A Real Options Approach to Evaluating Supply Chain Resilience Investments
Organizations that experience supply chain disruptions may suffer significant harm, including monetary loss and reputational harm. To mitigate these risks, organizations may invest in resilience capabilities such as redundancy, flexibility, and agility. The likelihood and cost of disruptions, as well as the costs and advantages of resilience measures, are all subject to uncertainty, making investment decisions in resilience difficult.
This article proposes a real-options approach for evaluating investments in supply chain resilience. The theory of real options offers a framework for calculating the worth of investments that give investors the flexibility to react to uncertain future events. The approach considers the costs and benefits of resilience measures as well as the option value of delaying the investment decision until more information is available.
To apply the real options approach to supply chain resilience investments, this article outlines a step-by-step process that includes identifying the investment options, calculating the costs and benefits, and determining the option value. A fictitious example of using additional suppliers to reduce supply chain redundancy is used to illustrate the strategy.
The article concludes that a real options approach can help organizations make more informed investment decisions in supply chain resilience. By considering the option value of delaying the decision and the potential costs of future disruptions, organizations can better understand the trade-offs between investing in resilience and maintaining financial flexibility.
One of the problems with investing in supply chain resilience is the difficulty in measuring the economic effects of such investments. Due to their inability to clearly demonstrate the financial advantages of investing in resilience measures, organizations may find it difficult to justify their actions.
The economic effects of supply chain resilience investments can be difficult to measure for several reasons. One factor that makes it challenging to estimate the potential economic benefits of resilience investments is how difficult it can be to predict the likelihood and impact of potential disruptions. Furthermore, the advantages of resilience measures might not be noticeable right away; rather, they might not be noticeable until after a disruption.
Another challenge is that the economic benefits of resilience measures may not be evenly distributed across an organization or its stakeholders. For instance, spending more money on backup and redundancy systems may increase short-term costs for an organization, but long-term benefits could include lower risk and a better ability to recover from disruptions. However, these benefits may be difficult to quantify and may not be immediately realized by all stakeholders.
Additionally, conventional financial metrics like return on investment (ROI) might not fully account for the advantages of resilience investments like increased market share, lower reputational risk, and higher customer satisfaction. As a result, organizations may be reluctant to invest in resilience measures due to the difficulty of measuring their economic impact.
A real options approach can be a suitable method for making investment decisions regarding supply chain resilience capabilities because it recognizes that the value of the investment can change over time as new information becomes available. Supply chain disruptions are often unpredictable, and investing in resilience capabilities can involve significant upfront costs, making it difficult to assess the economic benefits of the investment. By using a real options approach, companies can better account for uncertainty and the potential value of delaying investment decisions until more information is available. This can result in more informed investment decisions that better align with the company’s risk appetite and strategic objectives, while also improving the company’s ability to respond to supply chain disruptions.
What are real options?
Real options can be thought of as the ability to delay or defer a decision in order to gain more information or to avoid committing to a specific course of action until conditions become clearer. This concept comes from the field of finance, where it is used to evaluate investment opportunities and manage risks.
In the context of supply chain resilience investments, real options can be used to evaluate the potential value of different resilience measures by taking into account the flexibility and adaptability of an organization in the face of uncertainty. The goal is to identify the best strategies (plan of action or set of decisions) for managing the risks and uncertainties associated with potential supply chain disruptions while also maintaining the ability to respond effectively to changing conditions.
The essential principle in decision analysis is simple: choose the decision that offers the best average value (1)
For example, suppose that a company is considering investing in redundant supply chain systems to increase resilience. Assessing the value of the flexibility and optionality that these investments offer would be part of a real options approach. The model would consider elements like the likelihood of a supply chain disruption, the price of the investments, and any potential financial gains from continuing operations in the event of a disruption.
Resilience as real options: single step example
Suppose the company is considering a one-time decision about whether to invest in an additional supplier for a critical component. The upfront investment required to onboard each new supplier is $1 million, and the company estimates that the annual savings from having an additional supplier would be $500,000 per year, assuming no disruption occurs. However, if a disruption occurs, the company could save up to $2 million in the first year by having an additional supplier, and then $500,000 per year thereafter.
