions affecting your orders, identifying specific orders and suppliers at risk due to various issues, from natural disasters to overlooked invoices, ensuring you can minimise time to detection.
Swift Communication: By centralising communication and enabling collaboration between suppliers and departments, Kavida facilitates quicker resolution of issues, minimises time to response.
Data Driven Sourcing: Kavida’s platform utilises over 30 metrics to assess supplier performance and operational risks, empowering procurement teams to make informed, risk-based sourcing decisions, thereby minimising potential disruptions and costs before placing orders.
AUTHOR
Deana Claessen
Content Manager
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Just-In-Time In 2024
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