Supply Chain Planning Under Uncertainty: A Real Options Approach

Introduction

Effectively managing supply chains proves to be the best way for a business to maintain its competitive edge (Blasgen, as cited in Carroll, Stalk, & Sarm, Power of Patience section, para. 3). In a manufacturer's quest to manage its supply and demand chains, one simple word aptly portrays a certain, common, contemporary concern that a company can count on having to cope with — uncertainty. During the best, as well as the worst, of purportedly predictable and yet simultaneously unpredictable economic times, uncertainty mandates that decision makers consider a new paradigm of decision-making. In light of operational needs in the supply chain realm, this paper presents a survey of the supply chain planning and real options literatures, while also exploring the intellectual developments in these areas as they relate to supply chain management.

As one group of decision makers, supply chain planners attempt to meet customer demands while keeping production, inventory, and delivery costs at a minimum. Uncertainty in the supply chain presents a significant challenge to this process. In confronting current challenges relating to supply chain planning under uncertainty, the application of real options accounts for managerial flexibility, risks, and changes in future environments. The supply chain planning literature purports that the primary goal for planners includes designing a network of suppliers, manufacturers, logistics providers, and customers in an efficient manner to maximize value to the entire supply chain. Recent contributions in this discipline reveal that uncertainty in the specifications of a supply chain network should be a driver in the planning phase. Some sources of literature are based on the suggestion of proactively managing uncertainties during the planning phase, including mechanisms for dealing with uncertain phenomena that provide management with alternate means to conduct business when circumstances or events disrupt normal operations.

During this literature review, the researcher explores a range of scholarship that ultimately contributes to the determination of the study's hypothesis: when decision makers face the challenge of continuously making vital business decisions in an uncertain environment, then utilizing the new paradigm of decision-making — the application of real options — equips decision makers to make better strategic, as well as tactical, supply chain decisions. The following research questions help maintain focus on the hypothesis:

1. What challenges do supply chain professionals regularly face?
2. What constitutes an uncertain environment?
3. How do real options potentially equip decision makers to make better strategic, as well as tactical, supply chain decisions?

In "From Raw Materials to Customers: Supply Chain Management in the Service Industry," Jack S. Cook, Ph.D., information systems specialist; Kathy Debree, food market representative; and Amie Feroleto, Human Resources Supervisor define supply chain management (SCM) as follows: "a familiar concept in manufacturing, but service industries are just now recognizing the value of successfully implementing it. Although certain concepts should be applied while successfully managing a supply chain, companies coordinate their individual supply chains in many different ways. Thus, in application, supply chain management practices exist along a continuum, from more traditional approaches, where the organization focuses only on the direct effects upon itself, to the more expansive, supply chain, channel-wide perspective" (Cooke, Debree, & Feroleto, 2001, para. 1).

SCM, a long-term evolutionary approach, provides constraints on risks inherent to uncertainty within planning processes. The need for driving operational efficiencies, along with the quest to improve collaboration among all participants within the business spectrum, spawned the development of supply chain management as a discipline, created by modern management science and industrial engineering. Uncertainty in the supply chain presents a significant challenge to planners as they attempt to meet customer demands while keeping production, inventory, and delivery costs at a minimum. Managing uncertainties in supply chain operations is not a new experience or challenge; however, recently this venture has taken on a new level of significance. This new significance — a product of recent developments — has caused parties to address supply chain issues with greater urgency (Brindley and Ritchie, 2004). Increased competition, changing customer demand, social and political standards, government regulation, and the cost and availability of raw materials are currently leading to a rapid increase in the complexity of supply chain configurations and strategies. These factors have introduced new and increasingly complex sources of uncertainty, and dealing with them constitutes one of the most significant challenges contemporary organizations face.

Supply Chain and Uncertainty

During the planning and design of a supply chain system, the process of identifying and understanding the sources and types of uncertainty proves vital, as ignoring these factors possesses the potential to trigger adverse consequences on the supply chain.

