Tuesday, January 18, 2011

Risks - Quantifying Risk

There are three basic elements to quantifying contract risk.
  • The first is likelihood or probability that the risk will occur.
  • The second is the consequences from the risk occurring.
  • The third is the degree of protection the Supplier providing against the financial exposure to the risk.

While the past is not always a good indicator or the future, for most purchase risks there may be indicators that help identify the likelihood of the risk occurring. Indicators come from the Supplier’s performance or commodity history that should tell you the frequency that the Supplier has experienced the problem and the frequency that is experienced in the industry. Indicators will also come from understanding how the Supplier manages against the potential risk by the tools and controls they employ to manage against the risk.

The consequences from the risk materializing include the direct, indirect or consequential impact of the problem. Those costs are the real impact to the Buyer should the risk materialize. For example, if a supplier doesn’t ship a product when needed the direct impact could be the cost to acquire the item from another Supplier, but it could also impact your ability to make and sell a much larger product or complete delivery of a program so their failure can cause a much larger consequence. In quantifying the consequences you need to take into account the impact any Buyer managed activities will have to help reduce or mitigate the risk.

The degree of protection from the Supplier is based upon a number of factors.
1.     What they committed to manage or assume.
2.     The standard of that commitment.
3.     The remedies available to the Buyer.
4.     Limitations on the types of damages available to the Buyer.
5.     Limitations on the amount of damages that may be recovered.

For example if the Supplier proposed that in the event of a claim of Intellectual Property infringement that their sole obligation was to refund the price of the purchase and they limited their liability to the amount paid for the product that gave rise to the claim, you would not be well protected. Here what that language would provide you.

Buyer must pay
Supplier would pay
Third Party Claim for damages caused by the infringement
License fees to continue to use the infringing product
Cost to purge inventory of infringing items and rework to replace with non-infringing item
Cost to purchase non-infringing  replacement
Only to value of their product
Special damages awarded if infringement was willful

Most decisions to accept risk require business or management approval. If I were to approach management I would be prepared with answers to the following question to help them understand and quantity the potential risk:
  1. What alternatives do we have with other solutions or Suppliers?
  2. What is the cost, schedule, or other impact of any alternatives?
  3. What are the risks we need to assume?
  4. What is the Supplier’s history with those risks?
  5. What is the probability of the risk?
  6. What are the consequences and financial exposure if the risk were to occur?
  7. What’s the degree of Supplier’s contract protection?
  8. What's the probability that protection will be exceeded?
  9. What’s our ability to manage the risk?
  10. What will be the cost of managing the risk?

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