How to Set Performance Targets in Inventory Control

1
How to Set Performance Targetsin Inventory
Control

• Dr. Everette S. Gardner, Jr.

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How to Set Performance Targets in
Inventory Control

• Clean up the parts list
• Develop a basic forecasting system
• Use the forecasts to classify parts (ABC)
• Decide what to stock
• Decide where to stock it
• Divide the inventory into control groups
• JIT, MRP, EOQ, Annual buy
• Develop benchmark performance measures

3
Clean Up the Parts List

• Code substitute items
• Ensure historical demand recorded against primary
  items
• Delete obsolete items (no longer used in current
  product line)
• Do the part numbers apply to other customers or
  products?
• Review items with no recent demand
• Stocking rules usually depend on demand in the
  last 6 months or the last year
• Negotiate with vendors to return parts for credit

4
Water Filtration Company
Status of 23,192 inventory items
5
The Importance of Forecasting

• Forecasts determine production and inventory
  quantities
• MRP Master schedule
• EOQ Order quantity, leadtime demand, safety
  stock
• JIT Requirements to internal and external
  suppliers

6
The Importance of Forecasting (cont.)

• Better forecast accuracy cuts inventory
  investment. Example
• Forecast accuracy is measured by the standard
  deviation of the forecast error.
• Safety stocks are usually set at 3 times the
  standard deviation
• If the standard deviation is cut by 1, safety
  stocks are cut by 3

7
Forecasting Tools for Inventory Control

• Simple exponential smoothing
• Weighted-moving-average technique for stable
  items
• Highly recommended for repair parts demand
• Trend-adjusted exponential smoothing
• Estimates and projects growth (or decline) in
  demand
• Types of growth
• Exponential
• Linear
• Damped
• Both models are easily modified to handle
  seasonal demands

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Origins of the Damped Trend

• Reference
• Gardner McKenzie, Management Science, 1985
• Operational requirement
• Automatic forecasting system for military repair
  and maintenance parts
• Theory
• Lewandowski, IJF, 1982 (M1-Competition)
• Trend extrapolation should become more
• conservative as the forecast horizon increases.

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The Damped Trend

• Error Actual demand Forecast
• Level Forecast Weight1(Error)
• Trend ?(Previous trend) Weight2(Error)
• Forecast for t1 Level ?Trend
• Forecast for t2 Level ?Trend ?2 Trend
• .
• .

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Automatic Forecasting with the Damped Trend

• Constant-level data
• Forecasts emulate simple smoothing
• Consistent trend
• Forecasts emulate Holts linear trend
• Erratic trend
• Forecasts are damped

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Automatic Forecasting with the Damped Trend
In constant-level data, the forecasts emulate
simple exponential smoothing
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Automatic Forecasting with the Damped Trend
In data with a consistent trend and little noise,
the forecasts emulate Holts linear trend
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Automatic Forecasting with the Damped Trend
When the trend is erratic, the forecasts are
damped
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Automatic Forecasting with the Damped Trend
The damping effect increases with the level of
noise in the data
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11-Oz. Corn chipsMonthly Inventory and Sales
Actual Inventory
Sales
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Damped-trend performance
11-oz. Corn chips
Outlier
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Investment analysis 11-oz. Corn chips
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Safety stocks vs. shortages
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Safety stocks vs. forecast errors
Safety stock
Forecast errors
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11-Oz. Corn chips Target vs. actual packaging
inventory
Actual Inventory from subjective forecasts
Actual Inventory from subjective forecasts
Target maximum inventory based on damped trend
Month
Monthly Usage
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How to forecast regional demand

• Forecast total units with the damped trend
• Forecast regional percentages with simple
  exponential smoothing

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Regional sales percentages Corn chips
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Target Inventory Analysis

• Actual inventory based on subjective decisions
• 182.6 million
• Target inventory based on the damped trend and
  EOQ/Safety stocks
• 135.0 million
• Projected savings
• 47.6 million

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Water Filtration Company Water Filtration Company Water Filtration Company Water Filtration Company Water Filtration Company Water Filtration Company
Inventory Classification Inventory Classification Inventory Classification Inventory Classification Inventory Classification Inventory Classification
Active Items (some demand in past year) Active Items (some demand in past year) Active Items (some demand in past year) Active Items (some demand in past year) Active Items (some demand in past year) Active Items (some demand in past year)
Class Class Limits Total nbr. of items Percent of items Total sales forecast Percent of forecast
A gt 36,000 364 4 11,743,610 60
B 600 - 35,999 4,232 46 7,316,999 38
C lt 600 4,668 50 365,605 2
Totals Totals 9,264 100 19,426,214 100
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Water Filtration Company Water Filtration Company Water Filtration Company Water Filtration Company Water Filtration Company
Inventory Classification Inventory Classification Inventory Classification Inventory Classification Inventory Classification
Class Definition Number of items Percent of items
Active Items A Active items Sales gt 36,000 364 1.51
B Active items Sales 600-35,999 4,232 17.6
C Active items Sales lt 600 4,668 19.42
Slow Movers Z Zero forecast items no hits in 6 mon. 1,548 6.44
D Disposal items no hits in 12 mon. 11,526 47.95
Buys not based X One-time buys 146 0.61
on demand N New items established in last 12 mon. 968 4.03
Miscellaneous F Free (no-cost) items 27 0.11
P Problem items (missing data) 560 2.33
Totals 24,039 100.0
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What to Stock?

