Evaluating Potential Sources

Evaluating Potential Sources


The evaluation of an existing supplier is much easier that the evaluation of a new source.  Since checking out a new supplier often requires an extensive amount of time and resources, it should be done only for those suppliers that stand a serious chance of receiving a significant order.   The evaluation should answer the key question:  Is this supplier able to supply the purchaser’s requirements satisfactorily strategically, and operationally in both the short and long-term?


  • Level 1 – Strategic – Level one decisions are driven by a sourcing strategy that is linked with the organization’s strategy, goals, and objectives.  The term strategic sourcing captures the link between sourcing strategy and organizational strategy.  A purchase is strategic and mission critical when it has the potential to either help or hinder the attainment of the organization’s mission.  Procurement must categorize purchases into strategic and non-strategic buckets to drive the sourcing and selection process.
    • Linking Sourcing with Strategy – A supply professional must first make up alist of available suppliers from whom the necessary items can be acquired.  The first level of analysis is finding out which suppliers might be able to meet the buying organization’s requirements.  The second level of analysis is determining which of these the supply manager or sourcing team is willing to consider seriously as a source.  For items that are high risk and high value, the investigation may be drawn out and expensive, requiring collaboration of supply, internal users, and technical experts.  It is not possible to separate risk assessment from strategy development, so they are both discussed jointly as level one valuation criteria.
    • Risk Assessment – Every organization’s management makes decisions about the risk it is willing to take in light of the expected returns.  We cover risks in Week 8 (financial, market, liquidity, operational, regulatory, reputational and strategic), so we will not cover them again here, but there are four risk actions a form can take to mitigate risk: (1) avoid the risk altogether – the risk is too great given the expected return; (2) transfer the risk – this is where one would by insurance to transfer the risk from one party to the next, but in procurement,  this involves transferring the risk to the perspective supplier or third party;  (3) reduce the risk – the buyer and supplier share the risks in the relationship; and (4) retain the risk  – the buyer retain the risk in the relationship.  Procurement people can take several actions to mitigate these risks.  Examples would be to ask for advice such as engineering judgment, seek additional information, placing a trial order, or use derivatives to hedge spot and futures positions.  Other examples to mitigate risks would be to require bid bonds, performance bonds, or payment bonds to insure against risks of non-completion, avoid risk by not doing business in certain countries, or using multiple sourcing rather than single sourcing.  It is also possible to mitigate risk by negotiating payment terms on a progress basis (progress billing) or having a buyer put earnest money upfront for a purchase.  When a supply professional takes an action such as selecting a supplier or switching suppliers, or agreeing to certain terms and conditions, he/she should take these actions with the explicit understanding of both the risk at which the decision puts the organization, the return expected, and the balance between the two.
      • Loss Exposure – a supply professional must take risk into account when looking at the likelihood and the impact of the purchase.  The supply person must look at issues such as specification and possible internal theft (pilferage) in the purchase decision.  The may cause the supply professional to mitigate risk by buying in smaller quantities, insist on tamper proof packaging, choosing the appropriate transportation mode, following the advice of security experts, and making sure that quantities are carefully controlled throughout the acquisition and disposal process.


    • Strategy Development – In looking at strategy development for identifying potential suppliers, risk assessment is critical.  Once one assesses the risk involved with each strategic purchase by the type of risk and dollars extended.  One the risk criteria and dollars extended were set, then one can use a two by two matrix to characterize purchases by level of risk (high, medium, or low) and of value (high, medium, or low).  Within the four quadrants set up by the two by two matrix, one could then name the quadrants (for instance, quadrant one could be non-critical; quadrant two could be leverage; quadrant three could be a bottle neck, and quadrant four could be strategic.) and then map each purchase based on its risks and dollars extended.  Based on the product and the dollars it represents to the organization, the selection of the type of suppliers would become more self-evident based on the risks and dollars extended.


  • Level 2 – Traditional – Applying the traditional level two criteria of quality, quantity, delivery, price, and service is till a fundamental assessment task in evaluating potential suppliers.  These evaluated on the basis of the technical, engineering, manufacturing, and logistics strengths of potential suppliers.
    • Technical, Engineering, Manufacturing, and Logistics Strengths – Technical and engineering capability, along with manufacturing strength, impinges on a number of supply concerns.  The most obvious factor is the quality capability of the supplier.  It is possible, however, that a company capable of meeting current quality standards may still lack the engineering and technical strengths to stay current with technological advances.  The reason for buyer selecting one supplier over another has much to do with the strengths that are of importance to the buyer.  The evaluation of a supplier should not just focus on current capabilities, but on future strengths and the strengths which are important from the buyer’s perspective.  Normally, other functional areas in the company such as engineering, manufacturing, internal users, and/or quality control provide expert assistance to assess a potential supplier on technical and manufacturing strengths.  Should the supplier be a distributor, the emphasis might be more on logistics capability.  The nature of agreements with the distributors’ supplying manufacturers, their inventory policies, systems capabilities and compatibility, and ability to respond to special requirements would all be assessed, along with technical strengths of the personnel required to assist the procurement person in making the right choices among a series of differing acceptable options.


