June 15, 2005

Managing supply chain risk

Traditional supply chain models emphasize the benefits of consolidating production. But as Awi Federgruen explains, the recent flu vaccine crisis illustrates the risks of relying too heavily on a single supplier.


How did you become interested in the problem of supply chain risk?

Standard supply chain management texts and models have focused on the benefits of consolidating sources of supply because there are lots of benefits that come from economies of scale. Often, large investments are involved in putting up a production plant or a distribution center. Therefore, you’re better off doing it in fewer places and consolidating the production and distribution activities. Also, there are lots of advantages associated with pooling risks on the demand side rather than having lots of different locations taking care of smaller segments of the market.

But recently we’ve become aware of the fact that there are forces pointing in the opposite direction, and those have to do with planning for disaster or planning for major disruptions of the process. The issue that prompted me to start working on this is what we experienced last year in terms of the vaccine supply. The country is dependent on just two suppliers. Shortly before the flu vaccination season started, one of those two supply centers was completely taken out of the equation — it had to be shut down because it didn’t satisfy FDA regulations.

In what other contexts do these types of risks arise?

While the flu vaccine crisis was the catalyst for me to start looking into this problem, it’s a very general issue that arises in many, many different contexts. There are many forces that can cause a disruption in a particular source of supply, whether it be failure to meet quality standards or government regulations, fires, labor strikes or other things. And since 9/11, there are additional concerns of disruptions coming from planned sabotage. In fact, the expectation among homeland security experts is that future acts by terrorist organizations will be focused on key veins of the economy.

From this point of view, it’s better to have more sources of supply so that if one or two are taken out, there are others to take over. To stay with the vaccine context, there are many policymakers who have realized that the country has not been responsible in letting itself be dependent on two suppliers. That leads to the necessity of coming up with planning models that assess this type of risk and combine it with the other factors — the economies of scale that drive production and the benefits of risk pooling on the demand side — and find the appropriate trade-off of what the balance of facilities should be.

In the private sector, there are several examples of how competitors have fared very differently because they had different attitudes toward these types of risks. One case study is in the market for cellular phones. A couple of years ago, two of the major players in that industry were Ericsson and Nokia. Both of them were heavily dependent on chip suppliers. Ericsson relied completely on a single supplier. From the point of view of cost effectiveness, this was really the way to go.

Nokia relied on the same supplier, but it also put into place contingency plans that it could activate very quickly in the case of a major disruption. And lo and behold, a major disruption occurred because of a fire at the chip plant in New Mexico. Nokia was able to quickly mobilize alternative sources and alternative designs of its phones, and as a result it was able to sustain and increase its market share. Ericcson was left completely paralyzed, and it a lost a lot of customers to the competition. The disruption had major implications for Ericsson’s market share for years to come.

What was your approach to studying the flu vaccine crisis?

There are several parts to this problem. One is to figure out, if you have a certain set of potential suppliers, how many of them should you be using, and which of them should you be using? And then how much should you have each of them produce for the market to cover uncertain demand? Part of the problem in the flu vaccine case — and that’s true for most items that are sold in private industry as well — is that it’s subject to uncertainty in terms of how many people are actually going to request a vaccination.

A private company can determine how many plants it’s going to have and produce internally or make appropriate contracts with outside suppliers. At the national level, if we come to the conclusion that we want to have five suppliers of the vaccine instead of two, how do we bring that about? There’s a whole other set of questions that need to be resolved. Some people were arguing that there’s nothing we can do about this; it’s just not attractive enough for people to be in this industry. This is an industry where the investment costs of setting up a vaccine production plant are very large, somewhere between half a billion and a billion dollars, and this acts as a tremendous deterrent for companies to enter into the market.

There’s been a lively debate in Congress about this problem. In a year without a vaccine shortage, about 36,000 people die because of influenza or complications that arise from it, and there are about 200,000 hospitalizations that are attributed to influenza or complications arising from it. That’s a staggering cost to the economy if you think about what one single day in a hospital costs these days. The productivity losses to the economy from people missing work because they have the flu are estimated to be somewhere around $20 billion a year.

