Home > Inventory Management, Lean, Production Management > Why Shortage vs Stock is NOT a Tradeoff?

Why Shortage vs Stock is NOT a Tradeoff?

I have frequently come across factories that keep a lot of on-hand stocks and at the same time material shortage is among the top reasons of unexpected production downtime. Same goes for retail operations that have kept safety stock level arbitrarily high. More often than not, shortage is not reduced by keeping more stocks.

At first glance, this seems to be counter-intuitive. After all, textbook stock management models always indicate that safety stock level and the probability of shortage, which directly affects service level, has an inverse relationship. You reduce stock and you end up increasing the chance of shortage, which leads directly to loss of sales opportunity. On the other hand, more stock means more working capital, more product obsolescence, more warehouse cost …etc and hence serving customers is a financial tradeoff between shortage and stock levels.

In practice, this is not necessary true. In fact, I argue that in order to reduce shortage, you need to reduce your stock level first.

The reason is that excess stock level has many side effects that are not accounted by the textbook model. Most notable ones are the followings:

Inefficient use of procurement budget

Typically a fixed budget is allocated for procurement. High stock level reduces the flexibility of allocating budget to purchase what is really needed. This is very commonly seen not only in retail but also for large manufacturers’ raw material procurement and sales company operations.

Loose inventory management practice

Excess stock level tends to create an inappropriate peace of mind for managers. When less attention is given to keep stock level low, larger variability of turnover among SKUs is resulted. Replenishment of the SKUs that are really needed by operation is hence more likely to be forgotten.

Lack of continuous improvement incentives

This is the classical lean wisdom that when stock level is excessively high, problems are hidden behind the stocks. There is no pressure to improve supply chain responsiveness by reducing manufacturing lead time or improving overall material flow synchronization. Eventually, demand and competition will catch up with the limitation of the supply chain responsiveness. For example, studies have shown that US automobile manufacturers tend to keep higher dealer stock than their Japanese counterparts. This has been one of the major differences in competitiveness between US and Japan automotive companies.

Classical inventory model assumes that inventory decouples supply and demand functions. In practice, supply chain is complex and you cannot simply decouple supply and demand with stock. The key success factor to reduce shortage by reducing stock is to actively manage the complex relationship by better synchronization of manufacturing with customer demand.

Better synchronization can be achieved in 2 ways: more accurate forecasting and higher flexibility of execution. In today’s market of increasing demand volatility, there is a limit on how accurate you can predict the future by improving forecasting. However, lean methodology has taught us that there is almost no practical limit in improving execution.

Take the example of a manufacturing plant that I visited recently. They make products that are distributed across US through a franchise network. 5 years ago, their plant inventory alone was at 90 days and they only met 70% of customer orders. Today, their plant and downstream distribution center total inventory is less than 80 days while they are now meeting more than 96% of orders. The key to this change is that the manufacturing plant now is accountable for not only the plant inventory but also downstream DC and soon warehouse inventory. In this case, the overall stock reduction target has put manufacturing operation under pressure to reduce lead time and improve flexibility. Any such improvement has an impact to downstream supply chain stock level as well as customer satisfaction level. Such improvement cannot be achieved when manufacturing and supply chain stock are managed separately as silos. In order to achieve the next level of operational performance, they are evaluating a unified IT platform across manufacturing and supply chain.

By the same token, manufacturers are now using the latest information technology to synchronize better with their suppliers. An industrial equipment manufacturing plant that I visited has implemented an IT platform that allows them to see in real time the progress of WIP at its suppliers’ production lines. Such visibility allows them to control material synchronization between key supplying parts and the in-house final assembly operations, resulting in overall inventory and shortage reduction.

Are you wondering why your operation is keeping high stock level but still cannot reduce shortage? Do you see your manufacturing operation driving supply chain stock management? What is keeping your manufacturing operation from better synchronization with supplier operations as well as market demand?

  1. Raymond Kovach
    October 21, 2010 at 11:00 pm

    I’m going to argue, just for the express purpose of generating more discussion. Great topic. I agree with the high inventory tying up capital that could be used to buy inventory that is needed and the third point about lack of continuous improvement. I would argue that the “loose practice’ issue tends to be less and less as the computer systems and information sharing becomes better. The odds of items being manually pushed to the bottom of the stack in someones cubicle would be small, in my humble opinion. Also, again, just to play devil’s advocate, we could also argue that the cost of losing a customer is not factored in to the “trade-off” equation. In theory, and probably in practice as well, the potential loss of a customer due to a material shortage would be a large factor in the “risk/reward” graph when considering leaning down the inventory. Or perhaps a square diagram could be used to quantify the amount of risk to factor in. Four corners and in each corner the following: 1. Low Competition/High tolerance for outage, 2. High Competition/High Tolerance for outage, 3. Low/Low, and 4. High/Low. Depending upon the business environment a company is in, their “risk factor’ for lean inventory levels could be quite different from others. On one end of the spectrum, we could have a manufacturer of high end, after-market luxury automotive accessories. They would likely have less competitors and their customers would have a low tolerance for long lead times and back-orders. In that environment, would we perhaps apply a different weight to cost of carrying inventory than if we were functioning in a market with many competitors selling the same item, with little differentiators? (a commodity product or service). To over-simplify the analogy, your local Applebees likely cannot afford to keep extra wait staff just in case they get a larger than expected demand. The local high end French restaurant likely does since they are at the low comp/low tolerance category. Their inventory, both food and people resources are likely carried much fatter and the extra cost of doing so has been factored into the prices on the menu. Could the French restaurant benefit financially by adopting leaner practices? Perhaps. They could bring staff in from temp agencies to fill peak, unexpected (forecast inaccuracy) demands, but would their quality suffer as well? And would their customers tolerate slightly higher prices more than waiting longer to be seated or lower quality food? The temptation for the exclusive French restaurant to gain a short term competitive advantage by leaning out people and raw materials could cost them customers in the long term. Knowing your customers expectations of your business is critical to knowing where and how hard to apply lean practice. Agree?

    • KouMei
      October 21, 2010 at 11:05 pm

      Thanks for the great feedback.
      I agree that the cost of shortage is indeed a complex topic that worth an article on its own. Not only that there is different degree of opportunity cost depending on the market segment, but also many complex transactions tend to be resulted from shortage. For example, the labor time that is consumed to find a replacement, to negotiate a different delivery schedule and for some customers there could be an explicit penalty. THere are cases of not only lost of customers but lost of human lives (eg. critical medical drugs). I do agree that if the cost of shortage is high, then it could make sense to keep higher “well-managed” amount of inventory to balance the risk. My post mainly focus on the case when inventory is “exessively” high, at which I have found all too common.

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