We Need a Stress Test for Critical Supply Chains

We Need a Stress Test for Critical Supply Chains

by David Simchi-Levi and Edith Simchi-Levi - April 28, 2020

The global pandemic has exposed serious flaws in supply chains, including critical ones for industries such as pharma and medical supplies. Shortages of personal protective equipment for health workers and ventilators in hospitals are the most prominent ones. To prevent this problem from occurring again when the next disaster strikes, governments should consider establishing a stress test for companies that provide critical goods and services that’s akin to the stress tests for banks that the U.S. government and European Union instituted after the 2008 financial crisis. This test should focus on the resilience of companies’ supply chains.

A major reason for the shortages that have occurred during the pandemic is the lean global supply chains that have been deployed widely in order to reduce costs through efficient allocation of production to low-cost regions; just-in-time methodologies in manufacturing; and holding lower levels of inventory throughout the supply chain. These strategies rely on forecasting based on historical data and do not typically consider any major disruptions.

The automotive industry, in particular, discovered that these strategies might not always work when they were forced to deal with severe supplier problems after the 2011 earthquake and tsunami devastated northeastern Japan. This led to the application of a new methodology we developed that enables a sophisticated way to understand exposure to risk associated with unlikely events as described in this HBR feature and refined in this follow-up HBR article.

Our methodology has two central elements. One is time to recover (TTR), the time it would take for a particular node in the supply chain - a supplier facility, a distribution center, or a transportation hub - to be restored to full functionality after a disruption. The second is time to survive (TTS), the maximum duration that the supply chain can match supply with demand after a facility disruption. By quantifying each measure under different scenarios, a business can identify its ability to recover from a disaster. For example, if the TTR for a given facility is greater than the TTS, the supply chain will not be able to match supply with demand unless a backup plan exists. This approach provides companies with a way to financially quantify the cost of disruptions and prepare mitigation plans for the most critical parts of the supply chain that could be applied in different scenarios.

This approach is similar to the bank stress test instituted after the 2008 financial crisis to ensure that major institutions whose failure could cause the entire financial system to collapse had the wherewithal to survive a future crisis. It is a simulation model that helps bank managers and regulators gauge a bank’s financial strength. In the United States, major banks are required to estimate the capital they would need to ride out baseline, adverse, and severely adverse conditions. For example, banks might need to model an environment with high unemployment, a housing market crash, and a slowing economy. The Federal Reserve provides the details for stress testing each year by telling banks which specific assumptions to use.

Similarly, the U.S. government and those of other countries or blocs should require companies that provide essential products and services to report their ability to deal with disruptive events. It would encourage them to design more resilient supply chains.

In the case of health care, a government agency such as the U.S. Centers for Disease Control and Prevention (CDC) could take the lead and work with industries to establish standards and tests. Of course, when designing the standards and tests, economic nationalism - like countries’ priorities that have prevented the movement of goods across the global supply chain during the pandemic - should be taken into account.

Creating and implementing a stress test for companies in critical industries is possible. It would go a long way toward ensuring that the kind of shortages that have been occurring in the last few months don’t happen again.

David Simchi-Levi is a professor of engineering at the Massachusetts Institute of Technology. He co-founded LogicTools, a provider of software for optimizing supply chains that is now part of IBM; OPS Rules, an operations consulting company; and Opalytics, a cloud analytics platform company. His latest book is Operations Rules: Delivering Customer Value through Flexible Operations.

Edith Simchi-Levi is startup adviser and investor in New York City. She was the cofounder and vice president of operations of LogicTools, a provider of supply-chain-optimization software now owned by Llamasoft, and Opalytics which was acquired by Accenture.