An in-depth look at the framework that organizations can use to accurately evaluate risk and purchasing opportunities.

What you need to know: • 25 percent of organizations view China as the most likely source of volatility within

their supply chains, yet , nearly the same number of respondents see China as the area where they were most likely to expand their supply chains in the future.

• Due to a fundamental mispricing of risk, organizations are expanding their supply chains in countries that they know pose the most risk and potential for volatility.

• In assessing price forecasts for steel, the key factors to consider include raw material prices, wage rates, productivity, profitability, and supply-and-demand for each country.

• Equipped with market insight, accurate price histories, and information about target countries, organizations can effectively avoid risk and tap into potential opportunities.

Supply Chains Expand in Risky GeographiesWhen it comes to identifying supply chain risk and effectively tapping into global business opportunities, many organizations overlook the fundamentals and wind up making wrong and costly decisions. Last year, when IHS and Supply and Demand Chain Executive magazine surveyed supply chain executives, they learned that 25 percent of executives view China as the most likely source of volatility within their supply chains. Curiously enough, nearly the same number of respondents pinpoint China as the area where they were most likely to expand their supply chains in the future.

This brings up a pressing question: Why would firms knowingly expand their supply chains in countries that they know pose the most risk and potential for volatility? “We believe the answer lies in a fundamental mispricing of risk,” says Paul Robinson, IHS pricing and purchasing analyst. “This situation can be avoided with solid country risk analysis and price forecasting analysis.”

Take commodity grade steel sheet, for example. Used to make everything from automobiles to air conditioners, steel sheet is produced in several countries around the world. “Because of this international scope,” says Robinson, “companies can take a step back and look specifically at global developments in many different regions.”

The process starts with a thorough country risk analysis through which organizations can develop unique risk profiles for specific source decisions based on the sourcing relationships themselves. A steel purchase, for instance, is transactional in nature. There’s no servicing contract associated with the buy, no replacement parts to worry about, and very little quality differences between countries. “As a result,” says Robinson, “the risk profile for steel is fairly simple.”

IHS OpERatIOnal ExCEllEnCE & RISk ManaGEMEnt July 2014

Supply Chain Risk: How to Effectively Evaluate Sourcing Risks and Opportunities

Establishing Risk probabilities Next, says Robinson, establish subjective probabilities for these three key risks: Enforceability of private contracts, losses due to corruption, and losses due to crime. Enforceability of private contracts carries much of the weight, he notes, because the buyer’s goal is to get his or her hands on the steel – and because most producers possess histories of low crime and corruption.

Steel Sheet Country Risk Scores

Weight JapanUnited States

Germany turkey Brazil Mexico China

Enforceability of Private Contracts 60% 3 2 4 11 10 14 35

Losses due to Corruption 20% 6 5 8 28 61 60 73

Losses due to Crime 20% 2 10 11 26 59 86 65Steel Sheet Risk 3 4 6 17 30 38 49

Source: IHS Commodity Watch Update, November 2013

The risks laid out in the table above illustrate the probability of the triggering of a defined event. In this case, such an event would either be a worsening of contract enforceability or an increase in losses from corruption or crime. Not surprisingly, the U.S., Japan, and Germany lead from a risk perspective. “What may come as a surprise,” says Robinson, “is China’s position as a high-risk country due in large part to problems with contract enforcement.”

Hot-Rolled Sheet price Comparison (US Dolllars/Metric tonne)

Source: IHS Hot-Rolled Steel Sheet Price Comparison

In assessing price forecasts for steel, the key factors to consider include raw material prices, wage rates, productivity, profitability, and supply-and-demand for each country. This information can then be used to build forecasts for those countries. As you can see from the above chart, the Latin American producers (Brazil and Mexico), are notable outliers on the high side, whereas the Asian producers (China and Japan), are on the lower end of the pricing picture.

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25 percent of executives view China as the most likely source of volatility

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Supply Chain Risk: How to Effectively Evaluate Sourcing Risks and Opportunities

Supply Chain Risk: How to Effectively Evaluate Sourcing Risks and Opportunities

Identify Supply Chain Risk and Opportunities

Cost* Risk**Sourcing Score ([a*ln(b)]; US=1)

Sourcing Score ([a*ln(b)]; US=1)

China 687 48.6 2670 2.67Japan 694 3.4 849 0.85Turkey 679 17.4 1939 1.94Brazil 933 30 3172 3.17Mexico 764 37.6 2772 2.77United States 698 4.2 1002 1Germany 688 6.2 1254 1.25

Source: IHS

After developing a forecast for risk and price, you’ll need a framework to combine the two together. Because risk scores vary from country to country, it’s important to reduce that dispersion and ensure the risk section doesn’t do all of the “heavy lifting” in the final calculation. “Take the natural log of each of these scores to compress them down,” says Robinson. “In the end, you’ll still have relative differences, but they’ll be slightly smaller than they were previously.”

The final step in effectively identifying supply chain risk and purchasing opportunities is to multiply the scores by the price forecasts to get single sourcing risk scores for each country. The results for the steel example reveal that even though China’s position as the low-cost producer is expected to hold over the next five years, its higher profile doles out enough punishment to push China towards the bottom of the risk adjusted sourcing score list.

“Japan and the U.S., on the other hand, which were in the middle of the pack of our price discussion,” says Robinson, “move to the top of the sourcing score list reflecting their superior risk profiles.”

In Conclusion

When it comes to identifying supply chain risk and effectively tapping into global business opportunities, many organizations overlook the fundamentals and wind up making wrong and costly decisions. Equipped with market insight, accurate price histories, and information about target countries, organizations can effectively avoid risk and tap into potential opportunities.

We believe this represents a fundamental mispricing of risk – a situation that can be avoided with solid country risk analysis and price forecasting analysis.

aBOUt IHS

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