Multi-echelon Inventory Optimization and Lean/Six Sigma

The Emerging Role of Optimization in Business Decisions

For many, there was a point in the past when the idea of “optimization” used to summon images of Greek letters juxtaposed in odd arrangements kept in black boxes that spewed out inscrutable results.  Optimization was sometimes considered a subject best left to impractical theorists, sequestered in small cubicles deep in the bowels of the building to which few paths led and from which there were no paths out.  From that perspective, optimization was something that had to be reserved for special cases of complex decisions that had little relevance for day-to-day operations.

That perception was never reality, and today, growing numbers of business managers now understand the role of optimization.  Those leaders who leverage it intelligently, are not just valuable assets, but absolutely essential to achieving and sustaining a more valuable enterprise.  Global competition mandates that executives never “settle” in their decisions, but that they constantly make higher quality decisions in less time.  Optimization helps decision-makers do just that.  The exponential increases in computing power along with advances in software have enabled the use of optimization in an ever-widening array of business decisions.

 

How Lean Thinking Helps

Lean principles are applied to drive out waste.  One of the most predominant lean tools used for identifying waste is Value Stream Mapping which helps identify eight wastes, including overproduction, waiting, over-processing, unnecessary inventory, handling and transportation, defects, and underutilized talent.  In inventory management, this often happens through a reduction of lead times and lot sizes.

The reduction of lead times and lot sizes through lean in manufacturing has focused on reducing setup time to eliminate waiting and work-in-process inventory, as well as the frequent use of physical and visible signals for replenishment of consumption.  One of the challenges is that consumption or “true demand” at the end of the value network is never uniform for each time period, despite efforts to level demand upstream.

Acting and deciding are closely related and need to be carefully coordinated so that the end result does not favor faster execution over optimizing complex, interdependent tradeoffs.

 

The Importance of Six Sigma

Six sigma pursues reduced variability in processes.  In manufacturing, this relates most directly to controlling a production process so that defective lots or batches do not result.  It has been encapsulated with the acronym of DMAIC:  design, measure, analyze, improve, control.

There has been a natural interest in the convergence of lean and six sigma in manufacturing and inventory management so that fixed constraints like lead time and lot size can be continuously attacked while, at the same time, identifying the root causes of variability and reducing or eliminating them.

There are obvious limitations to both efforts, of course.  Physics and economics of reducing lot size and lead time place limitations on lean efforts and six sigma is limited by physics and market realities (the marketplace is never static).

Until it is possible to economically produce a lot size of one with a lead time of zero and infinite capacity, manufacturers will need to optimize crucial tradeoffs. 

 

Crucial Tradeoffs for Manufacturers

In a manufacturing organization, 60% to 70% of all cash flow is often spent on the cost of goods sold – purchasing raw materials, shipping and storing inventory, transforming materials or components into finished goods, and distributing the final product to customers.  So, deciding just how much to spend on which inventory in what location and when to do it is crucial to success in a competitive global economy.  Uncertain future demand and variations in supply chain processes mandate continuous lean efforts to reduce lead times and lot/batch sizes as well as six sigma efforts to reduce and control variability.

As long as we operate in a dynamic environment, manufacturing executives will continue to face decisions regarding where (across facilities and down the bill of material) to make-to-order vs. make-to-stock and how much buffer inventory to position between operations to adequately compensate for uncertainty while minimizing waste.

Taken in complete isolation, the determination of a buffer for a make-to-stock finished good at the point of fulfillment for independent demand measured by service level (not fill rate) is not trivial, but it is tractable.  But, for almost every manufacturer, the combination of processes that link levels in the BOM and geographically dispersed suppliers, facilities and customers, means that many potential buffer points must be considered.  Suddenly, the decision seems almost impossible, but advances in inventory theory and multi-echelon inventory optimization have been developed and proven effective in addressing these tradeoffs, improving working capital position and growing cash flow.

 

So What?

In many cases, the key levers for eliminating waste and variability in any process are the decision points.  When decisions are made that consider all the constraints, multiple objectives, and dependencies with other decisions, significant amounts of wasted time and effort are eliminated, thereby reducing the variability inherent in a process where the tradeoffs among conflicting goals and limitations are not optimized.

Intuition or incomplete, inadequate analysis will only result in decisions that are permeated with additional cost, time and risk.  Optimization not only delivers a better starting point, it gives decision-makers insight about the inputs that are most critical to a given decision.  Put another way, a planner or decision-maker needs to know the inputs (e.g. resource constraints, demand, cost, etc.) in which a small change will change the plan and the inputs for which a change will have little impact.

Multi-echelon inventory optimization perfectly complements lean and six sigma programs to eliminate waste by optimizing the push/pull boundary (between make-to-stock and make-to-order) and inventory buffers as lean/six sigma programs drive down structural supply chain barriers (e.g. lead time and lot/batch size) and reduce variability (in lead times, internal processes and demand).

