In short:

• After a stream of supply-chain issues, business leaders have realized the strategic importance of supply chains to the overall health of their organizations.
• We walk through a few techniques companies can use to pinpoint the risks that their suppliers present, assess the degree of risk and determine how much those threats matter.
• Beyond diversifying suppliers, growing businesses might mitigate these risks by increasing on-hand inventory for certain products. They should also focus on tightening relationships with their supply chain partners.

Before 2020, the supply chain may have been something of an afterthought for the owners and leaders of many small- and medium-sized businesses. Organizational leaders knew the company’s key suppliers, kept an eye on monthly purchasing costs, and may have helped resolve delays or other minor disruptions that popped up from time to time. But for the most part, so long as everything was running smoothly — and it usually was — logistics were not a top concern for the C-suite. It was the domain of operations and warehouse managers (or, increasingly, third-party logistics partners).

Of course, that all changed last year when widespread shortages and delays affected businesses around the world and across industries. Since then, the supply chain has become a front-and-center issue at the highest levels of a business. More recent issues like a grounded container ship blocking the Suez Canal and winter storms in Texas have emphasized the point.

“COVID has pushed all of these concerns up to the front of everybody’s mind, and it’s very boardroom-relevant now,” said Jim Yarbrough, a global intelligence program manager at BSI Group, who consults with businesses on reducing supply-chain risks. “The supply chain must be secure and resilient, and we need alternate suppliers; we need alternate routes.”

For a growing business, the impact of not having inventory to sell or materials to manufacture goods can be devastating — the Federal Reserve estimates the pandemic knocked out 200,000 businesses in 2020. These organizations can’t match the cash reserves of large enterprises, so the effects of a problem can be more immediate and severe.

Leaders are acutely aware of the need for a clear strategy to reduce risks in their supply chain, and they should also know they must continuously evaluate and improve upon that strategy. We consulted supply-chain experts to develop a clear picture of the risks business leaders need to consider when assessing their suppliers, what they can do to mitigate those risks, and how technology can assist in these efforts.

Supply Chain Risks Continue Mounting

Most of the risks that could disrupt your operations fall into four broad categories: economic, environmental, political and ethical. Examples of economic issues are a supplier going bankrupt, a recession, or a work stoppage at a key manufacturing partner. Environmental problems include natural disasters like a flood, earthquake or drought. Using child labor, forced labor or sourcing raw materials from a company that fails to give its workers the necessary protective equipment would be ethical concerns. Political risks could be civil unrest and a new leader who implements steep tariffs or puts restrictions on exports.

These are not new issues, though many of them have become more prevalent: For example, data from the international disaster database EM-DAT shows the frequency of natural disasters has steadily increased over the past 20 years. At the same time, concerns that could be broadly classified as environmental, social and governance (ESG) have come into focus. Take for instance the provenance of products: A growing group of consumers wants to know where goods originated and that they were made with sustainable and ethical practices. Similarly, environmental risks now extend beyond natural disasters to sustainability. If a company is dumping waste in waters or releasing harmful toxins in violation of local regulations, that could lead to a fine or even a forced shutdown.

Additionally, cybersecurity has become a much bigger threat in a business environment that relies heavily on technology to coordinate and manage activities, said Steven Melnyk, a professor of supply chain management at Michigan State University. For smaller companies, protecting against cyber threats comes down to choosing software vendors that follow leading cybersecurity practices.

Strategies to Assess the Risk of Your Suppliers

Small and midsize businesses need to know how the suppliers they work with directly, tier 1 suppliers, stack up in each of these categories. Leading organizations will look upstream to their tier 2 and tier 3 suppliers, but that often comes later. Achieving any level of insight is a big step in the right direction.

To reinforce their supplier networks, companies should first understand which types of risks various partners present and the degree of risk in each case. This is often not an easy nor fast exercise, but it’s critical.

“If the network comes down to one supplier deep in the supply chain and that supplier goes down or that one arc or node goes down, the whole thing falls apart,” said Joe Sarkis, a supply chain management professor at Worcester Polytechnic Institute.

To assess the risks of your suppliers, consider these strategies:

Basic supply chain mapping

Before you can evaluate suppliers (and perhaps your suppliers’ suppliers), you need to map out who they are, what they provide, and where they’re located. Collaborate with colleagues across your organization as you build this map to avoid overlooking a few suppliers, especially if they provide a few small items. You can create a basic map of these links in a spreadsheet or certain supply chain software. It’s important to update the map regularly as you add partners and stop working with others.

Weighted ranking

You can use a basic system that assigns weighted importance to risk factors like economic or political disruption, financial dependence, credit history, and natural disasters, said Jack Cunningham, a purchasing manager at a global consumer products company. If you choose to use this system, you’ll give each of those factors weighted importance and each supplier a score of 1-5 for each (with 5 representing the highest risk). Then, you’ll calculate the weighted average of those numbers to come up with a score that represents a supplier’s total risk — and compare the scores of various partners.

