Managing the Unpredictable Risks in Supply Chains

Global trade and the supply chains that support it are undergoing a period of profound change. Supply chains face threats including a resurgence of protectionism, climate change, decaying infrastructure, and human rights abuses. The Development Channel’s series on global supply chains will highlight experts’ analysis on emerging trends and challenges. This post is from Sang Kim, Associate Professor at Yale School of Management. 

The rise of outsourcing has transformed many companies into managers of global supply chains. While this change has brought many benefits—lowering labor costs, increasing productivity, and gaining access to international markets—it has also created new kinds of costs. In particular, firms are now vulnerable to supply chain disruptions. Factory shutdowns in Japan following the 2011 Tohoku earthquake cascaded across automotive and electronics supply chains. The 2013 collapse of Rana Plaza in Bangladesh, which killed over a thousand workers, damaged the reputation of many well-known clothing brands. And recent revelations that Indian textile company Welspun mislabeled products as Egyptian cotton already cost them one of their biggest buyers, Target.

There are two kinds of supply chain risks. Some are predictable; they include the uncertainties that businesses face on a day-to-day basis, such as delays in product deliveries, fluctuations in consumer demands, and product shortages. Because managers encounter these problems repeatedly, they have become adept at dealing with them. For example, managers collect and analyze data on past product shortages to forecast future ones, and build up their inventory to head off potential losses. The real challenge is managing unpredictable risks, including natural disasters, catastrophic equipment failures, and terrorist attacks. These risks are harder to plan for since they occur less frequently but with often much higher costs. For instance, in 2007, a power outage at a Samsung plant unexpectedly shut down production for a day. As a result, Samsung lost an estimated $40 million. Many companies struggle to manage such risks.

One strategy to address unpredictable risks is duplication. This means maintaining multiple copies of products and suppliers. For example, managers will build standby production lines, buy each type of part from multiple suppliers, or hold backup inventory for all their parts and products (in contrast to the selective and targeted inventory involved in predictable risks). Though duplication does protect against disruptions, it’s expensive if it is not carefully planned.

A cost-effective way for a duplication strategy to work is investing in making supply chains more flexible. This might involve designing products to use common, standardized parts so that a substitute can be readily found if the original part becomes unavailable after a disruption, or engineering production lines so they are capable of manufacturing multiple products, allowing for quick switches if a supplier shuts down. Some companies may enter into contracts with suppliers that allow for last-minute orders in the event of a disruption without necessarily buying regularly. While it may still be necessary to keep some additional inventory, a focus on flexibility lessens the need for costly and often unused duplication at every stage of the supply chain.

Although these contingency planning strategies cost money, managers must address unpredictable risks, as the costs of not doing so can be even higher. The 2000 Phillips Electronic shutdown illustrates the threat of this type of supply chain disruption. A fire started by lightning forced Phillips Electronics to close a cellphone chip factory in Albuquerque, New Mexico, leading to shortages of critical parts for two of Phillips’ customers, Nokia and Ericsson. Nokia, in an illustration of flexibility, had maintained relationships with its other suppliers, who freed up their production capacity to provide replacement parts on short notice. In the end, Nokia emerged from the incident relatively unscathed. Ericsson, on the other hand, did not have built-in flexibility and suffered big losses, which contributed to its eventual exit from the cellphone manufacturing business. As this example illustrates, a well-thought out contingency plan that increases flexibility can make or break a company. And with supply chains becoming increasingly complex and geographically dispersed, the capability to quickly respond to sudden disruptions is more important than ever.