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Goldilocks Inventory Levels

You may remember the story of Goldilocks from your long-ago youth. Sometimes the porridge was too hot, sometimes it was too cold, but just once it was just right. Now that we are adults, we can translate that fairy tale into a professional principle for inventory planning: There can be too little or too much inventory, and there is some Goldilocks level that is “just right.” This blog is about finding that sweet spot.

To illustrate our supply chain fable, consider this example. Imagine that you sell service parts to keep your customers systems up and running. You offer a particular service part that costs you \$100 to make but sells for a 20% markup. You can make \$20 on each unit you sell, but you don’t get to keep the whole \$20 because of the inventory operating costs you bear to be able to sell the part. There are holding costs to keep the part in good repair while in stock and ordering costs to replenish units you sell. Finally, sometimes you lose revenue from lost sales due to stockouts.

These operating costs can be directly related to the way you manage the part in inventory. For our example, assume you use a (Q,R) inventory policy, where Q is the replenishment order quantity and R is the reorder point. Assume further that the reason you are not making \$30 per unit is that you have competitors, and customers will get the part from them if they can’t get it from you.

Both your revenue and your costs depend in complex ways on your choices for Q and R. These will determine how much you order, when and therefore how often you order, how often you stock out and therefore how many sales you lose, and how much cash you tie up in inventory. It is impossible to cost out these relationships by guesswork, but modern software can make the relationships visible and calculate the dollar figures you need to guide your choice of values for Q and R. It does this by running detailed, fact-based, probabilistic simulations that predict costs and performance by averaging over a large number of realistic demand scenarios.

With these results in hand, you can work out the margin associated with (Q,R) values using the simple formula

Margin = (Demand – Lost Sales) x Profit per unit sold – Ordering Costs – Holding Costs.

In this formula, Lost Sales, Ordering Costs and Holding Costs are dependent on reorder point R and order quantity Q.

Figure 1 shows the result of simulations that fixed Q at 25 units and varied R from 10 to 30 in steps of 5. While the curve is rather flat on top, you would make the most money by keeping on-hand inventory around 25 units (which corresponds to setting R = 20). More inventory, despite a higher service level and fewer lost sales, would make a little less money (and ties up a lot more cash), and less inventory would make a lot less.

Figure 1: Showing that there can be too little or too much inventory on hand

Without relying on the inventory simulation software, we would not be able to discover

• a) that it is possible to carry too little and too much inventory
• b) what the best level of inventory is
• c) how to get there by proper choices of reorder point R and order quantity Q.

Without an explicit understanding of the above, companies will make daily inventory decisions relying on gut feel and averaging based rule of thumb methods. The tradeoffs described here are not exposed and the resulting mix of inventory yields a far lower return forfeiting hundreds of thousands to millions per year in lost profits.  So be like Goldilocks.  With the right systems and software tools, you too can get it just right!

Related Posts

## Goldilocks Inventory Levels

You may remember the story of Goldilocks from your long-ago youth. Sometimes the porridge was too hot, sometimes it was too cold, but just once it was just right. Now that we are adults, we can translate that fairy tale into a professional principle for inventory planning: There can be too little or too much inventory, and there is some Goldilocks level that is “just right.” This blog is about finding that sweet spot.

## Call an Audible to Proactively Counter Supply Chain Noise

You know the situation: You work out the best way to manage each inventory item by computing the proper reorder points and replenishment targets, then average demand increases or decreases, or demand volatility changes, or suppliers’ lead times change, or your own costs change.

## An Example of Simulation-Based Multiechelon Inventory Optimization

Managing the inventory across multiple facilities arrayed in multiple echelons can be a huge challenge for any company. The complexity arises from the interactions among the echelons, with demands at the lower levels bubbling up and any shortages at the higher levels cascading down.

An Example of Simulation-Based Multiechelon Inventory Optimization

Managing the inventory in a single facility is difficult enough, but the problem becomes much more complex when there are multiple facilities arrayed in multiple echelons. The complexity arises from the interactions among the echelons, with demands at the lower levels bubbling up and any shortages at the higher levels cascading down.

If each of the facilities were to be managed in isolation, standard methods could be used, without regard to interactions, to set inventory control parameters such as reorder points and order quantities. However, ignoring the interactions between levels can lead to catastrophic failures. Experience and trial and error allow the design of stable systems, but that stability can be shattered by changes in demand patterns or lead times or by the addition of new facilities. Coping with such changes is greatly aided by advanced supply chain analytics, which provide a safe “sandbox” within which to test out proposed system changes before deploying them. This blog illustrates that point.

The Scenario

To have some hope of discussing this problem usefully, this blog will simplify the problem by considering the two-level hierarchy pictured in Figure 1. Imagine the facilities at the lower level to be warehouses (WHs) from which customer demands are meant to be satisfied, and that the inventory items at each WH are service parts sold to a wide range of external customers.

