Sourcing from offshore suppliers in China, India, Eastern Europe, Latin America and other low-cost regions is so widespread that few manufacturers and retailers can be competitive unless they join in this trend. In fact, the U.S. Federal Reserve Board attributes much of the recent economic growth and low inflation to this offshore outsourcing "best practice."

However, the downside of offshore sourcing receives far less attention at the Fed or in any boardroom-at least until something goes wrong.

The more a company sources from distant, low-cost lands where financial transparency, operating visibility and reliable logistics are practically unknown, the risk of serious supply chain disruptions increases geometrically.

In a recent supply chain risk assessment study, Aberdeen Group, a Boston-based research firm, said that more than 80 percent of supply management executives reported that their companies experienced disruptions within the past two years serious enough to negatively impact their companies' customer relations, earnings, time-to-market cycles, sales, and overall brand perceptions.

Among the chief causes of these disruptions are the same best supply chain practices that companies strive for: low-cost country sourcing, lean inventory and supplier rationalization. While these strategies can improve efficiency, they can also remove buffer inventory and backup suppliers from the supply chain, amplifying the impact of unanticipated events such as supplier bankruptcies, quality failures, missed shipments and natural disasters.

Tim Minahan, Aberdeen Group's senior vice president of global supply management research and the author of the study, says, "The most surprising thing was that while 80 percent saw supply risk increasing, few companies [had] put emphasis on managing that risk."

More than three-quarters of companies in the study, called The Supply Risk Benchmark Report, expect supply risks to increase over the next three years due to supply market instability, new regulatory requirements, natural disasters and terrorist attacks. Aberdeen predicts that supply risk management will emerge as a major business discipline and measure of competitiveness within the next five years.

"More than 60 percent of companies without formal procedures for assessing and measuring supply risks plan to initiate supply risk management programs within the next year," says Minahan.

One place these newly risk-aware companies are starting is with strategic sourcing studies to gain a balanced look at cost and risk factors involved with offshore sourcing, manufacturing and distribution.

"Too many global companies just look at unit costs to make their sourcing decisions," says John Brockwell, head of JPMorgan Chase Vastera's supply chain management consulting practice. "They do not adequately analyze total landed costs, and they certainly do not weigh risk factors that can increase inventory requirements and working capital as well as disrupt production, sales and customer services."

Strategic Sourcing Studies
JPMorgan Chase Vastera, which is best known for its global trade management services and technology, also does strategic sourcing studies for clients that look beyond typical unit-cost or landed-cost comparisons. Analyzing the causes and impacts of physical supply chain risk is critical to good decision-making. Creating different "what-if" scenarios that model real-world variability allows the business to understand a range of potential costs versus a single perfect-world estimate. Among the risk factors considered are:

• Supplier stability

• Quality and impact of poor quality on cost and service

• Time-to-market

• Logistics capability in supplying product

• Total landed costs (freight, duty, brokerage, inventory carrying costs, etc.)

• Impact of variability on inventory/working capital

• Political and economic stability

Most companies conduct such studies when they are about to develop a new product, rationalize locations or move to a low cost environment for a mature product. The studies are strategic in that they form the basis for a go/no-go decision.

For companies focused on the lowest supplier costs for competitive reasons, the decision has already been made to be in China or even lower-cost countries such as Vietnam. The strategic study must look at how to deal with risk.

"If cost is their primary driver, we help them achieve the lowest costs with the least risk," says Brockwell. "We help them understand the risk, so they can plan for contingencies where possible."

Besides looking at the financial health of potential suppliers, JPMorgan Chase Vastera considers the overall working capital requirements in the entire supply chain.

"We analyze which entity has the most financial leverage in this supply chain and how that's to be optimized," says Brockwell. "The idea is to minimize risk for every trading partner. Suppliers, especially smaller ones, need to get cash faster. Manufacturers need to keep inventory off their books."

Much of Vastera's experience is in the high-tech, telecommunications and automotive industries where companies have no choice but to manufacture in low-cost countries to support their customers.

For example, one risk-adverse, high-tech supplier that JP Morgan Chase Vastera worked with preferred to maintain its maquiladora assembly operation in Mexico rather than move to a lower-cost country because of the good quality, solid operations and low overall risk it had enjoyed. But when one of the company's major customers set up operations in China and insisted that this company move some of its operations there to support them, the supplier had no choice.

"We helped them understand all of their costs, increased working capital requirements and other risks, so they could mitigate the risks of operating in the Chinese market," says Brockwell.

For companies that are not driven by customer pressure or lowest possible labor costs, JP Morgan Chase Vastera helps companies consider locations that present less risk and faster time-to-market.

"We are again seeing companies looking at Mexico and Central America because they are closer," says Brockwell. "There are very favorable trade agreements in the Western Hemisphere that minimize duties and present fewer trade conflicts. The shorter lead times provide a big advantage in terms of inventory and working capital."

The strategic studies also provide clients with a long-term view of operating in a particular part of the world. For example, China has tried the patience of both the U.S. and the European Union with aggressive pricing on commodities such as garments, shoes, children's furniture and other items to the point that successful anti-dumping actions through the World Trade Organization are a definite possibility.

