Buyers can unlock value for their organization by decreasing both their companies’ and vendors’ exposure to risk. For example, a food manufacturer unlocked value by partnering with their trucking vendor to mitigate the risk of fluctuating fuel costs. The companies agreed that the cost of fuel would be passed through to the company. At first that seems like a risky decision, but the vendor had a contractual incentive to be more fuel efficient, which they did by operating their trucks at lower speeds, idling less frequently for shorter periods of time, and using routing software. In the end, the risk of fluctuating fuel costs were mitigated decreasing risk to both companies and lowering costs to the food manufacturer.
Some buyers might think it is cost effective to allocate the risk of fuel costs to the vendor in a fixed fee agreement, so it may seem counter intuitive to think that partnering with a vendor would reduce the manufacturer’s costs. The problem with a knee jerk reaction to allocate risks is that the more buyers allocate risk to vendors—especially risks that are totally outside of the vendor’s control, like the cost of fuel—the greater potential for inflated costs to perform.
When buyers allocate uncontrollable risks to a vendor, vendors have little choice but to cover the potential cost of exposure in their pricing. Vendors who accept uncontrollable risks often include the potential cost of exposure, referred to by some as “risk premiums.” When I asked a service provider if his company ever returned the “risk premium” to the customer when no risk event occurred, he chuckled.
The value of the risk event, and correlating risk premium, depends on two factors: the degree of negative impact if the risk event materializes and the likelihood of the risk event happening. In the case of fuel costs, the impact could be significant and there exists a high likelihood of price increases. Therefore, the potential exists for a risk premium in exchange for accepting the risk of fuel costs in a fixed fee agreement.
Unfortunately for the buying company it may still face problems after allocating risks: allocated risk events may still occur impacting the buying company; the buying company may be paying a risk premium for a risk event with little likelihood of happening or little impact to their company; and in all likelihood, that risk premium will not be refunded if the event does not happen.
The better option would be to decrease the vendor’s risk by mitigating the risk. Risk mitigation means both companies work together to prevent the risk event from happening and/or reducing the impact of the risk event when it does happen. Only those risks that cannot be mitigated ought to be allocated to one of the companies.
The First Step To Decrease Risk– Identify The Risk
The first step to decrease risk is to identify those risks that are out of the vendor’s control versus those that are within their control. Typical examples of risks that are out of the vendor’s control include increased prices for raw materials or decreased demand for their customer’s product or service, which may reduce demand for the vendor’s products or services. Risks that are within the vendor’s control include predictable delays from the vendor’s organizational misalignment, inaccuracies in their manual data entry, and poor talent management.
When both companies are more transparent about the potential risks inherent in performance, they can find price-decreasing solutions based on reducing the possibility of the risk event from happening and/or reducing the negative impact of the risk event.
The Second Step To Decrease Risk – Mitigate The Risk
The second step is to collaboratively mitigate the risk. Collaboration requires cooperation, coordination and a fair bit of creativity. In the example above, the food manufacturer was just as savvy as the hauler at buying fuel. They worked together to mitigate the risk associated with fluctuating fuel prices by a) jointly monitoring fuel costs using a national index, b) agreeing that either company could purchase fuel so long as it was the lowest cost fuel at the time of purchase, and c) agreeing the hauler could consume fuel purchased by the food manufacturer for the manufacturer’s deliveries. This partnership was successful because both companies clearly understood and leveraged their operational strengths together.
The next time you think that you’ve saved money by allocating risk, like the risk associated with the cost of fluctuating raw materials, stop and ask yourself if your company should work with the vendor to mitigate that risk. You just might unlock real value for your company.