Assessing the Potential Impact of Supply Chain Disruptions

Stephen DeAngelis

January 10, 2012

In the introduction to a study on supply chain risk management, Stephan M. Wagner, from the Swiss Federal Institute of Technology, and Christoph Bode, from the WHU—Otto Beisheim School of Management, wrote, “We find a relatively unstable world on the one hand, and increasingly sensitive supply chains on the other.” [“An Empirical Examination of Supply Chain Risk Performance along Several Dimensions of Risk,” Journal of Business Logistics, Vol. 29, No. 1, 2008] To bolster their claims about the relative instability of the world, Wagner and Bode cite the results of a number of other studies. They write:

“There is strong evidence that … catastrophic events are becoming more frequent (Coleman 2006). Elkins, Handfield, Blackhurst, and Craighead (2005) observed that there has been an increase both in the potential for disruptions and in their magnitude. Likewise, Munich Re (2007, p. 46) stated in its annual report on natural hazards that ‘since 1950, there has been a long-term upward trend in the number of events and the amount of economic and insured losses.'”

To read more about Munich Re’s findings concerning weather-related disasters, read my post entitled Is Risk Assessment Getting More Difficult? To bolster their claim that supply chains are getting more sensitive to disruptions, Wagner and Bode write:

“Modern supply chains seem to be more vulnerable than ever. Over the last decade, almost all industries have seen increased competitive pressure in the business environment and the globalization of markets. These changes have compelled firms to make their intra-firm business processes and inter-firm supply chains either more efficient or more responsive, for instance, by outsourcing and offshoring many manufacturing and R&D activities, sourcing in low-cost countries, reducing inventories, or collaborating more intensively with other supply chain actors (Fisher 1997; Huit, Ketchen, and Slater 2004; Lee 2002; Wisner 2003). Although such supply chain design changes and supply chain management initiatives have great potential to make operations leaner and more efficient in a stable environment, they simultaneously increase the fragility and vulnerability of supply chains to disruptions (Craighead, Blackhurst, Rungtusanatham, and Handfield 2007; Wagner and Bode 2006; Zsidisin, Ragatz, and Melnyk 2005a).”

Wagner and Bode are not the only analysts who have concluded that companies can make their supply chains too lean. That’s why Timothy J. Pettit recommends that companies seek to keep their supply chains in a “Zone of Balanced Resilience.” To read more on that topic, see my post entitled Supply Chain Resiliency Still an Issue. Wagner and Bode believe that some companies defer addressing supply chain risk because it addressing it takes resources — resources than can affect profits. In order to rationally address risk management, companies need to have good information — which is sometimes not readily available. They write:

“At a glance, it seems obvious that firms are now compelled to tackle supply chain risks just as vigorously as they tackle other business risks. However, supply chain risk management comes at a cost and before firms engage in expensive actions they need to have information about the (1) probability of occurrence of supply chain disruptions and (2) the effect of these disruptions on performance. In particular, supply chain risk management activities are only justified if supply chain risks interfere with supply chain performance.”

They point to other studies that have shown that companies that fail to address risk management adequately often pay a big price. These studies have shown “how media announcements on supply chain disruptions affect the observable share price and shareholder value of the announcing firm. The results demonstrated that stock markets severely penalize announcements of supply chain disruptions.” For CEOs looking to keep their jobs, mitigating potential free falls in stock prices is a prudent course of action. To help CEOs determine what those prudent courses of action might be, Wagner and Bode “provide a detailed and empirically-derived operationalization of supply chain risk sources.” They point out that strategy development has two distinct parts: “process (how strategy is formed) and content (what is decided).” They add, “In addition to content and process, the internal and external context of the organization plays an important role for decision-making and should therefore be incorporated in this framework.” They continue:

“High organizational efficiency and performance result when firms consider the context in which strategy is crafted and implemented. For high efficiency and performance, organizations must match structure to the context and environment, i.e., forces outside the decision-maker’s control. If this ‘fit’ is not achieved ‘opportunities are lost, costs rise, and the maintenance of the organization is threatened’ (Child 1972, p. 8). Contingency theorists empirically tested direct relationships between particular contextual variables and organizational structure or performance (Lawrence and Lorsch 1967). However, from the contingency theory perspective, strategies are merely necessary responses to the environment. Therefore, Child (1972) proposed strategic choice theory as a corrective to the classic contingency approach. The strategic choice perspective negates the pure deterministic function between context and organizational structure, arguing that organizations have strategic choice when designing their structure. While strategic decision-makers are constrained by contextual factors, they still have some room for strategic maneuvering.”