Suppose the company estimates the probability of a disruption occurring in the next year to be 15%. If the company invests immediately, it would spend $1 million per additional supplier upfront, and potentially have no disruption in the short-term, resulting in an annual savings of $500,000 per supplier. If a disruption occurs, the company could save $2 million in the first year, but would have already spent $1 million upfront for each additional supplier.
Alternatively, the company could delay the investment decision and wait until a disruption actually occurs. If a disruption occurs in year 1, the company could save $2 million in the first year, but would only receive an annual savings of $500,000 per supplier in subsequent years.
Using a real options approach, the optimal timing of the investment decision is when the expected savings from the additional supplier are equal to the upfront investment cost. In this case, that would be when the expected disruption probability is 20%. Therefore, if the company expects the disruption probability to exceed 20%, it should invest in additional suppliers immediately, while if it expects the disruption probability to be lower than 20%, it should wait until a disruption actually occurs before investing.
If the company estimates the probability of a disruption to be 25%, the expected value of investing in an additional supplier would be:
(0.75 x $500,000) + (0.25 x $2,000,000 — $1,000,000) = $437,500
The expected value of investing in an additional supplier is less than the upfront investment cost of $1,000,000, so the company should not invest in additional suppliers at this time.
If the company estimates the probability of a disruption to be 30%, the expected value of investing in an additional supplier would be:
(0.70 x $500,000) + (0.30 x $2,000,000 — $1,000,000) = $450,000
The expected value of investing in an additional supplier is greater than the upfront investment cost of $1,000,000, so the company should invest in additional suppliers immediately.
Therefore, the maximum time to delay the decision is when the expected disruption probability is between 20% and 30%. If the expected disruption probability is below 20%, the company should delay the decision until a disruption occurs. If the expected disruption probability is above 30%, the company should invest immediately without delay.
Step-by-step guide for Real options implementation
- Identify the investment options: The first step is to identify the possible resilience measures that the organization could invest in to improve its supply chain resilience. These could include measures such as redundancy, flexibility, agility, or collaboration with suppliers or partners.
- Estimate the costs and benefits of each option: For each investment option, estimate the upfront costs, ongoing costs, and potential benefits in terms of reduced disruption costs, improved customer service, or other strategic benefits.
- Determine the uncertainty factors: Identify the key uncertainties that affect the investment decision, such as the likelihood and cost of future disruptions, the effectiveness of the resilience measures, or the competitive environment.
- Model the investment decision: Use a real options model to evaluate the investment decision under different scenarios, taking into account the potential costs and benefits of each option, as well as the uncertainty factors.
- Quantify the option value: Estimate the option value of delaying the investment decision, based on the potential costs of future disruptions and the cost of waiting for more information.
- Analyze the trade-offs: Evaluate the trade-offs between investing in resilience measures and maintaining financial flexibility. Consider factors such as the organization’s risk tolerance, its financial resources, and the potential impact of a disruption on its operations and reputation.
- Monitor and adjust: Monitor the key uncertainty factors and adjust the investment decision as new information becomes available. Consider using Bayesian analysis to update the estimates of disruption likelihood and cost over time.
The case for a real options apporach to resilience capability building
Real options can help organizations better understand the risks and uncertainties associated with potential disruptions and identify the best strategies for managing these risks. By evaluating the potential value of different resilience measures and their impact on flexibility and optionality, organizations can make more informed decisions about where to invest resources.
Formally, a strategy can be defined as a series of decisions contingent on all possible outcomes, as opposed to a single series of decisions for all occasions.
Real options can also assist organizations in evaluating the advantages of various resilience measures over time, while taking into account changing circumstances and potential uncertainties. By adopting a more dynamic approach to resilience, organizations can better adapt to changing market conditions and customer needs while also managing risk and uncertainty.
Overall, real options can provide a powerful framework for evaluating the economic benefits of supply chain resilience investments by taking into account the flexibility and adaptability of an organization in the face of uncertainty.
The real options approach can help organizations make more informed decisions about where to invest resources by taking into account the potential value of different resilience measures over time and the ability of an organization to adapt to changing conditions and mitigate risks.
(1) De Neufville, R. (1990). Applied systems analysis: Engineering planning and technology management (Vol. 990). New York: Mcgraw-hill.