Figure 1: General structure of one type of two-level inventory system

Imagine the higher level to consist of a single distribution center (DC) which does not service customers directly but does replenish the WHs. For simplicity, assume the DC itself is replenished from a Source that always has (or makes) sufficient stock to immediately ship parts to the DC, though with some delay. (Alternatively, we could consider the system to have retail stores supplied by one warehouse).

Each level can be described in terms of demand levels (treated as random), lead times (random), inventory control parameters (here, Min and Max values) and shortage policy (here, backorders allowed).

The Method of Analysis

The academic literature has made progress on this problem, though usually at the cost of simplifications necessary to facilitate a purely mathematical solution. Our approach here is more accessible and flexible: Monte Carlo simulation. That is, we build a computer program that incorporates the logic of the system operation. The program “creates” random demand at the WH level, processes the demand according to the logic of a chosen inventory policy, and creates demand for the DC by pooling the random requests for replenishment made by the WHs. This approach lets us observe many simulated days of system operation while watching for significant events like stockouts at either level.

An Example

To illustrate an analysis, we simulated a system consisting of four WHs and one DC. Average demand varied across the WHs. Replenishment from the DC to any WH took from 4 to 7 days, averaging 5.15 days. Replenishment of the DC from the Source took either 7, 14, 21 or 28 days, but 90% of the time it was either 21 or 28 days, making the average 21 days. Each facility had Min and Max values set by analyst judgement after some rough calculations.

Figure 2 shows the results of one year of simulated daily operation of this system. The first row in the figure shows the daily demand for the item at each WH, which was assumed to be “purely random”, meaning it had a Poisson distribution. The second row shows the on-hand inventory at the end of each day, with Min and Max values indicated by blue lines. The third row describes operations at the DC.  Contrary to the assumption of much theory, the demand into the DC was not close to being Poisson, nor was the demand out of the DC to the Source. In this scenario, Min and Max values were sufficient to keep item availability was high at each WH and at the DC, with no stockouts observed at any of the five facilities.

Figure 2 – Simulated year of operation of a system with four WHs and one DC.

Now let’s vary the scenario. When stockouts are extremely rare, as in Figure 2, there is often excess inventory in the system. Suppose somebody suggests that the inventory level at the DC looks a bit fat and thinks it would be good idea to save money there. Their suggestion for reducing the stock at the DC is to reduce the value of the Min at the DC from 100 to 50. What happens? You could guess, or you could simulate.

Figure 3 shows the simulation – the result is not pretty. The system runs fine for much of the year, then the DC runs out of stock and cannot catch up despite sending successively larger replenishment orders to the Source. Three of the four WHs descend into death spirals by the end of the year (and WH1 follows thereafter). The simulation has highlighted a sensitivity that cannot be ignored and has flagged a bad decision.

Figure 3 – Simulated effects of reducing the Min at the DC.

Now the inventory managers can go back to the drawing board and test out other possible ways to reduce the investment in inventory at the DC level. One move that always helps, if you and your supplier can jointly make it happen, is to create a more agile system by reducing replenishment lead time. Working with the Source to insure that the DC always gets its replenishments in either 7 or 14 days stabilizes the system, as shown in Figure 4.

Figure 4 – Simulated effects of reducing the lead time for replenishing the DC.

Unfortunately, the intent of reducing the inventory at the DC has not been achieved. The original daily inventory count was about 80 units and remains about 80 units after reducing the DC’s Min and drastically improving the Source-to-DC lead time. But with the simulation model, the planning team can try out other ideas until they arrive at a satisfactory redesign. Or, given that Figure 4 shows the DC inventory starting to flirt with zero, they might think it prudent to accept the need for an average of about 80 units at the DC and look for ways to trim inventory investment at the WHs instead.

The Takeaways

1. Multiechelon inventory optimization (MEIO) is complex. Many factors interact to produce system behaviors that can be surprising in even simple two-level systems.
2. Monte Carlo simulation is a useful tool for planners who need to design new systems or tweak existing systems.

Related Posts

## Goldilocks Inventory Levels

You may remember the story of Goldilocks from your long-ago youth. Sometimes the porridge was too hot, sometimes it was too cold, but just once it was just right. Now that we are adults, we can translate that fairy tale into a professional principle for inventory planning: There can be too little or too much inventory, and there is some Goldilocks level that is “just right.” This blog is about finding that sweet spot.

## Call an Audible to Proactively Counter Supply Chain Noise

You know the situation: You work out the best way to manage each inventory item by computing the proper reorder points and replenishment targets, then average demand increases or decreases, or demand volatility changes, or suppliers’ lead times change, or your own costs change.

## An Example of Simulation-Based Multiechelon Inventory Optimization

Managing the inventory across multiple facilities arrayed in multiple echelons can be a huge challenge for any company. The complexity arises from the interactions among the echelons, with demands at the lower levels bubbling up and any shortages at the higher levels cascading down.

