Inventory Planning is more than figures in a formula

Roger OakdenGlobal Logistics, Logistics Management, Logistics Planning, Supply Chains & Supply NetworksLeave a Comment

Inventory in warehouse

Uncertainty and risks.

Increasing response to orders (that is reducing lead times) is apparently becoming the requirement of buyers, from consumers to retailers to tier 1 suppliers and back through supply chains. If this situation is true (and I have doubts about the actual situation vs the hype), then having sufficient inventories at critical nodes in your supply chains will become a vital element of the business.

As discussed in recent blogs, a supply chain is a complex system where sales growth and decline, customer service levels, inventory investment, utilisation of assets and operational costs have a non-linear, but tightly interwoven relationship that increases risks. If there is a situation of increasing Uncertainty in your Supply Network, affected by complexity, variability and constraints and an increasing desire for responsiveness by the market, this leads to Instability in the system.

Instability in the system will be evident by increasing variability in the measurement of sales forecast error, inability to meet delivery in full, on time (DIFOT) requirements and a similar situation with suppliers. To reduce instability requires structural and process changes to be made within your organisation; which, in turn may influence improvements to be made at your Tier 1 suppliers and customers.

Given the above scenario, calculating the amount of inventory required and the lot sizes to buy for each SKU becomes an exercise requiring people with a good knowledge of inventory management principles. But, as I have mentioned previously, too many education and training organisations do not place an emphasis in this area. We therefore must rely on the media for the latest information; However, I was surprised recently to read a four page article in a supply chain magazine describing the latest twist to the economic order quantity (EOQ) calculation.

EOQ is not the solution

The EOQ equation first appeared in a 1913 article by Ford Whitman Harris in the American magazine Factory: the magazine of management, so it certainly is not new. Over the years, academics have written articles to promote and extend the EOQ formula as the main approach for calculating a lot size.

Calculating the ‘economic’ lot size means that trade-offs are calculated between production and procurement costs and the cost of holding inventory to the cost of a stock-out. EOQ is a planning tool to minimise the total preparation costs (ordering and set-up) and inventory holding costs. However, the tool was developed in what might be called ‘simpler’ times for calculating lot quantities of bulk commodities.

The original formula was based on a number of assumptions, which can be challenged under today’s more complex situations and when used for items other than bulk commodities. The assumptions are:

  • The rate of demand for the item remains constant
  • The order lead time for the item is fixed
  • The cost to order the item remains constant
  • The purchase price of the item remains constant
  • The delivery of the total order is made at one time

The assumptions were acceptable for the situation in which the formula was used, but they are less so for complex systems containing multiple risks. The underlying assumptions in EOQ illustrate that the formula and its modifications have limited use. Maybe in budget planning and calculating the lot sizes of indirect items.

Inventory planning requirements

If EOQ is not the solution for today’s inventory management, then what is? Rather than promote a ‘solution’, the initial step is to identify the requirements of an application, based on the customer service policy and the inventory part of the supply chain strategy. Firstly, there are two structural requirements:

  1. The financial investment required will be an output, not the target figure which cannot be exceeded. The previous blog identified the many elements in a supply chain that can affect inventories. If the financial investment target is exceeded, you must change the customer service policy or supply chain strategy, then re-calculate the inventory investment
  2. Where there are long and more complex supply chains, analyse where inventories:
    • should be held e.g. in-house, customer, supplier, third party
    • in what form e.g. raw and packaging material, part-finished, finished and
    • for what function e.g cycle stock, safety stock, in-transit inventory and safety stock and slow and obsolete (SLOB) required by sales

When calculating inventories, there are two groups. The first addresses continuing business is to improve the chance of meeting the in-full and on-time (DIFOT) expectation of customers and to minimise logistics problems. For each SKU calculate:

Cycle inventory. Inventory at the mid-point through the replenishment cycle (half the order quantity). The most appropriate order policy is based on batch size, change-over times and operational sequencing

Fluctuation inventory. Inventory held in excess of the cycle inventory to overcome the uncertainty associated with unplanned events. This inventory is called either safety stock, reserve stock or buffer stock. It is affected by the variance in demand, supply and lead times. Fluctuation inventory can be reduced through

  • process improvements to the interface points of customer push and operational pull (called decoupling points) and
  • identifying opportunities for postponement of adding value to items

The second group of inventories address business strategy objectives. Three inventory types are calculated for each relevant SKU:

Anticipation inventory. When inventory is built in advance of a peak demand. This can be for a product launch, seasonal demand, public and religious holidays, planned shutting for maintenance, extended holiday periods or supplies of a item becoming restricted

Hedging inventory. Buy and hold additional commodities (e.g. natural fibres, grains and metals) when the global price is considered to be low. Instead of investing in physical goods, the future price of the material can be secured through trading contracts of future purchases on the international commodity exchanges

In-transit or transport inventory. If items are purchased by the brand owner and they arrange transport, the inventory value becomes part of the company’s assets and therefore is designated as in-transit inventory. The calculation of in-transit inventories and safety stocks is affected by the length of trade lanes, seasonal delays and events. A current example is the new grouping of container shipping companies, which has caused a re-positioning of container ships and consequent delays

These five inventory types show that planning inventories and lot quantities is more than plugging figures into a pre-determined formula. As with any algorithm, the challenge for Logisticians and inventory planners is understanding and justifying the assumptions behind calculated outcomes.

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About the Author

Roger Oakden

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With my background as a practitioner, consultant and educator, I am uniquely qualified to provide practical learning in supply chains and logistics. I have co-authored a book on these subjects, published by McGraw-Hill. As the program Manager at RMIT University in Melbourne, Australia, I developed and presented the largest supply chain post-graduate program in the Asia Pacific region, with centres in Melbourne, Singapore and Hong Kong. Read More...

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