Friday, May 2, 2014

Focus and Leverage Part 345

This is the third part in my series on what I intended to write about in this blog, Focus and Leverage, when I started it in 2010.  I finished my last posting, Part 344, by telling you that there is a way to reduce your raw material inventory by 30-40% while virtually eliminating part’s stock-outs.  So if your company is experiencing problems with your raw materials and purchased parts availability, then this posting should be of interest to you.  I've written about this in other posts, but I recently received a request from a reader of this blog to write more on this subject.

Most businesses are linked one way or another to some kind of supply chain that needs raw materials or SKU’s from someone else in order to do what they do and then pass it on to the next customer in line until it finally reaches the end consumer.  In many organizations, the inventory system being used is one referred to as the Minimum/Maximum system.  In this type of system, companies evaluate their inventory and then based upon need and usage, they establish minimum and maximum stock levels for each item in inventory.

The traditional basic rules and measure for these type systems are usually quite simple and generally follow three basic rules:
Rule 1:  Determine the maximum and minimum stock levels for each item
Rule 2:  Never order more so as to exceed the calculated maximum level
Rule 3:  Never reorder until the stock level goes below the calculated minimum level

The assumptions behind these rules and measures are rooted in traditional cost accounting’s belief that the key to profitability is through cost reductions and in order to save money and minimize your expenditures for inventory, you must minimize the amount of money you spend for these items.  The assumption is that the purchase price per unit of product could be driven to the lowest level by buying in bulk and the company would save the maximum amount of money on their purchase.  In reality though, there always seems to be situations of excess inventory for some items and stock-outs situations for others.  Why is that?  Let’s look at the typical top-level rules for managing this Min/Max System.

  • The system reorder amount is the maximum amount, no matter how many items are currently at the point-of-use
  • Most supply systems, only allow for one order at a time to be present in the re-order system, for a specific item
  • Orders for items are triggered only after the minimum amount has been met or exceeded
  • Total item inventory is usually held at the lowest possible levels of the distribution supply chain which is typically at the point-of-use storage location
  • Items are inventoried once or twice a month and then orders are placed as required.

 This type of system appears similar to the following figure:

This type of system creates two significant problems.  First, even though significant amounts of inventory exist for required items, it is not uncommon for companies to experience stock-outs of items when they are needed.  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.  Even though inventory is excessive, many times the parts needed are out-of-stock.  This stock-out pattern repeats itself over time as is seen in the graph below.

What we see here is inventory levels starting at their maximum level and then as time goes by, stock items are used to produce products.  At some point in the future, the minimum stock level is reached or exceeded and an order is placed to refill back to the calculated maximum level.  Un fortunately, many times there are stock-outs that may exists for an extended period of time as depicted in the graph below.  So if the Min/Max system is not the answer, then what is?

Constraints Management offers a distinctly different type of distribution and replenishment model.  This model is a very robust parts replenishment system that allows the user to be proactive in managing their supply-chain system.  Unlike the Min/Max system, It’s also a system based on specific usage, either daily or weekly, rather than some minimum amount.  This replenishment system also argues that the majority of the inventory should be held at a higher level in the distribution system (supply chain) rather than at the lowest level and believes that the use of minimum/maximum amounts should be abolished.  Instead of using some calculated minimum amount to trigger the system to reorder, reorder should be triggered based upon daily usage and vendor lead time to replenish.

Stock is positioned at the highest level in the distribution system so that  all available inventory can be used to satisfy demand at multiple points of use.  That is, if there are multiple locations that must be replenished, then inventory is not released to the point of use until it’s needed,  Many times when using the Min/Max system, distribution to the point of use occurs too early and requires cross-shipments between users to avoid stock-outs. In addition, more frequent ordering can be completed because the central warehouse sums the demand usage of the various consumption locations.  Larger order quantities can then be accumulated at the central warehouse sooner than at each separate location.  In addition, buffers are positioned at points of potential high demand variation and stocked and restocked at levels determined by the amount of stock on hand, demand rate and replenishment lead time.  Finally, order frequency is increased and order quantity is decreased to maintain sufficient buffers at optimum levels and avoid stock out conditions which cause interruption to the flow of parts.  One of the key point in this system is that you re-order what you have used on a more frequent basis rather than waiting for the minimum stock level to be reached or exceeded.

The criteria for TOC’s replenishment model are actually quite simple.  The system reorder amount  needs to be based on daily or weekly usage and the lead time of the SKU to replenish.  The system needs to allow for multiple replenish orders, if required and orders are triggered based on specific buffer requirements, with possible daily actions, as  required, because all inventory must be available when needed.

In addition, SKU inventory is held at a higher level, preferably at central supply locations or comes directly from the  supplier /vendor.  So instead of the repeating stock-out problems observed in the Min/Max graphic, the graphic below reflects what happens when we use TOC’s replenishment model.  There are two very important distinctions between the Min/Max system and TOC’s model.  First, stock-outs are now virtually eliminated and second, the average amount of inventory held in the system has been reduced by 30-50%.  Think about it, no stock-outs and because of the drop in inventory, cash flow has improved proportionally.

In my next posting, I’ll be discussing another facet of the Theory of Constraints, the way projects are managed.  In this posting, I’ll demonstrate how to deliver projects on-time, on-scope and on-budget while typically reducing the time it takes to complete projects by 40-50%.
Bob Sproull

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