Inv How-To Manual V Erwin Opalla

INVENTORY MANAGEMENT
HOW-TO MANUAL Version 2.3

Erwin Opalla Ottobrunn July 2008
July 2008
TABLE OF CONTENT
Chapter A B C D E F G Subject Financial Background and Implication of Inventory Management Basics of Forecasting Misleading Inventory Turns Practical Application of Inventory Management Problems with Minimum Order Quantities Lot Sizing Models Safety Stock Calculation
page 2 / July 2008
MEASURE YOUR BUSINESS
When you can measure what you are speaking about and express it in numbers, you know something about it; but when you cannot express it in numbers, your knowledge is of a meager and unsatisfactory kind.
By Lord Kalvin
page 3 / July 2008
CHAPTER A
FINANCIAL BACKGROUND AND IMPLICATION OF INVENTORY MANAGEMENT
July 2008
FINANCIAL BASICS OF INVENTORY

Many companies try to reduce cost and increase cash flow by tighter control and management of inventory, reducing for example excess inventory. Excess inventory is any quantity much larger than needed, desired, or required! But many companies are unaware of the amount of excess and obsolete inventory. Excess inventory is all inventory that does not have true demand (orders) or anticipated demand (forecasted orders). The sales force is usually concerned with the most current goods that produce the highest margins. So over time excess and obsolete inventory build up, tie up cash which is not available any longer for future investments. The next slides should explain some basic financial concepts in relation to inventory management. The main purpose of any manufacturing company is to make a profit. So the understanding of the underlying financials is crucial for anyone being involved in inventory management.
page 5 / July 2008
INVENTORY THOUGHTS
Inventory is an investment, just like the money spent for capital equipment, product development or advertising. Its sole purpose is to generate income. Excess inventory is something not producing any return for the company. Inventory is classified as a current asset on the balance sheet, which means it is expected to be consumed or converted to cash in less than a year. Buying excess inventory has immediately a negative impact on cash flow. Too much inventory, more than 1 year-of-supply for example, may not be longer worth its original cost. In this case auditors request that money is set aside in the form of obsolescence reserve for obsolete, slow-moving and/or excess inventory. The resulting obsolescence expense hits immediately the profit line. Excess inventory results in unnecessary capital investment in the form of a) warehouses stocking the excess, b) workers to handle and transport the goods, c) insurance, damages, shrinkage etc.
page 6 / July 2008
CONFLICTING INVENTORY OBJECTIVES

AREA Marketing / Sales TYPICAL RESPONSE We need all products from our sales catalog in our warehouse available at all times to beat competition. Inventory is too low! If we can produce in larger lot sizes our set-up cost will go down, reducing our unit cost and avoiding manufacturing variances. We can reduce our unit cost if we buy larger quantities using quantity discounts. Where do we get the funds from to pay for this high level of inventory? The levels should be lower. High inventory levels affect negatively our liquidity. We are out of space. We need another warehouse to stock all the goods. FOCUS High availability of ALL goods.
Production
Large lot sizes. Low unit cost.
Purchasing
Large lot sizes. Low unit cost. Low total inventory carrying cost.
Finance
Warehousing
Less space and low holding cost.
(Adopted from Tersine: Principles of Inventory and Materials Management)
page 7 / July 2008
RETURN-ON-ASSETS
July 2008
INDICATORS OF SUCCESS
Being competitive and making profit in todays business environment is crucial for the survival of manufacturing companies. There are at least three indicators of being successful: 1. Quality, 2. Price, 3. Lead time Lead time
Quality Price
Today customers expect goods with a high quality at low cost in shortest lead-time. For example, to get the same revenue as a year ago most companies face the dilemma to sell more products, from a volume point of view, but at lower prices affecting negatively their profitability. The question is, what strategy should be chosen to stay competitive and profitable?
page 9 / July 2008
STRATEGIC APPROACH
The DuPont Corporation was the first major company recognizing the importance of looking at both Profit Margin and Total Asset Turns in assessing the performance of an organization. For this reason the Return-on-Asset ratio (Net Profit After Tax / Total Assets) was broken down into the Profit Margin and Total Assets Turns. This breakdown provides a lot of insight for management on how to improve the profitability of a company.
ROA =
Net Profit After Tax Total Assets = Profit Margin Total Asset Turns = Net Profit After Tax Sales Sales Total Assets
page 10 / July 2008
STRATEGIC APPROACH
The owner or stockholder invests money in a company to get a return in the form of a profit. If the profit is too low the investor might decide putting his money in a bank, because of higher return, or close down the company and invest in a different one. In the past managers focused on the margin earned and have ignored the turnover of assets. But excessive funds tied up in assets can reduce profitability as well as excessive expenses. Return-on-Equity represents the profitability of funds invested by the owners and should be as high as possible, but it could be high for wrong reasons if total assets were financed with too much debt!
page 11 / July 2008
MODIFIED DUPONT FORMULA

