Supply Chain Management For Dummies. Daniel Stanton

amount for your product if they had to pick it up 100 miles away or had to wait for it for a year. In other words, the placement and availability of a product have a big effect on its value to your customers and on your revenue. Inventory acts as a buffer against uncertainty about who’s going to buy your product, how much they’re going to buy, when they’re going to buy it, and where they’re going to want it.

      Whether your customers buy your product in a store or through a website, your ability to provide them all the products they want when they order them is called your service level. High service levels are good for business. Customers tend to buy from suppliers that meet their needs quickly, so high service levels can increase revenue and grow market share. Achieving a high service level typically requires you to have inventory on hand. To maintain a 100 percent service level, you’d need to have an infinite amount of inventory, which is unrealistic, so you need to find ways to manage the tension between reducing inventories to lower costs and increasing inventories to maintain acceptable service levels.

Companies balance inventory levels and service levels by optimizing their inventory. Inventory optimization is a process of reducing inventories to the minimum level necessary to maintain the desired service level. Inventory optimization starts with forecasting, the process in which you try to guess how much product you’re going to sell and when you’re going to sell it. Companies have many ways to generate forecasts, ranging from rules of thumb to sophisticated statistical modeling. No matter what forecasting method you use, the truth is that your forecast is still a guess. A common joke among supply chain professionals is that the first law of forecasting is that the forecast is always wrong.

      The way to deal with potential errors in a forecast is to keep extra inventory on hand. The better the forecast is — the more confidence you have in it — the less extra inventory you need to keep to meet your desired customer service levels. If you don’t trust your forecast and want to make sure that you have products to sell when customers want them, you need to carry extra inventory.

      The degree to which a forecast is wrong is called forecast error. Improving your forecasts involves reducing this error as much as possible. Two kinds of errors can occur in a forecast:

       An unbiased error is random and generally is a result of imperfect information.

       A biased error is an error that occurs in a pattern. A forecast might always be higher or lower than actual sales, for example.

Figure 3-3 shows an example of a biased forecast that’s always higher than the actual sales. If you can measure the amount of bias, you can take the bias into account to create a new adjusted forecast.

      FIGURE 3-3: Biased forecast.

It’s often easy to spot forecast bias by creating a graph that compares forecast data with actual data.

      

The degree of forecast accuracy is usually measured as the mean absolute percentage error (MAPE).

      When everything is said and done, the real way that most companies deal with the potential for errors in a forecast is by increasing their inventory. So the better the forecast is — the more confidence that you have in it — the less extra inventory you need to keep to meet your desired customer service levels. But if you don’t trust your forecast, and you want to make sure that you have products to sell when customers want them, you need to invest in extra inventory. Inventory that you buy because of uncertainty about the future is called safety stock.

      Inventory versus downtime

      Manufacturing operations focus on maximizing the amount of product that they’re able to make in a given period. Sometimes, manufacturing processes need to be shut down. Planned shutdown times typically are based on the shifts that people work. Planned shutdowns may also occur so that the company can perform maintenance or change over equipment to make different products.

      Unplanned shutdowns also happen for a variety of reasons, all of which are bad. An unplanned shutdown could be caused by a power outage, a broken piece of equipment, a strike, or a new government regulation. An unplanned shutdown also can be the result of running out of raw materials. You can’t make a product unless you have the components that go into it.

      The other kinds of unplanned shutdowns are hard to predict and control, but you can easily prevent shutdowns due to a lack of raw materials by maintaining inventory. As a result, many manufacturing operations managers prefer to have extra inventory as an insurance policy — to make sure that they never run out of materials that would cause an unplanned shutdown. That extra inventory, of course, ties up working capital and eats up space.

      Lean Manufacturing techniques help minimize the number of unplanned shutdowns caused by inventory stockouts while minimizing the amount of inventory in a supply chain.

One of the key elements of Lean Manufacturing is the use of a kanban for inventory replenishment. A kanban is an automatic reorder trigger for inventory. Containers can be used as kanbans to trigger inventory replenishment at each step in a supply chain, for example. When the last item is pulled from a container, it’s time to order a new container. This process provides a smooth, step by step flow of inventory. When you use a kanban system, there’s no way for inventory to be pushed down to the next step in a supply chain; it can only be pulled by the downstream kanban.

      

Toyota developed a unique approach to managing the flow of products through its manufacturing process, allowing the company to minimize inventory costs and unplanned shutdowns. This approach involves tools and techniques that are collectively known as the Toyota Production System. As other companies adopted this approach, it became known as the Lean Manufacturing technique because it reduces the inventory fat in a supply chain. Chapter 4 includes more information about Lean.

      Procurement versus logistics

      Procurement teams look for ways to get the same materials at lower cost. Two common ways reduce costs are to buy in larger quantities and to buy from a supplier in a low-cost region. Both of these options are likely to provide a lower cost per item, but they also can have the unintended result of increasing logistics costs.

For one thing, increasing the amount of material that you order each time, called the lot size, also increases the amount of inventory that you have. You start with no inventory; then you receive a shipment of whatever lot size you agreed to purchase from your supplier. You gradually use that inventory to make products, or sell that inventory to customers, until you have no inventory left. Eventually, you run out of inventory again. Over that period, how much inventory did you have on average? The answer is that the average amount of inventory — and the average amount of working capital that you had tied up in inventory — is half your lot size. Therefore, on average, the more you order at one time, the more inventory you end up with. You can see how this process works in Figure 3-4.

      Ordering in larger quantities also means that you need to have extra space to store inventory and more people to manage it. Although increasing the lot sizes may get you a lower cost per unit, it could end up increasing your inventory costs even more.

      A similar problem comes up when you consider suppliers located farther away. The price per unit may be lower, but the increased transportation costs can eat up all those savings and then some. Shipping items a longer distance can also force you to buy in larger quantities. The farther you have to move something,