SUPPLY CHAIN RISK MANAGEMENT IN CONTRACTS

A supply chain is just like any other chain. It is only as strong as its weakest link. So how do you try to protect against shortages or interruption in supply? What can you include in a purchase contract to manage risk with your supply chain? There are many things that can impact you supply of critical parts or materials such as:

• Excess demand versus available capacity.
• Reduction in capacity caused by plant closures, layoffs.
• Production problems.
• Quality yield problems.
• Changes to design that impact your ability to use the product.
• Natural disasters at manufacturing locations, subcontractor or material supplier locations.
• Strikes, Lockouts and other labor disputes.
• Loss or damage in transit.
• Import or export restrictions or bans.
• Legal problems with the parts or materials – infringement of IP rights, not complying with laws.
• Product problems such as safety problems that can halt production until a solution is found.
• Product discontinuance or end of life.
• Product transitions to newer versions.
• Enactment of laws such as environmental laws banning the use of specific substances.
• Limited sources (custom or unique items)
• Supplier or subcontractor financial problems impacting their ability to purchase needed supply or run operations.
• Custom or unique product with only one source creates risk in the event you have a problem.

There are a number of ways these risks can be managed. Some may be managed through initial part or material selection for use in your product. The fewer custom or unique parts or materials you use, the more potential sources you can have. Thorough supplier qualification helps manage some risks. Some risks may be managed by sourcing strategies such as multiple sources of supply or inventory strategies with multiple stocking locations. Some of these risks may be managed contractually. A strategy to manage potential risk may you need a combination of all the potential ways.

Most strategies to manage risk cost money and that becomes a trade-off between cost versus the risk. Dual or alternative sourcing costs money, and dual sourcing may impact the price you pay as you are splitting volumes. If you have dual qualified sources but are only buying from one, when you need that alternative supplier they may not have capacity and it will take time for them to ramp up to your needed volumes creating shortages. Inventory both ties up money and costs money. With inventory you also have the risk of loss, damage or it becoming obsolete. Some products also have limited shelf life you have to manage or it may not be usable.

As the focus of my blog is about contracts and negotiation of contracts, I wanted to share some thoughts on how to try to contractually manage some of these risks.

