Understanding and implementing vendor risk management will help your business avoid unacceptable risks and protect its reputation. When you identify potential third-party vendors to supply goods or services and after you outsource to a supplier, perform a vendor risk assessment to mitigate risk.
What is Vendor Risk Management?
Vendor risk management (VRM) is a continuous due diligence process implemented before and after purchasing from or outsourcing to third-party suppliers. Vendor risk management includes lessening risks of poor data security controls, cybersecurity failures, regulatory violations, and business interruption or disruption from supplier failure or significant supply chain delivery delays.
Vendor risk management may be called supplier risk management.
Types of Vendor Risk
There are many types of risks associated with vendors and suppliers. Here are some of the most common:
Financial Risk
Cost savings is the primary reason companies outsource, but if a supplier experiences financial difficulties, it can jeopardize your company’s operations. This type of risk is often difficult to predict or mitigate, so you need to plan strategies to reduce financial and vendor risk. Additionally, if suppliers don’t stick to the contract terms you agreed on, this can be a sign of potential issues down the road.
Ethical Risk
A vendor’s involvement in illegal or unethical practices, such as child labor, can negatively affect your company and damage your brand. Ethical risks can be minimized through careful screening of suppliers and ongoing monitoring.
Environmental Risk
There is a risk that the supplier or vendor’s operations will cause environmental pollution. For example, using hazardous materials in manufacturing or mining activities can contaminate soil and water in their area of operations.
Having a supplier involved with this risk can lead to bad publicity and damage the company’s reputation. Plus, your company also indirectly contributes to environmental pollution. Environmental hazards can be minimized through careful screening of vendors and suppliers and ongoing monitoring.
Political Risk
A vendor based in a country with unstable political conditions can affect the quality and reliability of its products or services. Political risks can be mitigated through careful selection of suppliers and diversification of the vendor base.
Economic Risk
The economy can affect a vendor’s ability to meet your company’s needs. It can also affect the price of its products or services. For example, the supplier’s country may have an unstable currency, making it difficult to predict the cost of goods over time.
Fourth-Party Risk
When your vendors maintain relationships with outside parties like service providers and other types of suppliers and partnerships, the fourth-party risk becomes another vendor risk management complication.
According to Michael Welch in CIOInsight’s “Interview: The Growing Challenge of Fourth-Party Risk”:
“Fourth-party risks are the unseen risks introduced by your third-party partners. As an organization’s vendors maintain relationships with other vendors and partners, they become fourth parties to the organization. Depending on the relationship and role your third party plays in your everyday operations, it could determine the level of risk introduced to your organization.
The cybersecurity effectiveness of these fourth parties ultimately impacts the primary organization’s security because an attacker can exploit a chain of trusted relationships to gain access to the primary organization.”
Your company can perform vendor tiering to rank vendors by their level of security risk with security ratings.
Why is Vendor Risk Management Important?
Vendor risk management is essential because dependence on poorly performing or disreputable vendors will significantly impact your business operations, data, and information security, financial results, and business reputation. You need to be sure that vendors meet regulatory requirements.
In vendor and supplier collaboration, it’s inevitable for supply chain disruptions to occur with the following:
- Lack of knowledge about vendor risk
- Inadequate assessment of third-party risk
- Poorly designed contracts
- Unclear understanding of the consequences of disruptions
- Inadequate contingency plans to mitigate risks and promote supply chain resilience
- Fragmented responsibility for managing vendor risk across organizations
With this in mind, proper vendor risk management is essential to protect an organization from the consequences of disruptions.
Here are some of the main reasons supply management is important:
1. To protect the organization from financial losses
Being one step ahead of the game is always good, which applies to supply chain risk management. An organization can avoid or minimize financial losses by having a plan in place to deal with disruptions.
2. To maintain compliance with regulations
Organizations must often comply with regulations set by industry bodies or government agencies. If a vendor cannot meet its regulatory obligations, the organization may be at risk of non-compliance. A plan can help ensure that suppliers comply with all the necessary regulations.
3. To safeguard the organization’s reputation
An organization’s reputation can be severely damaged if it is associated with a vendor that has ethical or other issues. For example, if a company uses child labor in its supply chains, the news will quickly spread, and customers may start to boycott its products and the products of its associated brands.