Value at risk (VaR)

The Association for Supply Chain Management (ASCM) has a metric called Value at Risk as part of its Supply Chain Operations Reference (SCOR) model, and it’s another way for businesses to compare the amount of risk that various suppliers present. A company will consider categories of risks — whether they be risks related to politics, weather, ethical practices, quality, or other categories — and assign probabilities to the likelihood of occurrence. For example, if there’s a 10% chance that a hurricane will hit particular geography; and the supplier in that region is your only provider of a certain component, and the value of the product affected would be $3 million, then the Value at Risk is .1 x $3,000,000 = $300,000. Based on these calculations, your company might shift orders to less risky regions or carry enough inventory to cover typical recovery times.

Segmenting suppliers

When using any of these techniques, factor in the importance of various suppliers to your business. You can segment suppliers into groups, much like an ABC inventory analysis. (More on that in the next section.) A partner in the A segment might make a key component for a consistent bestseller, while one in the C segment could offer an easily replaceable product. You shouldn’t necessarily base this ranking on sales alone: A critical supplier in a part of the world with minimal risk may still warrant lots of attention because you’d see a substantial revenue drop if that supplier weren’t able to deliver. At the same time, sourcing a few non-critical or easily replaced components in a high-risk area may not be a major concern.

“I can point at a map and say, ‘You must be risky here because I see a lot of typhoons there’ or whatever, but you really need to understand ‘What is that supplier doing for our company?’” Yarbrough said. “How important are they to our bottom line and everything we aim to do?”

Strategies to Mitigate Supplier Risks

Diversify your supplier base.

Once an organization has assessed the risk of its supply chain partners, the best way to build resilience is to diversify its supplier base. That means finding redundant suppliers for key parts and materials that are located in different parts of the world so, for instance, a hurricane in a certain region doesn’t halt all shipments of a crucial material. It could also mean finding partners closer to home — maybe not in the same country but on the same continent.

Identifying and onboarding a supplier could take anywhere from weeks to a year or more, according to experts we interviewed. A new supplier for a commodity like a ball bearing could be live in a week, while one that provides a specialty part for highly regulated products like medical devices could take a year or longer due to strict standards and testing, said Tony Nunzio, founder, and CEO of consultancy ICC Logistics Services.

Modify your inventory planning and management strategy.

Modifying your inventory planning and management strategy is another way to increase resilience. You’ve likely already considered this: Many manufacturers, distributors, and retailers are struggling to decide how much inventory to carry in light of recent supply-chain snags. Over the past quarter-century or so, many products-based companies have adopted a just-in-time (JIT) inventory strategy. Organizations practicing JIT attempt to stock only materials and goods they expect to sell, along with a small buffer of safety stock, in an effort to reduce costs.

Last year’s supply-chain disruptions and others since, however, could spark a shift to a more cautious stocking strategy.

“Agility lost out to lean, in my opinion, in the early ‘90s,” Sarkis said. “I think agility’s going to be coming back after COVID, but it doesn’t necessarily mean you’re inefficient. It’s just that you have opportunities to be able to minimize risk.”

Even if a just-in-case (JIC) inventory approach gains traction, JIT is not on the brink of extinction. The reason it became popular — it can lower purchasing and inventory carrying expenses — is the same reason it won’t go away. Any company that practiced JIT without factoring in changes in forecasts would have run into problems well before the past year, said Peter Bolstorff, EVP of the ASCM.

Procurement teams will and should continue to use the economic order quantity (EOQ) formula to calculate ideal order sizes, reorder point (ROP) to determine when to place orders and safety stock to figure out the right amount of buffer stock. There are far more advanced models, but these are the starting points for finding ideal inventory levels, or inventory forecasting.

Even as businesses consider holding more inventory, it doesn’t make financial sense to increase stock on-hand for every SKU, nor is it feasible for most. Here are a few ideas to help you determine the ideal amount of buffer inventory to keep in your warehouses:

ABC inventory analysis

A simple ABC inventory analysis is a great way to find out which products pull the most weight for your business. Those select items that make up the majority of your revenue or profit fall into the A category; the next-biggest sellers are in the B group; and the least popular items are in the C group. Companies often find A products represent 70-80% of all sales, B items 15-20% and C goods just 5-10%. Cunningham, the purchasing manager, said that in his experience, 20% of products usually account for 80% of sales, reflecting the Pareto principle, or “80-20 rule.” It makes sense to carry larger quantities of those A products, or the components needed to make them because your business will take the biggest hit without them. On the other hand, certain SKUs in the C group might not be worth selling if it costs more to continue offering them than the profit they drive.