Fact and Fantasy in Multiechelon Inventory Optimization

For most small-to-medium manufacturers and distributors, single-level or single-echelon inventory optimization is at the cutting edge of logistics practice. Multi-echelon inventory optimization (“MEIO”) involves playing the game at an even higher level and is therefore much less common. This blog is the first of two. It aims to explain what MEIO is, why standard MEIO theories break down, and how probabilistic modeling through scenario simulation can restore reality to the MEIO process. The second blog will show a particular example.

Definition of Inventory Optimization

An inventory system is built on a set of design choices.

The first choice is the policy for responding to stockouts: Do you just lose the sale to a competitor, or can you convince the customer to accept a backorder? The former is more common with distributors than manufacturers, but this may not be much of a choice since customers may dictate the answer.

The second choice is the inventory policy. These divide into “continuous review” and “periodic review” policies, with several options within each type. You can link to a video tutorial describing several common inventory policies here.  Perhaps the most efficient is known to practitioners as “Min/Max” and to academics as (s, S) or “little S, Big S.” We use this policy in the scenario simulations below. It works as follows: When on-hand inventory drops to or below the Min (s), an order is placed for replenishment. The size of the order is the gap between the on-hand inventory and the Max (S), so if Min is 10, Max is 25 and on-hand is 8, it’s time for an order of 25-8 = 17 units.

The third choice is to decide on the best values of the inventory policy “parameters”, e.g., the values to use for Min and Max. Before assigning numbers to Min and Max, you need clarity on what “best” means for you. Commonly, best means choices that minimize inventory operating costs subject to a floor on item availability, expressed either as Service Level or Fill Rate. In mathematical terms, this is a “two-dimensional constrained integer optimization problem”. “Two-dimensional” because you have to pick two numbers: Min and Max. “Integer” because Min and Max have to be whole numbers. “Constrained” because you must pick Min and Max values that give a high-enough level of item availability such as service levels and fill rates. “Optimization” because you  want to get there with the lowest operating cost (operating cost combines holding, ordering and shortage costs).

Multiechelon Inventory Systems

The optimization problem becomes more difficult in multi-echelon systems. In a single-echelon system, each inventory item can be analyzed in isolation: one pair of Min/Max values per SKU. Because there are more parts to a multiechelon system, there is a bigger computational problem.

Figure 1 shows a simple two-level system for managing a single SKU. At the lower level, demands arrive at multiple warehouses. When those are in danger of stocking out, they are resupplied from a distribution center (DC). When the DC itself is in danger of stocking out, it is supplied by some outside source, such as the manufacturer of the item.

The design problem here is multidimensional: We need Min and Max values for 4 warehouses and for the DC, so the optimization occurs in 4×2+1×2=10 dimensions. The analysis must take account of a multitude of contextual factors:

• The average level and volatility of demand coming into each warehouse.
• The average and variability of replenishment lead times from the DC.
• The average and variability of replenishment lead times from the source.
• The required minimum service level at the warehouses.
• The required minimum service level at the DC.
• The holding, ordering and shortage costs at each warehouse.
• The holding, ordering and shortage costs at the DC.

As you might expect, seat-of-the-pants guesses won’t do well in this situation. Neither will trying to simplify the problem by analyzing each echelon separately. For instance, stockouts at the DC increase the risk of stockouts at the warehouse level and vice versa.

This problem is obviously too complicated to try to solve without help from some sort of computer model.

Why Standard Inventory Theory is Bad Math

With a little looking, you can find models, journal articles and book about MEIO. These are valuable sources of information and insight, even numbers. But most of them rely on the expedient of over-simplifying the problem to make it possible to write and solve equations. This is the “Fantasy” referred to in the title.

Doing so is a classic modeling maneuver and is not necessarily a bad idea. When I was a graduate student at MIT, I was taught the value of having two models: a small, rough model to serve as a kind of sighting scope and a larger, more accurate model to produce reliable numbers. The smaller model is equation-based and theory-based; the bigger model is procedure-based and data-based, i.e., a detailed system simulation. Models based on simple theories and equations can produce bad numerical estimates and even miss whole phenomena. In contrast, models based on procedures (e.g., “order up to the Max when you breach the Min”) and facts (e.g., the last 3 years of daily item demand) will require a lot more computing but give more realistic answers. Luckily, thanks to the cloud, we have a lot of computing power at our fingertips.

Perhaps the greatest modeling “sin” in the MEIO literature is the assumption that demands at all echelons can be modeled as purely random Poisson processes. Even if it were true at the warehouse level, it would be far from true at the DC level. The Poisson process is the “white rat of demand modeling” because it is simple and permits more paper-and-pencil equation manipulation. Since not all demands are Poisson shaped, this results in unrealistic recommendations.

Scenario-based Simulation Optimization

To get realism, we must get down into the details of how the inventory systems operate at each echelon. With few limits except those imposed by hardware such as size of memory, computer programs can keep up any level of complexity. For instance, there is no need to assume that each of the warehouses faces identical demand streams or has the same costs as all the others.