Sales Gross Profit $1,471,600 Net Profit Total Equity $964,030 Net Profit Margin 4.7% $198,000 $4,212,000
COGS $2,740,400
Operating Expenses Total Expenses $1,273,600 $1,089,100 Interest $82,500 Taxes $102,000
Sales $4,212,000
Return on Equity 20.5%
Equity Multiplier 2.281
Return on Assets 9.0%
Inventory $632,400 Sales Total Asset Turnover 1.9 $4,212,000 Current Assets Accounts Receivables $405,000
Legend: * Net Profit Margin = Net Profit / Sales * Total Asset Turnover = Sales / Total Assets * Return-on-Assets = Net Profit / Total Assets or Net Profit Margin x Total Asset Turnover * Equity Multiplier = Total Assets / Total Equity * Return-on-Equity = Net Profit / Total Equity Return-on-Assets * Equity Multiplier
Total Assets $2,198,740
$1,358,160
+
Fixed Assets $840,580
Other Current Assets $320,760
page 12 / July 2008
MARGIN VIA TURNOVER

Different turnover-marginrelations yield the same ROA. Margin and turnover complement each other. A weak margin can be offset by a strong turnover and vice versa. In this example, because of more competition, the margin dropped from 9% to 3%. But because of better Asset Management, turns improved from 2 to 6, yielding the same returnon-investment of 18%.
Margin 9% 8% 7% 6% 5% 4% 3% 2% X X X X X X X X X Turnover 2.00 2.25 2.57 3.00 3.60 4.50 6.00 9.00 = = = = = = = = = ROA 18% 18% 18% 18% 18% 18% 18% 18%
Profit Margin
9% 18% 3%
Asset Turns
page 13 / July 2008
DUPONT FORMULA DETAILS

Actions to improve ROA (Return-on-Assets): a) b) c) Increase sales by increasing volume, sales price or some combination while maintaining or improving the margin on sales Decrease all kind of expenses, e.g. freight, admin, traveling, Reduce the amount of total assets employed, e.g. reduce the inventory level, improve collection of accounts receivable, get rid of unneeded fixed assets.
ROA =
Net Profit After Tax Total Assets = Profit Margin Total Asset Turns Net Profit After Tax Sales = Sales Total Assets
page 14 / July 2008
ROA (RETURN-ON-ASSET) EXAMPLE

For this example, both margin and turnover were increased by getting rid of redundant inventories, reducing so the inventory holding charge and therefore increasing the net profit without increasing sales! Before Inventory Reduction
ROA = Net Profit After Tax Sales Sales Total Assets 27,000 300,000 = 300,000 150,000 = 0.09 2 = 0.18 = 18%
After Inventory Reduction

ROA = Net Profit After Tax Sales Sales Total Assets 28,000 300,000 = 300,000 140,000 = 0.0933 2.1429 = 0.1999 = 20%
page 15 / July 2008
CASH CONVERSION CYCLE
July 2008
INVENTORY & CASH CONVERSION CYCLE

The Operating Cycle (OC) is the time between purchasing materials from suppliers and receiving cash from customers after sold as finished products. OPERATING CYCLE (OC) OPERATING CYCLE (OC)
Cash Inflow
Inventory shipped
Inventory (DOH)
Inventory received
Receivables (DSO)
Payables (DPO)
Cash Outflow
Cash Conversion Cycle (CCC) Cash Conversion Cycle (CCC)
page 17 / July 2008
INVENTORY & CASH CONVERSION CYCLE

The Cash Conversion Cycle (CCC), also called Cash Gap, is the time between paying cash to suppliers for inventory received and collecting cash from customers from sale as finished product. CCC = DOH + DSO --DPO CCC = DOH + DSO DPO
DOH is Days Inventory On-Hand, average age of inventory DSO is Days Sale Outstanding, average collection period DPO is Days Payable Outstanding, average payment period
When DPO is smaller than DSO the company would act like a bank!
page 18 / July 2008
MANAGING THE CASH CONVERSION CYCLE

The basic strategy to manage the Cash Conversion Cycle (CCC) is as follows: 1. Turn over inventory as quickly as possible but avoid stock outs that might result in loss of sales. The Days Inventory On-Hand (DOH) should be as low as possible. There are two reasons for this: a) Investors do not like to see a lot of cash tied up in inventory. Low inventory improves profit and frees up needed capital for investments. b) Inventory held for too long can become spoiled or obsolete resulting in an additional obsolescence reserve hitting the EBIT line on the profit & loss statement as an expense.
page 19 / July 2008
MANAGING THE CASH CONVERSION CYCLE

2. Collect Accounts Receivables as quickly as possible into real cash. This figure should be as low as possible. A low Days Sales Outstanding (DSO) means that the company collects its outstanding receivables quickly, which means that it is not giving interest free loans to its customers for long periods of time. 3. Pay Accounts Payable as late as possible without damaging credit rating and take advantage of any discount offered. The Days Payable Outstanding (DPO) should be as high as possible. A high number represents really an interest-free loan from its suppliers, as long as they are paid under stated terms.
page 20 / July 2008
CASH CONVERSION CYCLE REDUCTION

OPERATING CYCLE 150 DAYS
Inventory 70 days Payables 40 days
Receivables 80 days Cash Conversion Cycle 110 days Inventory reduction
Inventory 50 days
Receivables 80 days Cash Conversion Cycle 90 days
Payables 40 days

Receivables reduction Inventory 50 days Receivables 70 days Cash Conversion Cycle 80 days
Payables 40 days
page 21 / July 2008
CASH CONVERSION CYCLE FORMULAS

