Robust Strategies for Mitigating Supply Chain Disruptions Christopher S. Tang1 UCLA Anderson School, 110 Westwood Plaza, UCLA, Los Angeles, CA 90095, USA Email: [email protected] Tel: (310) 825-4203 Web: www.anderson.ucla.edu/x980.xml August 29, 2005 Abstract When major disruptions occur, many supply chains tend to break down and take a long time to recover. However, not only can some supply chains continue to function smoothly; they continue to satisfy their customers before and after a major disruption. Some key differentiators of these supply chains are cost-effective and time-efficient strategies. In this paper, we present certain “robust” strategies that possess two properties. First, these strategies will enable a supply chain to manage the inherent fluctuations efficiently regardless of the occurrence of major disruptions. Second, these strategies will make a supply chain become more resilient in the face of major disruptions. While there are costs for implementing these strategies, they provide additional selling points for acquiring and retaining apprehensive customers before and after a major disruption. Keywords: Unpredictable Disruptions, Supply Chain Management, Risk Management, Operations Strategies. 1 We would like to thank Professors Volodymyr Babich, Mohan Sodhi, and Arthur Geoffrion, Mr. Richard Paegelow, and the participants of the 2005 Stanford Supply Chain Forum conference for their helpful comments on an earlier version of this paper. 1 Introduction Our world is increasingly more uncertain and vulnerable. Over the last 10 years, we witnessed many types of unpredictable disasters including terrorist attacks, wars, earthquakes, economic crises, devaluation of currencies in Asia, SARS, tsunamis, strikes, computer virus attacks, etc. According to two independent studies, one by the Center for Research on the Epidemiology of Disasters (www.cred.be) and the other by the world’s largest re-insurer Munich Re (www.munichre.com), historical data indicates that the total number of natural and man-made disasters has risen dramatically over the last 10 years. Moreover, Munich Re reported that the average cost of these disasters has increased by a factor of 10 since the 1960s. When disasters occur, major business disruptions follow. As many supply chain executives strived to improve their financial performance such as Return on Assets2, they implemented various supply chain initiatives to increase revenue (e.g., increase product variety, frequent new product introduction), reduce cost (e.g., reduce supply base, Just-in- Time inventory system, vendor-managed inventory), and reduce assets (e.g., outsourced manufacturing). These initiatives are powerful and effective in a stable environment. However, these initiatives have created longer and more complex global supply chains, which are more vulnerable to business disruptions in a turbulent world. Examples of supply chain vulnerabilities are widespread: Ericsson lost 400 million Euros after their supplier’s semiconductor plant in New Mexico caught on fire in 2000; Land Rover laid- off 1400 workers after one of their key suppliers became insolvent in 2001; Dole’s revenue declined after their banana plantations in Central America were destroyed by Hurricane Mitch in 1998; and Ford closed 5 plants for several days after all air traffic was suspended after September 11 in 2001. The reader is referred to Chopra and Sodhi (2004), Christopher (2004), Martha and Subbakrishna (2002), and Monahan et al. (2003) for more details. As highlighted in Lee (2004), cost efficiency comes with a huge hidden cost should a major disruption occur, and one must balance the notion of cost efficiency with agility, 2 Return on Asset (ROA) is equal to Earnings before Interest and Tax (EBIT) divided by total net assets. 2 adaptability and alignment. Based on anecdotal observations, most supply chains tend to break down during major disruptions and many of them cannot recover afterwards. For example, as reported in Eskew (2004), out of the 350 businesses operating in the World Trade Center before the 1993 bombing of the World Trade Center, 150 of them were out of business a year later. In addition, supply chain disruptions can have long-term negative effects on a firm’s financial performance. For instance, Hendricks and Singhal (2005) investigated the long-term stock price effects and equity risk effects of disruptions based on a sample of 827 disruption announcements made over a 10-year period. They found that companies suffering from supply chain disruptions experienced 33-40% lower stock returns relative to their industry benchmarks over a 3-year time period that starts one year before and ends 2 years after the disruption announcement date. The detrimental effects of various major