"Our strategic studies consider the impact of such trade actions on supply costs," says Brockwell. "Whatever cost advantage originally assumed would quickly disappear if high tariffs or quotas were suddenly applied. We help our clients look at what might be happening over a time horizon appropriate for them."

Supplier Intelligence
Once a company is operating in a low-cost country, the focus shifts from purely a strategic view to an operational one that requires constant vigilance and ongoing monitoring.

"Companies sourcing in low-cost countries quickly learn that their supply chains are more fragile and need close attention," says Jim Lawton, vice president of marketing for Open Ratings, Waltham, Mass., a company that provides supply risk management services and technology. "Just one key supplier can cause a disruption that cascades throughout the supply chain to the point your ability to meet customer commitments and investor expectations are impacted."

	"Early access to information is important. No one wants to read about your supplier's problem on Yahoo or in the newspaper." - Dennis R. Lemon of BlueRiver-Consulting

Very large companies experienced with sourcing in China are aware of these risks and take extraordinary measures to deal with them. For example, says Lawton, Wal-Mart reportedly has hundreds of people in China performing 50,000 on-site supplier audits every year. But few companies have the resources to do these audits on their own, so Open Ratings provides the data and management services that companies need to evaluate and monitor a large number of suppliers and understand the risk they pose to their supply chains.

The primary Open Ratings product, SBManager, delivers an integrated set of solutions that aggregate business data from various sources to intelligently cleanse and unify master data, analyze performance, predict risks and opportunities, and make better decisions.

"At our heart, we are an aggregator of data, financial data, operational data, and performance data," says Lawton. "We have insights into how those suppliers are performing for dozens of other companies."

Some clients use that information to benchmark their suppliers' performance. For example, Open Ratings will report if the quality a company is receiving is not as good as what other companies are reporting. If a supplier is having problems with production or on-time shipments, the performance data gathered from many users will quickly share that information among the user base. Open Ratings also has a proprietary capability based on machine learning algorithms that recognize patterns and trends in large data sets. With a database of more than 100 million companies' accounting, operational and compliance information, Open Ratings can often predict if and when a supplier will experience financial or performance problems.

Dealing with suppliers in low-cost countries presents significantly more challenges because there is much less transparency into financial and operating data than Western companies are used to. Not only is financial data hard to obtain, but what is available rarely conforms to generally accepted accounting practices. There is often no way to know who owns the supplier and if that company is somehow connected to competitors. There is also the danger that a supplier is engaging in child labor or other illegal business practices, but it is very difficult to uncover such facts.

"You will only hear from a supplier what they think you want to hear," says Dennis R. Lemon, president of BlueRiver-Consulting in Tempe, Ariz. Lemon was previously Honeywell International's director of corporate supplier quality and health. His job was to determine if a supplier was financially and operationally capable of performing as expected over the life of the contract, and he now performs this service for a wide variety of companies sourcing from offshore locations.

Lemon says there is a risk pyramid for offshore suppliers, and it corresponds with the level of transparency into their businesses. Suppliers listed on an international stock exchange have the most transparency and the least risk, but there are few such companies. More suppliers are listed on national or regional exchanges in low-cost areas of the world, and the level of transparency and risk are better than with private companies. The vast majority of suppliers, however, are private companies that publicly disclose no financial or operating data, and the risk with them is significant.

For example, Lemon once worked with a Chinese supplier that was partially owned by the military. None of the financial information provided by the civilian owner made any sense. As it turned out, any profit that the company made went straight to the government, so the civilian owner made sure he never had a profit. The expenses just grew to meet the increased revenue.

To deal with the lack of transparency with such offshore suppliers, Lemon used Open Ratings services while at Honeywell, and he continues to use them now with his clients, especially in closely knit industries such as high-tech and aerospace where original equipment manufacturers (OEMs) commonly use the same suppliers. (Lemon is a member of the Open Ratings Board of Advisors.) The information shared is aggregated and anonymous, but it provides a view into supplier performance that is otherwise impossible to obtain.

"Early access to information about supplier quality and delivery problems is important," says Lemon. "No one wants to read about your supplier's problem on Yahoo or in the newspaper. The more companies that use a service like Open Ratings the better the data."

Help Your Supplier
On more than one occasion, Lemon says, desktop alerts from Open Ratings have warned that suppliers were drifting into financial difficulties. Given this warning, there was time to talk with key people within the supplier about these problems.

"When approached properly, suppliers usually admit to their problems," says Lemon, who adds that in many cases, these problems can be solved by changing payment terms to help them over the rough patch. "Good suppliers are worth helping, but you need the time to work out a solution."

To some degree, manufacturers and retailers can develop their own tools to monitor their suppliers' performance and financial well-being, but then the challenge becomes getting the managers to use these tools.

"Sourcing managers and engineers don't have time to research or monitor suppliers," says Lemon. "They want desktop alerts to let them know if there is a problem supplier that requires special attention."

