By James Kim
In this current economic climate, companies are looking for ways to reduce costs to keep up with the globalization of supply chains. But while it may seem like a good idea to consolidate the vendors in your supply chain, doing so may also increase your levels of third-party risk.
Vendor concentration risk is a company's vulnerability to supplier failure due to relying on only one or a few suppliers. If that supplier eventually is unable to meet its needs, this can lead to disruptions in the supply chain and, ultimately, lost sales and revenue.
Organizations might take their business to a single supplier or location for several reasons besides cost. Sometimes, the supplier may be one of the few sources for a niche product or service. Or, the company may simply have developed a strong working relationship with the supplier.
Whatever the reason, it’s important to be aware of vendor concentration risks so you can mitigate them. Here's a closer look at why organizations face these risks and how you can avoid them.
What Are Vendor Concentration Risks?
Concentration risk happens when a business overly depends on one or few suppliers for its business operations. There's more chance of a single point of failure this way, resulting in a major blow to sales, business growth, and the overall supply chain.
All businesses face some form of concentration risk, but service-based businesses outsourcing critical services like cloud technology and payment processing to third-party providers are particularly vulnerable. Outsourcing creates dependencies on external providers that can negatively affect business if those providers cannot perform as expected or go out of business altogether.
For commerce businesses, especially online retailers relying on third-party fulfillment companies, the risk is even greater because of the need to maintain adequate inventory levels to avoid late shipments and lost sales. Customer complaints and brand damage can result from these issues.
Sometimes, that single vendor may be integral to a product or service needed by the company — for example, if your company manufactures a large proportion of goods in one overseas factory. If geopolitical changes affect that country, or the factory can't keep producing enough goods to meet demand, then your business will have a high probability of loss.
Types of Vendor Concentration Risk
Concentration risk can come from several sources. Here are three examples specific to vendor risk management:
1. Relying on a Few Vendors
As we mentioned earlier, when there's only one vendor, there's no backup if things go left. A single vendor situation can lead to serious operational problems if the vendor experiences unexpected downtime or becomes unavailable for any reason.
While it's useful to build relationships with selected vendors for purchasing benefits, like discounts for large orders, many organizations have procurement policies to ensure they buy from more than one source for a particular product or service for business continuity.
A company might buy from multiple suppliers at multiple sites because there's a limited selection available from a single site or you're sourcing from different geographic areas to ensure global coverage.
Although this can help you avoid the risk of over-reliance on a single provider and minimize the impact of any single outage, it can also increase the complexity and cost of your operations.
2. Fourth-party Concentration
Fourth parties are companies that provide products and services to your third-party vendors — for example, any software your logistics provider uses to coordinate deliveries for your organization or the cloud infrastructure behind your online database providers.
A fourth-party relationship can create a lot of complexity in your supply chain, especially where you're unaware that most of your suppliers are using the same fourth-party vendor for their operations. Even if you have effective third-party risk management processes in place for business continuity, your supplier might not have the same standards.
Consider the Amazon Web Services (AWS) outages in December 2021, which affected devices and online services used by millions of customers. Any service outages or cyberattacks affecting fourth parties can create a serious imbalance in your value chain and put your organization at risk of disruption.
3. Geographic Concentration
For some sectors, geographic concentration can be a problem. Uncontrollable risk factors like natural disasters, extreme weather, geopolitical instability, civil unrest, terrorism, and epidemics can make it difficult for businesses operating in high-risk areas to operate efficiently, if at all.
A prime example of this problem is when manufacturers are in one region of the world. As we saw during the coronavirus pandemic, organizations reliant on Asian factories found their production halted in many countries as the virus spread.
In November 2022, Apple’s main factory in Zhengzhou, central China, suffered severe staff shortages after worker unrest following strict lockdown restrictions — this caused a global shortage of the latest iPhone 14 models, resulting in Apple losing around $1 billion every week.
Seasonal factors also create challenges for third-party vendors managing supply chains across multiple regions. If a vendor is near regions prone to flooding or storms, any damages to its systems could have a catastrophic impact on services that depend on it, including your business.
How to Identify Your Sources of Third-party Concentration Risk
Start by assessing your current level of dependence on vendors and performing a comprehensive review of your supply chains to identify any potential problems. Your business continuity plan can help you audit your business operations, identify where your organization relies on external vendors, and measure the risk thresholds for third-party concentration.
Look for warning signs. For example:
- Does your company have a single primary distribution point?
- Do you rely on a single cloud service provider for all your online activity?
- Is all your technology provided by one manufacturer?
- Which critical business functions do you outsource?
- How many of your suppliers use the same fourth-party?
- Is there a single region where most of your business is concentrated, either through vendors or customers?
- Are there specific events that could trigger disruptions?
Once you've identified problem areas, you can pinpoint areas where you need to improve visibility across your supply chain and develop contingency plans for responding to potential threats.
Reduce Concentration Risk With Third-party Risk Management
As you develop and strengthen your risk management strategies, keep in mind the potential threats that could disrupt your operational processes and what you can do to mitigate those risks before they happen.
Here are a few strategies you can implement to minimize the risk of over-reliance on your suppliers and mitigate the impact of any disruption:
Have workflows in place to take your team to perform thorough due diligence on all potential vendors before you start the onboarding process. This includes researching any recent M&A activity involving the vendor and asking about their subcontractor practices, cybersecurity protocols, and business continuity plans.
When combined with the automations of a powerful risk management platform like Certa, these steps will help you identify potential risks in your supply chain and allow you to make informed decisions about which companies to partner with — and which to avoid.
Once you have your risk dashboard up-and-running with Certa, you can auto-assign task management for your risk team for continuous monitoring of existing relationships, ensuring that any changes avoid introducing extra risks to your operations.
After due diligence, a dedicated approach to efficient documentation is crucial to detecting and reducing your third-party risks. Implementing service level agreements (SLAs) with critical vendors is one way you can mitigate the risks of vendor concentration, as these will help your firm avoid potential financial consequences if suppliers run into problems.
Vendor lifecycle management (VLM) platforms make SLAs and other contractual documentation a breeze to implement, store, and track. VLM tools can also monitor all your vendor scorecards to keep an eye on important supplier metrics — keeping your organization legally compliant while also helping you maintain the right levels of control across the various supply chain levels.
Whether you're sourcing from different regions or by engaging different third-party providers for each aspect of your service offering, diversification is key to ensuring you have a backup plan in case one of your sources becomes unavailable for any reason.
Create a contingency plan for situations like this by making sure you have a good mix of independent suppliers and partners to maintain continuity of supply. When your supplier base is from a diverse selection of places, you can better manage working capital needs and minimize your organization's exposure to certain industry fluctuations or economic cycles.