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When the Chain Breaks… Assessing Damages in Cases Involving Disruptions to Complex Supply Chains

Along with the opportunities of a global economy have also come great complexities in assembling and distributing goods for a global customer base. Typically, these supply chains involve several “tiers” of suppliers, each providing an incremental level of value-added service, machining, or assembly. Such supply chains can be found in nearly every industry including automotive, apparel, telecommunications, and information technology, among others.

To facilitate the movement of goods around the globe, not only must companies develop strategic business relationships with multiple tiers of suppliers worldwide, but arrangements must also be made with logistics providers to physically move the goods. In many such supply chains, a single good may utilize rail, plane, truck, and ocean freight simply moving from one supplier to another.

Disruptions to this complex supply chain can be caused by many factors. Certainly, adverse weather can impact the flow of these goods. Additionally, the failure of a supplier to produce parts in a timely fashion and ship them to the next supplier can also cause significant disruption. Further, the quality of the goods can also impact delivery quantities and timing. If a supplier has poor quality controls it may have a difficult time meeting production deadlines. Alternatively, poor quality parts may be shipped to the next supplier who will likely reject the parts, requiring the original supplier to produce additional quantities in an expedited fashion.

With an increasing global effort to utilize global supply chains and to do so on a lean, just-in-time basis, small deviations in shipment quantities or dates can result in significant disruptions to the supply chain. Supply chain disruptions of these sorts often may lead to significant damages, depending on the nature of the supply chain and the type of parts being produced.

Priming the Pump

As complex global supply chains evolve and production schedules are developed, suppliers and manufacturers will often communicate regarding expected delivery timing needs. During pre-production and testing phases, it is not always necessary to have defined delivery timelines as the parts are not being utilized in final assemblies. However, as full production needs approach, the supply chain begins to receive the flow of parts.

As it may take weeks for parts to be shipped across the globe, weekly part shipments may be necessary to ensure the continued flow of products throughout the supply chain. While there may be fluctuations in customer demand (often communicated with “releases” or purchase orders), the supplier may find it necessary to ship on a regular basis to ensure there is a continuous flow of parts arriving at the customer location. Variances between ordered quantities and shipped quantities may later be identified through periodic audits or reconciliations. As a supply chain operating in this manner relies on the continuous flow of parts, a missed shipment may result in the supplier being unable to meet the production demands of the customer. A complication of this sort will often result in additional costs incurred by both the supplier and the customer, and disputes may arise when there is a disagreement over which party should bear the costs.

Damages – Out-of-Pocket Costs & Lost Profits

Out-of-Pocket Costs

In the event there is a disruption in the supply chain, the shipment of parts may be temporarily halted for a period of time, resulting in a gap in the continuous flow of product being received by the customer. In situations where the supply chain is operating on a lean, just-in-time basis, a halt in the flow of parts even for a short period of time can result in a shortage. To make up for the shortfall, it may be necessary for the supplier to make efforts to bridge the gap by utilizing expedited or additional shipments.

Irregular, expedited shipments often come with significant increased costs. In addition to being more costly per shipment, the method utilized for expedited shipments (by plane, for example) may require the shipments to be made in smaller quantities due to space restrictions. As such, it may be necessary for the supplier to make multiple, smaller shipments at a higher cost. Under certain supplier-customer arrangements, the supplier may debit its customer for the full amount of the expedited shipping costs. However, in the event the customer claims the disruption leading to additional shipping charges was caused by the supplier, these costs may represent a form of damages sought by the customer. Alternatively, if the arrangement was such that the supplier paid for the shipping costs up front, the supplier may later seek to recover damages if it claims the customer was at fault for the disruption (e.g. irregular or shortened lead times requested by customer).

An assessment of damages requires not only an analysis of the actual expedited shipping costs incurred, but also a consideration for the shipping costs that would have been incurred “but-for” the supply disruption. A detailed analysis of historical purchase orders, invoices, shippers, and receiving documents may be necessary to determine the ordinary shipment sizes and methods utilized. Further, the lead time of historical shipments should also be considered in evaluating damages. It may be found that the supplier made unnecessary shipments of parts in an expedited fashion to satisfy customer demands that could otherwise have been satisfied by less costly means.

In addition to expedited shipping charges, the temporary disruption in the supply chain may require a modification to supply chain logistics to accommodate the new part requirements. It may be necessary to ship additional parts by some alternative means, such as by truck rather than rail, or by multiple partial shipments utilizing the same shipment method. For example, after a quality issue leading to the rejection of parts by a customer, a supplier may need to prepare additional parts for shipment immediately. If a regularly scheduled shipment is not an option, it may be necessary to utilize alternative carriers or shipping arrangements different from those typically utilized. The use of alternative short-term arrangements may lead to additional costs incurred by the supplier or the customer.