    • Management and Financial Evaluation – From a supply manager’s point of view about the supplier’s management a key question is;  Is the management of the supplier a corporate strength or weakness?  This will require a detailed examination of the organization’s mission, its corporate values and goals, its structure, qualifications of managers, management controls, the performance evaluation and reward system, training and development, information systems, and policies and procedures.  It is also useful to have an explanation about why the supplier’s management believes it is managing well and an indication of its most notable successes and failures.  A functional assessment of strengths and weaknesses in areas like marketing, supply, accounting, and so on will substantiate the overall picture and assessment.  When looking at the financial health of a potential supplier, buyers should examine a supplier’s credit rating, capital structure, profitability, ability to meet interest and dividend obligations, working capital, inventory turnover, accounts receivable and accounts payable, current ratio, and return on investment.  Financial stability is a usual indicator of good management and competitive ability, and financial statements are a useful source of information about a supplier’s past performance, and an inference of a supplier’s possible future performance.  We did a financial assessment of prospective supplier during the strategic cost phase, so we are very familiar with this concept.  There is general agreement among supply executives that a supplier’s management capabilities and financial strength are vial factors in source evaluation and selection.


  • Level 3 – Current Additional – There are other criteria buyers have to consider in evaluating suppliers.
    • Financial Considerations – these are financial considerations other than the ones already mentioned, such as: (1) can the supplier conduct vendor managed inventory (VMI), i.e. manage and own inventories so they do not show up on the financials of the buyer?  (2) can the supplier time its capital purchases to achieve tax savings? (3) does the supplier have the international finance capability to facilitate global supply agreements in terms of trade credit, payment, guarantees, and inventory financing?
    • Environmental Impact – A buyer would have to evaluate a supplier’s sustainability, or the ability to achieve economic prosperity while protecting the natural systems of the planet and providing a higher quality of life.  Decision makers must consider four types of capital:  financial capital (cash, investment, and monetary instruments), manufactured capital (infrastructure, machines, tools, and factories), human capital (labor and intelligence, culture, and organization) and natural capital (resources, living systems, and eco systems).
    • Innovation – Assessing a supplier’s potential for innovation requires evidence of continuing improvement and managerial and technical competence.  References from existing customers are relevant in this regard.  When innovation is a strategic issue, the skills required to assess a supplier’s potential go well beyond those of a typical supply professional.  Strategic innovation acquisition may involve mergers and acquisitions, patents, licensing, and contracts.
    • Regulatory Compliance – The supply professional obviously does not want supply arrangements to go to naught because of a lack of supplier attention to regulatory compliance.  The very broad range of regulations regarding trade, employee treatment, financial dealings, the environment, international business, workplace safety and health, and so forth requires a comprehensive approach to compliance valuation.
    • Social and Political Factors – can have a significant bearing on sourcing decisions.
      • Social – Social problems can be addressed through supply policy and actions.  It is possible to purchase certain services or goods from social agencies employing recovering addicts, former prisoners, or the physically and mentally handicapped.  It is also possible to purchase from suppliers located in low-income areas or certain geographical areas of high unemployment.  Government legislation requiring suppliers on government contracts to place a percentage of business with designated minority or female owned businesses has forced many purchasers to undertake searches for such suppliers.  There are problems and opportunities when exercising purchasing power in the social area.  Balancing the often conflicting goals of the organization (lowest total cost with social responsibility) and assessing and mitigating risks presented by supplier diversity programs adds a level of complexity to what may already be a complex sourcing decision.
      • Political – The question arises about how much of a premium should be paid to conform with political directives.  The debate over offshore outsourcing has raised the political stakes, and many public entities are passing legislation to prevent offshore outsourcing that results in a loss of jobs domestically.  Debate abounds of whether this is good for the economy in the long run.  In many deals with foreign countries, businesses have to give a certain of businesses to companies in that country.  Companies must be aware not to do business in countries on which the U.S. Government has on the Office of Foreign Assets Control (OFAC) list.  The growing role of government in all business affairs is likely to increase difficulties of this kind in the future.
      • Level 3 Criteria Conclusion – The suppliers performance according to level three criteria has become a matter of considerable concern in supplier selection.  Suppliers can and do affect the reputation of the purchasing organization and the potential reputational risk is high.  Although the full evidence of compatibility or reputational risk may not be forthcoming until well after a trading relationship has been established, significant clues can be extracted in face-to-face meetings between corporate leaders, examination of corporate publications, and reactions from customers.