What I learnt about inventory in Theory of Constraints (TOC) Paradigm?

What is the right inventory? This question has been asked and discussed in thousands of boardroom meetings, management reviews, and inventory planning discussions, but has largely remained unanswered.

This is because of the paradox: inventory is kept for fulfilling future orders and no one knows what is going to happen in future.

Forecasting for an unknown future leads to a mismatch in stock on hand and incoming orders, as reality is vastly different from the forecast. This is the root of the surpluses and shortages observed at various nodes in the supply chain. The longer the horizon of the forecast, the deeper the hole one has dug for oneself. That is, the longer the horizon, the higher the mismatch between reality and the forecast, and hence the higher the surpluses and the shortages.

Before we move on to answer the question, there is one more fundamental question which is seldom discussed: Why does one need inventory?

Wouldn’t it be amazing if companies could manufacture based on firm customer orders? Well, there are a few companies which manufacture exactly based upon customer orders, but most companies do keep inventories. Why are these companies keeping inventory?

The reason for keeping inventory is a function of supply lead-time and customer tolerance time.

If the customer tolerance time is less than the supply lead-time, then companies have no other option but to keep inventory whenever and wherever the customer needs it.

Now, coming back to the first question. One way to deal with the problem is to make accurate forecasts. And believe me, a lot of work has gone into improving forecast accuracy. There are super-sophisticated, complex IT systems which crunch tons and tons of data to accomplish such a feat. But none has solved the real problem, as the issue of surpluses and shortages remains in the supply chain even after deploying such sophisticated IT systems.

The TOC solution resolves the above conflict by abolishing the root of the problem — “The Forecast”.

The whole supply chain moves from a forecast-driven system to a consumption-driven system.

In the new paradigm, stock-outs and surpluses can be totally eliminated in the supply chain by only supplying the next link with what is sold/consumed by it and nothing more.

This solution is called the TOC replenishment solution.

The diagram below illustrates how the consumption-driven supply chain operates.

The plant replenishes the inventory consumed by the warehouse based upon the consumption information shared by the warehouse with the plant. Similarly, the warehouse replenishes the inventory consumed by the distributor based upon the consumption/sales information shared by the distributor. (The same logic can be extended between the distributor and retailer.)

The consumption-driven system provides a huge benefit over the forecast-driven system. First, it nearly eliminates shortages across the supply chain nodes, thereby creating high availability of items at the consumption point, which results in a reduction of lost sales. The second effect of a consumption-driven system is a reduction in surpluses across the supply chain. This ensures much better control over the quantum of inventories in the system.

Further, the consumption-driven supply chain remains in sync with market demand, as inventory moves from one node of the supply chain to another purely based upon market demand. This enables the system to plan inventory for sales, thereby creating a great sales focus.

All these effects — ‘reduction in loss of sales’, ‘control on inventories’, and ‘sales focus’ — lead to an increase in sales and a reduction in inventory, resulting in higher inventory turns and hence higher return on investment (ROI).