TOC Inventory Management: A solution for shortage and
excess dilemma / Namkee Chung / S.Korea / 2013
Generally speaking, inventory asset takes around 30%
of total assets for a manufacturing firm and almost 90% for a distribution
company. Note that there is no need of inventory management in case of bulk
purchasing when a price raise is expected for certain materials or parts; there
are fewer risks of maintaining excessive stocks as long as it is certain to
gain the more profits with the more stocks. Also note that work in process or
WIP is better to be dealt with operation management instead of inventory
management since WIP inventory may vary depending on production planning
method, production capacity of each process, and changeover system.
The core competency factor for distribution industry
is a systematic control between sales and supply of goods. After all, it is
impossible to avoid stock-out and overstock with the purchasing planning system
based on the above demand forecast. Another method is needed that can function
regardless of sales forecast. As such, there are great concerns about stock-out
and overstock due to variation of demand when inventory management is solely at
hands of a production planner to determine production volumes and timing. The
key issues to be dealt with inventory management are rather decision-making
issues as following than the data collection and application; - Selection of items
for base stock - Location of inventory - Determining order quantity and timing
- Decision for optimal inventory level
Firstly, to
decide items for base stock, choose ones whose demand is large enough.
Secondly,
location of inventory refers to a physical place for stored goods.
Thirdly,
order quantity and timing strongly affect stock-out and overstock occurrences,
Lastly, an
optimal level of inventory can be determined by ordering time and quantity as
well.
Since an official record of 2-3% of stock-out rate
would actually represent over 20% off-the-record rate, we need to keep the rate
near zero. What would be the solution to keep the minimum stock while securing
the maximum sales opportunities? It is only possible when the inventory control
system is built up independently from demand forecast. improving sales forecast
accuracy is not that easy. In fact, there is no ‘accurate demand forecast’ in
real world, and that is the most prominent problem of inventory management. when
the supply lead time is longer than the customer lead time, in order to prepare
the required stocks in advance, there is no other choices but to place
pre-orders by predicting quantity and timing. This is one of inventory control
methods depending on demand forecast. The forecast-dependent pre-order system
is frequently used also for goods in distribution. because each function of the
supply chain seeks only a local optimization, it makes the supply lead time
longer and the longer lead time brings the more dependency on sales forecast.
Inventory management should be implemented in a way to
reduce the supply lead time rather than improving forecast accuracy. The
inventory turns ratio is cost of goods sold (or net sales) divided by average
inventory assets. despite the improved inventory turns, the number of unsold
items would go up due to stock-out, and the sales would go down. Like
previously mentioned, inventory should be controlled up to the point where it
does not create any stock-out even during the process of improving inventory
ratio. Even though we can fix the ratio by item, it could just be a target, and
it does not imply any managerial advice. The inventory turns ratio itself does
not provide any insight on how to decide an optimal inventory level nor how to
manage it effectively. the suggested solutions are to get rid of the three main
concerns – the reasons why operating a large inventory. - Make replenishment
period shorter, - Improve demand forecast accuracy, - Enhance supply
reliability
Two-bin system is to fix an order point and order
quantity to facilitate the administration. This system is mainly useful for low
value items, standardized goods with a shorter lead time, and office supplies.
Continuous Replenishment Planning (CRP) does not refer to a replenishment
system itself but rather an operating program for it. It is a procedure or a
scheme of business process of controlling inventory for goods for sale,
indicating a method of replenishment for a certain location where goods are
sold or consumed. Therefore, in order to implement CRP, it is a prerequisite to
determine specific order quantity and time. In order to expect those benefits
from CRP, a proper decision making process should be established so that it can
make the best use of information on current supply, narrow variations in lead
time, and cope with fluctuating demand and business environment.
Vendor Managed Inventory (VMI) is an arrangement where a supplier
decides when and how much of customers’ stocks to be replenished. In that case,
the vendor receives the payment only for those which have been consumed by the
mother company. The VMI method can also be applied when a manufacturing company
is managing inventory for a distributor. The seller supplies goods in
accordance with the consumer demand except when there are sufficient stocks in
the distributor’s warehouse.
Co-Managed Inventory (CMI) is similar to VMI in its structure
of overall business process, but it is different in that suppliers and buyers
are working together.
Supply Chain Management (SCM) is a business administration system
to effectively operate the supply chain. SCM connects sales to manufacturing by
regulating inventories in the supply chain. Related feedback from managers,
supervisors, and staff is quite common, and can be summarized as follows; -
Demand forecasting system is in a mess. - Inventory managers are negligent in
monitoring stocks. - Purchasers buy too many for some items and too few for
some others. - Information from sales/distribution is not sufficiently shared.
