Question

Part II: Evaluate Disaster Risk in Supply Chain

Suzy Jones is trying to decide whether to use one or two suppliers for the motors than go into the chain saws that her company produces. She wants to use local suppliers because her firm runs a JIT operation. Her factory is located in a coastal town that is prone to hurricanes. She estimates that the probability in any year of a "super-event" that might shut down all suppliers at the same time for at least two weeks is 5%. Such a total shutdown would cost the company approximately $100,000. She estimates the "unique-event" risk for any of the suppliers to be 10%. Assuming that the marginal cost of managing an additional supplier is $12,000 per year, should Suzy use one or two suppliers?

Answer 1

We can use following equation which states the probability of a total disruption of n supplier simultaneously

P (n) = S + (1 – S)* Uⁿ

Where

S is the probability of supper event where all suppliers will be disrupted = 5% or 0.05

U is the probability of unique event where only one supplier will be disrupted = 10% or 0.1

Now using it for 1 or 2 suppliers

P (1) = 0.05 + (1 - 0.05) * (0.10) ^1

= 0.05 + (0.95) *(0.10) = 0.145

And

P (2) = 0.05 + (1 - 0.05) *(0.10) ^2

= 0.05 + (0.95) *(0.01) = 0.0595

Expected Monetary Value (EVM) for supplier = (n*C) * (1- P) + (L+ n*C) * (P)

Where,

P is the probability of a total disruption (as calculated above)

n is the number of supplier

L is the financial all incurred in a supply cycle if all suppliers will be disrupted = $100,000

C is the marginal cost of managing one supplier = $12,000

Therefore,

EMV for one supplier = 1 *$12,000 *(1 - 0.145) + ($100,000 + 1* $12,000) *(0.145)

= $10,260 + $16,240 = $26,500

EMV for two suppliers = 2 * $12,000 *(1 - 0.0595) + ($100,000 + 2 *$12,000) *(0.0595)

= $24,000 *(1 - 0.0595) + $124,000 *(0.0595)

= $22,572 + $7,378 = $29,950

Here the Expected Monetary Value (EVM) or cost of managing two suppliers is more than the one suppler. Therefore company should choose one supplier.