1. Cash Conversion Cycle (CCC) CCC = DOH + DSO - DPO 2. Days Inventory On-Hand (DOH) DOH = Inventory / Daily COGS = Inventory / ( COGS / 360 ) 3. Days Sales Outstanding (DSO) DSO = A/C Receivables / Daily Sales = A/C Receivables / ( Sales / 360 ) 4. Days Payable Outstanding (DPO) DPO = A/C Payables / Daily COGS = A/C Payables / ( COGS / 360 )
page 22 / July 2008
SAMPLE CALCULATION PROFIT & CASH

BALANCE SHEET Current Assets Cash A/C Receivables Inventory Prepaid Expenses Total Current Assets Fixed Assets Land Building Machines Depreciation Total Fixed Assets Total Assets $200,000 $500,000 $218,800 ($78,220) $840,580 $2,198,740 $243,000 $405,000 $632,400 $77,760 $1,358,160 Current Liabilities A/C Payables Accrued Expenses Income Tax Notes Payable Total Current Liabilites Long-Term Debt $269,120 $130,390 $10,200 $300,000 $709,710 $525,000
INCOME STATEMENT Sales Cost-of-Goods Sold Gross-Profit Operating Expenses Net-Operating Income Interest Expense $4,212,000 $2,740,400 $1,471,600 $1,089,100 $382,500 $82,500 $300,000 $102,000 $198,000
Stockholder's Equity Capital/Stock Retained Earnings Total Stockholder's Equity Total Liabilites & Equity
$766,030 $198,000 $964,030
Earnings Before Income Tax Income Tax Expense Net Profit
$2,198,740
For illustration purposes the cash conversion cycle will be calculated on the next slide.
page 23 / July 2008
SAMPLE CALCULATION PROFIT & CASH CONT.
In this example 83 days represents the average length of time a dollar is tied up in current assets. To free-up cash this number must be reduced.
page 24 / July 2008
CHAPTER B
BASICS OF FORECASTING
July 2008
FORECASTING INTRODUCTION
A detailed discussion of forecasting methods is beyond the scope of this presentation. The interested reader should refer to standard text books available from different authors. The focus of this forecasting section is to highlight some general characteristics of good forecasts.
Forecasts will always be wrong. Forecasts should include an estimate of error. Forecasts are more accurate for groups of items. Forecasts are more accurate for shorter periods of time.
George W. Plossl, Production and Inventory Control Applications
page 26 / July 2008
FORECASTING DILEMMA
A normal discussion which was forwarded to me in Jan07. Shannon, supplier, has not shipped a product XXX in the last 12 months. There was no usage and no forecast!
Sales to Ottobrunn (Order point) Ottobrunn to Shannon (Supplier) Shannon to Ottobrunn Ottobrunn to Sales Sales to Ottobrunn Logistics Ottobrunn Operations Shannon Product Management Can my customer have 10 pcs of product XXX? Can you supply 10 pcs of product XXX? No stock, impossible to make 10 pcs, absolute minimum we could make are 250 pcs. Sorry, you have to buy 250 pcs or nothing because no further usage in Ottobrunn. You cant be serious, how the hell will we make our target! No usage and no forecast means no inventory! What do you expect? Why is the factory empty, how the hell will we make our target? The business is in the toilet, lets move everything to India.
page 27 / July 2008
FORECASTING APPROACHES
You Can Never Plan the Future from the Past

by Sir Edmund Burke
I Know No Way of Judging the Future but by the Past

by Patrick Henry
page 28 / July 2008
WHY TO FORECAST DEMAND

Backlog
Forecast Demand
Actual Orders
2 to 4 weeks
Time
Normally the backlog is for the near future. Turn-around orders will come in which must be forecasted to satisfy customer expectations of short lead times. Without forecasting raw materials and/or components have be ordered after receiving orders resulting in long lead times and maybe lost customers!
page 29 / July 2008
MANUFACTURING STRATEGIES
Forecast
Forecast
Production T
Production T
Chase Strategy A production planning method that maintains a stable inventory level while varying production to meet demand.
Level Strategy A production planning method that maintains a stable production rate while varying inventory levels to meet demand.
APICS Dictionary, 11th Edition

page 30 / July 2008
REGULAR VIS IRREGULAR DEMAND

Regular Demand
Demand Demand
Irregular Demand
Time
Time
Items with regular demand can be statistically forecasted compared to Items with irregular demand, e.g. promotiondriven demand or intermittent demand (=large portion of zero values), which could be forecasted in well understood business scenarios. Better approach might be discrete forecasting (=future demand for known products will repeat) or tender management.
page 31 / July 2008
HOW TO DETECT IRREGULAR DEMAND

Irregular demand consists of either both or one of the following two components:
Sporadic Demand Zero Demand Periods ZDP > 0.4 ZDP = Zero Periods / Total Periods
High Fluctuating Demand Noise Level NL > 0.5 NL = MAD / Mean
Legend: ZDP is Zero-Demand Periods NL is Noise Level MAD is mean absolute deviation Mean is arithmetic mean
page 32 / July 2008
IRREGULAR DEMAND CALCULATION