• Compare costs
• Cost to stock (Avg inventory balance x holding
  rate) (number of stock orders x transportation
  cost)
• Cost to not stock Number of customer orders x
  transportation cost
• Transportation costs for not stocking may be both
  in- and out bound, depending on whether we choose
  to drop-ship from the vendor

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What to Stock? (cont.)

• Simplify decisions using hit rules
• A hit is one customer order for any number of
  units. Cost comparisons usually result in minimum
  number of hits that must occur before it is
  economical to stock.
• Example
• Class A 6 hits in 6 months
• Class B 4 hits in 6 months
• Class C 3 hits in 12 months

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Water Filtration Company Water Filtration Company Water Filtration Company Water Filtration Company Water Filtration Company Water Filtration Company Water Filtration Company Water Filtration Company Water Filtration Company
Inventory Status as of July, 2009 Inventory Status as of July, 2009 Inventory Status as of July, 2009 Inventory Status as of July, 2009 Inventory Status as of July, 2009 Inventory Status as of July, 2009 Inventory Status as of July, 2009 Inventory Status as of July, 2009 Inventory Status as of July, 2009
Class Definition Definition Definition Minimum hits to stock Excess stock qty. Nbr items stocked Nbr items not stocked Total
A Active items Sales gt 36,000 Active items Sales gt 36,000 Active items Sales gt 36,000 6 in 6 mon. gt 6 mon. 290 74 364
B Active Items Sales 600 - 35,999 Active Items Sales 600 - 35,999 Active Items Sales 600 - 35,999 3 in 6 mon. gt 6 mon. 3,108 1,124 4,232
C Active items Sales lt 600 Active items Sales lt 600 Active items Sales lt 600 4 in 12 mon. gt 12 mon. 2,938 1,730 4,668
Z Zero forecast items no hits in 6 mon. Zero forecast items no hits in 6 mon. Zero forecast items no hits in 6 mon. - All - 1,548 1,548
D Disposal items no hits in 12 mon. Disposal items no hits in 12 mon. Disposal items no hits in 12 mon. - All - 11,526 11,526
X One-time buys One-time buys One-time buys - All - 146 146
N New items established in last 12 mon. New items established in last 12 mon. New items established in last 12 mon. - Same as ABC 170 628 968
Totals 6,506 16,776 23,452
Totals 6,506 16,776 23,452
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Where to Stock?

• Centralized order entry is mandatory
• Apply the hit rules by location
• This automatically tailors the range of stock to
  the customer base at each location
• Must designate who suppliers whom when a hit
  occurs at a non-stocking location
• Recognize that consolidating stocks makes
  dramatic reductions in total inventory investment

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Who Supplies Whom?
Stocking Warehouses LA forecast FL forecast CA/OR forecast
1 LA FL LA CA/OR FL only 0
2 LA CA/OR LA FL 0 CA/OR only
3 FL CA/OR 0 LA FL CA/OR only
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Effects of Consolidating Inventories
Manufacturer of Communication Systems
Investment (millions)
Number of Warehouses
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Monthly Item Migration Processing
Original Class Result of monthly review Action
N (new items) Enough hits in last 6 months to stock. Generate forecast, change N to A,B, or C
At least 1 hit in last 6 months, but not enough to stock Generate forecast, change N to A, B, or C
No hits in last 6 months, but hits occurred 7-12 months ago Set forecast zero, change N to Z (zero forecast)
No hits in last year Change N to D (disposal)
A, B, or C (active items) No hits in last 6 months Set forecast zero, Change A, B, or C to Z (zero forecast)
Z (zero forecast) No hits in last 12 months Change Z to D (disposal)
1 or more hits Change Z to A, B, or C
D (disposal items) 1 or more hits Generate forecast, Change D to A, B, or C
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Control System Inventory Class Production Schedule Lead-time Behavior
JIT A, B Level Certain
MRP A, B Variable Reliable
EOQ/Safety Stock A, B Variable Variable
Annual buy C Any Any
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The Economic Order Quantity (EOQ)

• Controls
• Cost per order
• Holding rate ( of inventory value)
• The EOQ
• Increases with the order cost
• Decreases with the holding rate
• Do not treat order cost and holding rate as fixed
  values. Instead, do what-if analysis to hit
  target values for
• Inventory investment on the balance sheet
• Stock replenishment workload

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Inventory tradeoffs for Class B items Inventory tradeoffs for Class B items Inventory tradeoffs for Class B items Inventory tradeoffs for Class B items Inventory tradeoffs for Class B items Inventory tradeoffs for Class B items Inventory tradeoffs for Class B items Inventory tradeoffs for Class B items Inventory tradeoffs for Class B items Inventory tradeoffs for Class B items Inventory tradeoffs for Class B items