Spending too much time and effort with internal research can sometimes be self-defeating. For example, Lemon says that an automotive company he worked with wanted to source its spark plugs from a Chinese company that it did not know. The company spent considerable time gaining research and references about the supplier.

"By the time we did our due diligence, the supplier had allocated all of its capacity," says Lemon. "You have to be able to move fast and do adequate due diligence."

Lemon points out that the secrecy that abounds in low-cost countries creates problems even for services like Open Ratings. Three years ago, Lemon was looking for an offshore supplier and screened the possible candidates with Open Ratings SBManager. Lemon then narrowed the field down to one supplier, but further research indicated that one third of its suppliers were not being paid. This fact eluded SBManager because the algorithms had trouble dealing with foreign languages. Open Ratings has since partnered with other database providers to provide better supplier intelligence.

"Buyers, quality engineers and supply chain managers all expect a crystal ball that provide instant, 100-percent accurate information," says Lemon. "That expectation is unrealistic in many parts of the world today. The information is getting much better and more accurate, but you still have to think and use good business sense."

For example, Lemon points to a major OEM that outsourced critical components to an Asian supplier without ever visiting the facility. It was only after the supplier's poor quality disrupted its U.S. production line that the company visited the supplier and found a very small, dirty facility that bore no resemblance to the manufacturing facility that was presented by the supplier.

"No technology or tool is a substitute for due diligence and common sense," says Lemon.

Even if the OEM has done due diligence and monitors the supplier's performance, surprises are bound to happen. Lemon recalls an OEM that depended on a private supplier in China for over 3,000 parts. One day, the president of the supplier walked into OEM's local office and announced that he was retiring and was closing the business in a matter of weeks. Fortunately, the OEM was able to convince the man to continue the business. Otherwise the company would have had to scramble for new suppliers with little time to negotiate or conduct any due diligence.

"No technology or service would have helped in this situation," says Lemon. "No one at the OEM thought to ask about the supplier's succession plan."

Lack of transparency is not the only cause of supplier risk in low-cost countries. Cultural issues create risks that many U.S. manufacturers and retailers are ill prepared to deal with.

"American companies are very impatient in their business dealings," says Lemon. "They try to negotiate contracts very quickly based on price and delivery times, and then they move on to the next contract. That approach does not work in Asia and many other parts of the world where the relationship with the supplier and its key people is more important than the contract itself."

Lemon advises U.S. companies to spend more time and resources in the supplier's country understanding the business issues. At the very least, U.S. companies should invest in people locally who can nurture that relationship.

A common problem with suppliers in even the most cosmopolitan Chinese cities such as Shanghai and Hong Kong is the uncertainty of whether or not the managers truly understand an issue. The supply chain professionals for these suppliers are supposed to be the communications link with the foreign customer, and they would lose face if they admitted that they did not understand the customer's instructions.

"You have to listen very carefully to what they are not saying, so you can determine whether or not they really are comprehending what you are saying," says Lemon. "You think you are communicating, but often you are not. It is confounding."

According to Lemon, most companies significantly underestimate the effort and all the resources required to transition manufacturing operations offshore or to develop a supply chain to support offshore manufacturing.

"Most companies looking for offshore sourcing are still largely driven by unit price savings, not total landed-cost savings, and they do not really have the resources for gathering risk data," says Lemon. "Offshore failures and production problems are much more difficult to fix than problems close to home. Companies need to leverage every resource they can to lower the risk of offshore sourcing."

Tips for Working with Suppliers in Low-Cost Countries

Dennis R. Lemon, president of BlueRiver-Consulting in Tempe, Ariz., learned about working with offshore suppliers when he was Honeywell International's director of corporate supplier quality and health. His job was to determine if a supplier was financially and operationally capable of performing as expected over the life of the contract. Lemon offers several rules of thumb for working with suppliers in low-cost countries. • In China, suppliers on the East Coast have the greatest amount of experience working with U.S. and European companies, so they understand how to provide foreign companies with the information they need. But to gain better prices, many foreign companies are looking to suppliers in the interior of China, and they are far more difficult to work with and rarely provide the transparency that Western companies want. • Many Western companies want to be the dominant customer with their offshore suppliers to gain clout. But many suppliers are so thinly financed that any slowdown in the dominant OEM's business can sink the supplier and then leave the OEM without a source of supply. "No OEM should take more than 25 percent of that supplier's capacity to help the supplier spread its risk," says Lemon. • Maintaining multiple sources for critical parts is important, even if it increases total costs. In certain industries, however, spreading this risk is very difficult. In aerospace, for example, production volume is low, but quality must be very high. There just are not enough suppliers with the quality and expertise to spread around the risk. • When a manufacturer first outsources to a low-cost country, the focus is entirely on tier-one suppliers that the company deals with directly. As the outsourcing matures and expands, companies need visibility into the tier-two and tier-three suppliers because their quality and capability become critical risk factors as well. OEMs must convince their tier-ones of the need for input into the selection of their suppliers. "Gaining enough trust to work with the suppliers' suppliers is not easy to do, because it goes against the way they are used to operating," says Lemon.