Every supply chain is rife with variability and uncertainty. This adds costs, problems with customers, and headaches and firefighting for supply chain managers.
Safety stock plays a critical role in a helping you run a good supply chain despite the inherent variability and uncertainty.
Safety stock allows you to seamlessly meet unpredictable spikes in demand, and it allows you to protect your customers from production breakdowns, supplier failures, or unusually long shipment times. Safety stock helps increase sales, reduce late shipments to your customers (keeping them happy or avoiding contractual penalties), and reduce the cost of expediting by minimizing the times you are short on stock.
However, safety stock is not free. It ties up cash that could be better invested in other parts of the business. It costs money in terms of the opportunity cost of that capital, the cost to insure the inventory, the cost to store the product, and the cost of theft or damage.
Also, it is not a good strategy to simply have large piles of safety stock throughout the supply chain. While this might help you meet unexpected spikes in demand or cover for the late shipments, it can also become a huge liability if the demand fails to materialize or the product becomes obsolete before you can clear the inventory.
This is where inventory optimization comes in. Inventory optimization helps you manage the delicate balance between the benefits and costs of safety stock. Inventory optimization determines where you should buffer inventory and how large those buffers should be. It also helps you maintain the correct amount of inventory and safety stock for each item at each location.
It achieves this by analyzing the full supply chain simultaneously and suggesting changes in where you buffer, suggesting changes to your service levels, and providing scientifically-determined safety stock numbers to replace the current rule-of-thumb numbers. To maintain the right inventory levels, you just need to repeat the run on a weekly or monthly basis and update the safety stock targets.
(As a side note: If you still think the amount of safety stock is too high, you don’t want to just reduce it. Instead, use inventory optimization to help you identify and fix the root cause of the problem and let safety stocks decrease naturally).
Inventory optimization should not be confused with inventory management. We have found that companies, for the most part, have good inventory management systems. That is, companies have systems in place that keep track of inventory, provide inventory visibility, and place and manage replenishment orders. But these same companies lack the processes and systems for developing a good safety stock and buffer strategy. Without a good safety stock strategy, the best inventory management systems will not help a supply chain cope with variability and uncertainty.
What this all means is that leading firms now realize that using inventory optimization to set the right safety stocks is a critical business process. The business will not run as well if you do not have a robust and disciplined process in place.
Innovations in inventory optimization technology and processes over the last few years now make this very accessible for firms. For example, the innovations provide better optimization, allow for different decisions at different times throughout the year, and better integrate into your existing systems and workflows.
I teach graduate level business classes and have used the “Factory Physics” book by Hopp and Spearman. In this book, they mention that you can either choose how you will buffer against variability or it will be “chosen” for you. When it is “chosen” for you, it shows up as lost sales, late shipment penalties, expediting, and a more chaotic supply chain.
Inventory optimization is a process to help you get control of variability and uncertainty in the supply chain.
Michael Watson is the world-wide leader for IBM’s ILOG supply chain applications. He has been a leader within this group since 1998. He is also an adjunct professor at Northwestern University teaching graduate level operations and supply chain classes in the professional engineering management program and Kellogg’s MMM program.