Calculating inventory carrying costs

It’s essential to have a strong grasp on carrying costs, or the expenses associated with keeping items on hand. There are a lot of expenses to consider when calculating carrying costs: storage, insurance, taxes, labor, shrinkage, obsolescence, and more. Opportunity cost is an important consideration here because money tied up in inventory could have been spent elsewhere, like on a marketing campaign or a new hire. But some products are more expensive than others to hold, and managers need to know those costs at the item level as they make stocking decisions. They can then weigh those carrying costs against the value of potential lost sales and determine whether the projected revenue justifies the expenses.

Recognize the potential of scenario planning.

Interest in scenario planning surged after so many organizations were blindsided last year. Companies want to be better prepared for the next disruption, and scenario planning tools can help by projecting the financial effects of, say, a key customer leaving, receiving no orders from two suppliers for three months, or a sudden surge in demand. Awareness of the financial impact of best-case, worst-case and average-case outcomes can inform decisions about how much inventory to carry. Decisions are based on data rather than best guesses.

Treat your suppliers like true business partners.

As should be clear at this point, your success is dependent on your suppliers, shipping carriers, and everyone else that plays a role in your supply chain. You need to remember this as you strengthen your supply chain. It may require shifting the way you think about suppliers, from simply “the person we buy something from” to a true strategic partner.

At the heart of this is the age-old art of relationship building. Wherever possible, take the time to get to know your primary point of contact at each supplier.

“Once [businesses] start down this road of investing time and effort in the relationship with their suppliers, it’s always beneficial,” Yarbrough said. “I’ve never seen it go the other way; it’s always been really beneficial for both parties. It doesn’t really matter what size of organization you are to do that, to see the benefits.”

This small investment of time and money could pay dividends down the road. If an issue arises, who is the supplier more likely to alert: the person that simply submits purchase orders or the one who knows their name and calls to check in every month? One procurement leader Sarkis interviewed said without the close relationships he built with Chinese suppliers, his business would’ve been in serious trouble when the pandemic hit.

To earn priority treatment, supply-chain leaders need to make an effort to understand their partners’ businesses and what they can do to be great customers. A personalized approach to each supplier will make it clear that you value them and view this as a mutually beneficial relationship.

Which Supply Chain Technology Do You Need?

Many of the steps you can take to strengthen your supply chain depend on access to up-to-date, reliable information. A few critical systems can help you track all the nodes in your supply chain, providing a real-time picture of your end-to-end operations.

To get started, growing businesses should invest in tools for inventory management and procurement. Inventory management systems are essential in improving inventory planning and analysis, especially as companies consider keeping more items on hand. Procurement software can help you keep tabs on all of your suppliers by showing the performance, contacts, and transaction history for each. Companies that manufacture will see quick ROI with a manufacturing solution that helps plan production runs and ensures they have enough capacity to meet demand. One other core piece is a demand planning application that can help forecast future sales based on historical sales data and other inputs from complementary systems.

Collectively, these systems are often referred to as supply chain management (SCM) software because they help businesses manage the entire flow of goods, from sub-suppliers through delivery to end-users. Together they record a great deal of information that can be culled into digestible dashboards and reports. For example, how often are supplier shipments arriving late? How fast are products in a certain category turning, and at the current pace, when will you run out? Tracking this data will also reveal shifts in supply and demand that you can use to produce accurate, trustworthy forecasts so you’re prepared for the future.

SCM systems are typically integrated with an enterprise resource planning (ERP) platform that provides a global view of your business — not just operations but also finance, HR, sales and marketing, and more. The ERP allows leaders to see how changes or issues in their supply chain affect other aspects of the organization, like cash flow and cost of goods sold (COGS). That level of detail is absolutely crucial for businesses that want to build a more resilient supply chain without straining their bottom line.

The Bottom Line

The past 14 months or so illustrate why small and midsize business leaders can’t simply hope for the best with their supply chains and turn their attention elsewhere. The connection between supply chain management and financial success, even solvency, is now crystal-clear.

Top decision-makers must be involved in efforts to strengthen the supply chain. They need to realize that risk and reliability are critical factors when making any decision related to their supply chain and adapt accordingly. At the same time, they should recognize the value of establishing trust and goodwill with new suppliers and strengthening relationships with existing ones.

The best advice we can give is: Keep supply-chain risks top-of-mind in 2021 and beyond.

“I think people are going to put their feet back up on the desk again,” Nuzio said. “I don’t think we’re going to be as serious about this as we really should. If they haven’t done it yet, I think they’ve got to [address supply chain risks]. I think they’ve got to pull out all the stops to say what, if anything, can happen, and how can we do our best [to mitigate that]?”