Category Archives: Strategic Management

Inventory Drivers – Outbound Lead Time

Inventory driverThere are three different types of Lead Time all of which affect Inventory Levels in similar but different ways.  The three types are Inbound, Internal and Outbound lead-time.  Each of these can in turn be broken down to other types of lead time which again affects Inventory levels.  In this posting I want to concentrate on Outbound Lead time because one aspect of it defines most of the effect all the types of lead-time will have on inventory levels.  Specifically, the customer sets the lead time they are willing to wait to receive material once an order has been placed.  The standard joke is that all customers want to receive their orders the day before they place the order but in fact, acceptable lead time is very dependent on the industry you are looking at.  For instance, things like office supplies or cleaners can and usually are delivered the same day but nobody would expect to be able to order a new airplane for delivery the same day (maybe not the same year).  The more customized a product is, the longer the accepted lead time for that product.  How long the customer is willing to wait for their order will, to a large extent, define how much and what type of inventory a supplier must have.  If the customer expects same day delivery then you must keep finished goods on hand at levels higher than the usage rate.  As acceptable lead time grows longer the type of inventory will shift from finished goods to componentry to raw materials to on demand inventory.  This has a direct effect on Inventory Value as the cost of inventory goes up as it moves from raw material to finished goods.  In the end this means that the shorter the acceptable lead time the higher your inventory costs are likely to be.Inventory Driver Lead Time Outbound

The other main aspect about outbound inventory is the logistics of moving from point A to B.  Let’s take the case of a customer that expects same day delivery.  They place an order and you have plenty in stock.  No problem, you can accept the order.  But hold on a minute; they want the material delivered to Vancouver and your stock is in Toronto.  The only way you can deliver within 24 hours is to ship by air but that is too costly.  You can ship by truck but that means 7 day in transit which the customer will not accept.  For you to regularly service this customer properly you are going to have to create a secondary warehouse in the Vancouver area with all the attendant extra costs and increased inventory levels.  This raises the question of whether there is enough business in the Vancouver area to support these extra costs.  Again, the acceptable lead time is affecting your inventory levels and costs.  There are a number of different ways to move your stock but they all have different cost and time profiles. These cost profiles need to be balanced against the cost of inventory and secondary warehouses.  Finally, all this needs to be balanced against customer requirements and the competitive environment you sell in.  (Is there a competitor active in the Vancouver area or will you have it all to yourself for a time).  Each of these considerations and decisions will tend to push inventory levels higher or lower depending on how you chose to meet the requirements.

One thing that is certain about all this is that a large part of the discussion and decision process is more strategical than tactical.  You are setting limits on what markets you are willing and able to pursue, on capital expenditure you are willing to make, on logistical structures and distribution channels that you are willing to use.  These are all strategic decisions.  Once they are made then you can move on to the more traditional tactical decisions.  And all these decisions are required due to customer acceptable lead time.  Far from being a straight forward discussion of keeping inventory lower than a specific value, Inventory Management at this level is a very tangled web with all the various factors interacting with each other.  It actually may turn out to be cheaper to carry more inventory but reduce logistical time and costs.  Again, this goes back to an earlier blog that the only reason to have inventory is if it is cheaper to have it than not have it.  In this case the cost of the inventory is less than the logistics cost created by not carrying the extra inventory.

Next posting we will explore the effects caused by inbound lead time.  In the meantime, enjoy thinking about this topic.  Talk to your friends and co-workers about their experience and thoughts on this topic, especially what it means for your organization.   And, as always, I would love to hear back on your (and their) thoughts.flag

Inventory Drivers – Order Quantity

Inventory driverWelcome back to the ongoing series about Inventory Drivers.  Changing gears slightly I would like to move from accuracy to Order Quantity.   There are two aspects to Order Quantity – Minimum and Maximum.  There are also two different operational groups involved – Purchasing and Production.  All of these affect inventory levels both directly and indirectly plus you also need to consider whether you are looking at individual materials or aggregate levels.  The primary effect of order quantity on inventory levels is reflected in the standard formula for Average Inventory levels of individual items which is:

Average Inventory = ½ the lot size + safety stockInventory Driver Order Qty

The immediate and direct effect of this is that the larger the lot size the larger the average inventory.  Thus it would appear to make sense to reduce lot sizes as this would automatically reduce average inventory levels.  The problem, of course, is that there may be downsides to reducing the lot size.  If reducing the lot size increases your cost by more than the value saved by reducing inventory then this is a bad idea.  An easy example of this would be if you were receiving a liquid product by tank truck.  Reducing the lot size of each order will reduce the average inventory but the cost of shipping will be the same for both lot sizes.  Since the cost of transportation per unit is simple the cost divided by the number of units (let’s say Kilograms in this case) then the cost per kilogram goes up as the number of kilograms per load is reduced.  (I specified a tank trailer as you probably cannot replace the reduced material quantity with a second material which you could do if the material was in drums in a standard truck.)  The point is that the minimum and maximum levels you currently use are probably a reflection of some other constraining factors.  Even if you originally calculated the ideal quantity using the Economic Order Quantity (EOQ) formula it was then rounded to reflect some other factor or factors such as truck size, packaging quantity, takt time…  Does that mean that EOQ is a waste of time?  Absolutely not, but you must recognize that it is only a starting point.  Rounding from the EOQ is easy because when you graph the cost pattern you get a “bathtub” pattern not a bell curve.  In a bathtub pattern (or curve) you have high points at either end with a long flat lower area in the middle. (It looks like a cut-out of a bathtub silhouette, hence the name.)  Since the EOQ point will be in the middle of this flat zone, rounding the number has very little effect on the ultimate cost per unit.  What we need to do in order to reduce inventory levels is to slide the whole curve down.  In order to do that effectively you must first understand what other factors affect the size.  If it is an internal quantity it may not be that difficult to determine what other factors are driving the lot size (mixer size, takt time,,,).  By modifying the appropriate factors you then modify the EOQ which gives you a different range for rounding.  For purchased material this may be a little more difficult as you may not have access to understand, or the ability to change, the cost structure at your suppliers organization.  In addition you also have a set of logistics based cost factors that may also be affecting the final order quantity.

One important consideration about order quantity is that you may not have to order in multiples of the order quantity.  It is possible that the quantity represents a minimum and that once you pass that quantity you can move to a smaller multiplier or even to a lot size of 1 (order exactly what you need).  Again, understanding the drivers that affect the lot size will define the flexibility in the lot size

Bottom line, this is an exercise in strategy versus tactics.  Management instructions (strategy) for inventory reductions will probably be expressed as an aggregate (eg: reduce inventory by 20%) but proper inventory management (tactics) will require you to plan your reductions at the individual material level.  You need to identify those materials that can be reduced, that have a large enough quantity to achieve your aggregate goals and the drivers that affect the inventory levels (in this case, order quantities) before you create a plan to satisfy the strategy.  Failure to do this will almost certainly result in the inventory quickly growing back to its original quantity.  There are reasons for the inventory on hand and if you do not understand and control those reasons you cannot control the inventory levels properly.

Enjoy thinking about this topic.  Talk to your friends and co-workers about their experience and thoughts on this topic, especially what it means for your organization.   I would love to hear back on your (and their) thoughts.flag