uncertainty in supply chainThere is no doubt that uncertainty in your supply chain costs you money every year, but the multi-million dollar question is “how much?”  To answer this question, we first have to identify what causes uncertainty in a supply chain.  From there, we can gain an understanding of how the additional costs of uncertainty manifest themselves.

Uncertainty in the supply chain is caused by many factors, chief among them are changes in demand and demand variability, seasonality, transportation, receiving variability, and quality issues.  All of these factors impact the inventory levels you need to carry excess inventory in order to continue normal operations without risk of stock-outs in your stores or line-down situations in your factories.  As a result, the natural solution is to hold excess inventory so that we can still meet our customers’ demands despite whatever is happening in the world around us.  This is an important part of risk mitigation, because companies today cannot afford lost production or lost sales as a result of any type of supply chain disruption.

Further muddying the inventory waters is something called “organic inventory growth.”  That is, permanent inventory buffers that are caused by one-time events.  For example, if one of your factories has a rough quarter and really gets beat up because of a line-down situation that was caused by a longer-than-expected lead time from a supplier, there is a natural tendency to ensure that it never happens again.  We see this manifest itself at every company we work with; there are always situations where we find buffer inventory added to an existing safety stock target.  A buffer for your buffer, if you will.  These situations persist because there is rarely a mechanism in place to back out the additional buffer inventory, so they just continue to pile on over time.

Once we understand where our uncertainty comes from, we can measure how much it costs us by multiplying the dollars of excess inventory (excess inventory being that which you hold above what is needed assuming “normal” operations) by our holding cost.  So if we have a fictional firm with a 15% holding cost that holds $1MM in excess inventory because they have unreliable transportation times, that extra inventory represents a $150K cost to the firm each year.  And this is very typical of companies that we have worked with at OPS Rules.  We can always find a business reason to hold a little extra inventory here or there, and while in each instance it may not seem like much, the dollars do add up.

There is of course an important trade-off here: namely that as you increase your inventory, your ability to meet higher service levels increases.  This cannot be understated, because service level is at the core of your business.  If you cannot meet your customers’ expectations, they will go elsewhere.  On the other hand, the cost of higher service levels usually increases exponentially as you approach 100%.  In other words, you may only need 5% more inventory to move from an 85% service level up to 90%, but going from 98% to 99% could mean 20% or more additional inventory.  A typical trade-off curve will look something like this:

savings

Let’s look at a more specific example of how this plays out in a real life scenario.  We had a client that was experiencing some pain from high variability in their lead times from suppliers.  Some orders would be processed and shipped in a matter of days while others were taking weeks or even months…and this was for the same product from the same supplier!  As a result of this, the company made it a habit of holding extra inventory as a buffer against the possibility that a shipment would arrive much later than expected.  After assessing the issue using inventory modeling, we were able to determine that if they could cut lead time variability by 20%, they would be able to reduce inventory by over 15%.

We have a saying here at OPS Rules: “Show me uncertainty and I’ll show you the inventory and missed orders it drives.”  It is a rule of business that uncertainty will impact inventory.  As supply chain professionals, it is our job to understand what causes it and how to mitigate it with as little extra cost as possible.  To accomplish this, we employ methodologies that engage leadership and seek to fundamentally understand supply chain drivers so that we can we can deliver actionable plans for mitigation.

Written by Jeff Keene, a consultant at OPS Rules.