Walid Klibi, Kai Trepte, and James B. Rice Jr. write in MIT Sloan Management Review:
More than ever, companies need supply chains that are resilient to disruptions, whether the cause is a natural disaster, an infrastructure failure, labor actions, or a global pandemic. Yet the conventional approach to resilience is seriously flawed. Many companies follow a boom-and-bust pattern, making big investments in resilience after a supply chain disruption and then paying little attention to the issue until the next crisis.
This reactive way of protecting supply chains is based on the approach of mitigating the risk that a disruptive event will occur. But that is not enough for creating true resilience, which is the ability to bounce back as quickly as possible after a disruption. A more effective approach focuses not on risks but on outcomes — that is, on the value of maintaining operations when adversity strikes rather than on the cost of a supply chain disruption. The goal is a robust supply chain that can sustain value creation under any plausible risk scenario.
Developing such an approach is difficult. It requires companies to determine in advance how much to invest in resilience and how to implement those investments across different parts of the organization. These challenges have long frustrated efforts to make supply chains more resilient.
We have developed a framework to address these problems by applying the concept of real options to evaluating investments in resilience. Real options build on the principles used by the banking industry to assign a future value to financial investments in the face of long-term uncertainty. Here, real options are applied to tangible investments in supply chain capabilities, such as building up stockpiles, adding production or warehouse capacity, or lining up backup suppliers. Our option valuation approach is the result of extensive research with supply chain leaders in several global companies and was tested with a leading manufacturer.