Month JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC TTL Past Demand 346 312 387 350 406 364 353 338 392 385 372 365 4,370 Average Absolute Demand Deviation 364 18 364 52 364 23 364 14 364 42 364 0 364 11 364 26 364 28 364 21 364 8 364 1 244
Noise Level MAD = 244 / 12 = 20.3 Mean = 4,370 / 12 = 364 NL = MAD / Mean NL = 20.3 / 364 = 0.06
Zero Demand Periods ZDP = Zero Periods / Total Periods ZDP = 0 / 12 = 0
Zero-Demand-Periods are not greater 0.4, so the time series has not a sporadic demand and the Noise Level is not greater than 0.5 so we have not a time series with high fluctuating demand. This item is a proper candidate for statistical forecasting!
page 33 / July 2008
INDEPENDENT VIS DEPENDENT DEMAND

Parent Item Parent Item
Independent Demand
Assembly A
Component 1
Component 3
Component 1
Component 2
Items with independent demand (outside of the control of a company, e.g. customer orders) can and should be forecasted. Demand for items with dependent demand can be calculated from demand from their parent items and is not forecasted.
Dependent Demand
page 34 / July 2008
INDEPENDENT VIS DEPENDENT DEMAND PLANNING APPROACH

CATEGORY Demand Source Material Type Demand Estimation INDEPENDENT DEMAND External & Internal Customers Finished Goods, Spare Parts Statistical and Discrete Forecasts, Customer Backlog, Frame Orders DEPENDENT DEMAND Parent Items, Assemblies Raw Materials, Components, Work-in-process (WIP) Calculated from BOMs
Planning Method EOQ with ROP and Safety Stock, Forward Planning
Material Requirements Planning (MRP)
Items can have independent (customer order) and dependent (component for parent item) demand!
Legend: EOQ is Economic Order Quantity, ROP is Reorder-Point, BOM is Bill-of-Material
page 35 / July 2008
DEMAND CHARACTERISTICS
Independent demand inventory is sometimes called sales inventory and dependent demand inventory manufacturing inventory. In practice it happens very often that items have independent and dependent demand. The independent portion must then be forecasted and the dependent portion must be calculated!
Sales Inventories1 External, independent demand, based on the marketplace Demand is random, relatively continuous Demand must be forecasted Safety stock used to attain target service level
--------------------1) Finish-Goods-Inventory
Manufacturing Inventories Internal, dependent demand, based on production schedule Demand is lumpy and discontinuous Demand can be calculated Little or no safety stock needed to ensure a 100% service level
page 36 / July 2008
DILEMMA OF PLANNING/FORECASTING
MRPII
Business Planning
Disconnection Line
Production Planning
Demand Management
RCCP Planning
Master Scheduling
Detailed MRP & CRP
Plant&Supplier Scheduling
Execution
There is no direct link between a sales forecast in dollar by product line and a discrete product number in unit-of-measure used for manufacturing and/or procurement.
Source: Oliver Wight Co.
page 37 / July 2008
LINKING OF FUNCTIONS
CONTROLLING LOGISTICS
Business Planning
Yearly Sales Dollars Plant StdHours OpIncome, ROCA etc Resources
Production Planning = Sales and Operations Planning
Production Planning

Master Scheduling
Weekly Discrete Products StdHours per Key Resource Driving MRP
Monthly Product Families UOM RCCP
page 38 / July 2008
BOTTOM-UP VIS TOP-DOWN FORECASTING

In Bottom-Up forecasting, each product item is forecasted independently and the total group forecast is obtained by summing the item forecast. Most appropriate when item histories are stable and the emphasis is on the trends and seasonal patterns of the individual items. Group
Item A
In Top-Down forecasting, the group history is created and forecasted first, and then the total group forecast is distributed down proportionally among the individual items. Top-down is a better choice if some items have very noisy history or the emphasis is on forecasting at the group level.
Group
Item A
Source: Smart Software, Inc., SmartForecasts Version 6 Users Guide, Page 51

page 39 / July 2008
TOP-DOWN DOLLARS TO UOM
SALES DOLLAR
PRODUCT LINE TO PART NUMBER
MANUFACTURING
Unit-of-Measure
One way to convert sales dollars into manufacturing unit of measures is using average unit costs or price per aggregate unit.
page 40 / July 2008
TOP-DOWN CONVERSION
Projected Sales for Product-Line XYZ
= $ 4,645,000
= $ 367 / unit Projected Sales in Unit-of-Measure for XYZ
= 12,657 units
Conversion to unit-of-measure done via AVERAGE cost or price per unit.
page 41 / July 2008
TOP-DOWN PLANNING BILLS

Very critical are the planning percentages per part: * How often reviewed? * What parts to include? * Automatic or manual change?
Sales Increase by 50%
FAMILY ITEM A = 1,500 ea

FAMILY ITEM A = 1,000 ea PART 1 = 30% ( 300 ea ) PART 2 = 50% ( 500 ea ) PART 3 = 20% ( 200 ea )
PART 1 = 30% ( 450 ea ) PART 2 = 50% ( 750 ea ) PART 3 = 20% ( 300 ea )
Break down into discrete parts via a constant percentage!

page 42 / July 2008
BOTTOM-UP PLANNING
WW SALES AND GROSS MARGIN ANALYSIS EMEA AMERICAS ASIA/PACIFIC AXICOM
Entities: Ottobrunn Simel UK
Reporting Lines MV Joints H/S MV Joints C/A Low Voltage H/S
GAP Analysis
MV J H/S Part 1 Part 2 Part 3
History History History History
Forecast Forecast Forecast Forecast
In Bottom-Up forecasting, each product is forecasted independently and the total group forecast is obtained by summing the item forecast.
page 43 / July 2008
SELECTING KEY ITEMS FOR FORECASTING