The essence of supply chain risk management is developing courses of action to deal with events created by “forces outside the decision-maker’s control.” Wagner and Bode continue:

“We argue that supply chain risk sources are critical contextual variables that can be internal and external to supply chains and to the acting firms in a supply chain network. From a strategic management perspective, matching or aligning organizational resources with the organization’s context, and especially to environmental opportunities and threats, is a major task for decision-makers (Miles and Snow 1978; Venkatraman and Camillus 1984). As stated in the introduction, the literature has suggested that supply chain risk sources pose a threat for which many organizations are not prepared. If this assumption is correct, decision-makers must now reconsider their strategy and, if necessary, align the organization to this changed’ environment in order to achieve a strategic fit. This reasoning brings us to our hypotheses. We posit that the risk deriving from the various supply chain sources undermines supply chain performance. If this assumption finds support then the call for an organizational adaptation towards supply chain risk is substantiated.”

Wagner and Bode explain that, for the purposes of their study, “risk is equated with the damage or loss resulting from a supply chain disruption.” They continue:

“We define a supply chain disruption as the combination of (1) an unintended, anomalous triggering event that materializes somewhere in the supply chain or its environment, and (2) a consequential situation which significantly threatens normal business operations of the firms in the supply chain. For the affected firms, it is an exceptional situation in comparison to every-day business. The disruption has a certain probability of occurrence and is characterized both by its severity and by its direct and indirect effects. Since the resulting detriment is usually a function of time, supply chain disruptions involve time pressure, implying that decisions for mitigation must be made swiftly. Depending on its severity, other terms might be applied, such as, glitch, disturbance, accident, disaster, or crisis. Supply chain disruptions can materialize either inside or outside of a supply chain. Consequently, they can be highly divergent. For instance, the financial default of a supplier and an earthquake that destroys production capacity are situations with completely different attributes and therefore have different effects on the supply chain.”

In their study, Wagner and Bode “divide supply chain risk sources into five distinct classes: (1) demand side; (2) supply side; (3) regulatory, legal and bureaucratic; (4) infrastructure; and (5) catastrophic.” They note that the first two factors deal with traditional supply and demand scenarios. Their hypotheses are not surprising; namely: The higher the demand side risk or the supply side risk, the lower the supply chain performance.” Wagner and Bode posit similar hypotheses for the other sources of risk. They based their conclusions about these hypotheses “on a sample of 760 top-level executives in logistics and supply chain management.”

Their findings confirm their hypotheses about demand and supply side risks (i.e., the higher the risk, the lower the performance). That’s no surprise since analysts have been making those claims for a long time. That’s why companies are always trying to improve demand side forecasting and supply side resiliency. However, “in terms of regulatory, legal and bureaucratic risks, infrastructure risks and catastrophic risks, the study yields no empirical evidence for a negative relationship with supply chain performance.” While I’m not too surprised about the results associated with regulatory, legal and bureaucratic, and infrastructure risks, I am surprised about their conclusion associated with catastrophic risks. I think that evidence associated with catastrophes over the past twenty years clearly demonstrates that catastrophic risks can have a significant negative impact on supply chains. Wagner and Bode write:

“For the catastrophic risk measure, we generated a four-item scale that captures risks that originate from terrorism, socio-political crises, natural disasters, and epidemics, for instance (Helferich and Cook 2002; Kleindorfer and Saad 2005). In order to measure the dependent variable, supply chain performance, we adopted the scale from Rodrigues, Stank, and Lynch (2004) that focuses on the ‘downstream’ supply chain performance. The four performance items relate to delivery dependability, order fill capacity, delivery speed, and customer satisfaction.”

The fact that Wagner and Bode only interviewed executives associated with German firms may account for this apparent anomaly between their claim that “there is strong evidence that … catastrophic events are becoming more frequent” and their conclusion that there is “no empirical evidence for a negative relationship with supply chain performance.” They admit, “Germany is relatively immune to natural disasters.” Here are the conclusions that Wagner and Bode draw from their work:

“Several managerial implications can be deduced from this study. First, supply chain risks have a negative impact on supply chain performance. As a consequence, they underscore the importance of supply chain risk management concepts and measures. Second, while Hendricks and Singhal (2003, 2005a, 2005b) showed that severe disruptions have substantial negative consequences on the health of the affected firms, our findings take into consideration the frequency of occurrence of those effects. Given that severe disruptions (e.g., caused by regulatory legal or bureaucratic barriers, infrastructure breakdowns, or serious catastrophes) which lead to the release of ad-hoc announcements occur less frequently than ‘every-day’ demand side and supply side disruptions, these latter risk sources are in fact very important for achieving high supply chain performance. Thus, decision-makers should turn their attention to these two risk sources. Third, supply chain managers should bear in mind an acceptable cost/benefit trade-off in their firms’ mitigation endeavors concerning major contingency risks (Sarathy 2006). In support of a better utilization of risk management resources, our study advocates the allocation of scarce resources to the mitigation of demand side and supply side risks. This aspect ties in with the introduction where we explained that the series of recent catastrophes has stimulated the intense attention to supply chain risk management.”

The bottom line I reached from reading their study is that a company must know every aspect of its business and the environment in which it operates if it is going to make informed choices about how to deal with supply chain risks.