Given constant uncertainty in end-user demand and the economics of manufacturing in an extremely competitive global economy, business leaders cannot afford not to make the most of all the tools at their disposal, including lean, six sigma, and optimization.

Accelerating and Prioritizing Process Improvement Efforts

Process/Symptom/Value Matrix

If the supply chain were (as the term implies) really a linear, sequential relationship of entities exchanging goods, information, and currency in a binary, stepwise flow, it might not be quite so difficult.

However, you know that the supply chain really is a complex network of inter-dependent people, organizations and fixed assets, and that goods, data and currency pulse from node to node in almost any direction following the path of least resistance.

This “value network” contains the money you seek.  But, since the movements of material, data and cash are continuous, dynamic, and interdependent, the benchmarking results that tell you that you have some aggregate potential do not often change, despite your efforts to the contrary.

You don’t have a crystal ball, but you still need to make higher quality (i.e. more profitable/valuable) decisions in less time.

How do you prioritize your efforts to attack undesirable business symptoms with better decision processes so that revenue growth, return on net assets, and profitability are increased?

Let’s start with what we know.

We know the undesirable business symptoms.  These are the measurements that make our sleep fitful, cause our hair to turn gray, churn our stomachs, and make some business meetings uncomfortable.

Undesirable business symptoms directly and negatively impact financial measures that determine the value of the enterprise (e.g. Economic Value Added or EVA® ).  We want to ameliorate these symptoms.  A symptom that does not significantly inhibit revenue growth, return on net assets, or margins can be addressed as a secondary priority.

The problem is that the undesirable business symptoms are aggregate measures.  They require decomposition in terms of the root cause.  A Process/Symptom/Value Matrix (PSV Matrix) relates business decision processes to symptoms, ultimately allowing us to link potential root causes within each decision process to undesirable business symptoms.

For more on this idea, I’d be honored if you had a look at my short paper, “Finding Value in Your Value Network“.

Something else to ponder about as you head into this weekend is the motto of the State of New Hampshire, “Live free or die,” spoken by General John Stark on July 31, 1809.

Take good care and have a wonderful weekend!

Careful, Comprehensive Inventory Management (Part 4)

As a memory aid, I use A56σ to represent such a careful, comprehensive, and corporate approach to inventory management.  Each component of A56σ is essential for achieving sustainable, continuous improvement in inventory efficiency.  There are five concepts which I will alliterate with the letter “A” combined with the tools of six sigma.  Below, are the final points.  Please see my previous posts for earlier points.

Access – information and use it instead of inventory

Data is now more available than ever.  However, there are two key challenges in making use of it.  The first is the acquisition of data.  For everything, from where a particular serial number of an item is currently located in a supply network to syndicated data of leading indicators of demand, methods, technologies and markets exist for the acquisition of data.  Once you have the data, you must then organize, summarize, and analyze the data into information in such a way that better decisions can be made in less time.  As an example, knowing more about your customer’s demand sooner may help you operate your operations more effectively and efficiently to meet that customer’s demand when it actually comes to fruition.  Knowing the exact location of inventory as it transits and is transformed through your value network can, in some cases, help you respond more quickly to the changes in the market without adding more inventory.

Accelerate – continuously reduce lead-times and lot sizes

Whether you consider yourself a “lean” operation or a “six-sigma” shop or both (“lean six-sigma”), the reality remains that all manufacturers are obliged to constantly search for ways to reduce lead times and run times (batch or lot sizes) during which variation can occur.  This sometimes requires analysis of fixed versus variable cost such as the fixed cost to modify equipment so that change overs can be completed more quickly against the variable cost of carrying inventory for a longer time, or perhaps indefinitely.

6 σ – leverage techniques of process control reduce variation

In conjunction with continuously reducing lead-times and lot sizes, a careful and comprehensive approach to inventory management requires that you make use of what we have known for decades about statistics to identify variation (the reason for safety stock) and its sources, so that you can work continuously to reduce it.  As with the “Anticipate” process, you will reach diminishing returns, but your progress may not be linear or only incremental, and it will be difficult to anticipate when a step-function improvement will occur, so this is an ongoing responsibility.

So, there you have it, the A56σ approach to inventory management.  In summary,

  1. Anticipate market requirements
  2. Account for your actions
  3. Accurately calculate safety stock
  4. Access information and use it instead of inventory
  5. Accelerate by continuously reducing lead times and lot sizes
  6. Leverage the 6σ techniques of process control to reduce variation

You need to do all of these in order to manage your inventory carefully and comprehensively.  I suspect you are careful and comprehensive in your approach to cash management.  Since you spend so much of your cash on inventory, it’s time to take an equally intelligent approach to managing inventory.

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