Risk pooling in supply chain management: definition and importance

January 28, 2022

Dealing with supply chain risk is a vital part of operations management; retailers and other businesses that successfully mitigate and manage these risks will achieve a more efficient operation in the long run.

Among other things, businesses with a robust supply chain management (SCM) strategy can benefit from:

  • Reduced lead time variability and volatility
  • More efficient demand forecasting modelling
  • Having consistent and predictable inventory levels, making warehousing easier and reducing the need to carry safety stock while also minimising stockouts
  • Enjoying better service levels from suppliers and delivering better service levels to their customers

If you want to take advantage of these benefits and enhance your supply chain, it is worth exploring whether you should introduce elements of risk pooling into your SCM strategy.

What is risk pooling?

While modern supply chains are highly sophisticated, at their foundation, they're still widely based on supply and demand dynamics.

However, the flow of information that notifies you and your suppliers of the demand is not always efficient and effective enough to guarantee an adequate stock flow. This can lead to demand uncertainty around things like order quantities and frequency. On top of this, you must also consider things like the variability of demand driven by external factors, like changing fashion trends.

Risk pooling is the act of putting frameworks and strategies in place to mitigate these uncertainties.

What is the bullwhip effect, and how does risk pooling counteract this?

The bullwhip effect is a distortion in demand that travels upstream through supply chains. In the first instance, consumers fuel demand, leading to changes in supply volumes.

Many factors contribute to the bullwhip effect, including:

  • Demand levels change at all levels of supply chains. If consumer demand increases, your demand increases, your wholesaler's demand increases, their supplier demand increases, and so on up the supply chain.
  • Suppliers rounding order quantities up or down, leading to overstocks and shortages.
  • Average demand increases due to discounting activities throughout the supply chain.
  • Delivery inaccuracies caused by buyer or seller problems or issues with logistics management.

Here's an example case study of the bullwhip effect in action.

Let's say you're a fashion retailer. Your stores typically sell up to 10 winter coats per day before the winter months, and your average inventory on hand reflects this demand. However, there are warnings that the weather will be colder than usual this coming winter. As such, your stores quickly start selling 20 winter coats per day. Your inventory system that automates your ordering process recognises this and orders a more significant allocation of coats from your wholesaler. As a result, you have a trough in supply while your supply chain catches up in the short term.

As such, your wholesaler orders more coats from their supplier. If they supply other retailers and yourself, they will probably over order, so they have buffer stock in case of any weather-related disruptions. In turn, the supplier may increase what they manufacture to maintain a supply to the wholesaler, their customer. We now have two parts of the supply chain exaggerating demand to try and "future-proof" against the next few months.

The danger here is that two things may happen next:

1. First, your inventory systems will stop reporting sales if you run out of stock in the short term. Therefore, peaks and troughs in supply and demand will continue to exacerbate the bullwhip effect as you'll go from no sales to huge sales, which will see the above scenario repeated, just in higher stock quantities.

2. It turns out the winter isn't as harsh as predicted. As a result, you end up with vast overstocks of coats that you need to aggressively discount to clear distribution centres, reduce holding costs, and hit your inventory on hand metrics to make space for new season stock.

Risk pooling can help you counteract the bullwhip effect by moving your demand forecasting away from what you need "here and now" towards an aggregate demand model. Of course, you might still have peaks and troughs in the availability of products, but the two potential outcomes noted above will only occur on a small scale due to the risk pooling effect.

What are the potential benefits of risk pooling in supply chain and inventory management?

The potential benefits of risk pooling, as well as the potential disadvantages, all depend on your business model, usual supply and demand dynamics, and to some extent on your supply chain model.

By embracing risk pooling, you may enjoy the following benefits:

  • Shorter, or at least more consistent, lead times.
  • Increased agility to respond to demand fluctuations.
  • Inventory is being held closer to customers.
  • A leaner supply chain, leading to operational cost reductions.
  • Reduced carbon emissions, resulting to a greener supply chain.
  • Better economies of scale across your procurement, production, and selling processes.
  • Reduced transportation costs.
  • Reduced warehousing costs.
  • The ability to offer a more diverse product range to your customers.

And are there any potential disadvantages?

Some of the potential disadvantages of risk pooling include:

  • Higher stock and storage costs during slow sales periods.
  • Longer waits for products to be delivered.
  • Reduced customer service performance.
  • Higher processing and transaction costs, and potential for negative cash flow during slow sales periods.
  • Lower product variety and quality.
  • Reduced revenues and profits.

As you can tell, there is an enormous amount of risk management involved in risk pooling itself. As with making decisions about most elements of your supply chain, there are tradeoffs involved in risk pooling. Ensure you make decisions based on what works for your business, and consider which potential advantages outweigh the potential drawbacks of risk pooling before putting any strategy into place.

10 ways to pool risk in your supply chain

To help you understand how you can bring risk pooling into your broader supply chain management strategy, we have broken down your potential options into different areas of your supply chain. This may make it easier for you to understand where you can bring elements of risk pooling into your supply chain operations and where the potential advantages and disadvantages of doing so sit in the context of your business needs.

As with other supply chain risk management elements, taking steps in certain areas will automatically lead to you enjoying benefits elsewhere. For example, you may embrace inventory pooling to reduce warehousing costs, but it can also reduce your incoming and outgoing transportation costs and improve your logistics management.

