Risk propagation through payment distortion in supply chains

Abstract

The supply chain literature has devoted much attention to studying how the variability of orders propagates upstream. We explore how this insight extends to the variability of payments to suppliers and its impact on how risk is generated and propagates upstream. To do so, we model the financial features of a supply chain based on industry reports and empirical findings from the finance literature. Capturing policies and constraints of the agents in the supply chain in a formal model, we are able to generate and explain the behavior observed in real supply chains. We show that payment variability occurs and propagates, even if orders are constant, in a cash-constrained supply chain. Furthermore, our model reveals that payment variability may even become amplified under severe cash restrictions. We identify the factors that drive the propagation of variability—the industry risk, the firm's operational leverage, the existence of a financial leverage target, and the cost of debt. The model also makes it possible to explore states of nature not often observed in practice, but that may have an effect in managers' behavior, for example, bankruptcies. We numerically illustrate the impact of these drivers on the risk of upper echelons (suppliers and suppliers' suppliers) as well as the interactions between order and payment variability. We close by summarizing our findings and discussing future research opportunities.