Building Supply Chain Resilience Through Vertical Control

We study the value of two types of vertical control—vertical integration and direct sourcing—for firms seeking to increase resilience towards random raw materials shortages. We use a model of sourcing in a three-tier supply chain in which a Tier 0 buyer sources a critical component from Tier 1 suppliers, who in turn source raw materials from disruption-prone Tier 2 suppliers. With vertical integration, the buyer purchases one or more Tier 1 suppliers, taking control of their inventory and sourcing decisions. With direct sourcing, the buyer purchases raw material directly from Tier 2 and sells to Tier 1. We first study each type of vertical control in isolation, and show that, in general, both types are most valuable to the buyer when Tier 2 disruptions are highly correlated, and the likelihood and severity of disruptions are both moderate (neither too high nor too low); otherwise, the buyer may be better off employing traditional disruption mitigation strategies such as holding excess inventory and multisourcing. We also consider the buyer's choice between vertical integration and direct sourcing, and show that the buyer's preference between the two depends critically on the severity of disruptions, rather than their likelihood or correlation, with vertical integration preferred for more severe disruptions. Together, our results show that both types of vertical control—vertical integration and direct sourcing—can be valuable additions to the portfolio of strategies firms use to mitigate disruption risk, although they are not a panacea and are most effective under specific circumstances.