However, having supply chain risk management in place can help you be one step ahead and take necessary precautions to avoid such vendor risk disasters.
4. To avoid disruptions in the supply chain
Disruptions in the supply chain can have a ripple effect, causing delays and shortages of materials from vendors further down the line. But, a supply management plan can help mitigate the risk of these disruptions by identifying them and then putting protocols in place to avoid or mitigate them.
5. To ensure the continuity of operations
In some cases, disruptions to the supply chain can cause a complete shutdown of operations. This is especially true for companies that rely on just-in-time delivery of materials. A plan that expects disruptions from vendors and suppliers can help ensure operations can continue, even if it’s at a reduced capacity.
What are Some Vendor Risk Management Examples?
Vendor risk management examples include:
• Not having adequate contracts or approved purchase orders in place before procurement from a vendor
• Cyberattacks causing a cybersecurity data breach from vulnerabilities traced to the third-party vendor or supplier
• HIPAA data leaks or loss of other sensitive information
• Poor working conditions and violations of labor laws at the vendor location (that can affect your business reputation)
• Violations of anti-money laundering (AML) or other global regulations
• Vendor shutdowns or significant delivery delays due to poor financial management or financial failure that can impact business continuity
How can your business improve vendor risk management?
Vendor onboarding is a business-critical process that can pose serious risks if done manually. That’s where improved vendor risk management can save your business time, money and endless frustration. Learn how to implement better practices.
How Do You Manage Vendor Risk?
Organizations need to manage vendor risks just like any other type of business risk. This means understanding what might happen if a supplier fails to meet its obligations and taking steps to minimize the potential impact.
There are many ways to approach vendor risk management, but one common framework is to think about it in terms of three key elements: identification, assessment, and mitigation.
1. Identification
Before managing vendor risks, in your VRM program you must identify which suppliers pose the biggest threats. This requires looking at the organization’s overall exposure and the specific risks associated with each supplier or vendor.
To get started, ask yourself these questions:
- What products or services does the vendor provide?
- What is the total value of our purchases from the vendor?
- What is our dependence on the vendor?
- What is the vendor’s financial health?
- Are there vendor fraud risks?
- What is the supplier’s track record? Have they had any quality issues in the past?
- What is the political and social stability of the country where the supplier is located?
2. Assessment
Once you’ve identified which vendors pose the biggest risks (as a risk score), it’s time to assess the potential impact of those risks in your vendor risk assessment process. This step involves understanding what could happen if a supplier fails to meet its obligations.
To do this, ask yourself these questions:
- What are the consequences of a disruption in the supply chain? For example, would it cause a production stoppage? Would it lead to lost sales?
- How likely is it that the supplier will experience a disruption? What are the warning signs we should be looking for?
- How severe would the impact be? Would it be a minor inconvenience or a major crisis?
3. Mitigation
After identifying and assessing the risks, you can develop mitigation strategies. The goal here is to reduce the likelihood of disruption and minimize the impact if one does occur.
There are many ways to do this, but some common approaches include:
- Diversification
One way to reduce risk is to spread it out by working with multiple suppliers for the same product or service. This way, if one supplier has a problem, you’re not entirely reliant on them.
- Redundancy
Another approach is to have redundant systems in place so that if one supplier has a problem, you can quickly switch to another. For example, if you’re relying on a single supplier for parts, you might keep a stock of components from other suppliers on hand to continue production if there’s a disruption.
- Contracts
Another way to reduce risk is to include clauses in your contracts that protect you in case of a problem. For example, you might require the supplier to provide replacement parts at no cost if they experience a production stoppage.
No matter which approach you take, it’s important to have a plan in place to know what to do if a vendor has a problem. This plan should include contact information for key people, a list of alternative suppliers and vendors, and instructions on how to implement the mitigation strategy.
How to Implement Vendor Risk Management
Recommendations for implementing vendor risk management follow.
Establish a Company Policy for Vendor Risk Management
The company policy on vendor risk management should begin with vendor selection criteria, vetting procedures, and the number of vendors to choose from for sourcing each type of item.
Having multiple approved vendors may prevent supply chain disruptions. For example, a company may decide to vet and select three potential vendors, receive competitive pricing estimates, and rank the vendors before selection. If one supplier’s performance is poor, then the company will have other vendors to rely on.