- Customers change their minds too often. order cycle time and order quantity
affect stock levels, as well as overall related cost for inventory controls; a
frequent replenishment or a shorter order cycle time causes a heavier workload
and more transportation cost, but on the contrary, expenses are likely to be
reduced to maintain the inventory.
Replenishment can be done in four different models
depending upon the decision factors for order time and quantity. That is, order
time can be determined on either periodic or non-periodic basis, and order
quantity can be decided on either fixed or non-fixed quantity basis.
Target Inventory System involves setting a target inventory
and placing an order for what have been consumed during a given period of time.
In other words, it is a replenishment method to make up the actual consumption
for a cycle time. Placing orders at predetermined time intervals will
facilitate and simplify daily duties. here are the summarized business
processes; - Sales team to submit a replenishment request to plant (or
distribution warehouse) to make up what have been actually sold. - Plant (or
distribution warehouse) team to establish a production plan (or distribution
plan) based on the request, while purchasing team to set a purchasing plan for
materials/components in line with the actually produced volumes. - During this
process, an individual target inventory (22 units of sales, 10 of plant, and 20
of purchasing team) enables each function to independently work on its
planning. Such link in business flows between sales – distribution –
manufacturing – purchasing is the core issue of Supply Chain Management (SCM)
or Sales & Operation (S&OP), a major part of logistics management. can
be summarized from the perspective of the Decoupled Pull System as below; - As
sales team sells the goods, the stock level reduces in distribution warehouse
as many as the sales quantity. Then, distribution warehouse team places a
reorder to plant team (or a supplier) to make up the consumption. - The plant
(or the supplier) makes a shipment out of its on-hand stock to the distribution
warehouse, and adds up the same quantity to production planning. - The plant
team places a reorder for the subsequent materials as much as it has consumed
for production. To conclude, followings are the summarized features of Target
Inventory System.
First, it is a decoupled pull-based system. Although
order quantities match the actual sales, each functional operation can remain
independent. This benefit reinforces the capacity to cope with demand
variations by making full use of inventory functionality and by driving
cross-functional cooperation.
Second, it streamlines the inventory controls as the
order time can be fixed at a regular interval. There is no need to monitor
stock levels all the time and no need to be concerned about missing an order
time, so it reduces stock-out risks consequently.
Finally, what needs to be determined is the inventory
target only. Order time can be easily fixed upon the corporate policy or upon
the demand. To be specific, classify a set of products into A, B, and C group
and fix the order cycle time as daily, weekly, and monthly each. Then, except
under special circumstances, it is well enough to simply adjust the inventory
target only although the demand or lead time may vary. It makes it easy to
create an effective inventory management system.
It can be said that most of replenishment systems that
are currently deployed in business are Reorder Point Systems. This
method is still in use going through several modifications since Economic Order
Quantity (EOQ) has been proposed in early 1900s. Indeed, a pull-based method is
more appreciated than a push-based method in terms of effective demand controls
in most of business management systems. The number of items in stock must
increase in line with the more demand and the longer replenishment period. Replenishment
Period needs be defined in detail; it consists of order cycle time, production
lead time, and transportation lead time. First, order cycle time is the time
between orders. If orders are placed on every Monday, then, its order cycle
time is to be seven days. Second, production lead time can be defined as the
total time required to produce an ordered item including order processing time,
queue time, actual manufacturing time, and so forth. Finally, transportation
lead time refers to the time from production finished to customer order
delivered. Sometimes, the term ‘supply lead time’ can also be used, meaning the
sum of production lead time and transportation lead time, that is, the time it
takes from when you place an order until it arrives on your doorstep.
Therefore, replenishment period can be said to be the sum of order cycle time
and supply lead time. When the ordered items on Mondays arrive after five days,
the replenishment period can be counted to be 12 days, 7 days of order cycle
time plus 5 days of supply lead time. To sum up for a better understanding; -
The amount of supply stock is determined by the demand during the supply lead
time. The shop’s on-hand stock is determined by the demand during its order
cycle time. Available stock, the sum of supply stock and on-hand stock, is
determined by the demand during the replenishment period, i.e., supply lead
time plus order cycle time. total available stock (= supply stock + on-hand
stock) is proportional to the demand during replenishment period (= supply lead
time + order cycle time).
However, generally speaking, people tend to be quite
active in reflecting the demand rate but passive in reflecting replenishment
period. This is why they put more efforts in forecasting demand. However, in
fact, impacts of replenishment period are more critical having more indirect
influences described as following; - In most cases, the longer replenishment
period, the greater uncertainty, that is, the greater deviation of the period.