Excess demand versus available capacity.
You can make firm commitments for a specific quantity and spot buy for other needs to reduce the risk and the potential of winding up with excess inventory.
You could create a reserve capacity agreement where the supplier reserves a specific capacity for your purchase. You have a specific period to order your needed quantities, after which the supply may be sold to other customers
Reduction in capacity caused by plant closures, layoffs.
You could require advance notices of potential actions with the ability to increase orders and have the supplier hold inventory as a buffer against potential shortages
Production problems, Quality yield problems.
Normally if possible you would develop multiple sources of supply so if one supplier has these problems you can buy from an alternative source. If you have a single source supplier your contract should include standards the supplier must meet to retain that status and remedies they will provide in the event there are problems. For example you could require them to stock a quantity of known good product at a stocking hub. You could require them to develop a second source.
Changes to design that impact your ability to use the product or Product transitions to newer versions
You could require no changes be made to the design of the product without your advance approval. If you can’t get that you could require both advance notices of changes, and samples of the new product to determine if it will be an acceptable alternative. If it won’t be, get the right to either have the current version still be manufactured or have them build and hold inventory for the transition. They will of course want a commitment that you will buy all held in inventory and buy it within a reasonable period. In the buyer / supplier relationship its always less expensive for the supplier to hold the inventory as they hold it at their cost whereas the buyer holds it at the purchased price.
Natural disasters at manufacturing locations, subcontractor or material supplier locations.
Understand not just your supply chain but also supply chain of critical suppliers and material providers. Understand exactly where your items will be made. If you are concerned with potential risks require production be geographically dispersed. As an alternative require disbursed stocking hubs to reduce time impact of disasters.
Strikes, Lockouts and other labor disputes.
Do not allow lockouts to be considered a force majeure as the Supplier has total control over whether they exercise them. Understand when contracts will expire and work with the supplier to create a supply contingency plan to mitigate the impact.
Loss or damage in transit.
Specify packing, packaging to reduce the risk of damage. If possible select the carrier and shipping lane to reduce the risk loss in transit as different carriers and different shipping routes / lanes have different loss history.
Import or export restrictions or bans.
Most restrictions or bans do not occur immediately. For example when the EEC enacted the RoHS environmental standards banning certain materials from being used on products imported into EEC Countries, there was significant discussion before it was enacted, and one or more years in which to implement RoHS compliant products after which non-RoHS compliant products will be banned. Keep aware of any changes and at the first time you hear of anything that can potentially impact a product, ask the suppliers if they use it and what their plans are to eliminate it. The sooner you are aware the more time you have to qualify something else that complies.
Legal problems with the parts or materials – infringement of IP rights, not complying with laws.
Include IP Indemnity terms and Warranties that items comply with applicable law. Under the Indemnity require them to get a license from the IP holder if that is possible. Don’t give them a cheap way to walk away from the problem leaving you with an interruption in supply. As breach of a warranty only gives rise to damages, make sure that any financial limitation in any limitation of liability is significant enough so it will be cheaper for the supplier to correct the problem rather than walk away and pay you damages leaving your supply chain broken.
Product problems such as safety problems that can halt production until a solution is found.
These are the most difficult to protect against. Require initial testing to safety standards or certifications such as UL or CSA. Require all product contain a part number and date or lot code. Many times safety problems can be narrowed down to specific lots or dates. If you know what those are in sourcing through alternative sources such as distributors or brokers buy only those that have date codes that are not a problem. Have the supplier stock items or carry an inventory and hope that those are not impacted.
Product discontinuance or end of life.
Require a specific period that the must make the product available for purchase (and protect yourself on the purchase price). Require long end of life notices that allow you time to develop another source, qualify a new product or material. If you can’t do either, include the right to make an end of life purchase in whatever quantities you need. If you were purchasing a semiconductor or other product where the end of life is caused by a process
change such as a change in the process technology used to produce it, explore other alternatives. For example, with semiconductors I’ve used what’s called a “die bank” to purchase and have the supplier store completed semiconductor die that can be bonded, assempled and packaged at a later date to reduce the potential cost
if the full inventory wasn’t needed.
Supplier or subcontractor financial problems impacting their ability to purchase needed supply.
Qualify suppliers in advance to try to avoid this. If you can’t, consider requiring they create a second source they license to manufacture. Have them place a manufacturing package in escrow and get rights to purchase from all their suppliers in the event the escrow is released. With outsourcing you can have virtual suppliers, where they may only design the product and they contract with other parties to manage production, test, and fulfillment where if a problem occurred you could buy the completed product directly from their sources.
Custom or unique product with only one source.
While the goal may be to avoid single sources, many times it may not be avoidable. You can have single source several situations.
1. Only that supplier has what you want or need and the business is willing to accept the risks of a single source. A simple fact is many companies rush to be first to market with new products to try to lock the buyer into using them and will do that in a number of ways with things like proprietary interfaces, unique form factors, etc.
2. The buyer wants something that is unique or custom and the development with multiple suppliers is cost prohibitive.
3. The supplier is willing to assume the cost of development as long as future business is committed to allow them to recover their investment.
4. The buyer for other valid business reasons, determines that the savings and flexibility they will get from being single sourced outweighs the risk. For example a company may single source a specific piece of process equipment to reduce their spare parts inventories and have the flexibility to move production between different but compatible lines.

To manage the risk, in addition to all of the above, if your volume is high enough demand a second source. If you have financial concerns about the supplier require software of manufacturing escrow packages. In conjunction with the escrow, get a list of all their suppliers and get written agreement from the supplier that you can purchase directly from them in the event the escrow is released. For things like software, get their commitment that they will provide you with supplier or have them identify key individuals that are familiar with the code where you can hire them to support your future needs.