Keeping the right items in inventory assures good customer service and an appropriate inventory investment. But not all items in inventory have the same importance. Planners should concentrate on the few important items instead of the many trivial ones.
page 44 / July 2008
DOING FORECASTING RIGHT

Doing forecasting right, it must be understood that each forecast consists of two key components: Science component, which describes the forecasting method, e.g. singleexponential smoothing and Art component, which includes the marketing and/or sales adjustment.
page 45 / July 2008
STEPS IN FORECASTING
Determine the objective of the forecast, e.g. sales forecast. Determine which items to forecast, all or key items. Determine the forecast horizon, monthly, quarterly or yearly. Determine the forecast frequency, e.g. daily, weekly or monthly. Plot and clean historical data, e.g detect outliers or adjust missing data. Automatic selection of forecasting model, e.g. use computer software. Make forecasts. Validate results, e.g. adjust results where necessary. Implement results and make decisions, e.g. load into MRP.
page 46 / July 2008
FORECASTIG ERROR OVER TIME
Future period Time at forecasting Positive Error
Negative Error
To minimize the forecast error , a monthly forecasting approach should be chosen!
page 47 / July 2008
ROLLING MONTHLY FORECAST

Planning Horizon Rolling 6 Months Current Month + 1 Mth + 2 Mth etc. JUL AUG AUG SEP SEP SEP OCT OCT OCT OCT NOV NOV NOV NOV DEC DEC DEC DEC JAN JAN JAN FEB FEB MAR
The Planning horizon should cover at least the next six months. If monthly forecasts are placed, the planning lead time is 4 weeks although the total lead time (from placing an order till goods received in the warehouse) might be 12 weeks.
page 48 / July 2008
FORECAST BREAKDOWN TO MRP

GROSS-FORECAST MTH JAN DAYS 20 PLAN 20000 FEB 19 19000 MAR 24 24000 APR 20 20000
2
NET-FORECAST WEEK Product A Product B .... Product X TOTAL
14 750
15 300
16
17 500
200 5000
5000
600 5000
5000
MRP SCHEDULE WEEK 17 500
Product A SUB ITEM RAW PUR
1. Gross-Forecast by Month 2. Net-Forecast by Week 3. MRP Schedule
WEEK 16 WEEK 15 WEEK 14
500 500 500
page 49 / July 2008
FORECAST ORDERS FROM MRP TO CRP

Part A Fiscal Period Planned Order 1 100 Planned orders based on forecasted demand 2 3 4 5 6 7 200 300 8
Workcenter 4: Detailed Load Routing WC 4 Cutting H-Coating J-Coating Inspection Set-up (min) 18 24 ----Run-Time (min) 0.5 0.4 0.2 0.8 Total (100h) 2.8 1) 2.4 1.0 0.8 7.0
Load Hours 250 150 Load 50 1 2 3 4 5 6 7 8 Capacity
Period 6 7 15 5 158 185
Manufacturing hours part A Manufacturing hours part B Manufacturing hours part C Planned hours for other parts
Workcenter Summary Report Period Workcenter 4 Workcenter 5 Workcenter 6 1 2 3 4 5 6 185 7
Workcenter 4: Load Profile
MRP is Material Requirements Planning and CRP is Capacity Requirements Planning

1) Cutting: 18 + 0.5 * 300 = 168 = 2h48 48/60=x/100 x=(48/60)*100=80 2.8 hours
page 50 / July 2008
SHOULD ALL ITEMS BE FORECASTED?

Sales pro Year Parts % Trade Sales (000) 6,168 61,691 255,427 293,916 617,202 % Order Lines % <= $1,200 >$1,200 AND <=$12,000 >$12,000 AND <= $120,000 > $120,000 WORLDWIDE 15,738 13,875 6,819 1,048 37,480 42% 37% 18% 3% 100% 1% 10% 41% 48% 100% 38,080 116,188 248,137 145,305 547,710 7% 21% 45% 27% 100%
Legend: * Only competency 13005; CLP installation service exluded
27% > $120,000 3% 45% >$12,000 AND <= $120,000 18% 21% >$1,200 AND <=$12,000 10% 37% 7% <= $1,200 1% 42% 0% 10% 20% Parts 30% Trade Sales 40% Order Lines 50% 41% 48%
X Y Z A B C
$5,143K Inventory
60%
page 51 / July 2008
FORECAST SIMULATION
SmartForecast Item Master Items to forecast Forecasted Demand AMAPS Simulation Bill of Material Process & Routing
No Yes Implement Purchase Orders MRP Production Orders

Hours
Results Okay
Separate AMAPS MRP simulation run from production environment
Time
page 52 / July 2008
SAMPLE PROCEDURE
502K016
5/8 M2
EXRM 1213 EPKJ-5210 SMOE815

EPKT -1212
Planning Horizon Rolling 6 Months Current Month + 1 Mth + 2 Mth etc.

