Most supply chain managers spend a lot of their time looking for ways to reduce costs. But one of the big challenges with supply chains is that things are often interconnected, so making a change in one area to lower costs can cause a change somewhere else that actually increases the cost. That's not to say that you shouldn't look for cost-savings opportunities, but you need to understand how the system works to ensure that you aren't creating new problems in the process.

There are four decision areas that drive most of the costs in any supply chain. Thinking about all these items together can help you find true opportunities for savings.

Supply chain management involves making choices and trade-offs that help you maximize your profits over the long term. When you get right down to it, conflicts occur between any two functions in a business, as well as between any two businesses that work together as a part of a supply chain. Six conflicts, or trade-offs, are so common that every supply chain management professional needs to understand them and know how to manage them effectively.

Inventory costs money because it ties up working capital, eats up labor and real estate, and depreciates quickly. Many supply chain professionals and business analysts will even tell you that inventory is the enemy. You may wonder why everyone doesn't immediately eliminate all inventory. Wouldn't supply chain management be a whole lot easier if you didn't have to deal with warehouses, distribution centers, and stock rooms?

That approach has one major problem: Companies make money by selling products to their customers, and if they have no product to sell, they earn no revenue. When you think about what customers value — what they're willing to pay for — the product itself is only part of the equation. You have to consider, for example, whether customers would be willing to pay the same amount for your product if they had to pick it up 100 miles away or if they had to wait for it for a year. In other words, the placement and availability of a product actually have a big impact on its value to your customers and on your revenues! Inventory acts as a buffer against uncertainty about who's going to buy your product, how much they're going to buy, when they're going to buy it, and where they're going to want it.

Whether your customers buy your product in a store or through a website, your ability to provide them with all of the products they want when they order them is called your service level. High service levels are good for business. Customers tend to buy from suppliers that meet their needs quickly, so high service levels can increase revenue and grow market share. Achieving a high service level typically requires you to have inventory on hand. To maintain a 100 percent service level, you'd actually need to have an infinite amount of inventory, which is unrealistic, so you need to find ways to manage the tension between reducing inventories to lower costs and increasing inventories to maintain acceptable service levels.

Companies balance inventory levels and service levels by optimizing their inventory. Inventory optimization is a process of reducing inventories to the minimum level necessary to maintain the desired service level. Inventory optimization starts with forecasting, the process in which you try to guess how much product you're going to sell and when you're going to sell it. Companies have many ways to generate forecasts, ranging from rules of thumb to sophisticated statistical modeling. No matter what forecasting method you use, the truth is that your forecast is still a guess. A common joke among supply chain professionals is that the first law of forecasting is that the forecast is always wrong.

The way to deal with potential errors in a forecast is to keep extra inventory on hand. The better the forecast is — the more confidence you have in it — the less extra inventory you need to keep to meet your desired customer service levels. If you don't trust your forecast and want to make sure that you have products to sell when customers want them, you need to carry extra inventory.

The degree to which a forecast is wrong is called the error. Improving your forecasts involves reducing this error as much as possible. There are two kinds of errors that can occur in a forecast:

It is often easy to spot forecast bias visually by creating a graph that compares forecast data to actual data.

When everything is said and done, the real way that most companies deal with the potential for errors in a forecast is by increasing their inventory. So the better the forecast is — the more confidence that you have in it — the less extra inventory you need to keep in order to meet your desired customer service levels. But if you don't trust your forecast, and you want to make sure that you have products to sell when customers want them, then you need to invest in extra inventory.

Manufacturing operations focus on maximizing the amount of product that they're able to make in a given period. Sometimes, manufacturing processes need to be shut down. Planned shutdown times typically are based on the shifts that people work. Planned shutdowns may also occur so that the company can perform maintenance or change equipment to make different products.

Unplanned shutdowns also happen for a variety of reasons, all of which are bad. An unplanned shutdown could be caused by a power outage, a broken piece of equipment, a strike, or a new government regulation. An unplanned shutdown also can be the result of running out of inventory. You can't make a product unless you have the raw materials and components that go into it.

While the other kinds of unplanned shutdowns are often hard to predict and control, you can prevent shutdowns due to a lack of materials by maintaining inventory. As a result, manufacturing operations managers tend to prefer to have extra inventory as an insurance policy — to make sure that they never run out of materials that would cause an unplanned shutdown. That extra inventory, of course, ties up working capital and eats up space.

Procurement teams look for ways to get the same materials at lower cost. Two common ways to reduce costs are to buy in larger quantities and to buy from a supplier in a low-cost region. Both of these options are likely to provide lower cost per item, but they also can have the unintended result of increasing logistics costs.

For one thing, increasing the amount of material that you order each time, called the lot size, also increases the amount of inventory that you have. You start with no inventory; then you receive a shipment of whatever lot size you agreed to purchase from your supplier. You gradually sell that inventory to customers until you have no inventory left. Eventually, you run out of inventory again. Over that period, how much inventory did you have on average? The answer is that the average amount of inventory — and the average amount of working capital that you had tied up in inventory — is half of your lot size. Therefore, on average, the more you order at one time, the more inventory you end up with.

Ordering in larger quantities also means that you need to have extra space to store inventory and more people to manage it. Although increasing the lot sizes may get you a lower cost per unit, it could end up increasing your inventory costs even more.

A similar problem comes up when you consider suppliers located farther away. The price per unit may be lower, but the increased transportation costs can eat up all those savings and then some. Shipping items a longer distance can also force you to buy in larger quantities. The farther you have to move something, the more things can go wrong along the way. To compensate for this risk, you'll probably need to — yep, you guessed it — increase inventory.

The way to balance the priorities of purchasing and logistics is to take a total-cost analysis approach to sourcing decisions. Make sure that you're evaluating all the elements that will cost your supply chain money. You may find that a nearby supplier that can deliver in small batches and at a low transportation cost is a much better option than a lower-cost supplier in a distant location that would require you to spend more money on transportation and inventory.

Dr. Larry Lapide from MIT is one of the leading experts on S&OP. He says that there are key factors required for S&OP success, including: ongoing routine S&OP meetings; structured meeting agendas; cross-functional participation; participants empowered to make decisions; an unbiased baseline forecast to start the process; joint supply and demand planning to ensure balance; and support from an integrated supply-demand planning technology.