A Case for Fatter Supply Chains

Adding a bit more inventory and time into lean supply chains could bolster shareholder value and profitability during hard times.

Ice-cream loving dieters across the globe laughed with delight, and yogurt-eating weight watchers slathered bagels with butter, on Wednesday morning after hearing that a new $415 million federally funded study concluded that low-fat diets do not cut health risks.

The study, conducted by Rockefeller University, shed new light on dieting strategies in much the same way that two recent (but less generously funded) business studies provide fresh insights into “lean” supply chains. By relying on just-in-time (JIT) initiatives, lean supply chains squeeze inefficiencies out of the system by cutting extra inventory as well as time.

One concern about JIT initiatives, especially in the wake of major supply disruptions caused by hurricanes Katrina and Rita, is whether supply chains can become too lean, thereby leaving no margin for error when the unexpected occurs. Another worry is the short-term and long-term effects of the supply disruptions themselves. The studies attempt to provide some answers.

In one study, “The Effect of Supply Chain Disruptions on Long-term Shareholder Value, Profitability, and Share Price Volatility,” the authors draw a direct correlation between supply disruptions and shareholder value. It found, for example, that companies that suffered supply-chain disruptions experienced share-price returns 33 percent to 40 percent lower than industry and general-market benchmarks. Further, share price volatility was 13.5 percent higher in these companies in the year following a disruption than in the prior year.

Disruptions have a greater effect on profitability, say authors Kevin Hendricks, a professor at the University of Western Ontario’s Ivey School of Business, and Vinod Singhal, a professor of operational management at Georgia Institute of Technology. The study found that in the year leading up to a disruption announcement, companies averaged a stunning 107 percent decline in operating income, a 114 percent drop in return on sales, and an 11 percent rise in costs. In aggregate, says Singhal, these leading indicators warned of major supply problems that were brewing even before the disruptions were made public.

To be sure, “there is a limit to how much efficiency can be wrung out from supply chains,” notes the study, which counsels managers to focus on preserving gains by ensuring “disruption free performance of supply chains.”

The authors, who analyzed more than 800 disruptions announced by publicly traded companies between 1989 and 2000, found that up to 68 percent of these companies underperformed their respective benchmarks — a percentage the professors called “significant.”

Some disruptions were caused by production problems; others, by shipping delays. For example, Sony Corp.’s shortage of PlayStation 2 video games in 2000 was caused by a dearth of critical components; Motorola Inc.’s parts shortage in 1999 was fueled by an unexpected surge in mobile-phone demand.

The study also highlighted underperformance in several other profitability categories. For instance, in the year prior to the disruption announcement, return on assets fell by an average of 93 percent, inventory levels grew by 14 percent, and sales declined by 7 percent. Usually, an increase to the asset base would be good news, but Singhal points out that when the inventory builds up while sales fall, lower asset turnover is the diagnosis.


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