A computer simulation works as follows.

1. The real-world demand history and lead time history are gathered for each SKU at each location.
2. Values of inventory parameters (e.g., Min and Max) are selected for trial.
3. The demand and replenishment histories are used to create scenarios depicting inputs to the computer program that encodes the rules of operation of the system.
4. The inputs are used to drive the operation of a computer model of the system with the chosen parameter values over a long period, say one year.
5. Key performance indicators (KPI’s) are calculated for the simulated year.
6. Steps 2-5 are repeated many times and the results averaged to link parameter choices to system performance.
7.

Inventory optimization adds another “outer loop” to the calculations by systematically searching over the possible values of Min and Max. Among those parameter pairs that satisfy the item availability constraint, further search identifies the Min and Max values that result in the lowest operating cost.

Figure 1: General structure of one type of two-level inventory system

Stay Tuned for our next Blog

COMING SOON. To see an example of a simulation of the system in Figure 1, read the second blog on this topic

Related Posts

## Goldilocks Inventory Levels

You may remember the story of Goldilocks from your long-ago youth. Sometimes the porridge was too hot, sometimes it was too cold, but just once it was just right. Now that we are adults, we can translate that fairy tale into a professional principle for inventory planning: There can be too little or too much inventory, and there is some Goldilocks level that is “just right.” This blog is about finding that sweet spot.

## Call an Audible to Proactively Counter Supply Chain Noise

You know the situation: You work out the best way to manage each inventory item by computing the proper reorder points and replenishment targets, then average demand increases or decreases, or demand volatility changes, or suppliers’ lead times change, or your own costs change.

## An Example of Simulation-Based Multiechelon Inventory Optimization

Managing the inventory across multiple facilities arrayed in multiple echelons can be a huge challenge for any company. The complexity arises from the interactions among the echelons, with demands at the lower levels bubbling up and any shortages at the higher levels cascading down.

Four Ways to Optimize Inventory

# forecasting and inventory optimization

## Now More than Ever

Inventory optimization has become an even higher priority in recent months for many of our customers.  Some are finding their products in vastly greater demand; more have the opposite problem. In either case, events like the Covid19 pandemic are forcing a reexamination of standard operating conditions, such as choices of reorder points and order quantities.

Even in quieter times, inventory control parameters like Mins and Maxes may be set far from their best values. We may ask “Why is the reorder point for SKU_1234 set at 20 units and the order quantify set at 35?” Those choices were probably the ossified result of years of accumulated guesses. A little investigation may show that the choices of 20 and 35 are no longer properly aligned with current demand level, demand volatility, supplier lead time and item costs.

The nagging feeling that “We should re-think all these choices” is often followed by “Oh no, we have to figure this out for all 10,000 items in inventory?” The savior here is advanced software that can scale up the process and make it not only desirable but feasible.  The software uses sophisticated algorithms to translate changes in inventory parameters such as reorder points into key performance indicators such as service levels and operating costs (defined as the sum of holding costs, ordering costs, and shortage costs).

This blog describes how to gain the benefits of inventory optimization by outlining 4 approaches with varying degrees of automation.

## Four Approaches to Inventory Optimization

### Hunt-and Peck

The first way is item-specific “hunt and peck” optimization. That is, you isolate one inventory item at a time and make “what if” guesses about how to manage that item. For instance, you may ask software to evaluate what happens if you change the reorder point for SKU123 from 20 to 21 while leaving the order quantity fixed at 35. Then you might try leaving 20 alone and reducing 35 to 34. Hours later, because your intuitions are good, you may have hit on a better pair of choices, but you don’t know if there is an even better combination that you didn’t try, and you may have to move on to the next SKU and the next and the next… You need something more automated and comprehensive.

There are three ways to get the job done more productively. The first two combine your intuition with the efficiency of treating groups of related items. The third is a fully automatic search.

### Service-level Driven Optimization

1. Identify items that you want to all have the same service level. For instance, you might manage hundreds of “C” items and wonder whether their service level target should be 70%, or more, or less.
2. Input a potential service level target and have the software predict the consequences in terms of inventory dollar investment and inventory operating cost.
3. If you don’t like what you see, try another service level target until you are comfortable. Here the software does group-level predictions of the consequences of your choices, but you are still exploring your choices.

### Optimization by Reallocation from a Benchmark

1. Identify items that are related in some way, such as “all spares for undercarriages of light rail vehicles.”
2. Use the software to assess the current spectrum of service levels and costs across the group of items. Usually, you will discover some items to be grossly overstocked (as indicated by service levels unreasonably high) and others grossly understocked (service levels embarrassingly low).
3. Use the software to calculate the changes needed to lower the highest service levels and raise the lowest. This adjustment will often result in achieving two goals at once: increasing average service level while simultaneously decreasing average operating costs.