Further, after a quality issue is discovered relating to the parts received from a supplier, the customer will often incur significant administrative costs associated with product testing, quality sorts, or repackaging of parts. Parts may have to be inspected individually to determine whether they are fit for incorporation into the assembly or product being produced. Poor quality parts that are rejected as a result of the sorts may have to be disposed of, sent back to the supplier, or scrapped at large discounts. If there are labor or transportation costs associated with the sorting and disposal of parts or the shipment back to suppliers, this may represent additional damages to the customer. Alternatively, if scrap value associated with the rejected parts is recognized by the customer, this may represent an offset to damages as this benefit would not otherwise have been recognized absent the quality issue.

Damages relating to expedited shipping costs, administrative, and other out-of-pocket costs are often limited to the incremental difference in costs between the actual case (with supply or quality disruptions) and the “but-for” case (without supply or quality disruptions). In the “but-for” case, certain levels of these costs would still be incurred. As such, damages would be limited only to the additional costs that were incurred directly as a result of the quality issue or supply disruption.

Lost Profits

In instances where the end customer could not be serviced due to volume shortfalls associated with the supply disruption, the customer (e.g. Tier 1 supplier) may assert a lost profits claim associated with the profits that would have been recognized on the sale of products “but-for” the disruption. Often, a Tier 1 supplier may claim that if adequate parts had been available from the Tier 2, it would have been able to produce additional assemblies or product quantities and would have recognized profits on sales made to its customers. Further, in the event the supply disruption led to a contract termination, lost profits could also relate to parts already in transit. It may be the case that the Tier 1 supplier incurred costs to produce and ship parts, but was not able to recognize the full amount of revenue, and profits, associated with them.

However, the Tier 1 supplier will often go to extreme measures to ensure it is able to meet demand and maintain customer relationships. As such, out-of-pocket expenses may be significant, so as to reduce potential additional damages associated with lost profits.

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Causation

In certain instances, additional expertise may be necessary in order to establish that the additional costs were incurred directly as a result of a supplier failure. That is, that the damages can be causally connected to certain actions or failures of the supplier. An assessment of causation can be relevant with respect to validating supplier quality reports or the timing of purchases orders or invoices in order to establish the reasons for late shipments.

Additionally, an analysis of causation may be necessary to determine the structure of the supply chain. The damages incurred are often directly related to the complexities of the supply chain. While the actual world will be defined by actions of the supplier, the “but-for” world will often be defined by the way the supply chain should have worked. This will consider the flow of parts that should have occurred within the supply chain. Often, the “but-for” scenario assumes goods would have flowed on a continuous basis to ensure that parts arrived at the customer as needed.

Further, one wouldn’t expect damages to be in excess of the value of the goods reasonably expected to be in the supply chain based on the customer’s requirements. Certain suppliers may choose to manage their risk by maintaining excess goods in the supply chain. However, in the event of contract terminations, disputes may arise relating shipping costs or lost profits associated with these excess parts. It may be found that out-of-pocket costs or lost profits associated with these parts are not recoverable as damages, as any detriment to the supplier may have been caused by its decision to manage its risk rather than the actions of its suppliers or customers.

Mitigation

As in any case involving economic damages, the damaged party’s ability to mitigate damages is often an important consideration. A damages analysis should consider whether the necessary steps were taken to limit the costs being incurred, or to understand the alternative to the actions taken – often, shutting down a customer’s facility.

For example, if a party is claiming lost profits relating to a supply disruption, the option to make expedited shipments or modify shipping arrangements in order to meet demand and mitigate damages should be considered. Further, if parts were rejected due to quality failures, it is important to assess whether the customer made efforts to recover the costs of any damaged goods, scrap, or unused parts. To the extent the damaged party took steps to mitigate, or had the opportunity to mitigate and chose not to do so, damages would be offset by the costs avoided from doing so.

Conclusion

Global supply chains are often dependent on the seamless supply of parts between multiple tiers of suppliers across continents. When this supply chain breaks down, even temporarily, it can have broad-reaching effects on both suppliers and customers. The responsible party or ultimate cause for such disruptions is often disputed. However, the application of damages concepts remains unchanged across scenarios. An assessment of damages relating to a quality issue or supply disruption often will involve an actual vs. “but-for” analysis of both out-of-pocket costs as well as any lost profits associated with the halt in supply. Further, the issues of causation, as well as the parties’ opportunities to mitigate, can be especially important to consider in a dynamic, fast-paced global supply chain where multiple parties play a role in producing and shipping parts for the same product.