Christoph Bode

Negative Default Dependencies in Supplier Networks

Daniel Dumke — Mon, 18 Jun 2012 12:45:08 +0000

If people talk about disruptions and network effects within the supply chain, the associations are most often negative.

The picture of an automotive/just-in-time supply chain comes to mind, where a small screw from a distant supplier did not get delivered in time and all production processes within the whole network suddenly come to an involuntary halt.

But on the other hand there are companies profiting from these smaller and larger disruptions: competition.

To analyze these effects we have a look at the consequences of negative default dependence between suppliers. The full paper can be found here.

Default dependence and method

Empirical research on corporate defaults in the finance literature indicates that corporate defaults often cluster in time and that the default of a company is frequently affected by the defaults of other companies. […]

In the automotive industry there are several reasons why positive default correlation may exist in supplier networks. First, automotive suppliers face similar challenges, such as large and powerful customers who force suppliers constantly to cut costs and invest heavily in R&D or the volatile prices of raw materials. It is likely that the automotive suppliers have to suffer from the consequences of these challenges in a similar way or are reacting in a comparable manner to cope with them. Second, suppliers may maintain relationships with other suppli- ers and share “technical and explicit information as well as tacit information” and “work together closely, exchange ideas, and even engage in joint venture projects.” Being linked so closely may result in comparable strategic and operative actions and behavior of the supplier firms. The consequence is that decisions that lead to financial problems are likely to be taken by both suppliers that are linked through close supplier–supplier relationships.

However there are also reasons/situation in which default-events might be negatively correlated:

First, after a supplier default, customers might shift business to another supplier in the network.

Second, the default of a supplier can result in lay-offs and the competitor will be able to hire more and qualified staff.

Finally, due to the reduced number of alternative sources, the buying firm may become more dependent on the surviving supplier who, through the gained power, may be able to incur higher profit margins and, thus, gain in financial stability.

The authors use copula-functions.

Financial data to calculate default probabilities for a case study are derived from Datastream (Thomson Reuters). This data was used to calculate the individual default intensities.

For the worldwide 100 largest suppliers to the automotive OEMs in 2005 that were included in the Datastream database, we extracted the necessary data required for specifying and adjusting our model.

Figure 1 shows the default intensities for selected companies.

Figure 1: Company Characteristics (Wagner et. al, 2011)

The default dependencies were calculated using numerical results of a simulation.

Results and implications

The authors draw three conclusions from the results of their analysis.

First, our estimation of default intensities of selected first-tier suppliers in the automotive industry supports the concerns raised in the literature about the financial stability of automotive suppliers. Supplier default intensities above 5% are disquieting for the respective automotive OEMs.

Second, the simulation results depict that negative default dependence among suppliers in a supplier network has consequences for the survival probabilities of the entities in the network. The higher the individual default intensity of a supplier, the stronger the effect of negative default dependence on its survival probability after the default of the other supplier. […] for example, the portfolio with low default intensity suppliers demonstrated to increase the survival probability of the second supplier by 2.7% and the portfolio with high default intensity suppliers by 15.4% (in comparison to the independence case).

Third, in addition to the dependence level, the dependence structure, reflected in our model by the choice of copula, is an important factor for modeling default dependence in a supplier portfolio.

The following management implications can be given:

Purchasing managers should be aware that negative default dependence between suppliers may exist and take this into account for their sourcing decisions. A better understanding of the randomness and relatedness of supplier defaults internal to the supplier network can help firms to plan for uncertainty, take proactive measures to reduce risk (e.g., switch a supplier), and achieve better, less variable outcomes.

Firms should preferably establish relation- ships with suppliers that have low default intensities, and with suppliers that will benefit from the default of their competitors – given that the default of the competitor will not significantly shift the power in the buyer–supplier relationship

Conclusion

Not only surviving competitors can potentially profit from the default of its contestant, but also their clients may profit.

This research shows that interdependencies – no matter if positive or negative – have to be analyzed and should included in the decision making process.

One has to keep in mind though, that Wagner et al.‘s results heavily rely on their method to estimate the default dependencies within the supplier portfolio.

