Basic Order Quantity and Replenishment Logic
Inventory is a critical investment.
- It helps meet the companies cost, service, and quality objectives
- It acts as a buffer to compensate for inconsistency in demand and supply
- Is the best arbiter of a company's health.
Regardless of the type of demand planning process your company adopts, DemandCaster calculates a stocked item's optimal order point.
The inventory order point is the basis for establishing a companies optimal inventory levels (the level between too much and too little) when the following variables are taken into account.
- Replenishment lead time: Normal time from order placement to receipt for both production orders and purchase orders
- Volatility of historical demand: Weekly standard deviation of demand
- Projected (forecasted) demand during the lead time: Statistical and/or user defined forecast over the items replenishment lead time.
- Desired level of customer service: This is the Z-Factor / service level factor used to calculate the statistical safety stock.
The order point is the trigger that tells the system it is time to reorder. Some call this the min.
As can be seen in the following graphic, there is a cost to carrying inventory. As such, DemandCaster follows a process that segments your data to help you apply the most optimal policies to help meet your companies Cost, Inventory, Service, and Quality objectives taking into consideration the business supply chain network and overall complexity.
The order point is managed in the Order Point Calc Analytic and is calculated by adding the forecast during the lead time plus the safety stock. The formula is:
Order Point = Forecast + Safety Stock (SS)
Safety Stock is a buffer to accommodate natural variations in demand and supply. DemandCaster has multiple methods to calculate safety stock however, for this exercise, we will apply the weekly standard deviation method using the following formula:
Square Root of (Lead Time/7)*Service Level Factor*Standard Deviation of weekly demand
The above formula calculates the Standard Deviation Safety Stock value that is available in the Order Point section of the Analytics module. Standard Deviation of weekly demand in this formula comes from the database, which will be available for a download from Custom Reports soon.
Standard deviation in the Forecast tab is based on 52 weeks, while Standard deviation Safety Stock uses the safety stock time frame for the calculation. The safety stock time frame is located in the Options tab, under safety stock settings. For example, if a safety stock time frame is set for 3 years, and an item has only 2 years of history (meaning 1 year history is non existent/0), the leading zeroes are removed from this calculation, and only 2 years of history are considered for the calculation.
In short, the longer the lead time and higher the standard deviation the higher the safety stock required to maintain a desired level of service. To maintain high levels of service with longer lead times and variation, one must increase safety stock. However, increasing safety stock may improve customer service but hurts the cash flow!
If one desires to reduce inventory, the first thing that needs to be investigated is reducing lead time which is something that is often within an operations control. Thereafter, the items demand volatility may be addressed but this is more challenging since it typically lies outside of the control of operations. S&OP is often used to help manage volatility in addition to different types of vendor managed inventory processes or data sharing.
The second component of the order point is the items projected demand / forecast. DemandCaster uses numerous statistical methods to automatically calculate a best fit forecast. The forecast can also be user defined via a manual entry into DemandCaster, uploaded via a spreadsheet, or pulled in from a customer system. If the forecast is created from within DemandCaster it is desired to have three years of history to help identify seasonality though less history may be used.
The images below illustrate how changes in demand volatility, service level, and longer lead times impact order points.
The higher the service level objectives you need exponentially more inventory to cover the requirements.
The order point is reduced from 17,970 to 14,682 by removing a one time spike in demand. In the example we maintained the same forecast with a lower safety stock due to a reduction in standard deviation.
Though there are exceptions to this general approach, once the order point is established, DemandCaster suggests replenishment orders based on two distinct time horizons:
- During Lead Time
- Beyond Lead Time
Within lead time, DemandCaster sums the the quantity on hand and on orders and then subtracts open orders during lead time. Thereafter it compares the net available against the order point. If the net available is less than the order point, an order quantity is suggested. If it is greater, the calculation progresses the requirement week after week following the lead time until the projected inventory breaches the safety stock or 0. At that point a suggested order is created.