When disaster strikes: The business case for disruption risk management


Supply chains have become more complex due to lean initiatives, just-in-time sourcing, global footprints, multi-tiered partners, and significant increases in coordination of forecasting and B2B processes.  The benefits to these new processes are significant, but they come with increased risk of economic loss when – not if – disasters occur.


Supply chains have become more complex due to lean initiatives, just-in-time sourcing, global footprints, multi-tiered partners, and significant increases in coordination of forecasting and B2B processes.  The benefits to these new processes are significant, but they come with increased risk of economic loss when – not if – disasters occur.

Disruptions to supply chains due to disaster events are inevitable and can result in short term decreased output, market share loss, and declining stock prices.  Research has demonstrated that firms which experience disaster-induced business disruption may experience long term significant stock-price decreases and equity risk increases.

An unfortunate reality:  Disasters will occur
The 1997 Asian financial crisis, the 1999 Chichi earthquake in Taiwan, and the September 11, 2001 World Trade Center terrorist attack are a short but sobering list of recent events that risk management experts classify as High Impact Low Probability (HILP) events.  Such events can cause extreme supply chain disruptions.  As this list shows, HILP events can have a wide range of causes and impacts.

Economic impacts of disaster events
Disasters can be further classified based on their economic impact.  While disaster events may not fall neatly into macro- versus micro-economic impact categories, the division is helpful to better understand and plan for post-event effects. 

Macro-level impact
This year marks the 10th anniversary of the 1997 Asian financial crisis that devastated Asian economies and contributed to the 1998 recession of roughly one-third of global markets.  Such major financial crises directly affect businesses and markets, but the duration of these crises’ effects may be longer than commonly understood. The Asian Development Bank’s (ADB) annual Outlook (Spring 2007), reveals that “there is evidence of permanent output losses in the crisis countries, which have not been compensated by higher than ‘normal’ growth rates.”  Rather, “[…] growth has slipped by an average of 2.5% a year in the five countries that were most directly affected (Indonesia, Korea, Malaysia, Philippines, and Thailand). The persistence of such a gap implies large permanent losses of income compared with pre-crisis trends.”  These analyses of the long-term effects of the Asian financial crisis echo the 2005 findings by Cerra & Saxena of the International Monetary Fund (IMF) that “the level of output is permanently lower than its initial trend path.”

Other man-made disasters have similar rippling effects.  The terrorist attacks of September 11, 2001 on the World Trade Center sent consumer and business confidence into negative territory; and the temporary stop in air traffic over the US caused dramatic disruptions to logistics.  According to Cerra & Saxena’s report, some individual markets including the semiconductor industry, experienced a “boost from replacement and rebuilding demand” in the short term. However, a macro-economic dampening effect of the September 11 attacks was still being felt in 2004, according to the article “Managing Risk in Global Supply Chains” by Kleindorfer & van Wassenhove.  As the ADB and IMF papers underscore, these events pose significant economic challenges for which firms can develop strategic plans focusing on resiliency.

Natural disasters also fall into the category of pervasive, negative, long-term economic impacts at macro- and micro-levels.  The 1999 earthquake in Chichi, Taiwan caused a two week production disruption at two major semiconductor fabs, at a cost of $200-$300 million in lost revenue, damaged wafers, and damaged assets, according to Papakais & Ziemba’s 2001 article “Derivative effects of the 1999 earthquake in Taiwan to U.S. personal computer manufacturers”.  While there were additional negative variables (political tensions, electric power disruptions, Y2K demand, among others) the Chichi earthquake negatively affected the global semiconductor market in the form of shortages and resulting increases in memory chip prices.  Papakis & Ziemba noted that contract prices increased some 25% during October, 1999.

The Chichi earthquake also provides a rare look into the different effects felt among individual firms’ following a disaster event.  The data show that while both push- and pull-supply chain manufacturers experience negative effects, the point at which the effects are experienced is different.  One important source of this difference is the manner in which negative versus positive cash-to-cash cycles are impacted by volatile ASPs. 

In general, however, there is a paucity of data at the individual firm level surrounding disaster events (pre- and post-event) which has slowed the development of reliable economic and risk management models available outside of insurance firms.