Risk pooling strategies for stock management

1. Inventory pooling

Inventory pooling is where you consolidate several inventories into one; this can help you reduce your overall inventory holding and storage costs.

The most common means of inventory pooling is to store all of your products in one central warehouse. Alternatively, or alongside this, you may also move to a centralised inventory control system so that you have a single inventory figure for the stock you sell in retail locations and online.

If your business is global, you may choose to retain some elements of a decentralised system for inventory management while pooling elsewhere. For example, you might choose to hold stock that only sells well in one country in that location while keeping the fast-selling products at a central distribution centre.

Generally, inventory pooling helps reduce the levels of safety stock your business holds, as you'll have one inventory for the entire company. As such, slow sales in one location will typically balance out higher than forecast sales elsewhere, and because you have pooled your inventory, you won't need to redistribute stock too much. Inventory pooling can also deliver cash flow optimisation benefits and other advantages across your wider business.

Risk pooling strategies in transportation

2. Virtual pooling

Virtual pooling is a means of extending your company's stockholding capability without opening permanent warehouse space yourself. All you're doing with virtual pooling is storing inventory in another company's location. In many cases, this will be with a wholesaler, but you may even hold merchandise with an upstream supplier.

Depending on where you store inventory and the capabilities of those with whom you keep it, you may also be able to facilitate dropshipping to deliver orders direct to consumers. As such, as well as extending your inventory holding capability or reducing the stock you have in your warehouses, you can also potentially reduce delivery lead times and logistics and labour expenses from handling products at multiple locations.

3. Transshipments

Transshipments are a type of virtual pooling. Depending on your business locations and where you keep stock, it is often a strategy worth considering as an alternative to inventory pooling.

There are several ways to use transshipments within your business. It's worth having an internal operating procedure to understand when to implement these.

  • Lateral transshipments are stock transfers within your business to help counteract any supply chain disruptions. For example, you might say that, for a specific product, all your stores need to have a minimum of five days' outstanding inventory (DOI). When stock levels go below this, your internal systems identify locations holding excess stock and trigger an internal transfer.

  • Reactive transshipments are stock transfers you undertake when a specific area experiences a stockout or is close to selling out of something.

  • Proactive transshipments are stock transfers you undertake when you're able to anticipate a stockout ahead of time. These are similar to lateral transshipments, but taking such action will depend on your internal operation.

Risk pooling strategies in your procurement processes

4. Centralised ordering

Centralised ordering aims to take advantage of economies of scale to optimise your stock ordering and distribution process.

Instead of ordering products on a location by location basis, your business would place a single order to cater for the entire company. You would then distribute the order to your sites as applicable, depending on what your sales metrics tell you about prevailing demand in those places.

Moving to a centralised ordering model also helps you pool lead time risk - as you're only waiting on one delivery to one location. Once you have the order in your central warehouse, you can then decide where stock needs to go, ensuring a consistent supply across all your locations and potentially minimising the need for transshipments.

5. Order splitting

Order splitting sees you break down one larger order into multiple smaller orders with several suppliers. It is effectively risk pooling against potential issues that centralised ordering may bring.

You will have different lead times from different suppliers, but these will balance each other out. Therefore, you will receive stock "little and often," which may help with warehousing and could be helpful if you run "just in time" supply chains. However, this approach can also be heavily labour intensive and lead to more frequent stockouts.

Risk pooling strategies in supply chain production processes

6. Component commonality

Component commonality - also called part standardisation - has several products that share the same parts. Having the same components in producing several items can help reduce the over-ordering of particular elements and dramatically reduce the bullwhip effect further upstream.

On the flip side, if a shortage of raw materials or another disruption leads to failure of supply of the standard component, you may find yourself with a greater range of stockouts. Component commonality can reduce your costs and streamline a considerable portion of your supply chain but carries that significant risk element.

7. Postponement

Postponement is where your business delays making final decisions on ordering, production, or logistics until you have the most accurate possible demand forecast. Essentially, postponement means you make your decisions at the latest possible moment when you have as much data as possible.

This can be beneficial for ensuring order accuracy and inventory optimisation but puts pressure on suppliers and logistics partners to ensure they meet short lead times without fail.

8. Capacity pooling

Capacity pooling brings as much of the production process and your entire supply chain under one roof. The idea here is that you avoid inefficiencies by redeploying elements of your supply chain as necessary based on aggregate demand.

For example, say you have two suppliers producing different products. If one product sees a slump in demand, but the other sees an increase, you generally won't be able to use the supplier of the low demand product to help produce more of the high demand product.

In contrast, if you have those processes under your control, you can redeploy production based on what you need.

Risk pooling strategies in sales and distribution

9. Product pooling

Product pooling reduces product ranges to help generate more consistent demand levels, making it easier to make forecasts and distribute inventory.

Product pooling is something many businesses have embraced as their supply chains have evolved during the COVID-19 pandemic, and it is likely to become the norm in the next few years.

10. Product substitution

While product pooling will call on you to reduce your product ranges, risk pooling via product substitution means you need to maintain at least one alternative product. Hence, your customers have a choice where you do experience stockouts.

You can still manage your cash flow and inventory levels by aggregating demand across ranges rather than individual products, lowering your exposure to demand volatility and disruptions in your supply chain.

Discover how Serai can help you make smart decisions around which risk pooling strategies to introduce into your supply chain.

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