Evaluating Supplier Risk: Why Companies Should Consider Non-Financial Metrics
IntroductionAs supply chains deepen, companies are exposed to ever-growing counterparty risk. This is particularly relevant for large entities. Risk evaluation requires tracking a number of quantitative metrics which signal danger well ahead of time. Companies are wise to evaluate supplier risk continuously to minimize disruption to their production. Most companies have in place a formal risk management program, as documented in this report (MAPI members only).
The quest to track a rapidly rising number of suppliers (some companies count thousands of them) can take a toll on management teams. Risk monitoring departments simplify the task by focusing on information that is easy to source and interpret. Not surprisingly, procurement and finance managers reach for financial data first. Accounting figures are readily available, and if not, can be requested from a supplier as part of a partnership agreement. Financials convey clear messages. Their definitions are standardized, and executives not steeped in finance or accounting can grasp their meaning.
What is often overlooked are non-financial metrics. They vastly enlarge the scope of risk monitoring, picking up red flags that would not show up on balance sheets and P/Ls. For capturing efficiency of supply chains, no single set of metrics will be satisfactory. Companies are right to experiment with different blends of measures because their operations feature disparate supplier pools or technology. As a result, there is no right or wrong weight of financial vs. non-financial metrics.
What is important is that executives consider non-financial metrics as complementary measures of a supplier’s health. It is easy to zero in on profits, accounting returns, etc. But neglecting non-tangible assets, such as quality, innovation, or customer service risks, will lead to missing relevant early warning signals. Additional risks (not considered here) include suppliers’ cyber risks and the risks in suppliers’ own supply chains.
This short note will review the use of non-financial metrics but also compile a list of most commonly used measures (financial or not) and sort their relative importance. The object is to give companies an easy-to-understand menu of choices for consideration.
Why Use Non-Financials?Non-financial metrics often vanish from view because they are more difficult to compile than financial ones. It is difficult to capture the competitive strength or culture of a supplier through quantitative financials alone. A non-financial analysis of suppliers allows for better assessment of strategic fit and corporate goals, something that financial metrics do not supply. For example, some companies use interviews to compile a profile of a supplier that can be further quantified (members of MAPI’s Purchasing Council can view a related study here).
Second, financials may omit (or inadequately estimate) parts of assets that are intangible. For example, intellectual capital and customer loyalty are “soft assets” that remain vitally important in a supplier relationship. The ability to work jointly, build cultural affinity, and minimize supplier risk often escapes recognition. John Evans, vice president of procurement at Ingersoll Rand and a MAPI member, goes further and claims that “non-quantifiable or soft data are important in terms of raising flags to dig deeper,” suggesting areas such as management turnover, poor labor relationships, tier two supplier rumors, or obvious spend pattern reduction.
Another measure to single out for added attention is the propensity to innovate. It can be proxied by R&D spending, staffing levels, or patent counts. A company that innovates would want its suppliers to be innovative, too.
There are others. Managerial capabilities is an obvious one. It is subjective but could be quantified if indexed against peers. Frequent contacts with a supplier’s senior management and mid-level engineering staff can shed light on managerial quality and be ranked by internal votes.
There are also employee relations. Do your supply chain workers go out on strike often? How high is their staff turnover? Are employee relations cordial? These metrics can be compiled from private sources and indexed as appropriate.
Product quality certainly factors into a supplier’s strength. Supplier quality metrics are plentiful and can be replicated across technologies or corporate size. Safety and quality issues routinely dominate the rankings of suppliers’ burning issues, as is evidenced in this brief survey.
Then there is brand value. From a risk perspective, brand valuation matters less than the measures mentioned above. Correspondingly, its weight should be relatively small in overall aggregation. Brand is a measure of value itself, so its inclusion will enrich the overall assessment.
While it is hard to quantify many of these intangibles in dollars and cents, statisticians and economists can help devise non-monetary indices. The most important aspect is that these component measures be easy to aggregate and track over time.
How Important are Non-Financials?One way to judge the usefulness of non-financial measures is by assessing their predictive power. If they anticipate financial risk and performance of a supplier’s health, then they usefully augment purely financial measures. Even when they do not correlate with the financials, they nonetheless shed independent light on the longer-term strategic value of supplier relationships.
Investment in research and development can approximate innovation. In financial statements, it is recorded for a current period only. If innovation expenditures are eventually monetized through successful product launches, they augment future profits. The same can be said of effective marketing investment in customer relationships. These can raise top-line revenue and reduce transaction costs over future accounting periods.