### Fully automated, Item-Specific Optimization

1. Identify items that all require service levels above a certain minimum. For instance, maybe you want all your “A” items to have at least a 95% service level.
2. Use the software to identify, for each item, the choice of inventory parameters that will minimize the cost of meeting or exceeding the service level minimum. The software will efficiently search the “design space” defined by pairs of inventory parameters (e.g., Min and Max) for designs (e.g., Min=10, Max=23) that satisfy the service level constraint. Among those, it will identify the least cost design.

This approach goes farthest to shift the burden from the planner to the program. Many would benefit from making this the standard way they manage huge numbers of inventory items. For some items, it may be useful to put in a little more time to make sure that additional considerations are also accounted for. For instance, limited capacity in a purchasing department may force the solution away from the ideal by requiring a decrease in the frequency of orders, despite the price paid in higher overall operating costs.

## Going Forward

Optimizing inventory parameters has never been more important, but it has always seemed like an impossible dream: it was too much work, and there were no good models to relate parameter choices to key performance indicators like service level and operating cost. Modern software for supply chain analytics has changed the game. Now the question is not “Why would we do that?” but “Why are we not doing that?” With software, you can connect “Here’s what we want” to “Make it so.”

Related Posts

## Goldilocks Inventory Levels

You may remember the story of Goldilocks from your long-ago youth. Sometimes the porridge was too hot, sometimes it was too cold, but just once it was just right. Now that we are adults, we can translate that fairy tale into a professional principle for inventory planning: There can be too little or too much inventory, and there is some Goldilocks level that is “just right.” This blog is about finding that sweet spot.

## Call an Audible to Proactively Counter Supply Chain Noise

You know the situation: You work out the best way to manage each inventory item by computing the proper reorder points and replenishment targets, then average demand increases or decreases, or demand volatility changes, or suppliers’ lead times change, or your own costs change.

## An Example of Simulation-Based Multiechelon Inventory Optimization

Managing the inventory across multiple facilities arrayed in multiple echelons can be a huge challenge for any company. The complexity arises from the interactions among the echelons, with demands at the lower levels bubbling up and any shortages at the higher levels cascading down.

#### Recent Posts

• Smart Software to Present at Epicor Insights 2022
Smart Software CEO will present at this year's Epicor Insights event in Nashville. If you plan to attend this year, please join us at booth #9 and #705, and learn more about Epicor Smart Inventory Planning and Optimization. […]
• Smart Software and Arizona Public Service to Present at WERC 2022
Smart Software CEO and APS Inventory Manager to present WERC 2022 Studio Session on implementing Smart IP&O in 90 Days and achieve significant savings by optimizing reorder points and order quantities for over 250,000 spare parts. […]

## Four Ways to Optimize Inventory for companies with high demand and a growing number of orders.

### Inventory optimization has become an even higher priority in recent months for many of our customers. Some are finding their products in vastly greater demand. Cloud computing companies with unique server and hardware parts, e-commerce, online retailers, home and office supply companies, onsite furniture, power utilities, intensive assets maintenance or warehousing for water supply companies have increased their activity during the pandemic. Garages selling car parts and truck parts, pharmaceuticals, healthcare or medical supply manufacturers and safety product suppliers are dealing with increasing demand. Delivery service companies, cleaning services, liquor stores and canned or jarred goods warehouses, home improvement stores, gardening suppliers, yard care companies, hardware, kitchen and baking supplies stores, home furniture suppliers with high demand are facing stockouts, long lead times, inventory shortage costs, higher operating costs and ordering costs.

Top 3 Most Common Inventory Control Policies

# forecasting and inventory optimization

This blog defines and compares the three most commonly used inventory control policies. It should be helpful both to those new to the field and also to experienced people contemplating a possible change in their company’s policy. The blog also considers how demand forecasting supports inventory management, choice of which policy to use, and calculation of the inputs that drive these policies. Think of it as an abbreviated piece of Inventory 101.

Scenario

You are managing a particular item. The item is important enough to your customers that you want to carry enough inventory to avoid stocking out. However, the item is also expensive enough that you also want to minimize the amount of cash tied up in inventory. The process of ordering replenishment stock is sufficiently expensive and cumbersome that you also want to minimize the number of purchase orders you must generate. Demand for the item is unpredictable.  So is the replenishment lead time between when you detect the need for more and when it arrives on the shelf ready for use or shipment.

Your question is “How do I manage this item? How do I decide when to order more and how much to order?”  When making this decision there are different approaches you can use.  This blog outlines the most commonly used inventory planning policies:  Periodic Order Up To (T, S), Reorder Point/Order Quantity (R, Q), and Min/Max (s, S).  These approaches are often embedded in ERP systems and enable companies to generate automatic suggestions of what and when to order.  To make the right decision, you’ll need to know how each of these approaches are designed to work and the advantages and limitations of each approach.

Periodic review, order-up-to policy

The shorthand notation for this policy is (T, S), where T is the fixed time between orders and S is the order-up-to-level.