Number of Class B active items Number of Class B active items Number of Class B active items Number of Class B active items 3,600 3,600
Sum of annual demand forecasts Sum of annual demand forecasts Sum of annual demand forecasts Sum of annual demand forecasts 14,337,666 14,337,666
Sum of monthly demand forecasts Sum of monthly demand forecasts Sum of monthly demand forecasts Sum of monthly demand forecasts 1,194,806 1,194,806
Inventory carrying cost Inventory carrying cost Inventory carrying cost Inventory carrying cost 20.00 20.00

Order Cost Maximum Investment Maximum Investment Number of annual buys Number of annual buys Number of annual buys Number of annual buys Number of annual buys EOQ in weeks of stock EOQ in weeks of stock EOQ in weeks of stock
Order Cost Total Avg. per item Total Total Total Avg. per item Avg. per item Min Min Max
5 1,428,356 397 28,567 28,567 28,567 7.9 7.9 2.6 2.6 14.9
10 2,020,000 561 20,200 20,200 20,200 5.6 5.6 3.6 3.6 21.0
15 2,473,985 687 16,493 16,493 16,493 4.6 4.6 4.5 4.5 25.8
20 2,856,711 794 14,282 14,282 14,282 4.0 4.0 5.2 5.2 29.8
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Communications Systems ManufacturerTarget
inventory values for fiscal 2009
Class Control System Number of Items Maximum Investment Number of Annual Buys
A JIT 1,412 4,945,000 16,944
B EOQ 3,999 10,820,000 15,996
C Annual Buy 8,688 2,004,000 8,688
Totals 14,099 17,769,000 41,628
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Water Filtration Company Inventory
Values

Class Definition Definition Nbr items On-hand Excess On-order
A,B,C Active items On-hand ok Active items On-hand ok 5,754 3,884,064 0 1,958,932
A,B,C Active items On-hand excessive Active items On-hand excessive 584 887,048 491,960 23,220
A,B,C,Z Not enough hits to stock or zero forecast Not enough hits to stock or zero forecast 3,878 943,950 902,774 27,398
D Disposal items no hits in 12 mon. Disposal items no hits in 12 mon. 2,336 458,968 458,160 121
X One-time buys One-time buys 12 5,128 5,128 0
N New items established in last 12 mon. New items established in last 12 mon. 404 127,124 121,534 93,362
Totals 12,968 6,307,626 1,979,556 2,103,033
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Annual Purchasing Workload Estimates Annual Purchasing Workload Estimates Annual Purchasing Workload Estimates Annual Purchasing Workload Estimates Annual Purchasing Workload Estimates Annual Purchasing Workload Estimates Annual Purchasing Workload Estimates Annual Purchasing Workload Estimates Annual Purchasing Workload Estimates

New System Stock buys New System Stock buys New System Stock buys New System Stock buys Old System Stock buys Old System Stock buys Old System Stock buys Old System Stock buys
Class Nbr items stocked Annual reorders per item Annual reorders per class Class Nbr items stocked Annual reorders per item Annual reorders per class
A (JIT) 290 12 3,480 A(JIT) 290 12 3,480
B(EOQ) 3,108 4 12,432 B(EOQ) 3,108 12 37,296
C(Ann.) 2,938 1 2,938 C(Ann.) 2,938 12 35,256
Total 18,850 Total 76,032

New system Worst case estimate of number of drop-ship buys New system Worst case estimate of number of drop-ship buys New system Worst case estimate of number of drop-ship buys New system Worst case estimate of number of drop-ship buys Summary Workload comparisons Summary Workload comparisons Summary Workload comparisons Summary Workload comparisons
Class Nbr items not stocked Max hits for no- stock item Number of drop-ship buys Old system New system
Class Nbr items not stocked Max hits for no- stock item Number of drop-ship buys Stock buys Stock buys 76,032 18,850
A (JIT) 74 11 814 Drop-ship buys Drop-ship buys ? 11,624
B(EOQ) 1124 5 5,620 New items, one time buys New items, one time buys 600 600
C(Ann.) 1730 3 5,190 Redistribution actions Redistribution actions ? 1,600
Total 11,624 Total Total 76,632 32,674
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Monthly Inventory Performance Report
Lead-times Lead-times Lead-times
Lead-time exceptions 4.5
Average lead-time 3.20
Stock Levels Stock Levels Stock Levels
Target 19,900,878
Actual 23,422,012
Excess 3,521,134
Stock Status Stock Status Stock Status
Items in stock 92.20
Items out of stock 7.80
Items Out of Stock Items Out of Stock Items Out of Stock
With open order 82.2
No open order 17.8
Customer Orders Customer Orders Customer Orders
Percent shipped complete 94.3
Warehouse Refusals Warehouse Refusals Warehouse Refusals
Percent occurrence 2.8
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Conclusions

• Forecasting drives any inventory control system
• Standard ABC classification doesnt go far enough
• Decision rules for what/where to stock must be
  established early

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Conclusions (cont.)

• Performance measurement is essential to
• Justify a new system
• Tailor the system to the inventory
• Track progress

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Conclusions (cont.)

• The best inventory system is likely to be a
  hybrid of
• JIT
• MRP
• EOQ
• Annual buy