Get Vendor Recommendations from their Customers
As part of the vetting process, get recommendations from the potential supplier’s customers.
Obtain Credit Report Information and Vendor Financial Statements
To prevent dealing with vendors that could be put on credit hold by their suppliers or go out of business, choose financially healthy vendors. Subscribe to a credit report information service like Dun & Bradstreet. Choosing an unstable vendor may result in prolonged delivery delays, customer relations risks, and financial impacts on your business.
Use a Vendor Risk Management and Control Matrix to Evaluate Vendors
A vendor risk management matrix is a valuable tool in your vendor risk management framework.
With a vendor risk management and control matrix, your business can calculate a current estimate of risks and probability of occurrence, assign a risk score number, and determine any action steps required to mitigate unacceptable vendor risk. Perform a vendor risk matrix evaluation before vendor selection. Update the vendor risk matrix on an ongoing basis.
Have the Selected Vendors Sign a Service-Level Agreement (SLA)
As a tool in your vendor risk management program, using a signed service-level agreement will help you achieve better vendor performance or receive compensation in the form of “remedies or penalties” otherwise. SLAs may improve vendor relationships because vendors will understand your well-defined expectations from the beginning.
According to CIO magazine, “A service-level agreement (SLA) defines the level of service you expect from a vendor, laying out the metrics by which service is measured, as well as remedies or penalties should agreed-on service levels not be achieved. It is a critical component of any technology vendor contract.”
Onboard Suppliers Upfront upon Selection
Get required tax compliance forms from vendors electronically if possible. Screen the vendors against tax lists to validate the vendors.
Perform Ongoing Vendor Due Diligence
Vendor risk management requires continuous monitoring of risk exposure. Throughout the vendor lifecycle, continue to review your suppliers for potential risks to your business. You may use a combination of questionnaires and real-time automated screening in your risk management process for vendors.
In larger companies, you may want to conduct internal audits as part of your vendor risk assessment to ensure that adequate controls exist.
Apply the NIST Cybersecurity Framework to Vendor Risk Management
The National Institute of Standards and Technology created 5 NIST standards for cybersecurity:
- Identify
- Protect
- Detect
- Respond
- Recover
NIST is part of the U.S. Department of Commerce. These standards apply to cybersecurity threats that include vendors and their fourth-party relationships.
Select and Use Vendor Risk Management Software
To the extent that you can perform ongoing monitoring of new vendors and established suppliers with software that automates vendor risk management functions, consider using automation software as your third-party risk management solution for vendor risk mitigation and remediation. You may find other software efficiencies to streamline your business process workflows and produce significant time and labor savings.
How Does AP Automation Software Provide Vendor Risk Management Solutions?
End-to-end AP automation software screens vendors for fraud and non-compliance with global regulations (including AML, terrorism lists, and tax information matching) to prevent these types of payments and provide more effective vendor risk management.
The best AP automation software provides an integrated self-service supplier portal for onboarding, including tax compliance documents like W-9 forms, vendor-customer communications, and centralized contract and document storage. The system helps you conduct business and perform ongoing vendor risk assessments as a vendor management solution.
The AP automation software matches invoices to supporting documents, automates invoice approvals, and pays authorized bills to global vendors using mass payments for efficiency. Enterprise-grade security enhances data protection. You’ll see real-time dashboards to monitor accounts payable and other financial metrics trends.
Summary – Vendor Risk Management
Vendor risk management is an essential part of your governance, risk, and compliance (GRC) program. To lessen cybersecurity risks, other security risks (including HIPAA healthcare and GDPR information privacy leaks), financial risks, and reputational risks, implement a comprehensive vendor risk management policy that aligns with your enterprise risk management strategy. And establish a vendor risk management program to exclude high-risk vendors, beginning with vetting and vendor selection. Continue monitoring throughout the vendor relationship.
Software that automates vendor risk management process tasks in real-time will help companies perform ongoing due diligence on vendors and suppliers to reduce business risks, including operational risks, regulatory compliance risks, and fraud. Download our Levvel Research independent study results, “Best Practices for Managing Cross Border Transactions” to dive deeper on how to optimize vendor risk management.
