How to reduce absenteeism?

Supply Chain: How does one value reduction in risk when I reduce WIP inventory in a commodity market with regular price adjustments?

• In given industries, processors in the middle of the value chain buy raw commodity product at a market-driven price X from upstream manufacturers.  Several weeks or months later, they sell refined product to customers for a price Y.  The price Y is linked to the market-driven price for the raw commodity price by a given spread, but the raw commodity price has changed in the ensuring weeks/months.  If the price goes up, I make money; if the price goes down, I lose money.  To reduce volatility and price exposure, I want to improve my supply chain and decrease my WIP inventory so that my overall exposure is reduced.  The question is, how should I value (mathematically) this exposure reduction?   If history tells me that the price function is a random walk within a specific range, how do I calculate an expected value for this inventory reduction? To put it in numbers: I buy a product on Day 0 for $100.  Customers know this price and expect to pay $10 more than the market price for the raw commodity.  So, I expect to sell on Day 10 for $110.  However, when I go to sell on Day 10, the price has dropped to $90, and my customer will only pay $100.  I've now lost money because the price dropped while I was holding inventory.  The price could have gone up $10 (and I could have made more money), but as a business, I am more concerned with taming volatility than I am trying to hedge or game the market.  So I want to reduce WIP and limit my exposure to price fluctuations.  The question is, how much is it "worth" to me quantitatively if I reduce inventory?  What is the expected value? My statistics skills are rusty, and it's unclear if they were ever good to begin with.Insight from the better informed greatly appreciated.

• Answer:

  Let me answer you in stages because several factors are interacting here and need to be accounted for. Price Forecasting The first thing is you need to start tracking the price of your raw material every day (at any given time but it should be tracked at the same time every day) then you can use excel to extract the mean and standard deviation of your population and that will allow you to determine the normal distribution behind the data and make predictions based on the historic behavior. As long as you have enough data points your values should eventually resemble a normal distribution; later on you can look into other statistical distributions that can fit your data better (this is particularly relevant if there are increasing or decreasing trends affecting the price) but a normal distribution should be a good  enough start. Demand Forecasting It doesn´t matter how good your price data and forecasts are, you will never be able to reduce the Total Inventory (Raw Material, WIP, Finished Goods) unless you get better at demand forecasting by keeping inventory too low you might be missing selling opportunities and any quality problem will cripple your capacity to provide to your customers. You need to make sure you are producing what the market wants when the market wants it. Inventory Accounting In this particular case it becomes particular important to understand how you are keeping track of the inventory value of your raw material: LIFO, FIFO, Standard Costing, Average Purchase Prices and Series Controlled Inventory will provide very different inventory cost values for each batch of product and very different sales margins; although the averages for all of them should even out if you keep track during a long period. It is very important that you make a conscious decision on how you want to keep track of your inventory and that it makes sense according to your circumstances. Quality Non-conforming product, rework, defects are all ways were good raw material is wasted, if you want to reduce WIP you need to ensure the due diligence to prevent defects is done so you are not buying product just to waste it during the manufacturing process. Final Comment I understand you want to reduce WIP to reduce risk but as long as your raw material is non-perishable it would make sense to buy more when the price is low and you expect it to go up and to reduce order volume when price is high. This is particularly attractive if you have an insight as to how the material price is expected to behave in the future.