Disruption Risk and Optimal Sourcing in Multi-tier Supply Networks

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 like 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, 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; however, penalty contracts—in which the manufacturer penalizes Tier 1 suppliers for a failure to deliver ordered units— alleviate this coordination problem.