Sunday, 6 November 2011

The incredible balancing act of Unsold and OutOfStock

Inventory management is one of the key factors determining the performance of a supply chain. A small change of the inventory policy can lead to a dramatic alteration of the supply chain’s efficiency and responsiveness. Traditionally inventory management is challenging because it directly impacts both cost and service. Uncertain demand and uncertain supply make it necessary to hold inventory at certain places in the supply chain to provide adequate service to customers. As a consequence, increasing inventories will increase customer service and revenue, but also increases cost. According to the 22nd annual state of logistics report (pdf), the world is sitting on roughly $8 trillion worth of goods held for sale, and nearly $2 trillion in the U.S. alone. That's a lot of capital tied up in warehouses. Besides being a huge capital absorber, inventory also represents a tremendous amount of environmental footprint. If we could permanently reduce the amount of product sitting idle, we'd save money, energy, and material.

Effective inventory management is very hard. A recent article in the Financial Times illustrates this. Following the earthquake in Japan, many tech companies started to stockpile critical components to avoid shortages later on. However, unexpected low customer demand in US and Europe resulted in tremendous inventory levels. The components for which it was expected that there was a risk of shortage are now having the biggest problems in terms of oversupply. Deciding on the right level of inventory therefore is an incredible balancing act of unsold and out of stock where Operations Research can be your balancing pole supporting you in making the trade-off.

To illustrate, the above figure shows three warehouses and four customers. The supply chain manager has to decide how much stock to keep at each of the warehouses and which customer to serve from which warehouse. Stock keeping cost is given for each warehouse. Transportation cost is presented in the table below.

The supply chain manager is uncertain about customer demand but has to decide immediately on the number of stock keeping units at each warehouse, otherwise the available floor space will be leased to another company. He decides to go for the average demand. Using his MBA skills he optimises for minimal supply chain cost (warehouse and shipping cost) and decides to have 6215 SKU at warehouse 1 and 3000 SKU’s at warehouse 3. Perfect, ….or could he have done a better job? Actual demand will deviate from the average demand (average doesn’t exist, does it?) leaving the supply chain manager with either unsold stock like in the examples above or lost sales (on average 431 of either unsold or lost sales given the demand scenarios). Would minimizing for lost sales be a better option? Total supply chain cost will rise for sure, possible also increasing the level of unsold stock. Here Operations Research can be of assistance to find a balance. Using the available demand scenario’s (min and max in this case) the average total supply chain cost can be determined while varying the level of average lost sales (see graph below).  Note that the supply chain cost of the average demand is not the same as the average supply chain cost of the demand (the flaw of averages!).

This way the supply chain manager can make the trade off between supply chain cost and lost sales leading to better quality decisions. He/She can use this information to share with all players in the supply chain, like marketing and sales, production and procurement, building a shared view and plan. Operations Research will help find the balance between Unsold and OutofStock and keep it when incorporating deviations from forecasted supply and demand, enabling you to practice Sales and Operations Planning fact based.