When to order: Orders are placed like clockwork every T days. The used of a fixed reorder interval is helpful to firms that cannot keep track of their inventory level in real time or who prefer to issue orders to suppliers at scheduled intervals.

How much to order: The inventory level is measured and the gap computed between that level and the order-up-to level S. If the inventory level is 7 units and S = 10, then 3 units are ordered.

Comment: This is the simplest policy to implement but also the least agile in responding to fluctuations in demand and/or lead time. Also, note that, while the order size would be adequate to return the inventory level to S if replenishment were immediate, in practice there will be some replenishment delay during which time the inventory continues to drop, so the inventory level will rarely reach all the way up S.

Continuous review, fixed order quantity policy (Reorder Point, Order Quantity)

The shorthand notation for this policy is (R, Q), where R is the reorder point and Q is the fixed order quantity.

When to order: Orders are placed as soon as the inventory drops to or below the reorder point, R. In theory, the inventory level is checked constantly, but in practice it is usually checked periodically at the beginning or end of each workday.

How much to order: The order size is always fixed at Q units.

Comment: (R, Q) is more responsive than (S, T) because it reacts more quickly to signs of imminent stockout. The value of the fixed order quantity Q may not be entirely up to you. Often suppliers can dictate terms that restrict your choice of Q to values compatible with minima and multiples. For example, a supplier may insist on an order minimum of 20 units and always be a multiple of 5. Thus orders sizes must be either 20, 25, 30, 35, etc. (This comment also applied to the two other inventory policies.)

Continuous review, order-up-to policy (Min/Max)

The shorthand notation for this policy is (s, S), sometimes called “little s, big S” where s is the reorder point and S is the order-up-to level. This policy is more commonly called (Min, Max).

When to order: Orders are placed as soon as the inventory drops to or below the Min. As with (R, Q), the inventory level is supposedly monitored constantly, but in practice it is usually checked at the end of each workday.

How much to order: The order size varies. It equals the gap between the Max and the current inventory at the moment that the Min is reached or breached.

Comment: (Min, Max) is even more responsive than (R, Q) because it adjusts the order size to take account of how much the inventory has fallen below the Min. When demand is either zero or one units, a common variation sets Min = Max -1; this is called the “base stock policy.”

Another policy choice: What happens if I stock out?

As you can imagine, each policy is likely to lead to a different temporal sequence of inventory levels (see Figure 1 below). There is another factor that influences how events play out over time: the policy you select for dealing with stockouts. Broadly speaking, there are two main approaches.

Backorder policy: If you stock out, you keep track of the order and fill it later.  Under this policy, it is sensible to speak of negative inventory. The negative inventory represents the number of backorders that need to be filled. Presumably, any customer forced to wait gets first dibs when replenishment arrives. You are likely to have a backorder policy on items that are unique to your business that your customer cannot purchase elsewhere.

Loss policy: If you stock out, the customer turns to another source to fill their order. When replenishment arrives, some new customer will get those new units. Inventory can never go below zero.  Choose this policy for commodity items that can easily be purchased from a competitor.  If you don’t have it in stock, your customer will most certainly go elsewhere.

The role of demand forecasting in inventory control

Choice of control parameters, such as the values of Min and Max, requires inputs from some sort of demand forecasting process.

Traditionally, this has meant determining the probability distribution of the number of units that will be demanded over a fixed time interval, either the lead time in (R, Q) and (Min, Max) systems or T + lead time in (T, S) systems. This distribution has been assumed to be Normal (the famous “bell-shaped curve”).  Traditional methods have been expanded where the demand distribution isn’t assumed to be normal but some other distribution (i.e. Poisson, negative binomial, etc.)

These traditional methodologies have several deficiencies.

• Third, accurate estimates of inventory operating costs require analysis of the entire replenishment cycle (from one replenishment to the next), not merely the part of the cycle that begins with inventory hitting the reorder point.

• Finally, replenishment lead times are typically unpredictable or random, not fixed. Many models assume a fixed lead time based on an average, vendor quoted lead time, or average lead time + safety time.

Fortunately, better inventory planning and inventory optimization software exists based on generating a full range of random demand scenarios, together with random lead times. These scenarios “stress test” any proposed pair of inventory control parameters and assess their expected performance. Users can not only choose between policies (i.e. Min, Max vs. R, Q) but also determine which variation of the proposed policy is best (i.e. Min, Max of 10,20 vs. 15, 25, etc.) Examples of these scenarios are given below.

The process of ordering replenishment stock is sufficiently expensive and cumbersome that you also want to minimize the number of purchase orders you must generate

Choosing among inventory control policies

Which policy is right for you? There is a clear pecking order in terms of item availability, with (Min, Max) first, (R, Q) second, and (T, S) last. This order derives from the responsiveness of the policy to fluctuations in the randomness of demand and replenishment. The order reverses when considering ease of implementation.

