Jim DeLoach

One important source of operational risk relates to the organizations, people, processes, and resources comprising a company’s supply chain. In many sectors, companies increasingly depend on the external elements of the supply chain (e.g., suppliers, outsource partners, third-party logistics) in an effort to cut costs while increasing capabilities and global reach. Because every business depends on a well-functioning, cost-effective supply chain, every board should consider its oversight of supply chain risks. The following are seven suggestions for better board-level oversight of supply chain issues.

1. Strike the right balance when selecting a supplier. Time, cost, quality, and risk are four factors a company needs to consider when identifying potential suppliers, negotiating contracts, and evaluating supplier risk and performance throughout the lifespan of the contract. Boards should be leery when management emphasizes one or two factors over the others as this can result in unintended consequences. For example, seeking to reduce procurement costs when negotiating supply contracts should not lead to the unintended consequence of taking delivery of components that fail to meet critical quality specifications or timing requirements.

2. Make procurement decisions with an enterprisewide perspective. Striving for functional excellence is a laudable goal, but it has its limits. Companies can incur huge losses making procurement decisions in isolation, ignoring initiatives undertaken by the research and development, engineering and finance functions.

3. Ensure the supplier agreement spells everything out. When a contract clearly defines scope, business objectives, deliverables and performance specifications, it lays the foundation for ongoing monitoring of contract compliance and supplier performance and reduces the risk of costly disputes and misunderstandings. For example, the contract should clarify product and packaging specifications and quality control and inspection protocols so that performance can be monitored over time. It also should ensure that intellectual property and critical assets (e.g., proprietary molds and tools the company gives to the supplier) are adequately protected. Due to the complexity of managing suppliers operating in other countries, boards should ensure that the procurement process is supported by legal advisers knowledgeable of the applicable court jurisdictions, particularly in countries where laws, customs, and business ethics may vary.

4. Hold suppliers to the same level of accountability. The rigor of company processes for identifying, sourcing, measuring, monitoring, and reducing third-party relationship risks should be proportionate to the level of risk and complexity of those relationships. With respect to legislative and regulatory developments regarding disclosure of the actions a company has voluntarily undertaken to remove labor abuses from its supply chains, companies should seek the advice of counsel as to the status of these developments and the jurisdictions and circumstances in which they apply. Given this environment, a case can be made for adopting and enforcing a supply chain code of conduct—especially for vendors authorized to act as agents on behalf of the organization. Coupled with a code of ethics that details the principles and values by which the company operates, a code of conduct might address topics such as human rights, health and safety standards, environmental sustainability standards, ethical and responsible business behavior, and cybersecurity standards.

5. Conduct periodic third-party audits. A supply chain code of conduct is only as good as the vendors who sign it. That’s why a cost-effective third-party audit process is Such audits may be integral to the due diligence associated with vendor selection and onboarding. Conducted on a periodic basis, third-party audits may focus on: selected internal controls, such as cybersecurity; vendor performance against contract specifications; and compliance with laws and regulations. The audits may also be conducted before contract renewals.

6. Monitor supplier risk and performance over the life of the contract. The risk environment is not static over the life of the contract. All suppliers should be segmented based on factors such as risk, the level of spend, criticality, and alternatives in the market. The segmentation should drive the level of preselection due diligence, the contracting strategy, and the level and frequency of monitoring through contract duration. Ideally all facets of contract and supplier risk are addressed through performance reporting, including early warning alerts before it’s too late to act on a timely basis.

7. Pay attention to business continuity risk. There are many instances where a single-source supply strategy is the right business decision. In these cases, however, quality, time, and cost considerations often win out over business continuity risk considerations despite the risk of supply chain disruptions. Thus, risk assessments should consider what could happen to the organization’s business model if any key component of the supply chain were taken away, even though a cause may be somewhat elusive at the time of the assessment.

An assessment should also consider the implications of plausible and extreme scenarios stemming from the loss of strategic sources of supplies for an extended period, including exposure to data security risks and physical access to sensitive information, the financial impact, expected recovery time, and adequacy of current recovery and contingency plans. To illustrate, directors should inquire whether management has considered the following questions:

• What would happen if we were to lose, for any reason, one or more of the suppliers that we depend on for essential raw materials and components?
• How long would we be able to operate?
• What if there were significant disruptions in transportation?
• What contingency plans do we have?
• Have our key suppliers performed their own risk assessments with respect to key “Tier Two” or “Tier Three” suppliers? How do we know?

The board should be informed of the results of these assessments.