SCM Insights
December 9, 2015

Secure supply despite reduced capital lockup – how is this possible? (Part 1)

Matching themes: Inbound Supply Chain, operative procurement, Security of supply

The question above is probably much older than the term “supply chain management”, which first appeared at the beginning of the ’80s, became more pervasive in the ’90s and an established management term by the turn of the century.

There is no need to speculate about the point at which this issue began to be addressed by academics. All we can say is that the issue has become particularly important over the past 15 years given increasing globalization, intensified global competition and a decreasing value creation chain.

Fixed capital in the form of stocks and inventories reduces the freely available cash reserves and thereby limits companies’ freedom to act and invest, as well as their flexibility and agility (see: Wikipedia: Business agility). Furthermore, stock and inventory levels and the resulting cost of storing and handling the material directly impact corporate earnings. In normal circumstances, reducing stocks and inventories leads to an improvement in corporate earnings and a higher return of equity as long as critical breakdowns in supply are simultaneously avoided.

The synchronization quality of material flows determines inventory levels

The stock and inventory levels at a particular point in a supply network are determined by the synchronization of material flows between two value creation stages. Overall, the stock and inventory levels in a company are therefore the result of how well it succeeds in synchronizing goods and material flows throughout the entire network and allowing them to flow as steadily as possible. Relatedly, competing aspects must be carefully considered to ensure an overall ideal, economically speaking. On the whole, this is a highly complex process that must incorporate all aspects from the material requirements forecast and production planning to capacity planning on the supplier side.

The following simplistic example demonstrates how the change in frequency of supply has implications for inventory levels. The triangle shown in the figure represents the receiving and shipping warehouses. The receiving warehouse is supplied by several suppliers. If weekly inflows and outflows are constant, inventory in the receiving warehouse is higher the more varied the frequency between supply by the suppliers and the withdrawal of parts by production.

If production withdraws material from the warehouse regularly throughout the day, the average inventory at the time of weekly supply by the suppliers (Mondays) is 140% higher than if delivery occurs three times a week (Mondays, Wednesdays, Fridays). If weekly quantities supplied remain constant, the increase in the frequency of supply to a warehouse therefore has a con-siderable knock-on effect on inventory levels.

The following diagrams show the idealized inventory level development and the average inventory in the receiving warehouse where material is supplied once a week (upper diagram) and three times a week (lower diagram) over a period of five weeks. Weekly utilization was assumed to be 10,000 units and initial inventory 2,000 units. An initial glance at the graphs reveals that a more frequent supply (lower diagram) drastically reduced inventory levels.

Average inventory in the receiving warehouse where material is supplied once a week
Average inventory in the receiving warehouse where material is supplied once a week
Average inventory in the receiving warehouse where material is supplied three times a week
Average inventory in the receiving warehouse where material is supplied three times a week

By increasing the frequency of supply, the average inventory in this example is reduced from approximately 4,900 units to 2,000 units. Given an assumed parts value of EUR 100, the average lockup is thereby reduced by more than half, from EUR 490,000 to EUR 200,000.

A reduction in the quantity of parts in the receiving storage location also reduces the storage space and volume to be allocated. On the other hand, more supplies may increase transportation costs and the coordination burden with the result that the benefits will be reduced accordingly.

Deliveries on Monday, Tuesday and Wednesday
Deliveries on Monday, Tuesday and Wednesday

Furthermore, in the case of the assumptions made, the distribution of deliveries over different days of the week has a considerable effect on the quality of synchronization and thus inventory levels. Deliveries on Monday, Tuesday and Wednesday (upper diagram) will result in 33% higher inventory levels compared to deliveries on Monday, Wednesday and Friday (lower diagram).

Deliveries on Monday, Wednesday and Friday
Deliveries on Monday, Wednesday and Friday

To ensure such seemingly simple adjustments can even be implemented, expedient, flexible and highly automated processes are needed. Paper-based processes and media disruptions act as an effect brake in this context, although it is often difficult to eliminate them.

Paper-based, slow processes result in excessive inventory levels

The lack of material flow synchronicity is often due to the slowness and complexity of processes within a company. Wherever many procedures are paper-based and done manually, the option does not exist, simply due to time constraints, to improve the synchronicity of the material flows by increasing and better coordinating frequency of movement. This is because this would involve an increase in the activities to be initiated and monitored. An order of 6,000 units delivered on Monday is more expedient and easier to coordinate and handle than three orders for 2,000 units.

If the goal is to handle more processes using the same number of employees, more expedient, transparent and efficient procedures are needed. If this is not ensured, excessive inventories might materialize due to the existing inertia according to the pattern described above.

Lack of transparency, uncertainty and risks also lead to the build-up of safety stock

In addition, if shipments from particular suppliers or from particular regions are repeatedly not in conformity with the scheduling, qualitative or quantitative requirements, the build-up of additional safety stock is essential to ensure the supply of production is maintained without disruptions. Such irregularities may be due to many causes. These include unreliable or insolvency-prone suppliers and logistics service providers as well as general risks that are difficult to control. Accidents, machine breakdown or even environmental disasters like earthquakes can cause entire regions to fail.

The following applies in general: The higher the degree and number of uncontrollable risks and the more important a supplied part is for internal value creation, the more likely a company is to establish a minimum inventory level for a particular component or material group for the purpose of preventing critical supply breakdowns and special measures.

The safety levels in the inbound division of companies, which have insufficient or no transparency what-soever regarding the supply situation, will be especially high. Many companies are almost completely flying blind until the trucks are unloaded in the goods receipt area. They do not know what is being transported and only discover a lack of parts when there are no longer any planning options to remedy the defect.

The consequence is extremely expensive special measures such as short-term changes to the production plan with all its consequences, special transportation or even a drop in production with resulting delays in delivery to customers.

How can companies improve the situation, ie maintain security at the same time with reduced capital commitment? The different options are discussed in the second part of the blog post.


Werner Busenius

Till December 2016, Werner Busenius was Director Sales & Marketing at SupplyOn.

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