No Link Between Expenditures and Supply Chain Risk

Analysis shows no correlation between a manufacturer’s total expenditure with a supplier and the cost of a supply disruption


Cambridge, Mass.Dec. 18, 2013—A new Massachusetts Institute of Technology (MIT) study on supply chain risk shows no correlation between the total amount a manufacturer spends with a supplier and the profit loss it would incur if that supply were suddenly interrupted. This counterintuitive finding defies a basic business tenet that equates the greatest supply chain risk with suppliers of highest annual expenditure.

When applied to Ford Motor Company’s supply chain, the quantitative analysis by Professor David Simchi-Levi of MIT’s Department of Civil and Environmental Engineering and Engineering Systems Division shows that the supply firms whose disruption would inflict the greatest blow to Ford’s profits are those that provide the manufacturer with relatively low-cost components.

“This helps explain why risk in a complex supply network often remains hidden,” said Simchi-Levi, who is co-director of MIT’s Leaders for Global Operations program. “The risk occurs in unexpected locations and components of a manufacturer’s supply network.” 

A paper on the application of this work to Ford’s supply chain by Simchi-Levi and former graduate students William Schmidt, now an assistant professor at Cornell University, and Yehua Wei, an assistant professor at Duke University, is to appear in the January/February issue of the Harvard Business Review.

Focus on Low-Probability, High-Impact Risk

Traditional methods for identifying the suppliers and events that pose the highest risk depend on knowing the probability that a specific type of risk event would occur at any firm and knowing the magnitude of the problems that would ensue. However, risks—which can range from a brief work stoppage to a major natural disaster—exist on a continuum of frequency and predictability, and the sources of low-probability, high-impact risk are difficult to quantify. Manufacturers generally assume their greatest supply chain risk is tied to suppliers of highest expenditure. 

But Simchi-Levi reasoned that, because a company’s mitigation choices—maintaining more inventory or an alternative supply source, for example—are the same regardless of the type of problem that occurs, a mathematical model of supply chain risk should determine the impact to the company’s operations if any disruption occurs, rather than estimating the probability of specific types of risks. 

His model incorporates bill-of-material information (the list of ingredients required to build a company’s products); maps each part or material to one or more of the firm’s facilities and product lines; captures multiple tiers of supplier relationships (tier 1 are direct suppliers, tier 2 are suppliers to tier 1 firms and so on); includes operational and financial impact measures; and incorporates supplier recovery time if a problem occurs. 

As nodes are removed one at a time from the supply network, the model determines how best to reallocate inventory and obtain alternatives, and predicts financial impact. The resulting analysis divides suppliers into three segments depending on the cost of the individual components they provide and the financial impact their shortage would have: low-cost components/high financial impact; high-cost components/high financial impact; and low-cost components/low financial impact. 

Highest Risk from 2 Percent of Suppliers

When Simchi-Levi, Schmidt and Wei applied the model to Ford’s multitier supply network—which has long lead times from some providers, a complex bill-of-materials structure, components that are shared across multiple product lines and thousands of components from tier 1 suppliers—the model predicted that a short disruption at 61 percent of the tier 1 firms would not cause profit loss. By contrast, a halt in distribution from about 2 percent of firms would have a very large impact on Ford’s profits. Yet each of those firms in the 2 percent furnishes Ford with less-expensive components rather than, say, expensive car seats and instrument panels, which fall into the high-financial-impact segment. 

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