Find Your Focus: Factors To Consider When Calculating Risk

Categories : Procurement Goals | Reduce Risk | Evaluate Supply Market | Negotiate | Set Strategy Published on : Feb 28 2017

By: ProcurementIQ Analyst, Anna Son

While every market faces its own unique challenges and growing pains, there are some markets that are more risky than others. ProcurementIQ has identified three criteria that buyers can use to more accurately evaluate the market: supply chain risk, supplier profitability and financial risk, and price driver volatility. Understanding market dynamics and the underlying risks will not only help buyers make more informed purchasing decisions and negotiate better deals, but will also help to mitigate potential financial losses.

Supply Chain Risk

Markets with a higher level of supply chain risk pose a threat to buyers because suppliers will seek to pass any changes (i.e. availability and prices of key inputs) to the buyer. For example, ethanol, which is commonly used as an additive in a wide range of industrial and consumer products and gasoline mixtures, carries high supply chain risk. Suppliers produce ethanol by fermentation, distillation and dehydration processes. Corn, which is the most commonly used feedstock for fuel ethanol, is subject to severe weather, disease and other unforeseeable damages. During the three years to 2017, the price of corn has plummeted at an estimated annualized rate of 4.3%, exhibiting substantial volatility due to unexpected weather conditions that have negatively impacted the yield of corn. In turn, the fluctuating corn yields of feedstock growers in the United States represent the greatest risk for ethanol suppliers and could potentially impact the price buyers pay.

The biodiesel market also exhibits a high degree of supply chain risk. Biodiesel is an alternative fuel that can either be used as a pure fuel or blended with other oil-based fuel products. The risk in this market stems primarily from fluctuations in oilseed crop production, which is subject to unforeseen circumstances such as drought or other poor growing conditions. The output of feedstock sources, including soybean, sunflower and rapeseed crops, has fluctuated significantly in recent years. In fact, the world price of soybeans has plunged at an average annual rate of about 7.7% in the three years to 2017, according to ProcurementIQ estimated. Highly fluctuating soybean prices make it more difficult for biodiesel suppliers to maintain consistent pricing strategies, ultimately translating into volatile biodiesel prices for buyers.

In order to alleviate the impact of potential supply chain disruptions on their business, buyers should try to identify risks early on. While some risks are unavoidable, such as those triggered by natural disasters or geopolitical changes, there are steps buyers can take to mitigate them. For example, buyers should have a stream of both domestic and foreign suppliers in case one of those has to halt operations due to natural disasters or geopolitical changes. Additionally, buyers that source their products or parts from a single supplier, also known as single sourcing, should consider diversifying their sourcing portfolio. Although single sourcing helps ensure quality consistency and streamline operations, it exposes buyers to greater risk of supply chain disruptions and downtimes in the event that a supplier is unable to deliver key inputs. Furthermore, buyers can maintain contingency stock or develop internal supply chains, also known as vertical integration. When companies integrate vertically, they develop internal sources to obtain key inputs in order to reduce costs and mitigate supply chain risks.

Supplier Financial Health

A supplier’s financial health can serve as another metric to determine how risky the market is. In order to evaluate a supplier’s financial performance, buyers can look at the company’s profitability and bankruptcy risk. Markets in which most suppliers incur low and falling profit margins or operate with a high degree of financial risk would be considered a greater threat to buyers. For example, the average supplier in the deep sea cargo transportation services market operates with a high degree of financial risk. The risk is primarily a result of significant megaship costs, which they have yet to compensate for due to the oversupply of cargo ship capacity. Given that buyers heavily rely on cargo companies to transport goods, any delivery disruptions can take a toll on buyers’ operations. This was the case with the recent bankruptcy of Hanjin Shipping, which was previously one of the world’s largest shipping companies. For buyers that shipped goods with Hanjin, the company’s inability to pay for docking and unloading fees resulted in millions of dollars’ worth of merchandise being held at ports. Hanjin’s bankruptcy has had a ripple effect on a number of key buyers, ranging from drayage service firms to freight forwarders to retailers.

The newspaper advertising and catalog printing services markets are also considered risky. Due to the rising proliferation of digital platforms, market sales have spiralled downward in recent years, which has ultimately eroded supplier profitability. Considering the decline stage of these markets, the average supplier maintains low profit margins and operates with a high degree of financial risk. Recently, major newspaper firm Gannett announced it was planning to slash more than 100 jobs, while the New York Times is also preparing for budget cuts and layoffs. Similarly, a number of catalog printing service providers have consolidated or exited the market due to financial hardships caused by shrinking demand. For example, prominent printing and marketing firm Standard Register filed for chapter 11 bankruptcy in 2015.

Buyers should carefully evaluate a supplier’s financial health prior to signing an agreement to ensure the supplier will remain in business for the duration of the contract term. Buyers should also consider working with a supplier that has a diversified client portfolio, multiple product lines and the resources to stay afloat during economic downturns.

Price Driver Volatility

Price driver volatility measures the average volatility across external demand drivers and relevant input cost drivers, which are factored into ProcurementIQ's market risk calculation. A high level of driver volatility indicates that buyers are more vulnerable to fluctuations in demand and input costs. For example, price driver volatility in the drywall market is high. This volatility is largely driven by the rapidly changing prices of gypsum  building materials as well as demand from the construction sector, which is known for its boom and bust cycles. While the value of construction has increased strongly at an estimated annualized rate of 6.1% from 2014 to 2017, it has done so with a great level of volatility.

Similarly, the drilling rigs and drilling tools markets have high price driver volatility. Given that drilling rigs and drilling tools are typically used by water well drilling firms and oil drilling and gas extraction firms, demand for these products largely depends on US oil and gas production levels. In turn, oil and gas production is subject to changes in oil and gas prices, which typically display substantial volatility. For example, the world price of crude oil has plunged at an estimated annualized rate of 18.3% in the three years to 2017, while the world price of natural gas has dropped at an average annual rate of about 23.2%.

Generally, high price driver volatility undermines buyer power by increasing the risk of potential price swings, and thus, making it more difficult for buyers to budget their purchases. Therefore, buyers with long-term, large-scale needs should sign supply agreements to lock in favorable rates. Buyers should also track changes in raw material prices to better time their purchases and pay lower prices.

Do Your Homework

Although certain market risks are inherent and inevitable, buyers can shield themselves from potential market fluctuations by planning ahead. Buyers can assess market risk by evaluating supply chain risk, supplier financial health and profitability, and price driver volatility. Having a holistic view of the market and its underlying risks will better equip buyers during the negotiation process.

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