Flexibility Strategy Under Supply and Demand Risk

Abstract

Problem Definition: With heightened global uncertainty, supply chain managers are under increasing pressure to craft strategies that accommodate both supply and demand risks. While flexibility is a well-understood strategy to accommodate risk, there is no clear guidance on the optimal flexibility configuration of a supply network that comprises both unreliable primary suppliers and reliable backup suppliers. Academic/Practical Relevance: Existing literature examines the value of flexibility with primary and backup suppliers independently. For a risk-neutral firm, research shows that (a) adding flexibility to an unreliable primary supplier (in absence of backup supply) is always beneficial, and (b) adding flexibility to a reliable backup supplier (in absence of primary supplier flexibility) is always valuable. It is unclear, however, how flexibility should be incorporated into a supply network with both unreliable primary suppliers and reliable backup suppliers. This research studies whether flexibility should be embedded in a primary supplier, a backup supplier, or both. Methodology: We develop a normative model to analyze when flexibility benefits and when it hurts. Results: Compared with a base case of no flexibility, we prove that embedding flexibility in either primary or backup suppliers is always beneficial. However, embedding flexibility in both primary and backup suppliers can be counterproductive because the supply chain performance can decline with saturated flexibility, even if flexibility is costless. A key reason is that the risk-aggregation effect of embedding flexibility in an unreliable supplier becomes more salient when flexibility is already embedded in a backup supplier. Managerial Implications: This research refines the existing understanding of flexibility by illustrating that adding flexibility is not always beneficial. When there is a choice, a firm should prioritize embedding flexibility in a reliable backup supplier.