How do you “score” the performance of an inventory policy? There are two opposing forces that must be balanced: cost and service.

Inventory cost can be expressed either as inventory investment or inventory operating cost. The former is the dollar value of the items waiting around to be used. The latter is the sum of three components: holding cost (the cost of the “care and feeding of stuff on the shelf”), ordering cost (basically the cost of cutting a purchase order and receiving that order), and shortage cost (the penalty you pay when you either lose a sale or force a customer to wait for what they want).

Service is usually measured by service level and fill rate.  Service level is the probability that an item requested is shipped immediately from stock. Fill rate is the proportion of units demanded that are shipped immediately from stock. As a former professor, I think of service level as an all-or-nothing grade: If a customer needs 10 units and you can provide only 9, that’s an F. Fill rate is a partial credit grade: 9 out of 10 is 90%.

When you decide on the values of inventory control policies, you are striking a balance between cost and service. You can provide perfect service by keeping an infinite inventory. You can hold costs to zero by keeping no inventory. You must find a sensible place to operate between these two ridiculous extremes. Generating and analyzing demand scenarios can quantify the consequences of your choices.

A demonstration of the differences between two inventory control policies

We now show how on-hand inventory evolves differently under two policies. The two policies are (R, Q) and (Min, Max) with backorders allowed. To keep the comparison fair, we set Min = R and Max = R+Q, use a fixed lead time of five days, and subject both policies to the same sequence of daily demands over 365 simulated days of operation.

Figure 1 shows daily on-hand inventory under the two policies subjected to the same pattern of daily demand. In this example, the (Min, Max) policy has only two periods of negative inventory during the year, while the (R, Q) policy has three. The (Min, Max) policy also operates with a smaller average number of units on hand. Different demand sequences will produce different results, but in general the (Min, Max) policy performs better.

Note that the plots of on-hand inventory contain information needed to compute both cost and availability metrics.

Figure 1: Comparison of daily on-hand inventory under two inventory policies

Role of Inventory Planning Software

Best of Breed Inventory Planning, Forecasting, and Optimization systems can help you determine which type of policy (is it better to use Min/Max over R,Q) and what sets of inputs are optimal (i.e. what should I enter for Min and Max).  Best of breed inventory planning and demand forecasting systems can help you develop these optimized inputs so that you can regularly populate and update your ERP systems with accurate replenishment drivers.

Summary

We defined and described the three most commonly used inventory control policies: (T, S), (R, Q) and (Min, Max), along with the two most common responses to stockouts: backorders or lost orders. We noted that these policies require successively greater effort to implement but also have successively better average performance. We highlighted the role of demand forecasts in assessing inventory control policies. Finally, we illustrated how choice of policy influences the day-to-day level of on-hand inventory.

Related Posts

## Goldilocks Inventory Levels

You may remember the story of Goldilocks from your long-ago youth. Sometimes the porridge was too hot, sometimes it was too cold, but just once it was just right. Now that we are adults, we can translate that fairy tale into a professional principle for inventory planning: There can be too little or too much inventory, and there is some Goldilocks level that is “just right.” This blog is about finding that sweet spot.

## Call an Audible to Proactively Counter Supply Chain Noise

You know the situation: You work out the best way to manage each inventory item by computing the proper reorder points and replenishment targets, then average demand increases or decreases, or demand volatility changes, or suppliers’ lead times change, or your own costs change.

## An Example of Simulation-Based Multiechelon Inventory Optimization

Managing the inventory across multiple facilities arrayed in multiple echelons can be a huge challenge for any company. The complexity arises from the interactions among the echelons, with demands at the lower levels bubbling up and any shortages at the higher levels cascading down.

#### Recent Posts

• Smart Software to Present at Epicor Insights 2022
Smart Software CEO will present at this year's Epicor Insights event in Nashville. If you plan to attend this year, please join us at booth #9 and #705, and learn more about Epicor Smart Inventory Planning and Optimization. […]
• Smart Software and Arizona Public Service to Present at WERC 2022
Smart Software CEO and APS Inventory Manager to present WERC 2022 Studio Session on implementing Smart IP&O in 90 Days and achieve significant savings by optimizing reorder points and order quantities for over 250,000 spare parts. […]

#### Blog Categories

How to Choose a Target Service Level to Optimize Inventory

# forecasting and inventory optimization

## Summary

Setting a target service level or fill rate is a strategic decision about inventory risk management. Choosing service levels can be difficult. Relevant factors include current service levels, replenishment lead times, cost constraints, the pain inflicted by shortages on you and your customers, and your competitive position. Target setting is often best approached as a collaboration among operations, sales and finance. Inventory optimization software is an essential tool in the process.

## Service Level Choices

Service level is the probability that no shortages occur between when you order more stock and when it arrives on the shelf. The reasonable range of service levels is from about 70% to 99%. Levels below 70% may signal that you don’t care about or can’t handle your customers. Levels of 100% are almost never appropriate and usually indicate a hugely bloated inventory.

