Make Smarter Investments in Resilient Supply Chains

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

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. These open-checkbook investments are typically reflexive attempts to stem loss and maintain operational continuity, but they tend to decline rapidly as the disruption’s impact fades.

This pattern undermines efforts to build true resilience. It does little to prepare the organization for the next crisis, and it amplifies the bullwhip effect — where businesses expand too much when demand is high and cut back too drastically when demand falls, leading to excesses and shortages. We observed this pattern in the market for microchips during the COVID-19 pandemic: Initial shortages led to a rapid expansion of production, but once supply caught up with demand, many chipmakers were left with excess capacity and high inventories.

Such strategies tend to concentrate on mitigating risk, which managers often see as more tangible and actionable than building resilience. They rely on data showing the probability that a natural disaster or some other disruption might hit a link in their supply chain, and then they take action to protect that link. Businesses in earthquake zones might fortify their structures, while those in flood-prone areas might build levees or elevate their buildings.

However, the sources of risk are nearly unlimited, and protecting against even high-probability threats does little to reduce a company’s overall exposure to disruption. The duration, intensity, and impact of a disruption can also vary dramatically from one company to another. For instance, in 2005, Hurricane Katrina damaged the docks at Port Fourchon in New Orleans, making it impossible for many companies to transport their goods. The nearby Procter & Gamble coffee plant, designed to sit above the anticipated flood level, avoided water damage but still had to shut down temporarily because of the loss of a key supply source — clean water — and because employees were unable to come to work.

Risk mitigation, then, is oriented toward prevention rather than operational continuity. While mitigation efforts might reduce the probability of a disruption, they do not enable the company to re-create lost capacities and don’t help return the supply chain to normal operations.

A Fresh Approach

In contrast, our framework is designed to help organizations focus their resilience investments on building long-term supply chain robustness. The accompanying figure illustrates how our approach compares with existing methods for valuing resilience investments. (See “Approaches to Quantifying Supply Chain Resilience.”)

Best-guess calculations rely on a single value obtained simply by multiplying the potential impact by the probability of the event. A company generating a profit of $10 million exposed to a 2% chance of a total loss will conclude that a disruption would cost $200,000 and would be willing to invest up to that amount to mitigate the loss. However, this approach only approximates the likelihood of a disruption and its potential loss. Its utility for assessing low-probability, high-impact events is limited. It yields an average exposure to risk for a single point in time — a useful measure for insurance companies, but not for firms looking to make effective investments in resilience.

Value-at-risk methods take a more analytical approach but still give little guidance about when and how much to invest in resilience. They expand on classical supply chain models designed to maximize the return on assets or minimize total supply chain costs but, like best-guess methods, can obscure events that have a low probability yet are plausible. This may lead managers to focus on an event’s probability more than its disruptive consequences.

In particular, value-at-risk methods aren’t helpful in recognizing the upside value of actions that increase resilience. While they can quantify vulnerabilities in the supply chain, they do not provide guidance for when and how much to invest in resilience and fail to give managers the tools to justify resilience investments. This shortcoming can amplify the boom-and-bust cycle by focusing investments on the obvious risks following an event and allowing them to quickly fall off as memory of the event fades.

A manager using a classical value-at-risk model might determine that their company would have to spend $6 million to assess and qualify backup suppliers and that doing so wouldn’t deliver any additional cash flow over three years. The negative net present value (NPV) of the investment would convince the manager to postpone the project. But such an analysis doesn’t take into account the upside benefits — for instance, the revenue advantages from being able to maintain supplies if a disruption shuts down the original supplier.

The scenario-value approach is used by relatively mature organizations’ business continuity planning units to identify vulnerabilities in their value streams. Its advantage is that it links risks with their possible impacts, but it has limitations. Scenario planning is based on qualitative, even subjective, assessments, not quantitative ones. Scenarios also consider only a limited number of options as a way to reduce complexity in decision-making. Since the process can be subjective, comparisons of scenarios can be overly influenced by decision makers’ risk aversion. Finally, scenarios put risks into context but often don’t translate the context into financial terms.

How Option Valuation Works

Our approach builds on options theory to value and set funding levels for investments in resilience. Its goal is to focus resilience-building on re-creating lost core capacities and making steady investments over time.

This is by no means a new way to assess investments. As we noted previously, corporate finance departments use option valuation to make capital budgeting decisions in an uncertain business environment.4 Compared with other methods for valuing investments, such as NPV, option valuation encompasses actual and opportunity costs to assess the value of investing and compares them with the effects of taking no action. This enables companies to identify resilience investments that might not pass muster when relying on other methods.

