What I learnt about inventory in Theory of Contraints (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 unknown future leads to mismatch in stock on hand and the 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 in 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 the firm customer orders. Well, there are a few companies, which manufacture exactly based upon customer orders, but most of the 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 lesser 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 the 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 surplus 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, the stock-outs and the 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 below diagram 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 to plant. Similarly, 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 the shortages across the supply chain nodes. Thereby, creating a high availability of items at the consumption point, which results in reduction of loss of sale cases. The second effect of consumption driven system is reduction in surpluses across the supply chain. This ensures a much better control on the quantum of inventories in the system.

Further, the consumption driven supply chain remains in sync with the market demand, as the inventory is moving from one node of supply chain to other node of supply chain, purely based upon the 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’ leads to increase in sales and reduction in inventory, resulting in higher inventory turns and hence higher return on investment (ROI).

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This publication aims to propagate the Theory of Constraints(TOC) management Philosophy.

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