Make Smarter Investments in Resilient Supply Chains
Many companies invest in resilience only after a disruption. Applying the concept of real options can help decision makers fortify supply chain capabilities no matter the crisis.
Ken Orvidas/theispot.com
More than ever, companies need supply chains that are resilient to disruptions, whether the cause is a natural disaster, an infrastructure failure, labor actions, or a global pandemic. Yet the conventional approach to resilience is seriously flawed. Many companies follow a boom-and-bust pattern, making big investments in resilience after a supply chain disruption and then paying little attention to the issue until the next crisis.
This reactive way of protecting supply chains is based on the approach of mitigating the risk that a disruptive event will occur. But that is not enough for creating true resilience, which is the ability to bounce back as quickly as possible after a disruption.1 A more effective approach focuses not on risks but on outcomes — that is, on the value of maintaining operations when adversity strikes rather than on the cost of a supply chain disruption. The goal is a robust supply chain that can sustain value creation under any plausible risk scenario.2
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Developing such an approach is difficult. It requires companies to determine in advance how much to invest in resilience and how to implement those investments across different parts of the organization. These challenges have long frustrated efforts to make supply chains more resilient.
We have developed a framework to address these problems by applying the concept of real options to evaluating investments in resilience. Real options build on the principles used by the banking industry to assign a future value to financial investments in the face of long-term uncertainty. (The Black-Scholes-Merton model is a well-known example.) Here, real options are applied to tangible investments in supply chain capabilities, such as building up stockpiles, adding production or warehouse capacity, or lining up backup suppliers.3 Our option valuation approach is the result of extensive research with supply chain leaders in several global companies and was tested with a leading manufacturer.
Using real options as a model gives managers a method for assessing the full range of resilience investments and their probable effects on outcomes when the likelihood of future risks is unknown. The objective is to protect against downside losses while preserving upside performance.
The Downsides of the Boom-and-Bust Pattern
Companies affected by a disruption often commit significant sums immediately after the crisis to protect human life and physical assets and keep serving customers.
References
1. Y. Sheffi and J.B. Rice Jr., “A Supply Chain View of the Resilient Enterprise,” MIT Sloan Management Review 47, no. 1 (fall 2005): 41-48.
2. W. Klibi, A. Martel, and A. Guitouni, “The Design of Robust Value-Creating Supply Chain Networks: A Critical Review,” European Journal of Operational Research 203, no. 2 (June 2010): 283-293.
3. B. Kogut and N. Kulatilaka, “Capabilities as Real Options,” Organization Science 12, no. 6 (November-December 2001): 744-758.
4. S. Mathews, V. Datar, and B. Johnson, “A Practical Method for Valuing Real Options: The Boeing Approach,” Journal of Applied Corporate Finance 19, no. 2 (spring 2007): 95-104.
5. K. Harrington and J. O’Connor, “How Cisco Succeeds at Global Risk Management,” Supply Chain Management Review 13, no. 5 (July-August 2009): 10-17.
6. S.Y. Gao, D. Simchi-Levi, C.-P. Teo, et al., “Disruption Risk Mitigation in Supply Chains: The Risk Exposure Index Revisited,” Operations Research 67, no. 3 (May-June 2019): 831-852.