Disruption Risk and Optimal Sourcing in Multitier Supply Networks

Disruption Risk and Optimal Sourcing in Multitier Supply Networks

By
Erjie Ang, Dan A. Iancu, Robert Swinney
Management Science. July
2016, Vol. 63, Issue 8, Pages 2397-2419

We study sourcing in a supply chain with three levels: a manufacturer, tier 1 suppliers, and tier 2 suppliers prone to disruption from, e.g., natural disasters such as earthquakes or floods. The manufacturer may not directly dictate which tier 2 suppliers are used but may influence the sourcing decisions of tier 1 suppliers via contract parameters. The manufacturer’s optimal strategy depends critically on the degree of overlap in the supply chain: if tier 1 suppliers share tier 2 suppliers, resulting in a “diamond-shaped” supply chain, the manufacturer relies less on direct mitigation (procuring excess inventory and multisourcing in tier 1) and more on indirect mitigation (inducing tier 1 suppliers to mitigate disruption risk). We also show that while the manufacturer always prefers less overlap, tier 1 suppliers may prefer a more overlapped supply chain and hence may strategically choose to form a diamond-shaped supply chain. This preference conflict worsens as the manufacturer’s profit margin increases, as disruptions become more severe, and as unreliable tier 2 suppliers become more heterogeneous in their probability of disruption; however, penalty contracts—in which the manufacturer penalizes tier 1 suppliers for a failure to deliver ordered units—alleviate this coordination problem.