Interview with Dr. Vinod Singhal - Georgia Tech.

KNOWledge: Recognizing that your recent study "The Effect of Demand-Supply Mismatches on Equity Volatility:  An Analysis of Different Types of Supply Chain Risks"  builds on the previous research estimating Supply Chain Disruptions responsible for 7-8% decline in stock prices, how would you describe the effect that understanding financial impact has had to supply chains and their leadership?  Dr. Singhal: Managers and investors care about hard numbers.  For a long time supply chain managers did not have the data and numbers to back up the claims that supply chain performance matters.

I can think of at least three effects of understanding the financial effects of disruptions.  First, the popular business press has started paying much more attention to supply chain management issues. While much of the previous attention was driven by anecdotes about disruptions due to weather and natural disasters, business reporters are now more sensitive to other types of disruptions and use hard data to communicate the importance of managing disruptions.  Second, conferences on supply chain management are focusing on supply chain risk management issues by organizing special sessions and tracks to create awareness about best practices for dealing with risk issues.  Third, I think top management is becoming more sensitive to the fact that effective supply chain management can have a significant influence on shareholder value and the financial performance.  Supply chain risk management issues have now reached the board level in many firms.

KNOWledge: Even with the positive reception of the original study did you find any specific questions that required deeper exploration?

Dr. Singhal:  One question that I am constantly asked is about the effectiveness of different supply chain strategies in mitigating the negative economic consequences of supply chain disruptions.  My-coauthors and I have recently examined this issue using empirical data.  We find that in the case of disruptions, firms that have more operational slack in their supply chain experience less negative stock market reaction; firms that are more geographically diversified experience a more negative stock market reaction; and firms that are more vertically integrated experience a less negative stock market reaction.  These are things that people talk about but did not have evidence to support their claim.  Other questions that have raised include do stock analyst’s really care about supply chain disruptions, how quickly to firms recover from disruptions, and what do firms do to recover from disruptions.   I will be researching these issues in the future.

KNOWledge: Can you differentiate and expand on the decision to use equity volatility for this study?

Dr. Singhal: Equity volatility is a common measure of risk that can have a significant effect on firm value.  CEOs, CFOs, and board members are very concerned about equity volatility.  While much is known about how financial events affect volatility, there is little awareness about how volatility gets affected by supply chain related events.  This study shows that demand-supply mismatches (disruptions, excess inventory, and delays in product introductions) are associated with a 25% increase in volatility, and that the increase in volatility persists for at least two years.  These are very significant increase in volatility when compared to increases associated with other corporate events.  For example, CEO turnovers are associated with a 6% increase in volatility.

Volatility changes are important because they can affect the underlying economics in a number of ways.  First, an increase in volatility can increase the cost of capital that investors use to discount the future earnings or cash flows of the firm. A higher cost of capital can result in lower stock prices.  Second, suppliers and customers may be wary of dealing with a firm that has high risk, and may demand more favorable commercial terms before doing business with the firm. This can raise the cost of doing business for the firm. Third, increased volatility can make a firm’s equity a less attractive currency for acquisitions as potential targets may be less willing to do deals that depend on volatile equity prices. Finally, increased volatility can affect the willingness of lenders to extend credit, which could lead to credit crunch and liquidity concerns for the firm. It could also increase the probability of bankruptcy and the expected costs of bankruptcy.

KNOWledge: With the knowledge you have gathered through this research what guidance or practical steps would you offer to supply chain managers?

Dr. Singhal: I have three broad suggestions.  First, it is incumbent on supply chain managers to make their CEOs. CFOs, and board members aware of the primary sources of disruption risk in their supply chains, what can be done to mitigate these risks, and take proactive actions to mitigate risks.  Disruptions, even if infrequent, have the potential to destroy value that might have been painstakingly created over years.

Second, although the focus on making supply chains more efficient and lean makes economic sense, senior executives must recognize that lean and efficient supply chains face higher risk of disruptions.  There is a direct relationship between efficiency and risk.  Firms can no longer afford to focus solely on cost reduction.  Major supply chain investments and initiatives must also consider how these investments and initiatives affect the risks of disruptions.  Furthermore, such investments and initiatives must often be undertaken not because they reduce costs but because they increase the reliability and responsiveness of supply chains.  Such investments and initiatives should be viewed as insurance against avoiding shareholder value destruction should disruptions happen.

Third, firms need a systematic process for supply chain risk management that is regularly used.  The process should be championed at the highest executive level as this is critical for bringing about awareness of the importance of managing disruption risk.  A broad plan for developing and implementing such a process is as follows:

1. Assemble a cross-functional team of risk experts:  In most organizations, risk management is housed at the corporate level in insurance, legal and audit services.  But supply chain disruption risks require a different type of arrangement.  The knowledge of supply chain risks lies in marketing, operations, procurement, logistics, and information technology.  Thus, the cross-functional team must include members from these areas as they have sufficient experience to identify and quantify disruption risks. 
2. Characterize the major sources of risks:  The cross-functional team must regularly scan the internal and external environment to identify the vulnerable points of their supply chain.  This involves identifying the primary sources of risk, estimating the probability of each risk happening, estimating the financial impact of the risk, the amount it would cost to recover from the risk, and the amount of time it would to recover from the risk. 
3. Assess and prioritize risks:  Once the primary sources of risk have been identified and agreed upon, the next step is to assess and prioritize the risks that should be of serious concern to the firm.  Top management and the board should be made aware of the high risk issues.   Various alternatives should be considered to mitigate the high risk factors.  Such alternatives include developing contingency plans to deal with the risk should it surface, options for spreading risks through insurance, forward contracts, flexible contracts, and making organizational changes in how the supply chain is designed and operated so that these risks are mitigated in the future.
4. Monitor risk and take actions as needed:  Once the primary risk issues have been identified and contingency plans have been developed, firms should develop a system to monitor risks.  Leading indicators need to be tracked, two-way communication with supplier and customers must be done on a continuous basis, and visibility systems must be in place.  When risks surface the appropriate contingency plans are activated and the effectiveness of these plans in mitigating the risk is continuously monitored. 
5. Improve the risk management process:  Firms must continuously strive to improve their risk management processes.  As and when risk is dealt with, effort must be made to document the outcomes of the risk mitigation plans and highlight what worked and what did not work.  These lessons should be shared across the organizations and used to improve the risk management process.  Benchmarking a firm’s process against other firms that have well functioning risk management process can identify best practices and help make a firm’s process more robust and effective. 

 Figure 1. Median volatility of production disruptions, excess inventory, and product introduction
delay samples and their control samples.