What’s more, companies using our method don’t need to wait until a disruption occurs to make an investment in resilience and can determine in advance which ones make the most sense. In contrast, when companies make boom-and-bust investments after a disruption occurs, they are more likely to face supply shortages and higher costs — as seen with semiconductors during the pandemic — and longer delays in restoring lost supply chain capacity.

Companies can invest in more resilient supply chains in several ways. They can tap capital budgets to add capacity and create flexibility by building additional plants, distribution centers, or other facilities. They can use working capital to stockpile inventories of raw materials or other critical components in case supplies are disrupted. They can also line up backup suppliers who can step in when other suppliers are suddenly unavailable, using operating funds to cover the added managerial and labor costs.

The first step in our option valuation approach is to calculate the range of outcomes that a value stream could experience when a supply chain node is disrupted, and the effect of the disruption on profits. Then we consider the effect of making an investment that would quickly restore the node’s capabilities — for example, by prequalifying a backup supplier or stockpiling inventory — and compare that with a scenario where no such investment is made. By considering all of the ways the capacity could be restored, the company can decide which investments add value.

For example, a third-party logistics provider sought to ensure delivery of its products despite disruptions. It added distribution centers to build redundancy into its network and introduced robots, flexible conveyor systems, and automated storage-and-retrieval systems to make its warehouses more responsive. This enabled the company to assess a resilience investment without identifying every specific risk it might face. In each case, an analysis based just on NPV indicated that the investments would not be worth the cost unless there was a high probability that a disruption would occur. In contrast, our option analysis demonstrated that the investments were valuable because the improved outcomes, in terms of restored operations and revenues, exceeded their cost for even low-probability events.

Next, our method uses sensitivity analysis to estimate how much investment is needed to produce the desired outcome — showing, for example, that a $15 million investment in a stockpile of inventory would enable a supermarket chain to recover 95% of profits if suppliers were disrupted by a truckers’ strike. We’ve found that managers had a keen interest in understanding the level of resilience they could count on for a given funding level.

The final step aims to help companies set priorities for resilience projects based on their cost relative to their marginal value. The best actions are those that result in the greatest reduction in negative outcomes and the smallest effect on positive outcomes, at the lowest cost.

We have found that when managers rank their options in this way, it allows them to determine which projects to undertake first based on the value they provide compared with other company resilience initiatives.

Option Valuation in a Pharmaceutical Supply Chain

To demonstrate the utility of the option valuation methods, we used it to assess efforts by a pharmaceutical company to make proactive resilience plans. During the COVID-19 pandemic, the company was confronted by one of its suppliers demanding a new exclusive, long-term contract at a higher price. The company realized that any of its critical supplies could be at risk, and at the worst possible time, and that without backup suppliers, it could face a potentially devastating loss of revenues.

However, arranging alternative suppliers is not easy or quick. It requires vetting suppliers’ ability to meet federal product-safety and other regulations and reaching agreements covering service levels and intellectual property.

While the company recognized that prequalifying alternate suppliers would make its supply chain more robust, it faced two main issues: how to quantify outcomes — the reduction in profits stemming from the loss of the supplier — and how to communicate to executives how prequalifying backup suppliers would affect those outcomes.

Looking at the vulnerabilities and capabilities of each of the company’s product categories, we used a Monte Carlo simulation to model how a disruption would affect those value streams. After identifying which of the streams would benefit most from a resilience investment, we then considered potential resilience actions and their impact on the range of outcomes relative to their cost. For the first time, the company was able to use a standard measure to assess value-stream resilience and rank the value streams that could benefit from resilience investments.

We were also able to demonstrate to decision makers how improved supply chain performance, not risk mitigation, was the best criterion for allocating resilience funding. We had observed that managers who focused on risks when making resilience decisions often relied on storytelling instead of data. The projects that got funded were the ones with the most persuasive champion, not the ones that would have had the greatest impact on the organization. Communicating the relationship between funding and outcomes helped the pharmaceutical company make investment decisions based on improved performance rather than subjective factors.

Most importantly, we provided the company with a mechanism for ranking resilience investments based on their ability to affect outcomes rather than on the size of the investment. We created a four-quadrant matrix that plotted the cost of possible actions against the value of their outcomes. That allowed decision makers to quickly focus on the resilience actions requiring the least investment but promising the largest effect on a range of outcomes. For example, prequalifying a supplier ranked as a high-value investment because it reduced the time to activate a new supplier. Managers were thus able to choose actions most likely to reduce the range of undesirable outcomes and greenlight projects based on the value they generated rather than on where the spending came from.