This might induce additional uncertainty in the form of model risk.

Reference:

Wagner, S., Bode, C., & Koziol, P. (2011). Negative default dependence in supplier networks International Journal of Production Economics, 134 (2), 398-406 DOI: 10.1016/j.ijpe.2009.11.013

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An Empirical Investigation into Supply Chain Vulnerability

Daniel Dumke — Tue, 05 Jun 2012 06:30:56 +0000

One basic assumption in risk-aware supply chain design is the notion that the design of the supply chain actually has an impact on the vulnerability of the supply chain.
This question has been analyzed about six years ago in a broad empirical study by Wagner and Bode.

Method

The authors use a rather large sample of companies in Germany. Overall nearly 5000 supply chain professionals were asked to participate and 760 actually took part in the study.
Most sample companies had an industrial focus (72% versus service (20%) and trade (9%)).
This study is founded on a similar sample as this other study by Wagner and Bode analyzing the impact of risks on supply chain performance.

Model

The author focus on some supply chain design variables, which supposedly increase supply chain vulnerabilities. Figure 1 shows the assumed relationship between those drivers of supply chain vulnerability and three supply chain risk categories.

Figure 1: Concept: Relationship between Design and Risk

The authors propose the following hypothesis, which are then tested using the empirical data:

H1: The higher the drivers of supply chain vulnerability, the higher the level of demand side risk a firm faces.

H2: The higher the drivers of supply chain vulnerability, the higher the level of supply side risk a firm faces.

H3: The higher the drivers of supply chain vulnerability, the higher the level of catastrophic side risk a firm faces.

Results

The results show that all hypothesis are supported by the findings of the authors. However the design factors/vulnerabilities only explain part of the observed supply chain risks (7% for H1, 13% for H2, 3% for H3).
Demand side risk was influenced by strong customer dependence and strong supplier dependence.
Supply side risk was influenced by supplier dependence, single sourcing and global sourcing.
Lastly, catastrophic risk was impacted by the degree of global sourcing.

The authors draw the following conclusions:

First, the supply chain vulnerability variables in our model explain a rather small portion of the variance in the risk arising from demand side risk sources. It is a low but not astonishing value since the majority of the vulnerability variables focuses on the upstream supply chain. However, the results reveal that customer dependence increases demand side risk. This finding indicates that firms that are dependent on some customers are exposed to a higher risk of suffering from the detrimental effects of demand volatility and poor downstream information. This could be because of order batching or limited possibilities of demand pooling. […] This leads to the hypothesis that, beyond the investigated variables, there are several additional aspects both internal and external to the supply chain that determine a firm’s exposure to supply chain risk.

Second, risk derived from supply side risk sources is elevated by supplier dependence, single sourcing and global sourcing. Supplier dependence obviously amplifies the threat from poor quality, supply shortages, sudden demise of one of these suppliers, and poor logistics performance. Although this argumentation also applies to single sourcing, the single sourcing approach seems to be less hazardous than general dependence on some suppliers. This is because single sourcing is usually aligned with a closer relationship that might absorb some of the supply side risk.

Third, when it comes to risk from catastrophic risk sources it has to be taken into consideration that the sample data was collected in Germany which has been a very “calm” place with regard to disasters. Here, it is solely global sourcing that is a significant factor that exposes firms to higher risk from catastrophes. The implementation of a global sourcing strategy stretches the supply chain geographically which ultimately means more peril points for the information and material flow. The robustness and resilience of regional or national supply chains is usually higher. Surprisingly, the study shows that supplier dependence decreases the risk exposure to catastrophes. Again we would argue that this is because of lack in supply flexibility. Firefighting against the consequences of catastrophic events might be more successful with the ability to quickly adjust the supply.

Conclusion

I would argue that it is always hard to measure risk consistently in a qualitative study. People are likely to evaluate the same risk quite differently, which might lead to unclear results.
Furthermore the low impact of these specific design variables emphasizes the view that there are many more factors (internal and external) that impact the exposure to supply chain risk.