- Hence, the longer replenishment period means the bigger demand variability. -
Moreover, the longer replenishment period, the longer forecasting period of the
demand. - Therefore, the longer forecasting period means the lower demand
forecast accuracy. - Since target inventory consists of average demand for the
replenishment period and safety stock to mitigate any variability, a doubled replenishment
period should involve a doubled target inventory. Now, it is time to provide
the target inventory formula. - Fix an expected demand for replenishment
period. If demand rate is known, the demand forecast can be calculated by
multiplying the demand rate by replenishment period. - Add safety stock to
mitigate any uncertainty factor. This is determined by management policy
considering a target customer service level.
Q = T – A Q: Order Quantity A: Available Stock
(=On-Hand Stock + Open Orders – Actual Demand)
In order to lower stock levels and ensure sales by
reducing stock-outs at the same time, it is necessary to shorten replenishment
period. What are the main factors to make the order cycle time and supply lead
time longer? One of the factors is the habitual practice of order processing in
batch. Batch processing extends the order cycle time. Because many believe that
a bulk purchasing lowers the purchasing price easing the order processing work,
they take time to release an order until the orders are combined into a large
batch. Besides, what makes a longer production lead time is production in large
lots. People believe that decreasing set-up times while enlarging batch sizes
is the best way to improve productivity and reduce production cost per unit, so
ultimately it would create more profits. The reason why transportation lead
time to be lengthened is also similar. Since making a big transportation batch
can save transportation costs, people take time until the number of goods to be
delivered becomes big enough before beginning transportation.
In order to make the replenishment period short, it is
easier to reduce the order cycle time than supply lead time. Note that the
shortened order cycle time can reduce on-hand stock but not supply stock.
Supply stock can only be reduced with supply lead time decrease. Taking into
account of only the demand factor, it is enough to run a system to set a
shorter cycle time with a bigger demand or a longer cycle time with a smaller
demand. In this way, it is determined by management policy based on experiences
without meticulous calculations, and this is a better solution at a working
level. For example, divide each set of products into A, B, and C group based on
its sales quantity and unit price, then assign one week of order cycle time to
A group, one month to B group, and three months to C group each. Simplicity
works better.
Service level, in general, represents the percentage
of satisfying customers’ needs. In inventory management, Service Level can be
defined as the probability that goods are delivered as requested by customers. Safety
Stock refers to an extra level of stock added to average demand to immediately
enhance the service level. Safety stock is added only to on-hand stock and not
to supply stock. Recall that the supply stock is determined by the demand
during supply lead time, and on-hand stock is fixed by the demand for order
cycle time. In this sense, safety stock is a buffer to mitigate demand
variations during the order cycle time only, because there will be no more
stock-out risk once the cycle time is finished thanks to newly arrived items. the
decision factors of target inventory are demand rate (average demand per time
unit), demand variability, replenishment period, and replenishment period
variability. As a matter of fact, it is nearly impossible to attain a precise
level of forecast. Even with heavy investment of time and money, forecasting
accuracy is hardly improved. What we can expect to get is just some trend information
on demand rate. if inevitably required, it is better to use short-term forecast
rather than long-term one. Moreover, it is preferred to have forecasts by
product group rather than by individual item. The deviation of the sum is
normally smaller than the deviation of individual data, and this is what the
Central Limit Theorem has generalized as a theorem. Although sales forecasting
is a difficult task, an overall trend can be estimated to a relatively
satisfactory level of accuracy.
Risk Pooling. It is a concept to effectively offset an overall
uncertainty of the system by combining risk factors or uncertainties across
locations into a single location. goals; - Make replenishment period shorter -
Improve demand forecast accuracy - Enhance supply reliability –
Measures to shorten the replenishment period
1. Make order cycle time shorter by placing orders for
what have been actually sold on a previous day (or week, month, etc.).
2. Make a small size batch to reduce supply lead time.
3. Decrease or get rid of supply lead time by holding
inventory.
Measures to improve demand forecasting accuracy
1. Set a broad target area for demand forecasting.
2. Integrate each regional inventory to a centralized
distribution station for management. 3. Make the best
use of safety stock.
Measures to enhance supplier reliability
1. Make the best use of safety stock.
2. Reduce the number of emergency orders by placing
orders for what have been actually sold on a previous day (or week, month,
etc.).
Reorder Point System has its own value to be applied.
