Management Accounting

Will Your Supplier Still Be Here Tomorrow?

How to get a handle on the changing risk of your supply chain.
Sarah JohnsonApril 29, 2009

The U.S. automotive industry’s wobbly supply chain has become shakier in recent months with an increasing number of auto-parts suppliers going belly-up or becoming financially distressed as their largest clients — the Big Three automakers — continue to lose money and pull back their business.

The ripple effect throughout Detroit’s tightly integrated supply chain and the fast-moving financial crisis have wrought a situation where “suppliers can go bankrupt over night,” said Mike Agosta, Ford’s North American purchasing controller.

During a recent webcast run by Ernst & Young’s Transaction Advisory Services, Agosta warned that other industries will soon start feeling the supply-chain strain if they haven’t already. To be sure, with the credit markets and consumer wallets clamped practically shut across most industries, a high number of business-to-business companies have a riskier future.

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Agosta and Pamela White, finance director at Rolls-Royce North America, recommended that procurement offices and finance departments get better at monitoring their suppliers so they can put contingency plans in place and avoid as much as possible any disruption to their day-to-day business if a supplier does fail.

“It’s up to us, as [original equipment manufacturers] and customers of particular suppliers, to ensure we’re proactive in assessing their risk and possibility of failure,” said White, adding that the aerospace industry is also experiencing weaker supply chains.

To begin that process, the executives recommended, companies need to redefine their “critical” or “key” suppliers — those firms whose failures could wreak havoc on a company’s own ability to stay operational because it relies heavily on that vendor’s products or services. E&Y claims two-thirds of companies believe they would be adversely affected if one of their top three suppliers failed. Typically defined by the dollar-amount of volume in services or products they provide, key suppliers could also include lower-volume vendors whose products are patent-protected, putting companies in the lurch if they run into serious financial difficulty.

E&Y recommends companies categorize critical vendors into one of three labels: high risk (meaning, they’ve had a “disruptive shock” to their own supply chains or serious damage to their brand or market share); medium risk (their quality has gone down and they appear to be having working-capital troubles) and low risk. Previously, medium-risk suppliers did not receive as much attention at Rolls-Royce as they do today. “Now we’re saying, let’s hold up, let’s do some additional investigation and truly understand what’s’ driving that medium risk,” White said. “Under current economic conditions we’re in, that could change very quickly.”

Rolls-Royce staff is talking with vendors considered both medium and high risk on a monthly or bimonthly basis. In addition, the company is now having weekly internal meetings about its riskiest suppliers.

Companies should try to get a good sense of the financial condition of their riskiest, most critical vendors, and an updated contingency plan for either exiting the relationship or for lessening the effect that the vendor’s bankruptcy filing could have on the business, E&Y recommends. Companies may need to put struggling vendors on a “treatment plan,” in White’s words, which could entail better monitoring, new payment terms, and concessions to keep their business running.

Of course, getting a handle on a privately held vendor’s finances can be difficult. For that reason, experts recommend vendor contracts require some sort of access to current financial information (and now may be a good time to renegotiate contract terms, especially for companies that have the upper hand of a vendor teetering on the edge of the tank). Any reluctance from a supplier to turn over financial information could in itself be a red flag that the vendor is in serious trouble, noted Jim Plemmons, an attorney at Dickinson Wright PLLC.

Other issues to consider beyond getting an actual view of a vendor’s financial statements: What are you hearing in the news media and from competitors about your vendors’ well-being? What can you find out by visiting the supplier and talking with your contacts there more frequently? Has value of their work or product decreased? Has delivery performance fell? Does the vendor work primarily in one industry that is particularly in trouble right now? Could it be having problems with its own suppliers or other customers? Is it concentrated heavily in one location that is having financial difficulty?

In a separate webcast, Cynthia Jamison, national director of restructuring at consultancy Tatum, revealed the early warning signs of a company on the brink of insolvency. When these red flags are taken together and applied to an overall view of a vendor, they may indicate that the vendor should be more closely monitored or its relationship reconsidered. Consider whether the company has:

-Repeatedly missed projections.

-Aging receivables and high inventory levels.

-Lots of impairment charges, indicating previous investments were not correctly valued.

-Experienced high turnover among senior executives.

-Low employee morale, lack of enthusiasm among the rank-and-file, and disagreement among top staffers.