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.
- 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 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.
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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