Micro-level impact
Site-specific events have also proved to be HILP events.  For example, the 2000 lightning strike that started a fire at the Philips’ semiconductor fabricator No. 22 in Albuquerque, NM is so well known that it has become a staple in the risk management classroom.  Yet it bears repeating here because it was originally classified as a minor disruption due to a minor hazard event that had extraordinary consequences.  Philips’ original supply chain disruption prediction of one week proved to be dramatically off as the outage lasted for months.  The lesson to be learned in this instance is one of responsiveness and resiliency to disruption events.  A major telecommunications OEM immediately sent out a team to evaluate the situation at the fab and then promptly renegotiated with Philips and other suppliers worldwide to ensure that they had the type and number of chips necessary to launch their next-generation cell phones.  According to a 2005 article by Yossi Sheffi entitled “Building a Resilient Enterprise”, other telecommunications OEMs whose management did not take such steps, were unable to secure the chips necessary once the extent of the shortage was realized.

More recent natural disasters that are presently affecting the semiconductor industry include the two power outages (August 3 and September 20, 2007) at Samsung Electronics’ main chip manufacturing complex near Seoul, Korea, and the October 1, 2007 fire at Matsushita Battery Industrial Co., Japan.  We know that the initial power failure at Samsung’s complex has left Samsung unable to fulfill approximately 15% of its promised production of NAND.  This provided competitors an opportunity – Toshiba, for example, ramped up NAND production to fulfill supply shortages.  Samsung’s stock price has also continued to decline since August, despite minor upticks, with significant drops in the days surrounding both power outages.  The NAND market also experienced noteworthy price volatility during 3Q07, and the full impact of this disruption is most likely not fully known at this point.

The Matsushita battery fire is also a relatively new event.  However, estimates from the industry indicate a three month or longer period until Matsushita is fully back on line.  According to analysts at Lehman Brothers, the disruption is likely to drive LCD IT panel prices and memory prices lower, and will reduce availability of notebook batteries by some 4 million units – 14% of global demand – during Q4 2007.  Analysts at Lehman Brothers further predict that the disruption will affect notebook PC (NBPC) production, with decreases up to 13%, as a result of the fire.  If this is the case, the outage “…may impact 13% of DRAM used for NBPCs, or 5% of DRAM for total PCs,” the report states. In an already weak market after the memory ASP volatility this year, shortages in the battery industry due to recalls, and the susceptible LCD notebook, the Lehman Brothers report predicts that this disaster will not only affect individual firms, but may have a “somewhat negative impact on the overall IT sector, including the LCD industry and memory chip industry for the rest of 2007.”

The real business case for Disruption Risk Management
Two important guidelines come to the fore based on the brief review of the past decade’s more notable disastrous events:

  1. High Impact Low Probability (HILP) events should not be dismissed because of the ‘low probability’ terminology.  The discussion in this article of HILP events notes at least seven in the past ten years.  Low probability refers to the precise event at a precise location and point in time, not the eventuality of such an event occurring, nor the likelihood of such an event creating a significant disruption at some point in a firm’s supply chain.  Sheffi says given the far-reaching nature of electronics supply chains it would be a tremendous oversight to discount the high likelihood of being affected by a disruption due to a disaster event on a frequent (e.g., yearly) basis. 
  1. Comprehensive, long-term risk management is critical because there are statistically significant negative economic effects to firms as a result of major supply chain disruptions.  Furthermore, while the negative effects are greatest around the time of the event, major disruptions are shown to have a long-term, perhaps persistent, negative impact on individual firms, and in some cases industries, regional and/or global economies, as presented above. (cf. ADB & IMF reports; and Hendricks and Singhal, 2005).

Much as the Asian Development Bank (ADB) and the International Monetary Fund (IMF) publications have shown for macro-economies; Hendricks & Singhal’s 2005 article “An Empirical Analysis of the Effect of Supply Chain Disruptions on Long-Run Stock Price Performance and Equity Risk of the Firm” successfully demonstrates through detailed empirical analyses of the data how firms experience these negative economic effects.  To summarize, the data reveal that due to increased financial and operating leverage, firm and equity risks become significantly elevated.  In conjunction with the risk increases, there is a decline in stock prices, most notably during the years surrounding the event yet persistent over time.  The data on asset risk reveal only minor negative trends without the same level of significance as equity and firm risks (at 0.05 and 0.01 levels).  Finally, the economic research, and in particular Hendricks and Singhal, find that the ‘what, where and who’ of the cause(s) of the events are basically irrelevant to the unforgiving market, investors and clients/consumers; it is “the firm that experiences the disruption [that] pays a steep price,” they say.

