Optimizing Inventory around Suppliers´ Minimum Order Quantities

Recently, I had an interesting conversation with an inventory manager and the VP Finance. We were discussing the benefits of being able to automatically optimize both reorder points and order quantities. The VP Finance was concerned that given their large supplier required minimum order quantities, they would not be able to benefit.  He said his suppliers held all the power, forcing him to accept massive minimum order quantities and tying his hands. While he felt bad about this, he saw a silver lining: He didn’t have to do any planning. He would accept a large inventory investment, but his customer service levels would be exceptional.  Perhaps the large inventory investment was assumed to be the cost of doing business.

I pushed back and pointed out that he was not as powerless as he felt. He still had control of the other half of the procurement process: while he couldn’t control how much to order, he could control when to order by adjusting the reorder point. In other words, there is always room for careful quantitative analysis in inventory management, even when you have one hand tied behind your back.

An Example

To put some numbers behind my argument, I created a scenario then analyzed it using our methodology to show how consequential it can be to use inventory optimization software even in constrained situations. In this scenario, item demand averages 2.2 units per day but varies significantly by day of week. Let’s say the imaginary supplier insists on a minimum order quantity of 500 units (way out of proportion to demand) and fills replenishment orders in either three days or ten days in equal proportions (quite inconsistent). To spread the blame around, let’s also suppose that the imaginary supplier’s imaginary customer uses a foolish rule that the reorder point should be 10% of the minimum order quantity. (Why this rule? Too many companies use simple/simplistic rules of thumb in lieu of proper analysis.)

So, we have a base case in which the order quantity is 500 units, and the reorder point is 50 units. In this case, the fill rate is 100%, but the average number of units on hand is a whopping 330. If the customer would simply lower the reorder point from 50 to 15, the fill rate would still be 99.5%, but the average stock on hand would drop by 11% to 295 units. Using the one hand not tied behind his back, the inventory manager could cut his inventory investment by more than 10%, which would be a noticeable win.

Incidentally, if the minimum order quantity were abolished, the customer would be free to arrive at a new and much better solution. Setting the order quantity to 45 and the reorder point to 25 would achieve a 99% fill rate at the cost of a daily on-hand level of only 35 units: nearly a 90% reduction in inventory investment: a major improvement over the status quo.

Postscript

These calculations are possible using our software, which can make visible the otherwise unknown relationships between inventory system design choices (e.g., order quantity and reorder point) and key performance indicators (e.g., average units on hand and fill rate).  Armed with this ability to conduct these calculations, alternative arrangements with the supplier may now be considered. For example, what if, in exchange for paying a higher price per unit, the supplier agreed to a lower MOQ. Using the software to conduct an analysis of the key performance indicators using the “what if” costs and MOQs would reveal the cost per unit and MOQ that would be needed to develop a more profitable deal.   Once identified, all parties stand to benefit.  The supplier now generates a better margin on sales of its products, and the buyer holds considerably less inventory yielding a holding cost reduction that dwarfs the added cost per unit.  Everyone wins.