Sunday, August 4, 2013

Focus and Leverage Part 239

I’ve had several email requests to write more about the Theory of Constraints solution to supply chain problems.  More specifically, how can TOC dramatically lower your company’s inventory while at the same time virtually eliminate parts shortages.  In this posting I will attempt to explain how this works.

If you’re like most businesses today, your business is part of a supply chain that requires you to purchase raw materials or parts from someone else in order to make your and then pass them on to the next customer in line.  Eventually, after it is passed along far enough, it will reach the end consumer who buys it.  For many organizations the only system they know and have used seemingly forever is an inventory control system known as the Minimum/Maximum system (a.k.a. Min/Max).  In this type of system inventory is counted, shipped and replenished based upon some forecasted need, the actual usage and then a minimum and maximum stock level for each item in inventory is calculated.  So how does this Min/Max system work?

There are three simple rules that are followed when using this system:

-  Rule 1:  Calculate and set the maximum and minimum stock levels for each item you have in inventory.  The minimum is called the reorder point.

-  Rule 2:  When you reorder, you should never exceed the maximum level for any part

-  Rule 3:  Don’t reorder until the stock level for a part goes below the minimum level (i.e. the reorder point)

The assumptions behind these three rules are based on saving money. That is, if you want to save money, do so by minimizing your expenditures for inventory.  Companies who use the Min/Max system believe that the purchase price per unit of product could be driven to the lowest possible level by buying in bulk, thereby saving the maximum amount of money on their purchase.  The problem is that, even though there is lots of inventory in the system, there are still stock-outs situations and when there are stock-outs, production stops until they are received.
The actual top-level rules for managing this Min/Max System are as follows:

-  The system reorder amount is such that it takes the current inventory level back up to the calculated maximum amount no matter how many items are currently at the point-of-use.

-  Many of the supply systems I’ve seen only allow for one order at a time to be present for a specific part number.

-  Orders for specific items are triggered only after the inventory level goes to or below the calculated reorder amount.

-  Total item inventory is usually held at the lowest possible levels of the distribution supply chain which is typically the point-of-use storage location.

-  Items are inventoried periodically (e.g. once or twice a month) and then orders are placed as required.

Graphically, the Min/Max system looks like the following figure.  A minimum and maximum level is set for each item based upon historical usage and vendor lead time.  The items are used until this reorder point is reached or surpassed, at which point the item is reordered back up to the Max level.  This type of system can create two very substantial problems.

First, as demonstrated in the above figure, even though significant amounts of inventory appear to exist for the required items, it is not uncommon to experience stock-outs of items when they are needed and sometimes the stock-out period can be for an extended time.  Because the re-order amounts drive the inventory level for each item back to its maximum level, it is not uncommon to have the total inventory of parts at 40-50% more than is actually required.  Think about that for a minute. Even though the inventory levels appear to be enough for your needs, many times the parts that are needed are just not available.  This stock-out pattern repeats itself over time as is seen in the graph below. So if the Min/Max system is not the answer, then what would work better?
The Theory of Constraints has its own system for distribution and replenishment of parts.  This distribution and replenishment model is a very robust parts replenishment system that is proactive in managing the supply-chain system.  It’s a system triggered by usage rather than some calculated minimum amount.  TOC’s replenishment system maintains that the majority of the inventory should be held at a higher level in the distribution system rather than the point of use and that the use of minimum and maximum amounts should not be used.  Instead of triggering a reorder based on a reorder point, reorders are triggered based upon daily or weekly usage and the vendor lead time to replenish.  In other words, what you use is what you reorder.
In TOC’s replenishment model, inventory stock is not positioned at the point of use, but rather at the highest level in the distribution system such as a parts warehouse.  It is done like this so inventory can be used to satisfy demand at multiple points of use.  That is, rather than distributing it early to multiple points of use based upon a reorder point, it is held until multiple orders have been received.  Because of the more frequent ordering method which is based upon daily or weekly usage, the central warehouse sums the demand usage of the various consumption points and then distributes the orders.  In doing so, larger order quantities can then be consolidated at the central warehouse and distributed sooner than doing so at each separate location.  Stock buffers are positioned at points of potential high demand variation and stocked and restocked at levels determined by stock on hand, demand rate and replenishment lead time.  Finally, order frequency is increased and order quantity is decreased to maintain buffers at their optimum levels and usually always avoid stock out conditions.  In other words, you use a buffer and  re-order what you have used on a more frequent basis.  So what does this look like graphically?
The figure below demonstrates the positive effect on both inventory levels and the elimination of stock-outs.  Typically a 40-50% inventory reduction is achieved with much more stable inventory levels. So instead of the repeating stock-out conditions and the excessive amounts of inventory we saw with the Min/Max system, we see a very stable replenishment system.
Stop and think about it for a minute.  Wouldn’t you prefer a parts replenishment system that virtually guarantees no stock-outs and does so with much less inventory than you currently have on site.  Implementing this system translates into a much improved level of customer satisfaction (virtually no stock-outs) while cash flow is improving proportionally (40-50 % less inventory).




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