The Most Important Concept in Supply Chain Management – Risk Pooling

Risk Pooling: A statistical concept that suggests that demand variability is reduced if one can aggregate demand, for example, across locations, across products or even across time. By Edith Simchi-Levi, October 09, 2013,

If there is only one theoretical concept you need to understand to make better supply chain decisions, it isRisk pooling.

Very close but still a far second is the Bullwhip effect.

First introduced in the supply chain context in Designing and Managing the Supply Chain, risk pooling is a statistical concept that suggests that demand variability is reduced if one can aggregate demand, for example, across locations, across products or even across time.

This is really a statistical concept that suggests that aggregation reduces variability and uncertainty.

For example, if demand is aggregated across different locations, it becomes more likely that high demand from one customer will be offset by low demand from another.

This reduction in variability allows a decrease in safety stock and therefore reduces average inventory.

Risk Pooling

Operations Rules Rule 3.1 – Aggregate forecasts are always more accurate than individual forecasts is a useful guideline to think about the impact on various operations and supply chain decisions.

Several examples where risk pooling should be considered when making decisions:

1) Inventory Management – as mentioned above the less variability in demand the less safety stock is required to buffer against fluctuations. In addition, the more consolidated the inventory, the easier it is to manage overall and the less risk of obsolescence.  Apple has very few products and options therefore it comes as no surprise that according to Gartnerthey have the highest inventory turnover in the electronics industry – 74, which means Apple turns its entire inventory every five days.

(More: How Objective and Accurate is the Gartner AMR Supply Chain Top 25?)

2) Warehouse location and product flow –  the decisions on whether to have many warehouses close to the customers or more centralized locations should consider the risk pooling effects. By centralizing a product in one location, you can take advantage of the aggregated demand. On the other hand, you need to consider proximity to customers and other factors that may push towards maintaining more warehouses. The characteristics of each product also comes into play here as high demand products with low variability are not impacted as much by the risk pooling effect while low volume high variability products are highly vulnerable.

3) Transportation – the more consolidated the products and the warehouses are, the cheaper the transportation costs as shipments can be sent in larger batches. Therefore considering the transportation impact on these decisions is important.

4) Push-pull strategy – in a push-pull strategy the initial stages of the supply chain are operated on push while the final stages are operated on pull. So for instance, parts could be manufactured but assembled only after there is a good demand signal. The extreme case of this is Dell Direct where the components are ready and assembled only after the order is received from the customer.

5) Postponement – Delayed differentiation in product design by creating a more generic product and adding some of the details once demand is revealed. This allows the use of aggregated demand for the generic product which is much more accurate than the demand for the differentiated products. Benetton is famous for using postponement tactics at the actual sequencing point of the production process, whereby dying of the garments is not completed until the agent network have provided market intelligence on what particular products are in demand in which locations.

6) Product design – decisions on the number of choices and complexity in products can benefit from risk pooling considerations – the less color choices or other options the simpler the demand forecast and many other aspects of the supply chain since the aggregated demand is easier to determine. A famous example is HP which created a universal power cord for its LaserJet printers so that it did not need to differentiate between the ones shipped to different parts of the world.

How do you take risk pooling into account in practice?

Your customer value and business needs are the main drivers of your product offering, procurement and manufacturing strategy and delivery methods.

You also need to balance the tradeoffs of various strategic and tactical decisions using the appropriate analytics software.

But the concept of risk pooling helps you comprehend the impact of adding more products, options, warehouses and any other complexity into your operations.

About the Author: Edith Simchi-Levi was for many years the Vice President of Operations of LogicTools,  a supply chain optimization software and service provider, now part of IBM. She has extensive experience in software development and numerous consulting projects in logistics and supply chain management.