Should you include the reliability of your supply base in your safety stock calculations?
Vendor reliability is an area of primary concern in the current worldwide environment. The issue goes beyond performance - there are concerns that the financial viability of many vendors is so tenuous that they may not have the ability to survive long term. Risky supply situations like this are typically not included in the assessment of safety stock requirements, but have major impacts on the ability of firms to deliver consistent service levels. More than ever, firms are sourcing products from distant countries which greatly increases their exposure to these risks.
Safety stocks are used to account for variability in inventory flows in the supply chain. The areas of variability include:
- Lead time variability
- Demand variability
- Supplier yield (conforming supply versus required quantities)
- Worldwide events (such as natural disasters. oil price movements)
- Currency fluctuations between supply and demand markets
- Mergers and acquisitions
Safety stock requirements increase with volatility in the supply chain. This volatility is in fact a measure of supply chain risk and is typically assessed by event probabilities, or historical variances about averages. It is therefore incorrect to make assumptions that do not include variability in safety stock calculations, such as assuming constant lead times.
Safety stock calculations have been thoroughly evaluated and defined for the demand side, incorporating lead time variability and demand variability. However the procedure is not well developed to include supply side risk and variability factors into the decision making process.
A risk assessment program identifies risks, their probability of occurrence, their impact, and their “inter-relatedness” throughout the supply chain. These assessments are somewhat subjective, and getting agreement on these assessments to trigger actions can be challenging. A useful visual tool for communicating final assessments is a risk profile map.
The risk assessment process includes the mapping of the supply chain with vendors, intermediaries and customers, and determining points of significant vulnerability. Competitor influences on this chain also should be included. The ultimate outcome of a risk assessment program is a decision about approaches to deal with the risks identified: acceptance, avoidance, mitigation, or transference. Any decisions that result in a choice of raising safety stock levels need to be examined carefully, because not all risks are addressed by increasing safety stock buffers and therefore inventory costs. For example, large safety inventory buffers may be avoided for a risky product source by adding alternate suppliers. On the other hand, where sources are strategic in nature, or alternative suppliers do not exist for the product specifications imposed by the buyer, a high level of joint planning needs to be undertaken with the vendor.
Supply Chain Modeling to Determine Safety Stocks
There is no predefined “formula” for combining all of the supply side input items of variability to enable risk assessments for the supply chain to be put into a safety stock “result”. Each of these input items (lead time variability, supplier yield, risks assessed, etc.) are not exact numbers. There is a range associated with them. For example, the risk of some significant event occurring may have a probability range of 45% to 65%.
There are various modeling techniques that can be taken to develop solutions, but a highly recommended 2-step approach is described below:
- Optimize the network for cost and inventory levels using constant inputs (no lead time variability, no demand variability). This determines alternate solutions(s) of where to position product sources and inventory.
- After this step is performed, add variability to the solution(s) in the form of “what-if” situations. This is best performed by modeling the solution(s) with simulation software, so that standard deviations, means and probabilities can be incorporated. Setting up these simulation models requires a time commitment, but the approach can yield solutions that challenge common intuition, and therefore can improve the decision making process.
There are now software packages available that perform these two steps within one package, allowing distribution network optimization with variability of inputs.
The approach may appear complicated, but it is necessary for proper network and safety stock configuration as the following opposing points of view indicate:
- From a demand point of view, with either constant demand and lead times, or variable demand and lead times, a centralized distribution network configuration (few facilities) will always be more cost effective than a decentralized (many facilities) network configuration.
- Supply disruptions come with a price tag. In the same way that there is a cost associated with overstocking, there is also a cost associated with having being out of stock. From a supply point of view, centralization of inventory puts every downstream entity at risk to supply disruptions, at the same time. In a decentralized network, since each facility holds different safety stock levels, the impact does not necessarily affect the whole supply chain at the same time. That is to say, the risk, or potential volatility of overall supply chain costs is lower under decentralization from a supply perspective. Companies that have had decentralized chains with multiple suppliers have been able to recover more quickly from supply disruptions than those with centralized/vertically integrated supply chains.
Marc Wulfraat is the President of MWPVL International Inc. He can be reached at +(1) (514) 482-357s x 100 or by clicking here. MWPVL International provides supply chain, logistics distribution consulting services including purchasing and inventory management. Our services include: distribution network strategy; distribution center design; material handling and automation design; supply chain technology consulting; product sourcing; 3PL Outsourcing; and purchasing; transportation consulting; and operational assessments.