JUL AUG AUG SEP SEP SEP OCT OCT OCT OCT NOV NOV NOV NOV DEC DEC DEC DEC JAN JAN JAN FEB FEB MAR
T MW
Yearly sold items ~ 17,000

Daily/Weekly/Monthly * Items per MAMA table * Inventory value * Safety stock value * Planning parameters
Ottobrunn
ABC/XYZ
Planned Items ~ 3,700
MAMA Tables FG SS EE RA ZZ = = = = = Forecast and safety stock Only safety stock Forecast 10-digit kits EE Frames not included in FG & SS Items using combination of above
TED
Weekly/Monthly * Lead time (=Median) * Early and on time
page 53 / July 2008
PARETO OR ABC ANALYSIS

Pareto Analysis, also called 80/20 rule or ABC analysis, is a method to classify data according to their importance. It was invented by Vilfredo Pareto (1848-1923), an Italian economist and sociologist. He discovered that 80% of the wealth in Italy was held by only 20% of the population, hence called 80/20 rule. Separate the Important Few from the Trivial Many! This method is frequently used in inventory management to group items according to their yearly usage value. Close control is important for fast moving items with a high usage value. For slow moving items with a low usage value simple control is applied. In Inventory Management ABC Analysis is the more common term.
page 54 / July 2008
XYZ ANALYSIS
ABC analysis alone can generate very misleading results. Focusing on A-Items (high yearly usage value) as forecasts for coming periods could be wrong because values might be completely overstated. ABC analysis is a static method, describing historical data and represents the value component. In inventory management we are more concerned about the future. Will the past repeat? XYZ analysis is a dynamic method and complements ABC analysis. It represents the time component. How often was an item used and how good can it be forecasted?
page 55 / July 2008
ABC / XYZ BASICS
ABC / XYZ A
X High Usage Value High Forecastability
Y High Usage Value Medium Forecastability
Z High Usage Value Low Forecastability
Medium Usage Value High Forecastability
Medium Usage Value Medium Forecastability
Medium Usage Value Low Forecastability
Low Usage Value High Forecastability
Low Usage Value Medium Forecastability
Low Usage Value Low Forecastability
ABC analysis value component, static - alone gives misleading results. It must be complemented by a XYZ analysis time component, dynamic!
page 56 / July 2008
ABC / XYZ OVERVIEW

XYZ is TIME Component Q XYZ T ABC is VALUE Component ABC
Class Frequency
X Y Z
11, 12 times 6 to 10 times 0 to 5 times
$%
A
X A
#%
Z
Make-to-order, Tender Management, Discrete Forecasting Make-To Order, cumulative lead time
B C
Class
Usage
Items
A B C
80% 15% 5%
20% 30% 50%
Reorder-Point
page 57 / July 2008
ABC / XYZ CALCULATION

The steps for determining XYZ are simple and are described below. It is assumed that ABC is known and can be applied.
x=
x
i =1
Calculate the arithmetic mean. Calculate the standard deviation. Divide the standard deviation by the arithmetic mean getting the coefficient of variance. Classify your items into ABC and XYZ, see next slide for rules of thumb.
1 n 2 s= ( xi x) n 1 i=1
s cv = x
page 58 / July 2008
ABC / XYZ RULES OF THUMB

ABC A: 80% of usage value and 20% of items. B: 15% of usage value and 30% of items. C: 5% of usage value and 50% of items. XYZ (exact method) X: CV <= 40% Y: CV > 40% and <= 80% Z: CV > 80% XYZ (based on frequency) X: FREQ 11, 12 Y: FREQ 6 to 10 Z: FREQ 0 to 5 The frequency is an integer value counting how often there was a usage greater than zero in the active periods. Max 12 and min 0!
page 59 / July 2008
ABC / XYZ WITH MS EXCEL I

USAGE-USD % Cum% ABC FREQ XYZ CLASS 1,412,252 2.00% 2.00% A 11 X AX 1,287,090 1.83% 3.83% A 9 Y AY 1,152,782 1.64% 5.47% A 10 Y AY 1,080,560 1.53% 7.00% A 11 X AX 986,931 1.40% 8.40% A 11 X AX 972,563 1.38% 9.78% A 11 X AX =COUNTIF([Usage],">0") 0 0.00% 100.00% C 2 Z CZ 0 0.00% 100.00% =IF([FREQ]<=5,"Z",IF([FREQ]<=10,"Y","X")) C 0 Z CZ 0 0.00% 100.00% C 0 Z CZ 0 0.00% 100.00% C 2 Z CZ 0 0.00% 100.00% C 0 Z CZ 70,438,129
From column [Cum%]: A-items 0 to 80% B-items >80% to 95% C-items >95%
Legend: * [Usage] refers to usage range

page 60 / July 2008
ABC / XYZ WITH MS EXCEL II

USAGE-USD 1,412,252 1,287,090 1,152,782 1,080,560 986,931 972,563 0 0 0 0 0 70,438,129 % 2.00% 1.83% 1.64% 1.53% 1.40% 1.38% 0.00% 0.00% 0.00% 0.00% 0.00% Cum% ABC FREQ XYZ CLASS 2.00% A 11 X AX 3.83% A 9 Y AY 5.47% A 10 Y AY 7.00% A 11 X AX 8.40% A 11 X AX 9.78% A 11 X AX 100.00% C 2 Z CZ 100.00% C 0 Z CZ 100.00% C 0 Z CZ 100.00% C 2 Z CZ 100.00% C 0 Z CZ
1. Calculate USAGE-USD per item, e.g. YTD usage quantity multiplied by unit costs. 2. Sort USAGE-USD by descending value and add Total Usage Value, here $70,438,129, at bottom of column. 3. Divide each items USAGE-USD by Total Usage Value in column [%]. 4. Add cumulative percentages in column [Cum%]. 5. From column [Cum%] determine ABC in column [ABC]. Rule-of-thumb: 80% of cumulative percentage A-items, >80% to 95% B-items and balance C-items. 6. Calculate the frequency (How often was the monthly usage greater than Zero?) per item in column [FREQ] with forumula: =Countif([Usage-Range], >0)!
page 61 / July 2008
ABC / XYZ WITH MS EXCEL III

