Why Buying Your Supplier Doesn’t Always Make Supply Chains More Resilient

When critical raw materials are not caught up in trade wars, they remain vulnerable in complex networks that can easily falter. Global pandemics, geopolitical instability, and extreme weather events have made supply disruptions increasingly common in the last five years. 

To mitigate risk, companies consider strategies like ‘vertical control,’ either taking over their lower tier suppliers, or sourcing raw materials directly from producers. This has gained traction in industries like automotive and electric vehicle (EV) sectors, where some firms have begun building their own battery manufacturing plants.

However, vertical control “is not a one-size-fits-all solution,” said Professor Robert Swinney of Duke University’s Fuqua School of Business. “It’s rather one of the possible solutions, and its effectiveness depends on the likelihood and severity of the disruption.”

In the paper, “Building Supply Chain Resilience Through Vertical Control,” Swinney and colleagues — Nitin Bakshi of University of Utah and Ali Kaan Tuna of Tilburg University — built a model to study the value of vertical integration to increase resilience and prevent raw materials shortages.

The researchers found that vertical integration is generally optimal when the disruption risk is moderate. Conversely, when risk is high or low, other forms of mitigation — such as offering premiums to suppliers to help subsidize their risk mitigation efforts, instituting non-delivery penalties on contracts, or diversifying suppliers — might be more effective.

Misaligned incentives between buyer and suppliers

In the paper, the researchers described a three-tier supply chain model which demonstrates that companies at different levels don’t have the same motivations to prevent disruptions.

The three-tier supply chain is described as such:

• Tier 0: Consumer-facing company that sells the final product (like an EV automaker)
• Tier 1: Component manufacturer (like a battery producer)

Tier 2: Raw material supplier (like companies mining nickel or lithium)

An EV automaker (tier 0) buys components like batteries from a supplier (tier 1), which purchases raw materials from lithium companies (tier 2) to create their own products. 

The researchers’ model reveals how the various tiers manage risk based on their financial incentives. For example, the battery manufacturers might do more to avoid shortages if they are paid more. They might diversify their raw material suppliers, or source from more reliable raw materials suppliers (which will probably cost more).

“If you're the buyer, you basically need to inflate the wholesale [battery] price enough, so that the supplier is going to have the proper incentive to mitigate its own upstream supply chain risk,” Swinney said. “You pay them more to put more skin in the game.”

Normally, the consumer-facing buyer has more incentive to mitigate disruption risk, because its stake in the event of missed sale is higher — the whole value of the car, profits plus production costs, including batteries. The Tier 1 supplier has less “skin in the game,” because if it can’t produce a battery because of raw material shortage, it will only lose the profits from the battery sale.

“It’s not nearly as much pain as the buyer would feel, if they missed out on sales,” Swinney said.

A range of risk-mitigation tools: contracts, diversification, vertical integration

One approach is simple: pay suppliers more. Researchers call this a “supplier mitigation” strategy, where higher prices motivate suppliers to better manage their own risks.

Other strategies include “multi-sourcing,” where companies buy materials from various suppliers. Or alternatively, they might hedge their inventory by purchasing materials in places more protected from risk (for example, a region less prone to weather events or political unrest).

Another option is for the buyer to directly control the sourcing decision.

“If the buyer purchases a supplier, then it can make all of those sourcing decisions for itself” Swinney said. “The buyer no longer needs to incentivize the supplier with a higher price to make the decisions it prefers.”

Enter “vertical control.”

The trade-offs of each strategy

Vertical control can take two different forms, the researchers explained. 

1. The Tier 0 automaker (the buyer) can acquire the Tier 1 battery manufacturer, gaining direct control over sourcing and risk management. This is ‘vertical integration.’
    
2. Alternatively, the automaker might directly deal with Tier 2 raw material suppliers, then provide those materials to the Tier 1 battery manufacturer. This form of vertical control is called ‘direct sourcing’ and has different cost implications for the automaker.

While vertical integration requires a lot of capital investment to take over the battery manufacturing company (higher fixed costs), going directly to the source to buy lithium or nickel can mean higher costs per unit (higher variable costs). 

The researchers found both forms of vertical control are less beneficial when the risk of disruption is most severe — meaning a disruption would lead to a significant and prolonged shortage of essential materials.

Imagine an earthquake, a low-probability event with a severe impact. “If the factory gets directly hit with an earthquake, then it could be offline for six months or more,” Swinney said. On the other hand, high-probability events, like hurricanes in certain regions, may have less severe impact. “A hurricane might cause transportation delays on local roads, but maybe it’s only going to interrupt the flow of material for a few weeks,” he said.

Why vertical control is less essential when risk is high

Interestingly, when facing high-impact events, vertical control becomes less necessary, Swinney said.

“You might think naively that when the risk is very bad, then you want to jump in and buy the supplier or just go around the supplier and get the raw materials yourself. But that's not the case,” he said. “The reason is that when the risk level is very high, the incentives of the supplier are not as misaligned with the buyer’s incentive.”

Swinney explained that in these situations, the suppliers will also do their best to counter such risk — so they won’t lose their margin. In this case, the incentives are more aligned, and the buyer only needs a small increase in the wholesale price to induce suppliers to implement risk-mitigation practices.

“The carrot that you have to offer is small, if the supplier is already facing a significant risk,” Swinney said.

However, if the risk is moderate, the buyer would need to offer a substantially higher wholesale price to incentivize the supplier to do more to protect against disruption. In such cases, vertical control can be more effective, Swinney said.

At the other extreme, when the risk is low, the cost of vertical integration outweighs any potential benefit of mitigating that minimal risk, he added. 

Alternative strategies: Penalty contracts and multi-sourcing

The researchers also considered other different strategies, including penalty contracts — penalizing the supplier if it fails to deliver the product — and diversification of Tier 1 suppliers (called ‘multi-sourcing’).

They concluded that penalty contracts and multi-sourcing would be beneficial in cases of severe disruptions. However, vertical control is still more efficient when the disruption risk is moderate.

Key Takeaway: A diversified approach to resilience

Swinney said these insights are relevant not only for multinational companies with global supply chains, but also for mid-size companies, such as startups (some of which are already vertically integrated), and businesses with domestic supply chains.

“My general takeaway is that vertical integration is not a one size fits all solution for risk mitigation. It is good in certain contexts. There are times when you would rather use penalty contracts, which are more sophisticated contracts but with their own limitations. Then there's a time for increasing sourcing diversity, and a time for increasing vertical control. And there's a time when using a simple contract is actually cheaper than doing any of the other things,” Swinney said.

“Ultimately, it all depends on the risk level and how this affects the different incentives of everyone involved.”