Hendricks and Singhal succinctly offer the following advice: “At a minimum, firms must carefully analyze the trade-offs between lower costs and negative economic consequences associated with higher risk of disruptions.  […] Investments in increasing reliability and responsiveness of supply chains could be viewed as buying insurance against the economic loss from disruptions.”

Supply chain vulnerabilities
Globalizing supply chains are the standard in today’s manufacturing processes: the procurement of raw materials and components through design to product distribution via a complex network of multiple businesses in geographically dispersed locations to an ever-maturing end-market consumer.  To fulfill dynamic supply and demand cycles while improving margins, manufacturers have had to reduce inventories, lead-times, and various redundancies, once common in production and distribution chains.

While significant growth, profitability, and stock performance continue to bear witness to the advantages of today’s business processes, disaster events leading to supply chain disruptions reveal the vulnerability of lean practices, globalization, modularity of production, as well as the interconnection of financial, information, and material flows.  As the ‘fat’ has been trimmed from supply chains, so have the inherent redundancies that buffered firms from disruptions.  As a result, there is greater risk to the chain and to the stock performance and financial leverage of the firm.

The answer lies in supply chain reliability and responsiveness
The means for surviving and even thriving in the wake of a major supply chain disruption lays in the resilience of the firm – specifically the resilience of the firm’s supply and value chains.  Hendricks & Singhal say resiliency is a strategic business goal that involves careful chain design with a keen eye to network diversification (for redundancy, flexibility, and responsiveness most notably) and serious coordination among supply chain partners to mitigate the impact of disruptions.

In short, supply chain management is critical not only to disaster preparedness and resiliency but more importantly to the long-term financial health and success of a firm.

Asian Development Bank, Spring 2007, “Ten years after the crisis: The facts about investment and growth” in Outlook pp. 46-65; http://www.adb.org/documents/books/ADO/2007/part01-ten-years-after.pdf.

Cerra Valerie, and Saxena, Sweta Chaman, 2005, “Did output recover from the Asian crisis?” in International Monetary Fund Staff Papers Vol. 25(1); http://www.imf.org/External/Pubs/FT/staffp/2005/01/pdf/cerra.pdf.

Hendricks, Kevin B., and Vinod R. Singhal, 2003, “The effect of supply chain glitches on shareholder wealth” in Journal of Operations Management Vol. 21(2003): 501-522.

Hendricks, Kevin B., and Vinod R. Singhal, 2005, “An Empirical Analysis of the Effect of Supply Chain Disruptions on Long-Run Stock Price Performance and Equity Risk of the Firm” in Production and Operations Management Vol. 14(1):33-52.

Kleindorfer, Paul R., and Luk N. van Wassenhove, 2004, “Managing Risk in Global Supply Chains” in The INSEAD-Wharton Alliance on Globalizing: Strategies for Building Successful Global Businesses, pp 288-305.

Kleindorfer, Paul. R., and Germaine H. Saad, 2005, “Managing disruption risks in supply Chains” in Production and Operations Management Vol. 14(1):53-68.

Lehman Brothers Equity Research, October 4, 2007, Technology – Industry Update – Korea.

Papakais, Ioannis S., and William T. Ziemba, 2001, “Derivative effects of the 1999 earthquake in Taiwan to U.S. personal computer manufacturers,” in Mitigation and financing of seismic risks; Turkish and international perspectives, pp. 261-276.

Sheffi, Yossi,  2005, The Resilient Enterprise: Overcoming Vulnerability for Competitive Advantage.  Cambridge, Mass: MIT Press.

Sheffi, Yossi, 2005, “Building a Resilient Enterprise” on the National Academy of Engineering Website http://www.nae.edu/nae/bridgecom.nsf/weblinks/CGOZ-6ZQRSV?OpenDocument.

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