International Political Risk and Sourcing Policy

Author(s):

Richard M. Vanatsky, C.P.M.
Richard M. Vanatsky, C.P.M., Senior Consultant, Andersen Consulting, Logistics Strategy Practice, Cleveland, OH 44114, (216) 781-3580

81st Annual International Conference Proceedings - 1996 - Chicago, IL

Abstract It is no secret that modern strategic realities for many manufacturers are driving them to source materials and components outside their home country. The result on a global level of these decisions is that manufacturing activity is becoming less concentrated in the traditional industrial powers and is spreading to newly industrialized and developing countries with varying degrees of political stability. The severe consequences from a supply disruption should convince manufacturers that they need to understand the nature and sources of international political risk. Once management has that understanding, they should craft a materials management policy which accounts for those risks. This paper presents a framework by which a company can identify an appropriate sourcing policy given the complexity of its inputs and the stability of its country sources. A case study in the international aerospace industry illustrates how this framework can balance the maximum bearable production risk from international sourcing against the costs of maintaining secondary sources and safety stock inventory.

In today's business environment, many manufacturing firms increasingly find themselves competing in a unified global market, yet they find themselves operating in a rapidly multiplying number of national sites with varying degrees of hospitality towards foreign businesses. The strategic realities of cost competitiveness and market access are key drivers behind increased overseas manufacturing. Recent studies indicate that these factors are having a macro-level effect on the global manufacturing picture. A shift is occuring in manufacturing from traditional industrial powers to a group of newly industrialized and developing countries such as China, South Korea, Taiwan, Iran, Brazil, and Mexico. In terms of manufacturing value added, Iran has risen from 34th to 15th on the global list for manufacturing value added since 1980. During the same period, China has created new manufacturing jobs at a rate of 2,810 a day, or 117 jobs an hour! Firms with manufacturing or sourcing activity in this group of countries will need to give strong consideration to the effects of political risk on their overall operations. Therefore, given these trends, it is reasonable to believe that the relatively new field of international political risk assessment will continue to grow in importance and sophistication.

What is political risk? There is no universally accepted definition of political risk. However, a useful definition might be that it involves the probability that political forces will cause significant changes in a country's business environment that will affect the profitability and other objectives of an enterprise with stakes in that country. The nature of political risk is that it can be divided into two categories: macro risk and micro risk. Macro risk occurs when all foreign enterprises in a country are affected in a similar way by political conflict. Instances of macro risk are usually dramatic. They happen during times of turmoil, often in less developed countries which are going through a period of severe shifts in political philosophy. In these turbulent times, foreign firms are tempting targets and occurances such as mass expropriation, kidnapping of executives, and boycotts can take place.

In contrast with macro political risk is the concept of micro risk, risk associated with political changes that affect selected industries, firms, or projects within a country. While macro risk is more dramatic, micro risk is more pervasive. It should come as no surprise that some industries and firms are more susceptible to micro risk than others. Studies have found that extractive industries such as mining and petroleum are particularly vulnerable to political risk. The arrival of foreign investment in these industries often gives rise to nationalistic sentiments that natural resources should be developed for the general welfare of all citizens of a country rather than for private profit. Also, financial institutions tend to be more vulnerable due to their significant potential for influence and control. High-tech industries tend to suffer less from political risk due to the host country's reliance on multinationals for technology. Of course, individual companies carry with them varying levels of risk based on their own distinctive reputations or behaviors regarding cooperation with their host governments.

Sources of Political Risk A number of major underlying forces cause political disruption and therefore, risk. In general, the most frequent sources of disturbances are from political forces hostile toward foreign business that are in conflict with the government's current policies. Examples are: competing religious groups, social unrest and chaos, vested interests of local businesses, recent political independence, armed conflicts and terrorism, and new international alliances. Common groups in which political risk are manifested include parliamentary opposition groups, nonparliamentary opposition (such as anarchist or terrorist groups inside or outside the country), nonorganized common interest groups (such as students, workers, or minorities), and foreign governments willing to aid internal rebellion. Ultimately the effects of political risk are felt by businesses in the following ways:

  • Asset confiscation without compensation
  • Expropriation with full or partial compensation
  • Loss of freedom to operate
  • Operations restrictions (e.g., restricted market share)
  • Contract breaches
  • Discriminatory taxes
  • Supplier manufacturing/delivery disruptions
  • Damage to property or personnel (from terrorism, kidnapping, etc.)
  • Repatriation restrictions (inability to transer funds to home country)

Political Risk Assessment To better get a grasp on international political risk, multinationals use a variety of approaches and resources. Their commitment ranges from part time involvement of a person in international treasury to the employment of full time staffs of political scientists. Approaches span from simple checklists to sophisticated scenario planning systems.