disruptions reported by Eskew (2004) and Hendricks and Singhal (2005) have motivated us to examine ways to identify supply chain strategies that are efficient and yet resilient to major disruptions. Based on different pieces of evidence gathered by other researchers, many firms find it difficult to justify certain costly strategies for mitigating supply chain disruptions that may not occur. This observation may explain why so few firms are taking bold steps to secure their supply chains. Therefore, in order to motivate firms to secure their supply chains, one needs to develop “robust” strategies that serve dual purposes. First, these strategies should be able to help a firm to reduce cost and/or improve customer satisfaction under normal circumstances. Second, the same strategies should enable a firm to sustain their operations during and after a major disruption. In this paper, we identify several robust strategies and we show how these strategies can help a firm to succeed before, during and after a major disruption. We also discuss some of the underlying challenges for selecting and implementing some of these robust strategies. Supply Chain Security Initiatives Soon after September 11, 2001, the U.S. government developed various security measures to improve supply chain security. First, the Container Security Initiative (CSI) 3 was launched in 2002 by the U.S. Customs3. This initiative calls for new technology to identify/pre-screen high-risk containers before they arrive at U.S. ports. Second, in 2002, the Department of Transportation and Customs launched the Operation Safe Commerce (OSC), which calls for new technology to track and monitor containers so as to ensure that each container was routed as planned and stayed sealed at all times. Third, the Customs-Trade Partnership Against Terrorism (C-TPAT) certification program was established in 2002 by the U.S. Customs. To entice companies to comply with the best security practices, C-TPAT certified companies are allowed to clear customs faster with less inspection.4 While these initiatives could improve security, some skeptics have certain doubts. First, as reported in Damas (2002), the estimated cost for implementing these new security measures is approximately $150 billion. Second, Rice and Caniato (2003) commented that these initiatives may not guarantee security in a long run because the actual security would depend on the continuous efforts of many parties. The reader is referred to Closs and McGarrell (2004) and Rice and Caniato (2003) for detailed description of these initiatives. At the corporate level, Rice and Caniato (2003) reported that few firms rely on insurance to secure their supply chains due to two key reasons. Firstly, insurance premiums for major disruptions are prohibitively expensive. For example, Delta Airlines terrorism insurance premiums increased from $2 million in 2001 to $152 million in 2002. Second, even though insurance can help a firm to stay afloat financially after a major disruption, it cannot protect a firm from losing its customers. Instead of relying on insurance, many firms have developed various risk assessment programs that are intended to: (1) identify different types of risks; (2) estimate the likelihood of each type of major disruption to occur; (3) assess potential loss due to a major disruption; and (4) identify strategies to reduce risk. Rice and Caniato (2003) and Zsidisin et al. (2000) and (2004) concluded the following points: 3 As a way to reduce the vulnerability of the United States to terrorism, President Bush reorganized various departments (U.S. Customs, Department of Transportation Security Administration, Department of Immigration and Naturalization Services, etc.) into a single department (Department of Homeland Security) in 2003. The reader is referred to www.dhs.gov/dhspublic/display?theme=59&content=4081 for details. 4 Lee and Whang (2003) develop a model to show how firms can reduce inventory due to less inspection time. 4 • Most companies recognize the importance of risk assessment programs and use different methods, ranging from formal quantitative models to informal qualitative plans, to assess supply chain risks. • Not only does a supply chain risk assessment program motivate a firm to develop contingency plans, it can be used to meet certain legal requirements such as the Sarbanes-Oxley Act of 2002 and KonTraG.5 • Having multiple suppliers for strategic parts is the most common approach to reduce supply chain risks.6 • Due to few data points, good estimates of the probability of the occurrence of any particular disruption and accurate measure of potential impact of each disaster are difficult to obtain.7 Apprehension Without Action Rice and Caniato (2003) and Zsidisin et al. (2000) and (2004)