## Factors Influencing Choice of Service Level

Several factors influence the choice of service level for an inventory item. Here are some of the more important.

Current service levels:
A reasonable place to start is to find out what your current service levels are for each item and overall. If you are already in good shape, then the job becomes the easier one of tweaking an already-good solution. If you are in bad shape now, then setting service levels can be more difficult. Surprisingly few companies have data on this important metric across their whole fleet of inventory items. What often happens is that reorder points grow willy-nilly from choices made in corporate pre-history and are rarely, sometimes never, systematically reviewed and updated. Since reorder points are a major determinant of service levels, it follows that service levels “just happen”. Inventory optimization software can convert your current reorder points and lead times into solid estimates of your current service levels. This analysis often reveals subset of items with service levels either too high or too low, in which case you have guidance about which items to adjust down or up, respectively.

Some companies adjust service levels to match replenishment lead times. If it takes a long time to make or buy an item, then it takes a long time to recover from a shortage. Accordingly, they bump up service levels on long-lead-time items and reduce them on items for which backlogs will be brief.

Cost constraints:
Inventory optimization software can find the lowest-cost ways to hit high service level targets, but aggressive targets inevitably imply higher costs. You may find that costs constrain your choice of service level targets. Costs come in various flavors. “Inventory investment” is the dollar value of inventory. “Operating costs” include both holding costs and ordering costs. Constraints on inventory investment are often imposed on inventory executives and always imply ceilings on service level targets; software can make these relationships explicit but not take away the necessity of choice. It is less common to hear of ceilings on operating costs, but they are always at least a secondary factor arguing for lower service levels.

Shortage costs:
Shortage costs depend on whether your shortage policy calls for backorders or lost sales. In either case, shortage costs work counter to inventory investment and operating costs by arguing for higher service levels. These costs may not always be expressed in dollar terms, as in the case of medical/surgical supplies, where shortage costs are denominated in morbidity and mortality.

Competition:
The closer your company is to dominating its market, the more you can ease back on service levels to save money. However, easing back too far carries risks: It encourages potential customers to look elsewhere, and it encourages competitors. Conversely, high product availability can go far to bolstering the position of a minor player.

## Collaborative Targeting

Inventory executives may be the ones tasked with setting service level targets, but it may be best to collaborate with other functions when making these calls. Finance can share any “red lines” early in the process, and they should be tasked with estimating holding and ordering costs. Sales can help with estimating shortage costs by explaining likely customer reactions to backlogs or lost sales.

## The Role of Inventory Optimization and Planning Software

Without inventory optimization software, setting service level targets is pure guesswork: It is impossible to know how any given target will play out in terms of inventory investment, operating costs, shortage costs. The software can compute the detailed, quantitative tradeoff curves required to make informed choices or even recommend the target service level that results in the lowest overall cost considering holding costs, ordering costs, and stock out costs. However, not all software solutions are created equal. You might enter a user defined 99% service level into your inventory planning system or the system could recommend a target service – but it doesn’t mean you will actually hit that stated service level. In fact, you might not even come close to hitting it and achieve a much lower service level. We’ve observed situations where a targeted service level of 99% actually achieved a service level of just 82%! Any decisions made as a result of the target will result in unintended misallocation of inventory, very costly consequences, and lots of explaining to do.So be sure to check out our blog article on how to measure the accuracy of your service level forecast so you don’t make this costly mistake.

Related Posts

## Goldilocks Inventory Levels

You may remember the story of Goldilocks from your long-ago youth. Sometimes the porridge was too hot, sometimes it was too cold, but just once it was just right. Now that we are adults, we can translate that fairy tale into a professional principle for inventory planning: There can be too little or too much inventory, and there is some Goldilocks level that is “just right.” This blog is about finding that sweet spot.

## Call an Audible to Proactively Counter Supply Chain Noise

You know the situation: You work out the best way to manage each inventory item by computing the proper reorder points and replenishment targets, then average demand increases or decreases, or demand volatility changes, or suppliers’ lead times change, or your own costs change.

## An Example of Simulation-Based Multiechelon Inventory Optimization

Managing the inventory across multiple facilities arrayed in multiple echelons can be a huge challenge for any company. The complexity arises from the interactions among the echelons, with demands at the lower levels bubbling up and any shortages at the higher levels cascading down.

#### Recent Posts

• Smart Software to Present at Epicor Insights 2022
Smart Software CEO will present at this year's Epicor Insights event in Nashville. If you plan to attend this year, please join us at booth #9 and #705, and learn more about Epicor Smart Inventory Planning and Optimization. […]
• Smart Software and Arizona Public Service to Present at WERC 2022
Smart Software CEO and APS Inventory Manager to present WERC 2022 Studio Session on implementing Smart IP&O in 90 Days and achieve significant savings by optimizing reorder points and order quantities for over 250,000 spare parts. […]