The system has an advantage of being deployed when there is no substantial
problems without sophisticated controls. The business processes can be much
more simple. Supplies like raw materials/components are well suitable for
Reorder Point system, those of which demand is not so big but that have a
common usability. To be specific, the following is the process of inventory
fine-tuning in preparation for seasonal variations. Estimate first the maximum
sales during a high demand season. Check then available stocks on hand for this
season. If you subtract the stocks on hand from the estimated maximum sales,
you can get the target to be added before the high season comes. You need to
raise the target level in advance up to this calculated point. Then, there will
be no problem of supplying the demand as forecasted without having overstocks. On
the other hand, you should not modify the target with a one-time sudden rise or
drop that does not imply a trend. This can be settled by releasing special or
extra orders. If the target inventory is changed with those one-time events, it
will keep triggering stock-outs or overstocks afterwards. it is called Buffer
Management that adjusts and controls the target inventory. Buffer Status (%) =
On-Hand Stock level / Target Inventory These systems allow us to assess the
priority not based on the smaller number of stock being more urgent but based
on the ‘relatively’ smaller number of stock comparing with the target being
more urgent.
“Instead of trying to be very precise in very
uncertain situations (like using sophisticated forecasting techniques), TOC
strives to build a robust design that is good enough. What complements
good-enough planning is a very flexible and priority-driven execution control
system that is capable of taking care of the exceptions.”
Buffer management allows to keep the optimal inventory
by providing signals which orders need to get an urgent attention in response
to demand variations including changes in demand rate, suppliers’ capacity, and
supply lead time, etc. In case of penetration of the red-line, check first
progress of open orders that have not yet been shipped to and call for an
immediate supply as early as possible. On the contrary, in case of penetration
of the green-line, postpone the shipment of open orders or do not place an
additional purchase order. What needs to be done next is to verify how largely
the buffer zone (the red or green) has been penetrated and modify the target
level accordingly. This is what we call ‘Dynamic Buffer Management (DBM)’. The
word ‘dynamic’ emphasizes here the meaning of active management and
readjustment according to ‘situational changes upon time’. There are three
types of circumstances in which the target level needs to be revised under
Target Inventory System, described as follows;
1.
The target inventory has been set too low.
2.
The target inventory has been set too high.
3.
There are some special factors to be considered such as seasonality and
promotions.
The size and duration of penetration are the two
important parameters to adjust the target inventory. If the inventory
penetrates ‘too much’ the red zone, the target level should be raised by one
block size; the criteria ‘too much’ include either ‘too large’ size of
penetration, ‘too long’ period of penetration, or ‘too big’ accumulated red
zone penetration. After waiting until open orders arrive, that is, waiting for
the replenishment time (this waiting time is so-called ‘Cooling Period’) passes
by, you may start again to keep track of red zone penetration, if any. The
reason why this cooling period is necessary is to check outcomes from the
adjustment first before reviewing any further adjustment. If you add
supplementary modification before the outcome is revealed, the adjustment
process will never end that will make the target level go up endlessly.
If the inventory penetrates ‘too much’ the green zone,
the target level should be lowered by one block size; the criteria ‘too much’
include either ‘too large’ size of penetration, ‘too long’ period of
penetration, or ‘too big’ accumulated penetration Once these assessments on
buffer penetration are done, the target inventory is to be adjusted downward,
and you may begin monitoring the actual stock level again. Then, if the stock
level falls nearly to the modified target, wait further until the replenishment
time ends and now observe newly again the penetration situation of the green
zone. Therefore, in this case, the cooling period is longer than the
replenishment time. If there is no such cooling period in this process, the
target level will almost endlessly go down.
In case where a sharp increase or sudden drop is
expected due to the seasonality and promotion, there must be extra attention
paid to this operation of buffer management. It can also be sought to temporarily
suspend the buffer operation depending on situation. The graph shows the upward
and downward temporary manipulations of the inventory level, ignoring the
target inventory. When a drastic demand increase is foreseen, prepare in
advance more stocks than the target, and stop the buffer management for a while
to do so. When the demand is back to normal, you may resume operation of the
system while keeping monitoring of the demand. In the same manner, when a rapid
drop is expected in the demand, begin lowering the stock level regardless of
the target. You need to stop the operation temporarily until the demand gets
back to a stable level.
a replenishment period is the sum of order cycle time
and supply lead time (= production lead time + transportation lead time). This
supply lead time is sometimes very long comparing with order cycle time, and in
such cases, target inventory becomes quite high relatively to on-hand stock.
