When a major, unforeseeable event like the 2011 Japan earthquake sends shockwaves through supply chains, how do companies adjust operations? Christian Durach, Tomas Repasky and Frank Wiengarten write that exposure to disruptive events increases the perceived probability of a recurrence, no matter how unlikely it may be. After the event, managerial decisions appear to be influenced, at least partially, by instinctual reactions and incomplete data.

It is very easy to pepper inspirational speeches with glib phrases like “expect the unexpected,” but when it comes to detailed strategic planning, it is very difficult for firms to prepare for the truly unforeseeable. Even more so for black swan-type, low-probability high-consequence (LPHC) events, due to their unpredictable timing and unknown impact. LPHC events include what insurers archaically refer to as “Acts of God” (volcanic eruptions, hurricanes, floods), man-made industrial accidents (like the Rana Plaza collapse) and terrifying pandemics (like COVID-19).

These events can be extremely disruptive, like the 2010 eruption of the Eyjafjallajökull volcano in Iceland that caused a virtual lockdown of European airspace. They severely impact global supply lines, with dire economic consequences. Especially as supply chains are increasingly designed for efficiency with low inventory levels, which makes them more vulnerable to disruptions.

In our recent research article, we noted that the cumulative effects of the March 2011 Great East Japan Earthquake such as power outages, fuel shortages, and breakdowns in supply and delivery lines, affected the entire country and significantly impacted Japanese industry, with an 80 per cent drop in vehicle production in April 2011 compared with January-February for example.

While the tsunami and earthquake in Japan have produced soul-searching about how the industry should react, we can only observe that empirical research has offered little guidance so far. In fact, such events have always been threats to firms, yet surprisingly little is known about how firms adapt, in terms of longer-term preparation for future LPHC events.

Two main approaches to improve corporate resilience

But should firms even bother making provisions for future shocks, if they are both improbable and unpredictable? Some fellow scholars have suggested that companies could simply not prepare at all, or purchase insurance.

After all, two of the most discussed theoretical approaches to improving operational resilience, that is, holding (excess) inventories and/or volume flexibility, come at a cost. While strategies for increasing flexibility (use of overtime, outsourcing, etc.) are considered more cost-effective than simply increasing inventories, they still require the firm to compromise between investing in resilience factors versus capital improvements and innovation. The risk is that inefficient inventory and flexibility investments may consume more resources than they can protect for firms and the economy.

But little is known about how most firms actually react to LPHC events beyond a few anecdotal examples observed in the immediate aftermath of the 2011 Japanese earthquake: Merck and ZF-TRW, an automotive supplier, responded by building up inventories, while Toyota stated that it did not intend to abandon its low inventory strategy in the face of disruptive events.

Firm responses to the 2011 Japan earthquake

We decided to address this gap of knowledge, considering that understanding inventory and flexibility patterns will allow us to explore their economic sustainability, drivers, and downsides and simply provide better guidance to industries.

Using the specific, geographically well-defined event of the 2011 Japan earthquake as a natural experiment, we carried out a study of more than 13,000 manufacturing firms between 2004 and 2017. We found that affected firms appeared to have increased their inventory levels and, for a shorter period, their volume flexibility. This first finding was somewhat unexpected since the development of long-term inventory buffers is economically impractical. This general assumption is supported by our analysis, which shows that the inventory shifts identified between 2013 and 2017 reduced the affected firm’s return on sales by between 17.5 and 23.1 per cent.

More detailed explorations into adjustments of different types of inventories showed an immediate increase in RAW (raw material) inventories, while WIP (work in progress) and FG (finished goods) inventories were reduced after the event with a one-year lag. We suggest that specifically increasing RAW inventories is a form of product flexibility – effective for addressing supply-demand imbalances for individual products, but less so than volume flexibility in addressing imbalances across a wide range of products – which is what occurred during the earthquake.

Tentative explanations for the behavioural patterns

The observed patterns were found to be altered by firms’ risk preferences, and availability of inventories prior to the event. Risk-averse firms were found to have significantly larger increases in RAW inventories after the earthquake than risk-seeking firms. An increased buildup of inventories was also noted in firms that had relatively high RAW and FG inventories prior to the event. In contrast, firms that had greater volume flexibility before the event appear to have reduced it to a relatively greater extent afterwards.

Regarding decisions about inventories, we suppose managerial perceptions, and preferences for familiar approaches over new, uncertain ones, may be an explanation: Managers who have already factored high uncertainty into their inventory and flexibility decisions prior to a disruptive event might see their forecast confirmed by the event and decide to maintain the already high levels.

In any case, if the patterns are driven by risk aversion and prior resource availability, it is likely that managers do not conduct a fully informed cost-benefit analysis after an LPHC event before deciding whether and how to adjust resilience. In other terms, they follow their gut feeling, no matter how irrational it may be. Indeed, it has long been argued in the psychological literature that exposure to LPHC events increases the perceived probability of the event recurring, even though the statistical likelihood remains extremely low or even unchanged.

Still, we find the timing and duration of the changes (delayed decline in WIP and FG inventories, temporary increase in flexibility) interesting, as they suggest that the affected firms made not only a one-time adjustment decision but also began some kind of search for a new operational equilibrium after the event.

• This blog post is based on Patterns in firms’ inventories and flexibility levels after a low-probability, high-impact disruption event: Empirical evidence from the Great East Japan Earthquake, in Production and Operations Management.
• The post represents the views of its authors, not the position of LSE Business Review or the London School of Economics.
• Featured image by Climate and Ecosystems Change Adaptation Research University Network, under a CC-BY-2.0 licence
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