Variability, whether it is in the demand for a product or the reliability of a supplier, is dealt with through the use of expensive safety stock. Therefore, if you can get control over variability, you will need less safety stock; you can do this through better demand forecasting for your product as well as finding reliable suppliers to deal with your supply problems. There is another way to reduce uncertainty and variability as well – risk pooling.
Risk pooling is a statistical concept where variability is reduced through aggregation. This means that the demand variability for your product is reduced when you add more customers into your customer pool. Adding more suppliers, similarly, reduces supplier variability.
An unreliable supplier has highly variable delivery times and is unable to offer consistent lead-time estimates when you place an order. This type of supplier causes problems because you aren’t able to give your customers consistent service.
Risk pooling is having 50 suppliers and being better off. Why would you be better off with 50 suppliers versus one? Because with the aggregation – the adding together of suppliers – the odds are good that at least one vendor will have good delivery times, accurate lead-time estimates, and consistent service.
To use an example that’s not technically related to inventory: if the dots on the face of a die represent a supplier’s delivery time in weeks, tossing fifty dice instead of one or two would increase the odds that at least one of the dice will land with a specific number facing up.
The same is true with respect to unpredictable customers. You are better off having a pool of 50 variable customers than having only one variable customer. The idea is that while the demand of some of these 50 customers will be low for the month, the demand of some of the others will be high for the month, and the low demand will be offset by the high demand. The greater the pool of customers, the less variability they exhibit as a group over a period of time – the variability smooths out as the number of customers increases.
Risk pooling can be used in a wide variety of inventory controldecisions. For example: the problem of choosing between separate warehouses that independently service their local areas versus one that is centralized and services all areas is easily resolved by thinking of the problem in terms of risk pooling.
How? Because local warehouses deal with a small pool of local customers, the demand variability is high and therefore will require you to have more safety stock. A single, centralized warehouse deals with a larger customer pool, meaning less demand variability and requiring a smaller safety stock. Other factors, such as freight costs, must be taken into consideration when making this decision, of course, but all things being equal might make risk pooling helpful in swaying your decision in one direction or the other.
Want to ask questions about risk pooling or have questions about inventory? Acumen Information Systems would love to help – contact us today!
