Production Chain Disruptions: Inventory, Preparedness, and Insurance

Firms use inventory and interruption insurance to manage disruption risk in their production chains. They also take preparedness actions to reduce the expected length of disruptions. We analytically explore these three measures in a two-stage production chain. We find that inventory and preparedness differ in their responses to insurance and to production-chain cost and risk characteristics. We prove that, for any fixed level of preparedness, insurance reduces both the total inventory and the downstream inventory but it can increase the upstream inventory. The total inventory, the upstream inventory, and the production-chain profit all increase (decrease) as cost (risk) shifts downstream in the production chain. Downstream inventory moves in the opposite direction. If the firm adopts the preparedness measure but not inventory, we prove that insurance has no impact on the relative levels of upstream/downstream preparedness. Relative preparedness is also unaffected by the distribution of processing cost in the production chain. However, when the firm can adopt both operational measures – inventory and preparedness – the relative preparedness is affected by insurance and by the distribution of processing cost across the production chain. We numerically observe that the production chain profit increases as cost shifts downstream and risk shifts upstream.