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Supply Chain Risk: Diversification Vs Under-diversification - Ideas for Leaders
Idea #468

Supply Chain Risk: Diversification Vs Under-diversification

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KEY CONCEPT

When catastrophe strikes a link in the supply chain, companies respond by dramatically diversifying their suppliers — only to eventually consolidate their suppliers as the memory of the disruption fades. This inconsistency is costly and ineffective.


IDEA SUMMARY

In 1997, a fire at the only Toyota supplier providing the carmaker with P-valves inspired a change of policy: from then on Toyota would dual-source every part. By 2000, however, Toyota, citing the economies of scale possible through single sourcing, once again consolidated its supply chain.

Companies that experience a significant disruption in their supply chain will often respond with a campaign to diversify their suppliers. It suddenly becomes a priority to find a variety of sources — to separate the eggs into different baskets.

The problem is that diversification inevitably increases transaction costs. In other words, there’s a trade-off: better protection against disruption but higher costs, or lower costs but a greater chance for disruption. The question for companies is, which is more important? That answer, according to research, is that it depends on the timing. After a major disruption, the prevention of future disruptions becomes a priority. Significant effort and money is spent to diversify the supply base.

Over time, however, the benefits of a diversified base no longer seem, in the minds of executives, to outweigh the costs. And thus, ineluctably, companies start to retrench, to look for opportunities to consolidate their suppliers… until the next catastrophic disruption, when the cycle starts over.

The ongoing oscillation begs some questions: are companies under-diversified before the disruption, over-diversified after the disruption, or both?

In a recent study, researchers designed a theoretical model that replicated the supply chain trade-off, and the occasional disruption of the supply chain. In the model, a single firm sourced a certain number of parts from two homogenous suppliers. Given fixed costs for each supplier, sourcing from both suppliers (diversification) was more expensive than consolidation. However, disruptions were more expensive if the supply chain was not diversified.

As expected, the theoretical model confirmed the oscillation between diversification and consolidation. It also showed that on average, companies under-diversify. The reason is that the decision to diversify is rarely positively reinforced (essentially, only when a disruption occurs). In contrast, the decision to opt for less expensive single-sourcing is continuously reinforced (every time a disruption does not occur).

Importantly, the researchers found that the under-diversification was statistically and could be economically significant. For example, in the condition “D” of their model, when dual sourcing was optimal, the under-diversification tendencies of their subjects (57% of them single sourced) resulted in costs that were 45% higher than the costs related to dual-sourcing at all times.


BUSINESS APPLICATION

Over time, companies tend to forget high-impact, low-probability disruption events. While the high impact may shock in the moment, it’s the low probability that companies will eventually focus on. The result is, on average, under-diversification.

To remedy this bias, sourcing decision makers should be frequently reminded of the costs of rare but high-impact disruptive events. Business continuity reviews and even simulated disruption events can help keep the costs of disruption high in decision makers’ minds. These steps are particularly important when the consolidation of your supply base is under consideration.    

It’s true that a theoretical model may not take into account all of the variables that may impact the diversification decision. There might, for example, be pressure from investors that cause decision-makers to opt for the short-term financial benefit of consolidation at the expense of diversification, which offers a more long-term return. Under-diversification is not always an irrational decision; however, sourcing managers and executives should keep the possibility of a costly disruption always in mind so as not to overreact to such an event and continue the costly cycle of oscillating between diversification and consolidation.


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Idea conceived

August 15, 2014

Idea posted

Jan 2015
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