The most elementary form of risk assessment, Sujective-individual analysis, involves soliciting overall risk impressions of key personal contacts within the country being studied, or by networking and gathering information from experts outside the country. The advantages to this approach are quick turnaround on information requests and the ability to obtain specific information on key issues relevant to the company. Its drawbacks: information of this sort can be biased in such a way that it represents the self interests of the host country sources. Also, the opinions gathered may conflict and thus provide ambiguous messages.

The approach known as Subjective-group analysis takes opinions of groups of experts, but collates these judgements through the use of various analytical tools, such as Bayes' Theorem or the Delphi technique (See References, Jeffrey D. Simon, 1992) These methods are fairly inexpensive ways to get the opinions of many experts, but they suffer from a time lag problem from the time the initial questions are prepared and a final assessment is reached. Objective-individual analyses are based on the use of "objective" data and quantitative techniques where "soft" data are replaced with statistical indicators of risk, such as strikes, political protests, and terrorist attacks, to derive a risk score for a given country. The primary benefit of this approach is that it can eliminate the pure speculation and biases that are associated with subjective methods.

The use of Objective-group analysis allows for groups of experts to use the same quantitative methods as Objective-individual methods to perform consistent cross country analysis. Staff members or outside consultants are needed to produce "objective" rankings of countries across several dimensions to produce political risk scores for a country. Unlike the Bayesian or Delphi methods, an attempt is made to translate subjective opinions of events into "hard" indicators of political instability. This approach allows for comparison of risk for many countries using identical measures and introduces a measure of objectivity to a sophisticated method of analysis.

Political Risk and an International Sourcing Case In order to demonstrate the usefulness of political risk assessment in an industrial environment, a business case is presented here pertaining to the international sourcing operation of a commercial aerospace manufacturer.

Many buyers of commercial aircraft are publicly owned national airlines that have significant leverage with their suppliers. During the bidding process, these suppliers are asked for concessions known as offset agreements to the governments/airlines. These offset commitments are provisions which require the seller to source a certain level of component manufacturing from factories in the buyer's country. Especially in developing countries, these agreements can help the purchasing country to finance the purchase and assist them in building a fledgling aerospace manufacturing base of their own.

A Framework for Managing Risk A primary operations risk involved in these strategies is that an interruption of supply from an overseas source will occur which could threaten a production line at other factories in the manufacturing network. Consider a component that is dual sourced between a domestic supplier and an overseas supplier with both producing a significant portion of the total manufacturing requirements. If the supply of the overseas vendor were interrupted due to political conflict, production of its portion of the schedule would have to be shifted to another source in order to maintain scheduled assembly requirements. Here, a critical factor is the time it would take for a domestic source to obtain the requisite additional materials and to reschedule its shop, assuming it had sufficient capacity to meet the addtional requirements demanded. If a component were sourced solely with an overseas producer and supply were interrupted, a more dire situation results. In this case, the critical variables are the time it would take for a new supplier to be found, pricing and terms to be established, the component's engineering to be done, tooling to be built, production to be initiated, certifications to be completed, and output to be ramped up to 100% of the scheduled requirements. Obviously, this is a much longer period of time than it would require to simply shift production to an already qualified supplier.

The severity of time and schedule losses in these "offload" scenarios would depend on the type of component being considered. High complexity parts such as turbine disks, large fabricated frames, and main bearings will generally be more expensive, more technically difficult to produce, and will have very long startup leadtimes. Clearly, these components are the most risky to source overseas primarily due to the offload startup leadtimes. For the purposes of developing this framework. For the purposes of developing this framework these parts will be referred to as "A" components and will consist of those whose startup leadtimes which are six months or greater.

