Know Your Supplier(KYS)

With each passing day, the global economy sinks further into recession as the contagion which started in the lending market spreads into mainstream sectors.  Newspaper headlines are littered with examples of businesses in every industry from automotive dealerships to fast food franchises which are at risk of insolvency due to credit challenges.

Unfortunately, supplier failures related to financial distress are becoming all too common even for the largest of companies.  It might seem obvious, particularly in today’s macroeconomic climate, to evaluate the financial strength of one’s supplier community.  However, historically supplier financial evaluation has not been a priority for most large buying organizations such as retailers and manufacturers.  Instead, supplier selection is typically led by the sourcing or procurement organization of a company.  Sourcing teams focus on product-specific factors such as price, quality and performance to specifications.  Vendor evaluations may also include the evaluation of sustainability policies or audits to ensure compliance with child labor laws.  Inputs for the RFPs sent to suppliers are typically generated from a cross-functional team consisting of product management (or merchandising), supply chain management and transportation management personnel.  There is surprisingly little due diligence done on a supplier’s financial health in sourcing processes.  Historically, finance functions have historically been viewed as more tactical than strategic in the supply chain.  Finance is engaged for individual order transactions to negotiate letters of credit, process inbound invoices and originate supplier payments, but not in supplier selection processes.

 

Suppliers can be divided into four general categories. They are:

  1. Manufacturers.Most retailers buy through company salespeople or independent representatives who handle the wares of several different companies. Prices from these sources are usually lowest unless the retailer’s location makes shipping freight costly.
  2. Also known as wholesalers, brokers or jobbers, distributors buy in quantity from several manufacturers and warehouse the goods for sale to retailers. Although their prices are higher than a manufacturer’s, they can supply retailers with small orders from a variety of manufacturers. (Some manufacturers refuse to fill small orders.) A lower freight bill and quick delivery time from a nearby distributor often compensates for the higher per-item cost.
  3. Independent craftspeople.Exclusive distribution of unique creations is frequently offered by independent craftspeople who sell through reps or at trade shows.
  4. Import sources.Many retailers buy foreign goods from a domestic importer, who operates much like a domestic wholesaler. Or, depending on your familiarity with overseas sources, you may want to travel abroad to buy goods.

 

Know Your Supplier – Explained

Risk of supply chain disruptions caused by the financial distress of a supplier can be reduced through a “Know Your Supplier (KYS)” practice.   This is not a formal regulatory provision, but instead a set of voluntary corporate actions to evaluate the risk of supplier failure when conducting sourcing activities.  They key change required is a mindset that balances focus on the price and performance of a supplier’s product with the overall health and scalability of a vendor’s business model.

Guidelines for Supplier Selection

  • It is important that effective processes for selecting suppliers be in place.
  • Typically, the selection process starts with the development of a complete specification and ends with the best suppliers being selected to provide the necessary requirements so that the organization receives the value it is paying for.
  • When organizations do not demand the best and are willing to accept mediocre or slightly above average supplier performance, the supplier base will not be challenged to improve, thus reducing their overall competitiveness.
  • To know one’s supplier’s financial position, sourcing organizations should team with their finance groups to conduct diligence on each vendor’s profile.  Questions asked might include:

 What is the debt position of the supplier?  What constitutes a breach of covenants that could impair supply chain activities?
 What are the cash flow cycles of the supplier?  How significantly are they impacted by one’s payment terms?

 What are the other customers of the vendor?  What percentage of their revenue is tied to the largest customer(s)?

 What is the supplier’s ability to expand operations rapidly?  What will be the financial impact to the vendor if one ask them to double or triple volume next year?

Does the supplier follow internationally accepted financial reporting standards such as IFRS?  Are their financials audited by an independent, third party firm?

Other factors to consider during supplier selection:

  •   Price
  •   Delivery capability
  •   Technical capability and support
  •   Reputation
  •   Maintainability
  •   After sales service
  •   Location
  •   Duration of operations
  •   Leadership
  •   Quality control methods and practices
  •   Compatibility with existing products

Criteria for Supplier Evaluation

  •   Expertise of sales representatives and technical staff
  •   Flexibility/readiness for changes
  •   Production capacity
  •   Information & communication systems
  •   Leadership
  •   Additional service
  •   Law requirements (i.e. obligatory food safety assurance systems, labeling, certification)

KYS requires an acknowledgement that in today’s supply chain, corporations are highly interdependent upon key suppliers and contract manufacturers to succeed.  Corporations should think of themselves as less in competition with individual companies, but instead engaged in a Battle of the Supply Chains. Unfortunately, very few companies view the financial success of their supplier community as a priority in their decision making processes.  In fact, most companies pursue an opposite approach seeking to push the burden of cost or risk disproportionately on to their suppliers.   Such imbalances in the buyer-supplier relationships usually manifest themselves in the form of vendor managed inventory, extended payment terms and open account trading.  (See my post on the Financial and Physical Supply Chain for more information on this).  Conventional wisdom suggests that focus on your own balance sheet and income statement performance is the key to long term success.  However, a myopic preoccupation with optimizing your individual financial performance in isolation at the expense of your business partners actually introduces more long-term risk and cost into one’s business…

 

Another important issue is whether it’s buying stock, paying for overheads, or spending on marketing and advertising, managing your suppliers is crucial for the successful running of your business.

But purchasing goods or services could put one’s business at risk if one doesn’t take precautions when choosing suppliers. There are many dishonest companies and fraudsters pretending to be trusted businesses, who will seek to steal your money if there is an opportunity. For example, it’s estimated that as many as 675,000 businesses have fallen victim to a fake invoice fraud at some point in their trading history.

To ensure one doesn’t lose out, one needs to know how to be fully in control of managing one’s suppliers. To spot the risks, it makes good business sense to make sure one really know who he/she is dealing with.

Self protect

Taking some straightforward steps to verify that one’s suppliers are who they say they can go a long way towards mitigating the risks.

One can find out a lot about one’s supplier’s reputation just by searching the internet – a good tip is to search the supplier’s name with keywords such as ‘scam’, ‘complaints’ or ‘fraud’ to see if they have been accused of any wrongdoing before.

Fraudsters can trick one into losing money by pretending to represent a more established business, so checking details and information are also important to be sure that one’s ‘supplier’ really is who they say they are. One common scam is for a fraudster to assume the identity of a known supplier and request that regular payments be diverted into a different bank account.

Just because one’s relationships with suppliers begin with the best intentions does not mean that they cannot become risky over time.

One should try to monitor supplier behavior and performance – if their service standards begin to slip, it could be a sign that the supplier is under financial pressure. If they were ultimately to become insolvent, a supplier could commit fraud by taking an order from your business that it knows it will not be able to honor, ultimately leaving one out of pocket.