Category Archives: Supply Chain Concepts

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 – Safety Stock

Inventory driverOne of the biggest Inventory Drivers is Safety Stock.  Safety Stock is, by definition, excess stock that you deliberately keep in order to insure higher Customer Service levels.  (We will talk about Customer Service in a later posting.)  There are many ways of calculating how much safety stock you need but the easiest is by calculating it based on the desired service level.  The formula for this is:

 Safety Stock = Standard Deviation X Service Level Safety Factor

 The problem with this is that as the desired service level goes up so does the required inventory but not in a linear form but rather as exponential growth.  What this means is that, as a rule of thumb, for the last couple of percent increases in service level the required inventory will double.  Specifically, if you need 1 million dollars’ worth of inventory for 97% service level, you will need about 2 million for 98%, 4 million for 99% and infinite inventory for 100%.  So when upper management says you are never allowed to stock out, it is statistically impossible (no such thing as 100% only 99 with a whole bunch of 9’s after the decimal). The more important point is that no organization can afford to carry enough inventory to ensure they never stock out. Fortunately theory and reality rarely match exactly and there are a number of controls and expedite tools to get better service levels than mathematically projected.  The larger point here is that most people (and ERP systems) just do the calculations and never question the answer.  This can lead to much higher inventory levels than necessary.  We need to control the inventory levels which means controlling the drivers (such as Safety Stock).

Regardless of the calculated number, one of the easiest ways to reduce it is to investigate the standard deviation of the demand and find ways to reduce it.  This will automatically reduce the calculated safety stock levels.  If your organization is already invested in Lean Six Sigma, this is a prime area for waste reduction and deviation control.  Some of the other areas that will affect safety stock are:

  • Inventory Accuracy levelsInventory Driver Safety Stock
  • Lead Time
  • Demand Inconsistency
  • Warehouse Capacity
  • Production Capacity
  • Service part commitments
  • Shelf life
  • Logistics (Inbound and Outbound)
  • Government regulations

Another issue with safety stock is that once it has been set, many organizations fail to review the number on a regular basis (at least annually).  For anyone using MRP this is critical because the system will automatically use the safety stock level quantity in the order point calculation.  Let’s say that a material has been discontinued and all the stock sold off.  If the safety stock level has not been reduced to zero then the system will automatically generate a new requisition to bring stock back up to at least the safety stock level.  If there is a standard lot size embedded in the system then the generated requisition will be for that lot size.  Unless someone notices that this is an obsoleted part it WILL be ordered and brought in, thereby creating excess / obsolete inventory.  How good is your system and could this happen to you?  Using Safety Time rather than safety stock will help avoid this problem because the level is set by the forecast rather than a fixed number.  If there is no forecast in the system than the quantity will auto set to zero.  This is also useful if you have a highly seasonal product as the safety stock quantity goes up and down in response to the forecast.  Of course that solution does assume a relatively accurate and up to date forecast which is a whole different topic.  (See my previous blog on Forecast Accuracy.)

The critical thing to remember in all this is that Safety Stock is all about balanced risk.  You are balancing the cost and risk of obsolete or slow moving stock against the risk of shorting a customer order.  Given the costs and repercussions of shorting a customer, most organizations will tend to keep a little more stock than necessary to ensure fewer stock outs.  While not necessarily a bad thing it should not be carte blanche to let the inventory run wild.  In the end inventory is just money in another form and no company can let their costs get out of control.

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