Moreover, the number of open orders increases, thus, the available stock
(=on-hand stock + open orders – actual demand) increases accordingly because
the quantity of open orders is proportional to the supply lead time
In these cases, the rules of determining buffer zones
(green, yellow, red zones) must change. It may not be appropriate to keep the
regular principle, i.e., setting each size of the zones to one third of the
target inventory. If the same rule was applied to set the red zone to a third,
stock-out risks from the on-hand stock could be very small regardless of its
red sign. It means that the red zone signal does not work properly as a warning
system because of enough open orders to be delivered soon. To make up for this
kind of situation, it is desirable to fix the red zone size smaller than a
third and the green bigger than a third. To sum up from the perspective of
actual application, you have to make the order cycle time shorter and place orders
more frequently, if it takes long time from the point of order to arrival, that
is, if your product has a long supply lead time. While doing so, there are not
much of stock-out risks because you have a plenty of open orders that will
arrive soon despite the currently low level of on-hand stock. Moreover, if you
set the red zone size smaller than a third of the target, the stock-out
alarming system will become much more functional.
If you have sufficient available stocks despite a
lower level of on-hand stock, potential risk of stock-outs will not be so
significant. This is because there are ordered volumes to be soon delivered. In
this case, rather than placing a new order, it is more effective to call for
urgent supply of the open orders. In the case in which the available stock is
not sufficient, you need to place a new order. If the on-hand stock is
particularly not enough, you have to make it immediately. operating two
separate buffer zones for two types of stocks can be very useful, especially
when supply lead time is considerably longer than order cycle time. Hence, a
good performance indicator on stock-out management should incorporate not only
the quantity but also its duration period. Taking one step further, it should
also involve financial loss caused by the stock-outs. In Theories of
Constraints (TOC), this kind of measurement is called Throughput-Dollar-Days
(TDD). It is a calculated value of a product’s throughput dollars multiplied by
days of all the commitments not delivered.
Likewise, a good performance indicator for overstocks
includes the length of stay. This value is calculated multiplying the overstock
value (inventory dollars) by the number of extra days it is kept in the system.
It is called Inventory-Dollar-Days (IDD) in TOC terminology. IDD will increase
as the amount of overstock inventory goes up or as the days of stay gets
longer. Remember that our objective is to manage the IDD to not to further
increase or to make it reduced. TDD measures the financial value and delayed
time of stock-outs, as well as loss coming from unfulfilled market demand. On
the order hand, IDD measures the value of overstock that blocks flow of the
system, and it is used as an indicator monitoring how fast each stock moves in
developing SCM solutions, it is a valuable approach to set a target inventory
and to distribute/produce according to actual sales quantity.
The forthcoming 4-step procedure is suggested to be
followed,
1.
[Operate a centralized distribution station] Supplier (manufacturer or
distributor) to establish a centralized distribution station and hold inventory
for most of items in this location.
2.
[Regional warehouse to place orders on the basis of actual shipment] Each
regional warehouse to fix a target inventory for each item and place an order
for the same quantity as it shipped out on a previous day (or week) to the
centralized distribution station.
3.
[Retail store to place orders on the basis of actual sales] Each retailer to
fix a target level for each item and place an order for the same quantity as it
sold on a previous day (or previous week).
4.
[Buffer management] Each of centralized distribution station, local warehouses,
and retailers to keep track of demand variations and adjust the target level
when necessary.
The objective of operating a centralized distribution
station is to minimize forecasting errors. Taking into consideration of that,
make a smaller target level towards the downstream to the retail level. To make
it safe, keep the most of inventory at a center, a little less at a regional
stock, and much less at retailers. Although the centralized warehouse will have
an inventory rise, it is still less than the sum of the decreased amount
of inventory in each retail shop and regional warehouse. By rule of thumbs, it
can cut the inventory nearly to 2/3 of the previous level. It doesn’t raise
transportation cost although item composition and order cycle time has changed.
the starting point is to place most of inventory at
supplier’s (or distributor’s) centralized distribution station so that
retailers can place daily orders to the center (or regional warehouse) for the
same quantity as the sales of previous day. Inventory is kept for
common/flexible purpose Plant’s production planning becomes stabilized. Retailers’
inventory becomes reduced Retailers can have a larger space for displaying
stands. Retail sales increase. Quality of fresh products is improved. New
product launching is accelerated. New distribution channels are created. Overall
Inventory level is reduced in distribution network It becomes less dependent on
demand forecasting
in case of the materials of which supply lead time is
longer that customer lead time, it is a must to secure the inventory in
advance. you have to arrange the materials in advance to be available within
the customer lead time. MTO (Make-to-Order) is a production system to start
manufacturing of customized products only after a confirmed order for the
products is received. MTO production method can be effectively operated by
combining a replenishment system to MRP. Reserve inventory for the items that
require to be held in stock and maintain the optimal inventory level through a
replenishment system.