There are people in Congress that have been arguing that what the government should do is take over the entire process and set up its own production facilities. There are many, myself included, who don’t believe in that approach because the government typically is not very efficient in producing goods and services.

What steps should the government take to address the flu vaccine problem?

There are basically two extremes. There’s one extreme that says there’s not much we can do about it. The Republicans used this crisis at the time to argue that manufacturers were driven out of the market because of the enormous risk of litigation and that what we need to do is reduce the ability of people to sue physicians and the pharmaceutical companies, and if we do that, then we’ll see a reentry of potential suppliers that have been deterred by the risks. I personally don’t believe, and I think most experts don’t believe, that that is really the big deterrent. The big deterrent comes from the very large investment cost combined with a great deal of uncertainty about what the demand size will be.

So on one end the spectrum, people say, “Well, there’s not much we can do about this problem. Maybe we can change the legal environment and make it more friendly toward suppliers, and that will induce more companies to enter into the market.” On the other end of the spectrum, you have people who say, “This is such a vital commodity with such enormous public-health and productivity implications that the government should be in the business of producing and distributing the vaccine.” So the question is, is there an approach in between by which you can ensure that the right diversification in terms of the number of suppliers is achieved without basically nationalizing the process?

Part of this research project is to think about what mechanisms the government should put in place to ensure, or at least make it very likely, that a sufficient number of suppliers and a sufficient total supply will be in place without the government taking over the process. One mechanism is to reduce the risks for manufacturers by offering a buyback agreement. The government would say, “We are going to compensate you for any unsold items at a rate lower than the normal market price but nevertheless a significant buyback rate.” That would mitigate the risk for manufacturers and induce them to produce higher quantities.

The reason manufacturers are holding back on producing more is because they say, “I don’t know what the demand is going to look like — maybe I’m going to be stuck.” A lot of manufacturers did get stuck with unsold supplies, and unsold supplies are basically worthless because a vaccine is a product that you can’t carry over from year to year. But a buyback agreement would reduce the risk in a major way, and it’s not very costly for the government to put into place. It’s an innovative idea in the area of public health policy and public policy in general, but in private supply chains, this kind of agreement is used in many, many industries.

So that’s the first mechanism. The second one is to be much more specific and disciplined in terms of specifying what the target population should be. Part of the problem that manufacturers face is that in one year the Centers for Disease Control recommend that half a million people get vaccinated, and in another year, 70 million or 150 million. From a medical point of view, it doesn’t seem like the needs are changing so radically from one year to the next. If we had a really good set of recommendations in place that stayed in place — not forever, but say, 5 to 10 years — then this would make the planning environment for suppliers much more reliable.

The third mechanism is for the government to engage in a reverse auction, which again is a mechanism that is in place in many private supply chains. The government would basically auction off the order for certain quantities of the vaccine to the lowest bidders that can ensure that they meet all the quality standards that are required. To overcome the barrier of the investment cost, the government would auction off orders to produce the vaccine for, let’s say, four or five years at a time.

Those are some of the ideas that we’ve come up with and are trying to analyze very specifically. The whole question is, if you know ideally how many suppliers you want to have, how do you make this happen in a free-market environment where you want to intervene in the least heavy-handed possible way but nevertheless provide the right incentives for the right number of suppliers to arise?

What other areas of the economy are particularly vulnerable to supply chain risk?

In thinking about other sectors of the economy that might be vulnerable, another example is oil, particularly oil refinery capacity, which is the bottleneck right now. It’s the main force that is driving oil prices up, more so than the oil supply from the oil-producing countries themselves. Last summer the United States was operating at 98 percent of capacity, and that wasn’t so different from the rest of the world. There are quite a few refineries in the country, but a very large proportion of the supply comes from a small number of refineries. So that’s another sector where I think we have to be very careful about whether we have the right kind of supply diversification, because oil is a commodity that has ripple effects throughout the economy.

 

Awi Federgruen is the Charles E. Exley Professor of Management and chair of the Decision, Risk and Operations Division at Columbia Business School.

Read the Research

Awi Federgruen

"Policy Recommendations for Managing the Flu Vaccine Supply"

View abstract/citation  Download DOC  

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