USAGE-USD 1,412,252 1,287,090 1,152,782 1,080,560 986,931 972,563 0 0 0 0 0 70,438,129 % 2.00% 1.83% 1.64% 1.53% 1.40% 1.38% 0.00% 0.00% 0.00% 0.00% 0.00% Cum% ABC FREQ XYZ CLASS 2.00% A 11 X AX 3.83% A 9 Y AY 5.47% A 10 Y AY 7.00% A 11 X AX 8.40% A 11 X AX 9.78% A 11 X AX 100.00% C 2 Z CZ 100.00% C 0 Z CZ 100.00% C 0 Z CZ 100.00% C 2 Z CZ 100.00% C 0 Z CZ
7. Calculate XYZ category in Column [XYZ] with a nested if-formula. =If([XYZ]<=5,Z,If([XYZ]<=10,Y,X)) 8. Determine CLASS category in column [CLASS] with formula: =[ABC] & [XYZ] 9. Prepare ABC / XYZ analysis overview.
page 62 / July 2008
ABC / XYZ EXCEL RESULTS

XYZ
ABC A Data Items Items% Usage Usage% Inventory Inv% Res25% Res100% Items Items% Usage Usage% Inventory Inv% Res25% Res100% Items Items% Usage Usage% Inventory Inv% Res25% Res100% X 69 2.50% 19,083,592 27.11% 1,596,775 16.06% 34,564 0 31 1.12% 667,003 0.95% 172,619 1.74% 7,056 0 75 2.72% 166,513 0.24% 98,749 0.99% 8,687 0 175 6.35% 19,917,108 28.29% 1,868,143 18.79% 50,307 0 Y 134 4.86% 26,752,108 38.01% 1,948,628 19.60% 16,520 0 173 6.27% 3,952,292 5.61% 748,739 7.53% 28,843 0 199 7.22% 621,558 0.88% 331,880 3.34% 33,754 881 506 18.35% 31,325,958 44.50% 3,029,246 30.47% 79,116 881 Z Grand Total 93 296 3.37% 10.74% 10,475,689 56,311,389 14.88% 80.00% 954,298 4,499,700 9.60% 45.26% 2,011 53,095 0 0 313 517 11.35% 18.75% 5,945,577 10,564,872 8.45% 15.01% 1,326,590 2,247,948 13.34% 22.61% 101,115 137,013 38,925 38,925 1,670 1,944 60.57% 70.51% 2,726,583 3,514,654 3.87% 4.99% 2,764,252 3,194,881 27.80% 32.13% 135,687 178,129 1,187,916 1,188,796 2,076 2,757 75.30% 100.00% 19,147,849 70,390,915 27.20% 100.00% 5,045,139 9,942,529 50.74% 100.00% 238,813 368,236 1,226,840 1,227,721
ABC
C
Usage Obsolescence Reserve
Total Items Total Items% Total Usage Total Usage% Total Inventory Total Inv% Total Res25% Total Res100%
Items Inventory
page 63 / July 2008
ABC/XYZ INVENTORY POLICY RULES

AX, AY, BX Statistically forecasted, make-to-stock policy, short lead times, safety stock policy should be used Can be statistically forecasted, make-to-stock or assemble-to-order policy, medium lead times Tender management or discrete forecasting if applicable, make-to-order policy, long lead times No forecasting due to low usage and/or sales value, safety stock policy should be used only, economic order quantity can be applied No forecasting and safety stock, make-to-order policy, order quantity LFL (lot-for-lot), cumulative lead times
BY AZ, BZ CX, CY
CZ
page 64 / July 2008
PRACTICAL FORECAST EXAMPLE
The next slides show detailed steps converting historical sales data into forecasts. MRP screens are shown as well. Cognos Query is used to extract historical sales data from TED (Tyco Electronics Data Warehouse). Microsoft Access is used to change vertical historical data into horizontal time periods. Software used for forecasting SmartForecasts for Windows, Version 6, Commercial Edition, from Smart Software, Inc.
page 65 / July 2008
COGNOS QUERY
Data & Filter
The query data contain all fields of interest and the filter definition downloads only selected historical data records from TED. Save into a comma separated file!
page 66 / July 2008
HISTORY AND FORECASTS
36 months historical values
12 months forecasted with Smart Forecast for Windows
History
Current
AMAPS MRP relevant months with forecast values always total forecasted months minus current month. Current month forecast values will NOT be loaded into AMAPS!
page 67 / July 2008
FORECAST FILTER
The Crosstab query filters from historical sales data only items which should be forecasted (=Finished Goods, Quick-Ship, Off-the-shelve). Vertical time periods are changed to horizontal ones for easier forecasting.
page 68 / July 2008
COPY FILTERED DATA
Copy query content from Microsoft Access into Smart Forecast for Windows. If needed sort periods in right sequence.
page 69 / July 2008
FILL BLANKS WITH ZERO
Fill blank cells with zero. Zeros are valid historical values but blanks are treated as gaps in the time series and forecasts will start at blank cells.
page 70 / July 2008
FORECAST TOURNAMENT
1) Configure ---> Files; Variable Labels = 6 2) Forecast tournament with Smart Forecast for Windows. Automatic selection of forecasting method 3) Forecast horizon = 12
page 71 / July 2008
BASIC FORECASTING STEPS