Of course as the complexity, technology content, and dollar value of parts decrease, it is generally true that their startup leadtime and production shift capabilities become more favorable. To complete the model, two more classifications are added: "B" components, whose startup times range from six months down to two months (parts such as machined brackets, tubes, and manifolds), and "C" components whose startup times are less than two months (simple bracketry, clips, and small machined parts).

Merging this component classification scheme with concepts from international risk assessment will produce a useful model. It would be unwise not to perform sophisticated country risk analysis in this industry due to the resources at stake and the consequences of supply disruption. The methodologies selected should have two main attributes: good cross country rating capabilities and the ability to continually update classifications. This would suggest that a process which includes elements of Bayesean Subjective-group analysis with those of the Objective-group technique. Whatever the specific methodology, the output of the process should be specific country ratings which can be frequently updated. For purposes of this model, the ratings should enable managers to classify countries into three categories: High-risk, Moderate-risk, and Stable country sources.

Sourcing Policy Matrix Commercial aerospace manufacturers are no different from firms in most industries in that they are striving for lean, streamlined operations. However, the goals of squeezing out inventory, reducing the supplier base, eliminating overhead, and reducing transactions costs are generally in conflict with the objective of reducing production risk from international sourcing. The reality of business strategies and marketing commitments in an aerospace firm will continually be pushing manufacturing toward a maximum-bearable risk position. The pressures of cost and inventory reduction are the opposing forces. A framework for balancing these forces is presented in Exhibit 1. The Sourcing Policy Matrix presented here provides policies that represent maximum bearable risks for different component type/country source combinations Thus the policies outlined in each cell of the exhibit are designed to guide decision makers to implement solutions that minimize cost at the level of maximum-bearable risk.

As one moves horizontally from left to right on this grid, the level of political risk grows and the sourcing policy becomes more conservative. As one moves vertically from top ("A" components/high complexity) to bottom ("C" components/low complexity) , the level of exposure to production risk diminishes and more cost efficient policies can be utilized. Thus the northeastern-most cell in the grid represents the most dangerous coupling: high complexity, long leadtime items with high risk country sources. In this area, single sourcing is never recommended. Dual sourcing with an appropriate inventory safety stock on the foreign supplier's schedule is recommended. The domestic source should be a most trusted, reliable supplier or an in-house shop. Acknowledgement from the domestic source should be secured that they have sufficient capacity and access to raw materials to handle 100% of the component requirements on relatively short notice. Lastly, a documented contingency plan should be published which details the transition to be implemented in the case of a supply interruption. As one moves in a southeasterly direction on the matrix, the sourcing policies become less conservative, but more cost effective.

Framework Limitations The balancing of production risk and strategic marketing accommodations is only one of a number of huge challenges that international sourcing management faces. During the decision making process, the sourcing manager must also consider the costs of the inputs he/she is supplying to manufacturing. Therefore, issues such as exchange rate risk, transportation, leadtime, quality control, and negotiating leverage enter into decisions. The policies that stem from this framework must be balaced with these traditional forces to make good sourcing decisions.

The framework presented in this paper is not intended to answer all of the questions arising out of international sourcing operations. No model can be that comprehensive. It is, however, intended to provide a structured method of setting sourcing guidelines. Paired with a sound method of assessing international risk, it can provide a model with which to set policies which balance the strategic realities that a firm faces, with rational operations that are as economically efficient as possible.

References

  1. Garret Wasney, "Global Manufacturing Survey: Mission Possible," World Trade, November, 1994. p. 46.
  2. Stefan H. Robock, International Business and Multinational Enterprises (Richard D. Irwin, Inc., 1989) p.378.
  3. Barbara C. Samuels, Managing Risk in Developing Countries - National Demands and Multinational Response (Princeton University Press, 1990) p.16.
  4. Jeffrey D. Simon, "Political Risk Analysis for International Banks and Multinational Enterprises, "Country Risk Analysis - A Handbook (International Economic Consultants, 1992). pp. 120-123.
  5. Thomas Gladwin and Ingo Walter, "How Multinationals Can Manage Social and Political Forces," The Journal of Business Strategy. 1980 p. 55.
  6. William P. Kelly, "American Politics, Multinational Business," Managing Multinational Corporate Risks (NFTC Foundation, 1986) p.51.

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