In "Quality Planning for the Manufacturing Supply Chain," Robert G. Batson, a professor of industrial engineering, and Karen D. McGough, a research engineer with the Naval Surface Warfare Center in Panama City, Florida (2006), examine companies' interactions from a global perspective. The International Organization for Standardization (ISO) 9001 defines "product realization as that 'sequence of processes and subprocesses needed to achieve the required product or service'" (Batson & McGough, 2006, para. 1). Batson and McGough further note that Clause 7, Product Realization, contains Clause 7.1, "Planning of product realization," which states that the organization shall plan and develop the processes needed for product realization. Clearly, the manufacturing supply chain is a system of such processes.

Trust in effective decision making in a collaborative planning environment, according to findings by Kenneth J. Petersen, Gary Ragatz, and Robert Monczka (2005), significantly impacted the effectiveness of five of the eight planning processes studied. In "An Examination of Collaborative Planning Effectiveness and Supply Chain Performance," Petersen, Ragatz, and Monczka also stress that numerous businesses are trying to secure a competitive edge by more methodically integrating their suppliers into key supply chain processes. For this to take place, more strategic and operational cooperation must occur between buyer and supplier firms — a process that frequently involves a degree of collaborative planning. Contemporary technology enables firms to more readily exchange planning information (Petersen, Ragatz, & Monczka, 2005). Their study, which surveyed purchasing executives from firms involved in collaborative planning with suppliers, examined a number of factors that support effective planning, along with the impact that effective collaborative planning exerts on performance in the buying firm.

Results from the study show that effective collaborative planning depends on information quality and the level of trust firms share. The authors state: "Collaborative planning activities between supply chain partners are expected to lead to better performing supply chains" (Petersen, Ragatz, & Monczka, Introduction section, para. 1). Numerous other researchers have also explored the perception that enhanced collaborative planning produces positive effects on joint business outcomes (Mohr and Spekman; Monczka; Handfield; as cited in Petersen, Ragatz, & Monczka). Ultimately, effective collaborative planning improves supply chain performance as it facilitates decisions that reflect a broad view of the supply chain, accounting for interactions among various supply chain firms. Improvements may be observed in better on-time delivery, reduced purchase prices, increased inventory turns, enhanced responsiveness, better quality, and reduced overall cost.

Merriam-Webster Online (2008) defines "uncertainty" as the "lack of sureness about someone or something." Brindley and Ritchie (2004) define it as "the absence of information concerning the decision situation and the need to exercise judgment in determining or evaluating the situation, alternative solutions, possible outcomes, etc." In addition, Parks (2007) attests that uncertainty exists in engineering contexts as follows: "Oil forecasts are a roll of the dice. You may know as much as the oil experts. That is, you know that a barrel of oil is pricey and getting pricier. Beyond that, nobody — not even those who get paid to prognosticate — has a real handle on the push and pull that goes into figuring how much oil people need, how much can be pumped, and how much can be refined." Uncertainty generally involves concern and apprehension regarding a decision or situation, principally about a future outcome or result, and this apprehension may make planning for the future a difficult task.

Uncertainty, propagated across every aspect of the supply chain, can lead to inefficiency in operations and reduce value. In the supply chain literature, a large number of studies have investigated the sources of uncertainty and techniques to manage them (Levi-Levi et al., 2004). Some of the major factors contributing to uncertainty include: the challenge of matching supply to demand, fluctuation of inventory and backlog across the chain, inaccuracy in forecasting, delivery lead time, manufacturing yields, transportation time, and component availability (Levi-Levi et al., 2004). According to Gupta and Maranas (2003): "The need to account for uncertainty in the planning decisions can essentially be traced back to the core functionality of planning models, which is to allocate resources for the future based on current information and future projections. The foremost consideration in incorporating uncertainties into the planning decisions is the determination of the appropriate representation of the uncertain parameters."

In any supply chain, volatility in the demand for goods and services may be categorized as one of the most important sources of uncertainty. The failure of a business to take necessary measures to protect against volatility could have devastating consequences, traditionally manifesting as extremely higher production costs, customer dissatisfaction, and loss of market share. Forecast error proves to be primarily a source of uncertainty. Given the increase in product variety and the decrease in product life cycles, product demand has become increasingly difficult to forecast. As businesses consider entering new markets, developing new products, or expanding in existing markets, uncertainty regarding the size of customer demand should always constitute a pertinent consideration. Like demand uncertainty, supply uncertainty serves as another significant source of uncertainty in the supply chain. When a firm orders goods or services from its supplier, uncertainty arises regarding both the quantity that will be delivered and the time the order will arrive.

