Tuesday, January 18, 2011

Risk - How Suppliers try to manage risk, liability, and costs

Prior to the Contract they should:
·       Manage the quotation and any representations made before or during the process to only those things that can be clearly delivered.
·       Ensure that their response to the Quotation is clear, states any necessary assumptions or clarifications including the clear definition of deliverables by both parties.
·       Review of requirements as to suitability of what is requested / proposed

In the Contractual Terms they will.
  • Refuse to accept the transfer of the cost, risk or potential liability by simply striking out a clause.
  • Accept a limited transfer of the cost or risk by any combination of the following::
    • Limit the remedies a Buyer has for the Supplier’s failure to meet the obligation such as by saying that a specific remedy is the “sole and exclusive remedy”
    • Limit the standard of performance they provide to reduce the potential of them failing to perform such as wanting to commit to use commercially reasonable efforts.
    • Place a dollar limit on their liability for failing to perform.
    • Include qualifying language in the commitment to water down their commitment and their potential liability. For example adding a requirement of knowledge for a specific commitment.
    • Propose language or terms to transfer some of the risk and cost to the Buyer such as language where the parties agree to share in the cost..
  • Ensure there are clear definitions of deliverables and dependencies.
  • Ensure there is a clear definition of responsibilities for all parties.
  • Accept only those terms that can be reasonably performed and managed.
  • Seek relief from performance for problems caused by parties not under their control such as Buyer specified Suppliers or subcontractors or Buyer supplier items.
  • Require clear measurement criteria and acceptance tests
  • Ensure any warranties and performances are tied to what they can reasonably manage.

For Risks they assume they will:

  • ·       Transfer risks contractually to their suppliers and subcontractors.
  • ·       Perform qualification of subcontractors, and Suppliers.
  • ·       Flow down of responsibilities and liabilities. 
  •      Manage the activity and deliverables.
  •         Implement strong change control and change management.
  • ·       Ensure all involved meet performance requirements.

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?

Risks - Procurement Risks

In every significant procurement activity there are a number of potential risks. There are business and performance risks, legal risks and financial risks.  While I will address the risks in more detail in my book here’s a few examples of the types of risks that exist.

Business / performance risk involve having the right product or service at the right time.  This includes both the initial delivery but also on going use and support. Examples of business and performance risks are:
  • Late delivery
  • No delivery 
  • Product or Service does not meet business requirements
  • Activity requires substantial involvement and management by internal resources to be successful
  • Supplier failures impact other activities (with potential claims by third parties for delays).
  • Supplier fails to have the resources required to meet long term requirements

Legal risks involve ensuring the continued use of the purchase and protection against potential legal claims by third parties.  Examples of legal risks are:
  • Claims for patent or other proprietary rights infringement,
  • Claims for injuries or property damage by third parties,
  • Claims by the Supplier for delays, damages, or changes.      
  • Claims by the Supplier's employees, such as Supplier's failure to pay wages or benefits,
  • Claims by government for failure of the Supplier to pay required benefits, taxes etc.
  • Failure of a contractor to pay their subcontractors, which could result in liens against the work. 
  • The impact of bankruptcy or insolvency on the work, rights in the work and Buyer owned materials or equipment loaned or consigned to the Supplier.

Financial risks involve ensuring that you get value for the initial purchase and the total life cycle cost remains competitive. Examples of financial risks are:
  • All the legal risks and all performance risks will have a financial impact if not protected or managed.
  • Product or services costs substantially more due to lack of control.
  • Product or Service costs substantial more due to required changes.
  • Change in Buyer’s requirements combined with either no rights of termination for convenience or excessive cost of termination has the Buyer continuing to pay for work no longer needed.
  • Cost of long term service or support is uncontrollable or excessive. 
  • Losses sustained for other breaches of the supplier's obligations such as breach of confidentiality requirements.

Each of these risks need to be managed in both the qualification and negotiation process.  Some risks may be transferred contractually to the Supplier. Others risks may need to be managed by the Buyer. If you transfer risks to the Supplier, the Supplier must have the assets and resources to stand behind those commitments, otherwise the risk and resulting cost may fall back on you. Risks that cannot be transferred to the Supplier need contract terms that allow the Buyer to manage them.

Examples of transferring the risk are:
  • A fixed price contract is an example of a transfers the financial risk of performance.
  • An indemnification provision against claims by third parties for personal injuries is a transfer of a legal and financial risk.
  • The requirement that the supplier carry insurance is a transfer of the financial risk that the supplier may not have sufficient resources to stand behind the indemnification.

Examples of terms managing the risk are:
  • Requirements for approval of Subcontractors, personnel.
  • Requirements for approval of any changes to the Product or Service  

Most of contract negotiation falls into two areas:
  1. Establishing whether the Buyer or Supplier will be responsible for the risk. That determines who pays any costs or damages if the risk occurs. That negotiation will also include the negotiation of any limits on their financial responsibility.
  2. For risks that the Buyer must assume, the negotiation will be about the tools and controls that they Buyer feels they need to manage the risk and whether the Supplier will agree to provide them.