Unpredictability is the enemy of inventory management. Unpredictable product demand and unpredictable supplier lead times both require the inventory manager to keep more safety stock as a hedge against this uncertainty. Over very large customer or supplier pools however, this unpredictability often evens out.
If you have a supplier who has what you need 50 percent of the time, then two such suppliers guarantees that one or the other will have what you need 75 percent of the time. The more suppliers you have, the better your chances that at least one will have the item you need in stock. This statistical concept also applies to product demand. The aggregate demand of a large pool of customers is easier to forecast than that of a single customer.
Increasing your customer base to the point where you can enjoy this benefit is easier said than done. However, you can also benefit from risk pooling by aggregating your current demand. For example, if you kept T-shirts of several colours in your inventory, you would need safety stock for each colour to cover their individual demand uncertainties.
While demand for a particular colour is highly variable, the aggregate demand for T-shirts of any colour is less variable. This suggests that you can reduce your safety stock by only carrying white T-shirts and then dying them to the colours specified by your customer orders. This is called delayed differentiation. Dell uses delayed differentiation by keeping computer components in inventory and delaying their assembly into particular models until after an order is received.
Risk pooling through demand aggregation can be done in other ways. Multiple warehouses that service separate towns will each require safety stock to cover the variable demand for the town they service. By consolidating these local warehouses into a single centralised warehouse, the overall safety stock can be reduced to cover the more predictable aggregate demand of all the towns taken together.
Another way to benefit from demand aggregation is through smarter product design. Product lines that use the same batteries, power cords, and accessories avoid SKU proliferation and the resulting safety stock bloat.
While risk pooling can be used after the fact to reduce safety stock, it’s also a useful conceptual tool for making decisions about product diversification/consolidation, increasing/decreasing warehouse locations, and adopting/removing in-house product assembly.
For more information on how to manage your inventory more effectively, contact us.
