For most companies involved in manufacturing and distribution supply chains, inventory plays a critical role in determining just how healthy those two KPIs are for them.
We began by saying that everybody thinks their inventory is strategic. However, when we begin to dig deeper, we are likely to discover that most CEOs, CFOs and supply chain managers cannot linked investments in inventory at the SKU-location (SKUL) level to any real strategy that drives that specific investment.
Then, we went on to say that, if an enterprise is going to really have the composition of its overall inventory investment be driven by strategy, then the follow data elements must be known—at the SKUL level—with reasonable accuracy:
- Average daily usage (actual demand)
- Lead time
- Demand variability
- Supply variability
- Minimum order quantities and multiples, if any
- Relationships between SKUs (e.g., bills of material, kit assembly requirements, product affinities)
- Unit cost
- Customer tolerance time
We also suggested that inventory investment is only strategic when it does all three of the following things:
- Absorbs variability (demand, supply or both)
- Decouples lead times
- Provides real (calculable) ROI
How do these eight factors help us decide about inventory investments strategies?
To answer this question, we are going to use the following “routing” diagram for two end-items. (This is a manufacturing environment, but you will not have trouble translating the concepts to a distribution environment.)
[Note: This example is adapted from Ptak, Carol A., Chad Smith, and Joseph Orlicky. Orlicky's Material Requirements Planning. Third ed. New York: McGraw-Hill, 2011.]
If we begin with no inventory in the system, the cumulative lead time (CLT) for Part 300 is 22 days, consisting of ten days purchase lead time (PLT) for Part 100; five days manufacturing lead time (MLT) for Part 200 (intermediate component); and seven days MLT to produce Part 300. Similarly, the CLT for Part 400 is 19 days: 15 days to intermediate Part 200, plus four days MLT for Part 400.
Remember, we have said that inventory is only strategic if it does three things: 1) absorbs variability, 2) decouples lead-times, and 3) provides a hard (read: calculable) ROI.
So, let us consider what placing inventory at each of the “buffer” locations indicated in the following figure does for these three factors.
If resource ‘E’ is a capacity constrained resource (CCR), it means that the total throughput for both Part 300 and 400 will be limited by the capacity of ‘E’ to produce. We must also acknowledge that variability—anything that disrupts the flow of production at resource ‘E’—will reduce the total throughput at this resource. Therefore, it is in our best interest to buffer resource ‘E’ from variability wherever and whenever possible.
If we place inventory buffers on Parts 50 and 200, we automatically buffer CCR ‘E’ from variability. The buffer on Part 50 buffers ‘E’ from the supply variability from the vendor—including transit time variability; while the buffer on Part 200 absorbs variability in the purchase and manufacturing steps leading to the production that part. Since Part 200 is used in the production of both Part 300 and Part 400, the buffer on Part 200 protects both production routings. Adding a buffer on purchased Part 100 would provide further absorption of external variability.
Decoupling lead times
Buffers at Parts 50, 100 and 200 also decouple lead times. Even in the absence of shipping buffers on Parts 300 and 400, the positioning of buffers on Parts 50 and 200 decouples the cumulative lead time and reduces the lead time for Part 300 from 22 days to seven days (a 15 day reduction), and reduces the lead time for Part 400 from 19 days to four days.
Using the factors to determine buffer sizes
The following factors should go into determining the calculated buffer sizes:
- Average daily usage (ADU)
- Variability in supply and demand
- Lead time
- Lead time factor (based on whether the lead time is—in relative terms for your business situation—long, medium or short)
In another article in the near future, we will discuss the mechanics of how we recommend these factors be applied. For the present, suffice it to say, in order for a truly strategic assessment of inventory investments, your enterprise must have set policies that determine what the average on-hand inventory for each SKUL will be. Furthermore, the four factors listed above should be components of that calculation. Additional essential components would be the length of the replenishment cycle and the reorder point.
By employing these factors in a consistent way, we can determine the following for our strategically estimated stock positions for Parts 50, 100, 200, 300 and 400.
The strategic calculation and balance
If, in our example above, we assume that we must stock Parts 300 and 400, because the customer tolerance time is less than 7 days and 4 days (MLT), respectively, for these SKULs, then we can begin to strategically compare the before and after buffer sizes and resulting average on-hand quantities based on placing buffers at the decoupling points (i.e., Parts 50 and 200).
Here is a summary of the strategic inventory calculation:
Part No. 50
Part No. 200
Part No. 300
Part No. 400
Lead Time BEFORE
Lead Time AFTER
Avg Qty On-Hand BEFORE
Avg Qty On-Hand AFTER
Avg Inventory $ BEFORE
Avg Inventory $ AFTER
Net Change in Inventory $
The calculations in the table above assume that all other factors remain unchanged between the BEFORE and AFTER estimates, including lead-time factors, variability factors, average daily usage, and unit cost.
The calculated NET CHANGE in inventory for placing inventory buffers on Parts 50 and 200 would be a REDUCTION in inventory investment of $471,137. Taking action to add about $120,000 in inventory on Parts 50 and 200 decouples and compresses lead times on Parts 300 and 400. Since their buffers now need to cover fewer lead-time days, their dollar investment in inventory can be dramatically reduced—by nearly $600,000 ($590,080).
Any such reduction in inventory investment provides immediate benefits to cash-flow and longer-term benefits in terms of improved return on investment.
We call that becoming really strategic about your inventory investment in your supply chain. No more generic statements about needing to carry more of this, and less of that, based on seat-of-the-pants assessments. Instead, there can be real and effective logic driving decisions about which specific SKUs to stock at what levels and why.
If you would like to see the details of the calculations underlying such strategic inventory investments, please feel free to contact us.
How do you calculate your inventory investment dollars while protecting customer service levels? Let us know.