Recognizing the effects of uncertainty to achieved working capital efficiency

Pulp & Paper, Jul 2002 by Antanies, John

How do we reduce the variation of demand? There are lots of ways; one of the most common is vendor-managed inventory. "Oh great," the CFO says, "consignment inventory-just what I need-more inventory on my books

But this is not necessarily true. By deploying the right tools, such as a vendor-managed inventory system combined with components of a product tracking system, paper companies can better manage inventory for their customers, and when their customers unwrap that paper and scan it, guess what? They buy it, but without 30-day terms that extend the paper mill's cash operation cycle. And then there are the "hidden" benefits the producer captures by carrying the inventory as cost of goods rather than the customer valuing it at papermaker revenues. But above all, simple inventory visibility is not what provides the value; rather, it is visibility of customers' inventory policies-those policies that create volatility and uncertainty in the first place.

Figure 2 shows the relationship between inventory levels and paper machine efficiencies. In this example, we assumed a certain customer service level. The demand is fairly predictable-the standard deviation of predicted versus actual demand is 15. We want a paper machine efficiency of 95%. If you refer to the chart, you will see this efficiency requires an inventory level of 60 units. You will also see that if demand variation increases to 31, inventory requirements sky-- rocket to 300. In other words, doubling the variation of demand deviation causes the required inventory levels to increase five-fold.

If we reduce demand uncertainty to zero, we can reduce inventory levels to zero, assuming that we do not account for inventory in transit. But even if we achieve this utopia promised by so many enterprise software vendors (and so far, no one has achieved that performance) we have another huge problem: uncertainty! When will the fan pump go out again? How long will the pickup felt last? Will the pulp be bright enough? All of these operational challenges create a mountain of uncertainty that requires inventory or expedited transportation to sustain desired customer service levels.

UNCERTAINTY, INVENTORY, AND APPLICATION SOFTWARE.

We know most paper company CFOs want to reduce inventory-after all, there is a lot of money tied up in inventory. If you listen to analysts, you will notice inventory positions are also seen as health indicators for the company overall. So let's say our CFO puts out an edict to reduce inventory levels, which are too high. What's the knee-jerk reaction? Call your enterprise resource planning (ERP) or supply chain management (SCM) application vendor.

Let's examine a very simple example of quality uncertainty that leads to bloated inventories. Suppose we have promised a customer service levels of 99%. In other words, we have promised this customer that, on average, we will deliver its order on the date it wants, with the right quality and quantity, 99% of the time. That alone would allow that user to reduce its inventories-something a savvy paper salesperson would point out to the customer. So, now we close on the deal and send orders to the mill to be filled.