Product Liability RM methods of long supply chains

Lessons from Losses 2/2011. Supply chain risk management has become one of the most discussed areas to rise due to globalization. The outsourcing of production and cost efficiency targets with lean supply chains has led companies to face new risks. These risks are usually seen as continuity issues and threats to business and earnings.

How can a company ensure that it is really getting the goods –whether final products or components or raw materials – in time with a certain cost? At the same time long contractual chains lead to increasing risks of product liability. This needs to be addressed with liability based risk management methods adapted to the total risk management of the company.

Contractual risk management

Contracts are everywhere in a company’s operations: sales, purchase, maintenance, projects, supply chains. In our October 2006 Liability Newsletter Pialiina Lehto wrote of legal risk management in contractual chains. The issues discussed were about product liability of each contractual party in a production process involving suppliers of components in various stages and finally the producer of the final product.

The main lesson learned was that if a defect in a component leads to the final product being defective and it causes damage or injuries, the producer of the final product can – after paying the damage to the claimant – only turn to its own supplier for possible recourse.

If the defect was further in the supply chain the earlier suppliers may be protected by their stricter contract terms. This is a risk the final producer is taking on behalf of the component producers unless risk management is applied and the final producer’s position is secured. Therefore it is of vital importance to pay attention to the division of liability of any defects between the parties in the supply chain.

Contract risks are related to business processes

Contract risks are business risks related to the core business processes of a company. Through contracts the rights and responsibilities of the company like product prices and commitments to the clients are addressed. But also the rules for liabilities and the remedies available in case of a breach of the contract should be there. A well-organized contract management is a key to managing the risks related to contractual relationships.

They aren’t only based on legal and technical aspects, but also the substance of the agreement and the positions of the parties. A company needs a versatile arrangement of its organization and skills, company policy, guidelines and tools and constant state of alert to be able to balance the contractual risks with the business opportunities and contract risk management actions. These aspects of contract risk management were handled deeper in If’s Risk Consulting magazine 2/2007 in Helena Haapio’s article “Contractual Risk Management: not just a matter for lawyers”.

It is very important to ensure that the common will of the parties and clear tasks and specifications and rules for possible breach of contract situations are in the contract. But even with the best contract it may be difficult to execute the remedies against unwilling contract parties in a country with different legal and business culture. To protect a producer against liabilities stemming from defects in supplied components or raw materials other risk management methods are also needed.

Product liability in supply chain risk management

To prevent product liability and recall situations a company must be able to sell products without defects. In long supply chains it is much more difficult to assure this than in your own production. The company becomes dependable of its suppliers.

So the risk management of product liability means securing the quality of the suppliers. The suppliers must be selected carefully. The reliability of the candidate needs to be verified before it is worthwhile to even negotiate a contract. This task is easier to state than conduct but it is a fundamental matter in business relationships. In quickly expanding globalization and subcontracting and especially in the rapidly developing East Asia it has not been always possible to know the suppliers.

The methods used by Nordic companies include networking and establishing own purchasing units in the country in question. When the company can actually meet the potential supplier in their own production sites it may give a more realistic view on their ability to fulfil the expectations. The presence in the country of the supplier also gives a clear message of the seriousness of the issue. But compared to selecting a partner homeland or in Europe the same task on the other side of the globe is challenging.

Test orders for quality and delivery

The use of a new supplier cannot usually start with full capacity. The supplier should be required to produce samples and the first orders could be test orders for quality and delivery. The buyer can then conduct a careful analysis of the quality and confirm the compliance with specifications. Regular inspections of the received goods have decreased in streamlined supply chains but from a risk management point-of-view are always valid means of controlling a company’s product liability risk.

Even in well running long-term supply relationships the buyer should frequently be able to follow the actual quality and reliability of the supplier with supplier audits and random checks for consistency. For testing there are outside facilities and laboratories giving objective data of the quality and supporting the loyal contractual relationship. These actions may be in contrast with the cost efficiency targets as lean sourcing aims at reducing all costs, but necessary to keep the quality under control. The buyer can keep individual records on each supplier and react quickly if deficiencies appear.

When quality requirements are crucial companies may create their own certification systems for their suppliers. This means that the company usually requires the same level quality management from their suppliers as they have themselves and keeps auditing the compliance frequently. For example ISO management systems can be just one item of the requirements. The suppliers may also benefit from these certifications in their new sales as the certificate by a large producer is often published on the web site and is a recommendation to other clients.

Long supply chains also mean that products are produced of components from many producers. The supplier may have numerous sub suppliers and even they may have contracts with other companies. How can a company e.g. in Finland be able to control the whole chain? That is a difficult task and it is practically impossible to audit everyone in the production chain. But it is possible to audit your supplier’s own selection procedures and quality control methods towards its partners. Are they active and consistent? Some residual risk is determined to remain no matter how deep a company reaches its controls.

Liability and recall insurance

A producer usually takes out product liability insurance and possibly completes it with recall insurance. This gives protection for damages and injuries caused by defective products and cost related to recalling any dangerous products from the market. In order to manage the liability risks it may be necessary to foresee what would happen if the company as the final producer would be sued for liability based solely on its supplier’s errors and a defective component.

In this sense it is important to know and require that the supplier has its own product liability and recall insurances in place. Sometimes the buyer should be included to the supplier’s liability insurance as an additional insured to make sure that protection will be triggered in case of a claim.

Matti Sjögren