Daily Archives: December 27, 2007

Capacity, Inventory, and Lead Time

Recently, Supply and Demand Executive published an article called The Three Things You Need to Get Right in Your Extended Value Chain by Steve Mehltretter and Vadim Kapsutin which suggested that there are only three critical operational resources that businesses need to balance and get “right” in order to succeed:

  • capacity
  • inventory
  • lead time

Although I don’t agree that the problem is this simple, I do agree that these are three key operational levels that need to be well understood if a business wants to improve its operation and that the authors are right when they state that most companies struggle with effectively optimizing these resources holistically and in an integrated fashion across the extended enterprise. I agree that few companies understand their interactions well enough to make explicit and accurate trade-offs between them and take a “silo” approach to optimizing each resource independently and that this frequently leads to poor cost, quality, and delivery performance. These issues really need to be looked at as a whole, and not as three distinct problems.

The authors also note that operations research experts can derive the interactions and trade-offs on a mathematical basis, but the question of how managers can use the insight to make the right decisions within their organizations still goes unanswered for the most part. They also note that most managers don’t understand how each of these operational resources individually affect quality, price and (reliable, on-time) delivery – the dimensions that matter to the organization’s customers. I have to agree here as well. I also think that until the right optimization & simulation based tools to understand the tradeoffs are acquired by an organization, the situation is not likely to change.

Diving in, capacity is defined as machine capacity, labor capacity, and the physical space required to achieve a desired level of output within a desired period of time. It’s something that every business measures and controls, but few appropriately take the notion of demand “uncertainty” into consideration when planning and fewer still look at capacity in conjunction with inventory requirements and inbound/outbound order-to-delivery lead times. Volatility of demand and order-to-delivery lead time need to be an integral part of the overall resource planning exercise. This is the only way that an organization will be able to accurately determine where capacity should be located, what form it needs to take, and what levels need to be available.

Inventory is defined as the number of finished goods on hand as well as the number of unfinished goods and raw-materials on hand required to produce the finished goods. A high level of finished goods inventory (theoretically) allows for shorter order-to-delivery cycles and better customer service, but can come at a high cost. A low level of raw materials inventory can lead to significant idling of capacity or long lead times when demand suddenly spikes.

Lead time is defined as the amount of time it takes to get new raw materials into the processing plants and get finished goods from the plants or warehouses to the end customer. When not well understood, procurement may grant excessive lead times for piece-price reductions that cost the company more than it saves or finance may require unreasonably low levels of inventory that have the same negative effect when demand spikes.

The authors than include a nice chart that categorizes key trends, their drivers, and the resulting impact on critical operational resources.

Trend Drivers Capacity Impact Inventory Impact Lead Time Impact
Globalization new market emergence & low-cost labor locations more capacity required more transit stock and finished goods inventory longer and more variable lead times
Extended Enterprise technological and functional focus on “core” less capacity required more transit stock and finished goods inventory longer and more variable lead times
Product Complexity niche market, product localization, & shorter life cycles more capacity required more finished goods and raw material inventory longer and more variable lead times
Capacity Consolidation fixed and variable cost reduction, market share, new markets less capacity required less finished goods and raw material inventory longer lead times

Finally, it finishes off with some recommendations of the solutions that companies should employ to come to grips with these problems, which include:

  • Develop Buffers to Improve On-Time Delivery Performance
    Capacity and lead time can also be buffered like inventory. For example, telecommunications and computing always reserve redundant capacity and companies can pad lead time requirements for non-critical or non-fad goods.
  • Make Differentiated Customer Service Strategies a Reality
    Understand what each customer segment values in terms of cost, quality, features, and delivery performance. Don’t promise more than is necessary up-front, leaving room for buffers if needed, and balance inventory, capacity, and lead time to meet each customer need even in extreme situations.