Production Chain Disruptions: Inventory, Preparedness, and Insurance

Disruptions that temporarily interrupt production pose a significant risk for manufacturing firms. To manage this risk, firms can purchase interruption insurance and/or deploy operational measures such as storing inventory or taking preparedness actions that reduce the expected interruption length. In this study, we explore inventory, preparedness, and insurance in a two‐stage production chain that can experience disruptions at either the upstream or downstream stage. We analytically characterize an inventory‐only model and a preparedness‐only model in which the firm uses either inventory or preparedness effort to manage disruption risk, and a joint model in which the firm deploys both operational measures. We identify the relationships between the two operational measures within a stage and across the two stages. We also examine how insurance affects a firm's optimal deployment of and preference between the two operational measures. In addition to providing insights into the interaction of these three risk management measures, our results provide insights into the production chain design. For example, the firm can reduce its disruption risk management cost by allocating more production activity downstream (when possible) and this risk management benefit can, at times, outweigh the possible production cost increase associated with allocating more production downstream.