As manufacturers seek to source quality goods at the lowest cost, supply chains that were once confined to a single country or continent have stretched around the world. Managers have become adept at addressing recurrent risks—frequent, low-impact incidents such as demand fluctuations or supply delays that affect efficiency. However, they have devoted less energy to designing supply chains that prevent or mitigate the impact of disruptive risks such as labor strikes, political unrest, regulatory shifts, and natural disasters. These events can have severe and lasting repercussions on operations, so manufacturers would do well to devise strategies that alleviate this risk.
In the fluid environment found in many countries, disruptive events are a certainty; only the timing and magnitude are unknown. The challenge for manufacturers is to prepare for disruptive risks while maintaining the gains they have achieved from improved supply chain efficiency. Three strategies can help companies implement the necessary safeguards to reduce risk while improving performance.
Contain the Impact of Supply Chain Disruption
Complexity is a natural element of juggling the huge number of commodities flowing through a manufacturer’s supply chain. "Containing" the scope of the supply chain can lead to higher performance and lower risk by limiting disruptions to just one section of the supply chain.
Large manufacturer can segment their supply chains to improve profits and contain the impact of a supply chain disruption. For high-volume commodity items with low demand uncertainty, the supply chain should have specialized and decentralized capacity. In contrast, for low-volume products with high demand uncertainty, supply chains should be flexible with capacity that is centralized to pool demand.
The concept of containment also applies to regionalizing supply chains. While globalizing the supply chain by moving production to lower-cost countries has been popular for the past couple of decades, doing so has increased fragility, meaning that the impact of disruptions is felt across the entire network. Firms that had single sources of material out of Japan were negatively impacted by the earthquake and tsunami. As fuel costs increase, firms can reduce both the fragility of sprawling global supply chains and transportation costs by developing regional supply chains.
Trade Off a Little Performance for a Large Reduction in Risk
The reason that executives are reluctant to deal with risk is the perception (only partly true) that steps to mitigate risk will dramatically lower performance. One way to minimize a drop in performance while substantially lowering supply chain risk is to overestimate the likelihood of a disruption. Our research indicates that underestimating the likelihood of a disruption is much more expensive than overestimation over the long run. Therefore, manufacturers would be far better served by investing in efforts to shore up their supply chains (for instance, by building additional distribution centers) rather than doing nothing and hoping for the best.
Another way to maintain performance levels while significantly lowering supply chain risk: reduce the concentration of resources. Many manufacturers use centralized inventory or common parts to lower the cost of mitigating recurrent supply chain risks. However, extensive pooling makes the supply chain more vulnerable to disruptive risk. Toyota, for example, lost billions of dollars in sales and incremental costs as a result of its recall in February 2010, the result of a supply chain that used a part common in too many car models and sourced from a single supplier.
Management must recognize that dealing with recurrent risks tugs in the direction of more pooling, but mitigating rare, disruptive risks pulls the balance in the opposite direction. Even when the cost is high or economies of scale are serious enough to warrant a single source, companies should avoid adopting extreme levels of concentration. Having one supplier is risky, but retaining ten suppliers increases cost without reducing fragility. To find an equilibrium, managers must evaluate the cost of increasing or decreasing inventory, capacity, flexibility, responsiveness, and capability and of centralizing or decentralizing inventory or capacity. For these reasons, large companies such as Samsung Electronics always seek to have a second supplier.
Devise a Solid Plan for When Disaster Strikes
An effective plan for dealing with supply chain disruptions must be tailored to the manufacturer’s risk mitigation strategy. To reduce the amount of time it takes to detect a disruption, many companies have implemented IT systems that monitor the flow of materials (delivery and sales) and information (demand forecasts, production schedule, inventory level, quality) on a regular basis. Such systems typically issue alerts when something out of the ordinary occurs. For efficient but far-flung supply chains, detection is much harder than for those with contained scope.
A manufacturer and its partners can lower the time needed to redesign the supply chain by developing contingent recovery plans for different types of disruptions in advance—for example, though business continuity efforts. Manufacturers that have effectively overestimated the likelihood of disruption and reduced their concentration of resources have more options to recover, as there will be backup supply sources for critical parts or commodities. For companies that have contained their supply chain scope, another segment or region can serve as backup. But for those manufacturers that single-mindedly strive for increased performance with little regard for mitigating supply chain risk, there are no readily available options.
It is possible for manufacturers to boost performance while making supply chains more resilient. By containing the impact of disruptions in certain segments and regions, recognizing the true costs of such disruptions, and taking targeted action to infuse the right level of redundancy into the supply chain, companies can be well positioned to weather any storm.
Sunil Chopra is the IBM distinguished professor of operations management at Northwestern University’s Kellogg School of Management. He co-authored the books Managing Business Process Flows and Supply Chain Management: Strategy, Planning, and Operation, which was awarded the best book of the year for 2002 by the Institute of Industrial Engineers (IIE). He has been departmental editor for the journals Management Science and an associate editor for the Decision Sciences Journal, Manufacturing & Service Operations Management and Operations Research. His recent research has focused on risk management and sustainability in supply chains.
ManMohan S. Sodhi is professor and subject leader, operations and supply chain management, at Cass Business School, City University of London. He previously taught operations management at the University of Michigan Business School, where his research in the trucking industry was funded by the Sloan Foundation. His research interests lie in supply chain management, in particular in supply chain risk.