What are the downsides to non-financials? The first must be the sheer difficulty in quantifying them. The costs involve tracking (ongoing monitoring) as well as one-time expense in devising the measures. By contrast, financial metrics can be readily lifted from accounting reports.
A related cost is the additional workforce training required to track data. It is one thing to compile and analyze existing information, but quite another to process intelligence from an outside entity with a limited stake in the enterprise.
Another obstacle involves methodology. Financial measures oscillate around defined metrics and clear definitions. Not so with non-financials. They could be measured any one way with no consensus on definitions. For example, some measures may be tracked over time, others in static volumes or percentages, and yet others in index numbers. Some may be purely descriptive and difficult to quantify. In an example from a MAPI member company, the methodology includes a supplier’s systems covering quality, commercial and materials side, engineering, sustainability, EHS, and leadership, among others, as non-financial metrics.
One way to rectify this problem is to start small. Performance yardsticks can be expressed in general subjective terms (say, very good, good, so-so, bad, etc.). This allows aggregation with other similar measures that can be weighed into indices that are more general. Simplicity also means flexibility. Arbitrary changes to weights are possible, particularly when supplier relationships change over time. For example, quality can be overweighed at the expense of investment when a supplier scales up fast but lags in internal controls.
Another reason for retaining flexibility when evaluating non-financial weights is causal links. Companies search for performance metrics but not all metrics explain risk. Some links may change over time, and there are no explicit models that definitively explain supplier performance.
There are also purely statistical problems with non-financial measures. To the extent that they rely on surveys or small sample sizes, statistical error may not be far away. Questionnaires may be small or incomplete. In addition, some variables may be captured improperly, carrying measurement error down the evaluation path.
Finally, managers should beware of “evaluation overkill.” This occurs when too many variables – financial or non-financial – crowd into models. An overabundance of metrics dulls the sharpness of evaluation. When managers follow too many measures, they obscure the impact.
Metric ExamplesIt is advisable that companies perform some trial and error search for the most suitable measures. Plain copying what others have done is not a good idea. The selection process ought to reflect factors such as organizational objectives, corporate culture and strategy, competition, technology, and value drivers. As mentioned earlier, selecting metrics is a dynamic enterprise. What may appear relevant today need not be so in the next accounting period.
The matrix below suggests some financial and non-financial metrics of supply chain evaluation. To simplify, measures are shown in clusters. The assessment of importance stems from survey results and the author’s subjective evaluations. The list omits most pure financial metrics (such as profitability, sales, etc.) because they are widely known and used.
The assessment of importance is somewhat subjective, particularly where survey data are lacking. The order of importance is relative and not normative. That is, “less important” does not mean a measure is unimportant but merely that it is less important than “somewhat important” while the latter is less important than “very important.”
Not all measures are quantifiable. Where they can be captured numerically, perhaps the best approach is to construct a series of index numbers normalized to a base period. Non-measurable categories may be assigned subjective numerical values on a chosen scale and use the same scale to compare performance across suppliers. While not perfect, this blended methodology allows for aggregation, weighing, and comparisons.
A basic review of non-financial metrics yielded a rather far-reaching list grouped around several categories of relationship management. Supply chain leaders will assign weights of importance to selected indicators to aggregate them into composite indices measuring holistic supplier risk. These indices will also comprise financial metrics.
In the final instance, the object of this exercise is to build better-managed supply chains. Helping along the way are digital supply networks, which find ever-greater adoption rates. Tracking performance over time will serve two purposes: one, assess relative strength and weakness of particular suppliers; and two, focus attention on those aspects of the supply chain that are found to be lacking. Both components should be used proactively to improve the forward-looking efficiency of supply chains.
i M. A. Intaher, Key indicators for optimizing Supply Chain Performance: the case of light vehicle manufacturers in South Africa. Journal of Applied Business Research, 30(1), 277-287, 2014.
ii A. Gunasekaran, et al, A framework for supply chain performance measurement. International Journal of Production Economics (87), 333-347, 2004.
iii MAPI, Survey on Supply Risk Management, June 2017.
iv Alexandra Wrage, Managing Supplier Risks: Risk Sorting and Due Diligence Best Practices, MAPI meeting presentation, June 2016.
v Michael Watkins, Supplier Assessments; “What, When, How & Results”, MAPI meeting presentation, June 2017.
vi Stephen Laaper, Ryan Robinson, Paul Wellener, and Glenn Yauch. Embracing a digital future, Deloitte Insights, March 2018.