Towill, Childerhouse, and Disney (2000) classified supply chain uncertainty into the following four broad categories:

1. Process uncertainty affects the internal capacity of the organization to reach planned production.
2. Supply uncertainty indicates that the supplier cannot fulfill the organization's requirements in terms of time, right amount, and correct specifications — quality or price.
3. Demand uncertainty concerns the predictability of demand quantity and product variety.
4. Control uncertainty relates to the information flow within the organization and the way the organization transforms orders into production goals and material requests.

Uncertainty encompasses risks and contingency planning, both of which should be integral parts of supply chain planning and decision making. In "Supply-Side Contingency Planning," Gregory Gilbert and Michael Gips (2000) identify the following components as vital to dealing with risks:

Identifying risks involves considering all possible risks, along with their full impact on operations. Risks that involve the supply chain as a whole — including disruptions from utility suppliers such as water, electricity, and telecommunications — need to be assessed. The question must be addressed: what back-ups are in place for each supplier in case disruptions occur in their section of the supply chain? The risk management team should examine the supplier's managerial procedures, processes, financial health, and resources, and where applicable, their own suppliers.

Assessing risks, based on the potential impact of each risk, requires examining each risk for less recognizable effects and determining what measures need to be implemented to address all problems. A common example — the loss of power — proves particularly significant, as a power outage disrupts security precautions in addition to halting the production line. International suppliers run the risk of strikes, weather and natural disasters, and national security interruptions. Risks related to shipping also foster the need for a backup supplier in a second geographical area.

Risks and Supply-Side Contingency Planning

Gilbert and Gips (2000) cite the following example: "Disasters may strike all such companies in a geographical area, and if a business relies solely on this arrangement, it will have little recourse" (para. 26). They recommend the following considerations for addressing risks:

Ranking risks involves listing each risk according to impact and likelihood. The cost of business disruption versus the cost of a contingency agreement must be examined, as well as the level of risk the company is willing to tolerate. Supply chain professionals need to rank risks according to scenario and cost, and determine the tolerance level the company is willing to accept. Recovery times may be charted, and plans implemented to achieve targeted recovery times for different incidents (Gilbert & Gips, 2000).

Managing risks is best achieved in a well-prepared company. A useful guideline for supply chain professionals: invest significant detail in high-risk incidents and less in smaller risks. Gilbert and Gips (2000) also identify the following factors as vital considerations for effectively managing risks:

Supplier choice: The best suppliers are not affected by continual natural disasters or subject to civil and military unrest. Supply chain professionals need to examine the continuity planning, financial health, business stability, integrity, and reliability of utility suppliers (Gilbert & Gips, 2000).

Diversity provides for competitive bidding and prevents emergency incidents. Backup suppliers must be able to accommodate an increase in business when the need arises. Should a supplier face natural or military unrest within their region, diversity provides for the continued flow of supplies (Gilbert & Gips, 2000).

Stockpiling: Due to the critical nature of some equipment, numerous companies maintain an inventory of parts and components. A number of IT departments, for example, stockpile servers, disk drives, modems, monitors, and other hardware. Companies relying on suppliers with patented processes often stockpile goods, as no ready source of these inventories would be available if the supplier encountered a problem (Gilbert & Gips, 2000).

Insurance proves to be a viable option for companies depending on suppliers with patented processes. Purchasing the supplier outright offers a backup plan for some companies, though this may prove too costly. In addition, the acquisition of a new company compounds administrative burdens and could veer the business from vital core competencies. Furthermore, owning the supplier only reduces disruption risk arising from disputes, not from other risks such as natural or civil disasters (Gilbert & Gips, 2000).

Pooling resources with other companies at times provides a degree of backup protection. When disaster strikes one business, other businesses can assist the affected party. Challenges may arise with these arrangements, however, as disaster may strike each of the companies in a geographical area simultaneously, leaving those businesses that depend solely on such arrangements with little recourse (Gilbert & Gips, 2000).