Steps to a Resilient Supply Chain

Building resilient supply chains takes time, energy, patience, and fortitude. It involves assessing risks and vulnerabilities, building resilience and extending capabilities, with an eye to establishing robustness and value creation over time. Here are some steps companies can take to move from the boom-and-bust cycle toward a robust supply chain.

Measure how much resilience is needed. The lack of a clear way to quantify the amount of resilience needed is a problem that has hampered traditional resilience investment programs for many years. Practitioners have created their own measures and resilience indices but still struggle to identify the right investment level. Options valuation is a step to overcoming that obstacle.

Key to the process is identifying the right metrics. Two measures, introduced in 2009 at networking equipment company Cisco, can serve as key proxies for quantifying resilience: time to recover (TTR) and time to survive (TTS).5 TTR is how long it takes for a link in the chain to return to full functionality after a disruption, and TTS represents how long the link can support operations before customers are affected.6 If TTR exceeds TTS, customers will begin to feel the pain of the disruption, and revenues will fall.

A heavy equipment company we worked with is creating a resilience index so that all internal groups have a common way to measure resilience actions. The index used TTR and TTS as a starting point, classifying outcomes as low, medium, or high, based on how long it would take for a disruption to result in a critical loss of revenues. The index also takes into account the time it takes to find and establish contracts with backup suppliers and how long it takes to integrate them into the supply chain.

The pharmaceutical company also tapped publicly available information, such as an index of global risk factors, to compile a full list of possible supply chain disruptions.

Quantifying resilience investments in this way helps managers proactively confront the full range of possible business impacts, including those that could result from black swan events.

Integrate funding processes. Option valuation creates outputs that are compatible with capital budgeting, business continuity planning, and sales and operations planning. This makes it possible for managers and executives to align resilience with other business needs.

All of the important budgeting processes have a hand in making resilience investments. When a company wants to increase resilience by adding warehouse capacity, the high-cost, long-term investment typically falls under capital budgets. Adding inventory taps working capital, while adding backup suppliers utilizes operating funds for vetting and managing the new supplier.

By focusing resilience investments on the outcomes they produce, option valuation can bridge these silos and help the organization base investment decisions on the best results rather than on where the funds are coming from.

Promote long-term investments. In the boom-and-bust approach to resilience, organizations tend to wait until an adverse event occurs before committing funds to fixing the problem. Long-term robustness, however, requires regular, programmatic investment.

The problem with risk-based investing in resilience is that the number of possible risks is large, and the ability to guard against them all is limited. Option valuation focuses instead on the relatively small number of ways that supply chain capabilities can be disrupted and seeks to make sure the negative outcomes the disruptions cause are limited.

Doing this requires companies to set aside funds or make investments now for returning operations to normal when an adverse event occurs. After the 9.0-magnitude Sendai earthquake and subsequent tsunami that struck Japan in 2011, Toyota began to stockpile microchips in the event of a future shortage of this critically important component. When the COVID-19 pandemic sharply limited the availability of automotive microchips, Toyota maintained production at close to full capacity while other automakers had to cut production because of chip supply constraints. Toyota’s investments over time helped enable its exceptional performance during the chip shortage.

Use visualization to communicate impact. In working with business continuity, sales and operations, and financial planning groups, we developed a three-stage visualization that, we believe, helps leadership understand why resilience investments are necessary.

For example, the simple matrix described previously displays the level of resilience investment and the value of the resilience action (based on the cost and the outcome it produces), allowing decision makers to quickly identify the investment that generates the most significant results for the least amount of money.

We have found that when executives can see the full distribution of outcomes rather than just the average or a portion of them, it becomes much easier to motivate them to action.

Cultivate a resilience mindset. Our research shows that one of the key obstacles to building long-term resilience is that leaders are loath to make significant investments to manage disruptions that have not yet occurred. Overcoming this obstacle requires a resilience mindset.

An important step in creating a culture of resilience is to shift the focus away from all of the potential disrupters to look more narrowly at supply chain capabilities and the costs of losing them. How would the loss of an important supplier affect revenues? What about the inability to ship product, or the loss of a workforce? Once the emphasis shifts to outcomes, it becomes clear that the most important thing to worry about isn’t the risks but, rather, how to maintain operations when something goes wrong.

In a world where disruptions are the rule, the ability to prepare for rather than react to them can be a source of competitive advantage. Our option valuation method enables larger companies to set priorities for resilience initiatives while giving small companies a way to take resilience actions that fit within their budget. We believe that these proposed actions will move practitioners forward, toward a more resilient supply chain. For the practitioner, the path promises more prudent investments, better returns, and higher service levels across the many disruptions and unanticipated outcomes that we know we will all face. It is the path from boom-and-bust to robust.