Profit or Bust

New research finds that when a firm is bankrupt it has an impact on its supply chain – as well as on employees and shareholders.

New research finds that when a firm is bankrupt it has an impact on its supply chain – as well as on employees and shareholders.  
profit or bust finalMany of the world's well-known business brands have faced bankruptcy at some point in their existence. Some succumbed, some survived. Whatever the outcome, for corporations large and small, confronting the possibility of going bust is likely to have long lasting effects. 

In some jurisdictions, bankruptcy does not necessarily signal a corporation's demise, merely a period during which a firm can reorganise while gaining relief from creditors –even under the existing management. Take Chapter 11 of the Bankruptcy Reform Act of 1978 in the US. Many US firms, including General Motors and Kmart, for example, have sought Chapter 11 protection in bankruptcy, and survived to tell the tale.  

The impact of bankruptcy and the reorganisation involved as ailing firms struggle to survive, is not confined to a bankrupt firm's employees and shareholders, as Alex Yang and his co-authors John Birge and Rodney Parker, reveal.  There is the supply chain to consider. The fate of all the firms involved, good and bad, depends on a series of complex value chain interactions.

The authors constructed a simplified model of a supply chain consisting of two competing downstream firms, one which is distressed and may file for bankruptcy, and a common supplier. Using the model the authors identify three distinct but co-existing effects arising from the interplay of the supply chain members. The prominence of these effects at any given time partly depends on the cost of staving off bankruptcy. This can be considerable, with reorganisation costs including legal expenses, financing costs, and losses from selling assets to fund operations.

In the run up to entering bankruptcy there is a predation effect. Rival firms are incentivised to compete aggressively with the ailing company, drive it into bankruptcy, and grab its market share. If the supplier lacks pricing power both consumer and rival firm stand to benefit. If the supplier has strong pricing power it can take advantage of the rival firm's increased demand, extracting more value at the expense of the rival firm.

The bail-out effect, suggests that when reorganisation costs are low the supplier should support the distressed company through lower wholesale prices and avoid losing a sales channel. This redistributes the costs of bankruptcy. Better still, if the supplier can raise wholesale prices for the rival firm, the distressed company and supplier will benefit in the long run, while the rival firm suffers.  

As reorganisation costs rise, however, and the cost to the supplier of supporting reorganisation grows, the supplier's strategy changes. Now it becomes more profitable for the supplier to help the rival firm crush the near bankrupt company – the abetment effect. What the supplier loses from its customer going into liquidation, it gains through increased prices to the rival firm.

The research reveals that the outcome of bankruptcy situations is not as intuitive as might be expected. Distressed firms may benefit, to the cost of their rivals.  Rival firms cannot assume that having a competitor facing bankruptcy is a good thing. Suppliers must weigh up whether or not it would be better to support the ailing firm, or add to its problems. Policymakers should consider how the costs of reorganisation affect these supply chain interactions.

“The supply chain effects of bankruptcy” by S. Alex Yang, John R. Birge and Rodney P. Parker is forthcoming in Management Science.

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