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Inventory Management Review: Supply Chains Dependency

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Inventory Management Review: Supply Chains Dependency

Inventory Management Review: Supply Chains Dependency

In today's global economy, supply chains have become increasingly more diverse.  A shoe with final production in China may have leather produced in Italy, soles manufactured in Taiwan, laces made in Idaho with the plastics tips for the laces made in Washington, and packaging produced in New Jersey.  But what good is one of these parts without the other?

Oftentimes, the value is worthless without all the parts.  This dramatically increases the risk for many firms who, thanks to such an efficient supply chain, are very dependant on their suppliers.  If one supplier fails to ship an order, the entire supply chain could come to a halt.  Mathematically, dependency on your suppliers has a dramatic effect on the pooled service level your suppliers provide to you.

For example, if you have 10 parts from 10 suppliers who all offer you a 95% service level, then 95% of the time you should have all 10 shipments in on time, right?

Wrong (would I have asked if it was right?).  Statistically, there is 95% of any individual supplier will provide on-time delivery.  Collectively, the chance that everyone will be on time is calculated by multiplying the service level they each provide.  In this case that is 95% 10 which is 60%.

So, 95% may have been your goal, but 60% is what you're getting.  Typically, this is why customers with many suppliers demand higher service levels.  This can help protect you from late suppliers, but what happens in a complete disruption of the supply chain?

A disruption in any or all of these 10 suppliers can lead to a complete halt in production.

Two things are needed to prevent this from occurring:

1). for parts on which production is highly dependent upon, consider a higher service level, or identify and be prepared to implement immediate alternate solutions if the part becomes unavailable.

Mathematically, it just does not make sense to demand low service levels across the chain.  If your suppliers can't give you higher service levels, then you may need to keep higher stocks of raw materials from known-bad suppliers to accommodate the fluctuations in lead times they provide you with.

2). Reduce your supply chain risk

Take for example the effects of a lightning-induced fire at Royal Philips Electronics, N.V. which damaged millions of microchips.  As reported by MIT Sloan Management Review, both Nokia Corp. and Telefon AB L.M. both purchased microchips from Royal Philips for use in their mobile phone productions.  

The difference?  Nokia Corp. "almost immediately began switching its chip orders to other Philips plants, as well as other Japanese and American suppliers.  Thanks to its multiple-supplier strategy and responsiveness, Nokia's production suffered little during the crisis."

Ericson on the other hand relied solely on the microchips they acquired from Royal Philips.  The result?

"when the Philips plant shut down after the fire, Ericson had no other source of microchips, which disrupted production for months.  Ultimately, Ericson lost $400 million in sales."

In an earlier article posted on IMR, guest author Nick Koletic discussed the risks of JIT and aptly named supplier price gouging and supplier production breakdowns as two serious threats.  

The article quoted above, Managing Risk to Avoid Supply Chain Breakdown, from the Fall 2004 MIT Sloan Management Review, very thoughtfully points out other sources that disruption:

"Natural disaster, Labor dispute, Supplier bankruptcy, War and terrorism"

It's easy to think about how a supplier might try and gouge us for a price if they're our only supplier, but that doesn't make the other risks any less feasible.  Unless all of your suppliers are domestic or in Switzerland, war and terrorism are very real threats to your supply chain.  

Just imagine what it might have been like to own a cigar shop that relied solely on Cubans the day Castro took power.

A natural disaster is an incredible threat.  Unlike war or supplier bankruptcy, a natural disaster can occur at a moment's notice with no warning.  Sure, a lightning fire like at Philips is a rare occurrence, but how about floods and earthquakes?  Also, a natural disaster can generally wreak havoc on an entire area.

The importance here is two-fold:

First, the conditions Nick pointed out require careful monitoring and assessment of suppliers.  If you have a single supplier for a matter, beware, they could gouge you.  But with war and natural disasters, you just got unlucky, there is no one trying to screw you with ridiculous prices.

Second, natural disasters occur in regions.  This said, if you are going to diversify your suppliers, consider suppliers in multiple regions.  One of the reasons Dell is so successful with JIT is because they have a ton of suppliers nearby.  

Frequently, regions become specialized in products and an entire region becomes a major supplier for the entire world's production.  Silicon Valley, CA is a region known for its IT firms.  

Because natural disasters occur in regions, consider the ramifications of a massive earthquake in Silicon Valley and its effects on those reliant upon the chips produced there.  Reliance upon suppliers, even if there are many, can be dangerous if they are all nearby.

How Inventory Can Mitigate Risk

Well obviously, holding more inventory is always an effective solution to dealing with supply chain risks.  Unfortunately, it's also costly.  Perhaps raising your service level to 99% in each of those three parts from the example earlier is a strategy that will cost millions of dollars.  

If the costs are too high, maybe more inventory isn't the way to go.  But, the Sloan article did point out some good suggestions for what to do with inventory.  Most notably, they discussed centralizing inventory using pooling, a topic I have recently posted on.

Unfortunately, pooling isn't always a good option.  It relies heavily on the similarity of your SKU mix.  Sometimes the risk is there and a better inventory can't help you lower your inventory.  So maybe, you do need more inventory to prepare for a disaster.  I was curious though, should this inventory be always held, or should the remote possibility of disruption be weighted in the standard lead times suppliers have?

I discussed the matter with Sean Willems from Option and he pointed out that this type of disaster scenario is an all-or-nothing disruption.  It either happens or it doesn't, so if you want insurance against it, then you should keep a stock specifically designed to protect against that, and have that as a separate inventory level.

Again though, this is costly.  My suggestion would be to diversify your suppliers the best you can.  I realize that some supply chain specialists, especially JIT specialists think that it's best to "get in bed" with as few suppliers as possible so that good relationships can be built and a common goal can be worked towards.  I disagree.  

I think it is important to work with suppliers, and not to play them off each other for the lowest price.  However, I think that reliance on one supplier for a particular raw material is asking for trouble.  Mitigate your risk and get multiple suppliers.  Explain to them that it is just too risky to keep only one.

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