Reference:

Wagner, S.M., & Bode, C. (2006). An Empirical Investigation into Supply Chain Vulnerability Experienced by German Firms Erich Schmidt Verlag, 79-96

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Impact of Risks on Supply Chain Performance

Daniel Dumke — Mon, 25 Apr 2011 14:15:00 +0000

I am often astounded by the fact how many great articles I haven’t read yet. A good scientific paper contains an comprehensive description of the methodologies used, a theoretical foundation and literature review from which hypothesis are drawn, which are then confirmed or rejected in the course of the paper. And of course, it is always a plus to actually find some results in the course of the analysis.

From this category I would like to introduce an article by Wagner and Bode (2008) on an empirical examination of supply chain performance along several dimensions of risk. The complete article is defnitly worth a read and can be found here (free of charge).

Introduction & Hypothesis

The authors start by highlighting the major factors involved in the importance of supply chain risk management nowadays: There has been an upward trend in crisis and catastrophes, at least on the level of media coverage and awareness. Furthermore modern supply chains have been optimized for leanness in recent years, leaving them more exposed towards risks.
To decide on the the possible investments on mitigation strategies, a supply chain manager needs to know the probability of an adverse event and the effect of the disruption on supply chain performance.
Hendricks and Singhal (reviewed here 1, 2) already concluded, that SC risks can have severe consequences on performance and the stock price.The goal of this article was to establish a more direct link between what risks affect the performance most. The authors build their hypothesis building on contingency and strategic choice theory, arguing that the environment is a major determinant of business performance, nonetheless managers still can make “strategic choices” to improve performance. Of course this sounds like common knowledge, and it is, but it is essential from a scientific point of view to root his own ideas in a foundational theory.

Using a literature review the authors decide on the following risks to include into their research: (1) demand side; (2) supply side; (3) regulatory, legal and bureaucratic; (4) infrastructure; and (5) catastrophic.
From these risks five hypothesis emerge, following this structure:

H₁: The higher the demand side risk, the lower the supply chain performance. …

Methods

In contrast to Hendricks and Singhal, who analyzed the impact on the level of stock prices and public company performance data, Wagner and Bode conducted a survey with a final sample size of 790 supply chain professionals from companies located in Germany. Non-response bias has not been found. The questionnaire has been carefully designed, for each hypothesis multiple measures were included. E.g. demand side risk measures consisted of two items that capture the risk deriving from the interaction (or lack thereof) with customers and volatility of the market. The results were analyzed using correlation analysis and reliability evaluations

Results

The results show that in the view of the experts demand and supply risks have an impact on supply chain performance, whereas there is no significant relationship between regulatory, infrastructure and catastrophic risks and supply chain performance.

Results of Correlation Analysis (Wagner and Bode, 2008)

On first sight these results stand in contrast to the results of Hendricks and Singhal, where a huge impact of any disruption on performance has been encountered. This can be explained by the different focus of the analysis, where Wagner and Bode took a sample from all companies, which naturally only seldom experience severe disruptions whereas Hendricks and Singhal especially picked the larger (and worthy of a public announcement) disruptions. So a catastrophic event still has a negative impact on the sample group, but since the probability is so low it does not pose a significant impact on performance.

The managerial implications therefore are:

Importance of a supply chain risk management framework
Scarce resource should be deployed to mitigate the “every day” risks from supply and demand

Conclusion

This article also concludes as a text book example of “how to write a scientific paper”, it finishes with recommendations for the implementation of the results and further research gaps and still leaves something to say for critics like me:

It is very interesting to see the findings by Hendricks and Singhal in a new light, from the point of view of a supply chain professional.
But this study also points the perception of risks (have a look Part 1 and Part 2) as a major driving factor in these results.
Wagner and Bode also discuss the factual risk situation in the sample companies (all from Germany), which probably skews the results. All the risks mentioned might be (perceived or real) quite different in other countries.

Reference:

Wagner, S.M., & Bode, C. (2008). An empirical Examination of Supply Chain Performance along Several Dimensions of Risk Journal of Business Logistics, 29 (1), 307-325

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