Smart Forecast for Windows
1) 2) 3) 4)
Adjust forecast as needed; review manual for more details. Save forecasts results; press button Save All Export final forecast into Microsoft Excel. Load into MRP system; AMAPS in Ottobrunn.
page 72 / July 2008
FORECASTS IN MRP SYSTEM

Sample screen from Ottobrunns AMAPS
Demand generated by Forecasting is identified by an order type M/S.
page 73 / July 2008
PERIOD ORDER QUANTITY

Sample screen from Ottobrunns AMAPS
A dynamic Order Policy is used, here POS (=Periods of Supply).
page 74 / July 2008
SAP CLASSIFICATION OF MATERIAL
July 2008
TYCOS GIC SAP STOCK POLICY Z100

The following criteria are aimed for a stock material: AX, AY, BX
At least 5 months demand in the last 6 months. At least 3 customers in last 6 months No customer greater than 75% share in last 6 months A ratio of the last 2 months demand compared to the avg. demand in last 6 months. Supply MOQ < 3 months forecast At least 1 PPQ per weeks forecast At least 12 ship lines (hits) in last 6 months The X Distribution Chain status must be E2 (released). Material must not be included on the do not change to stock file.
Paul McCullagh, GIC EMEA

page 76 / July 2008

This is firstly a transitional MRP Group with a view to changing to Z100. When a new Stock material has been identified and agreed with the relevant PM it will be changed to a Z110 for an initial 3 month period. This then allows the Xelus forecast to be active in MRP. At the end of this period and if the material still meets the required criteria, it is then changed to a Z100. Any failed materials are reviewed on a individual basis with the PM to either change to Z120 or Z200. Z110 can also be used for a manual forecast provided by the PM to initiate supply for a new or strategic product. BY

page 77 / July 2008
A Z120 strategic material is Sales/Product Management initiated.These are materials that do not qualify to be Stock. These materials are effectively Make to Order with a replenishment lead time as a Z200. AZ, BZ There are 4 reasons why a material can be a Z120 : Customer Order with supporting schedule agreement for the MOQ. A buffer stock A forecasted part for specific customers in the form of schedule agreements Agreement to sell in PPQs.

page 78 / July 2008

CZ Back to Back ordering Logic only. No Xelus forecasts. No EDI forecasts. No Schedule agreements No Buffer stocks.

page 79 / July 2008
INVENTORY QUALITY RATIO (IQR)
July 2008
INVENTORY QUALITY RATIO (IQR)

The IQR logic divides inventory into three groups: items with future requirements, items with no future requirements but with recent past usage, and items with neither. The items in these groups are then stratified into typical ABC-type classifications using their future dollar requirements, their past dollar usage, or their current balances on hand. A rule or target inventory level is set for each item based on its classification. The balance on hand of each item is compared to the rule and the dollars of each item are categorized as either active (A1 or A2), excess (E1, E2 or E3), slow moving (SM) or no moving (NM). These are called the seven quality categories. The IQR is the ratio of active inventory dollars to total inventory dollars. In a theoretically perfect situation (i.e., with no excess, slow moving or no moving inventories), the IQR would be 100 percent. Using nominal target inventory levels of 412-24 weeks supply for A-B-C items, respectively, the IQR for most companies surveyed is in the 30-45 percent range.
Gary Gossard, Improving Inventory Performance and Bottom-Line Profits
page 81 / July 2008
OVERVIEW INVENTORY QUALITY RATIO
MRP / ERP
NM 12 SM
BOHV
Data Extract
E3 H
AWWRV
G H K
6
AWWUV
R
80 - 15 - 5 % 4 - 12 - 24
DEF E1 B A1
ABC B A2
E2
1992-2004 IQR International
page 82 / July 2008
INVENTORY QUALITY RATIO
IQR =
Active Inventory Dollars Total Inventory Dollars
IQR =
A1 + A2 A1 + A2 + E1 + E2 + E3 + SM + NM
Perfect IQR = 100%

page 83 / July 2008
AVERAGE INVENTORY QUALITY RATIO

Active Inventory Dollars Total Inventory Dollars A1 + A2 A1 + A2 + E1 + E2 + E3 + SM + NM
IQR =
IQR =
30-50% Average IQR = 30-45%

10%
page 84 / July 2008
INVENTORY QUALITY RATIO LOGIC

Analyzes inventory using: - Balance on hand and unit cost - Past usage and future requirements - Dynamic ABC and user-defined parameters Develops inventory quality categories: - Active: reqmt/use, balance within limits - Excess: reqmt/use, balance over users limits - Slow Moving: no reqmt, no use in 6 months - No Moving: no reqmt, no use in 12 months Measures overall inventory performance.
page 85 / July 2008
INVENTORY QUALITY RATIO SAMPLE
Quick Look Dollars ($1000) by Purch / Manuf and Quality Category

Purch Manuf P M Active 1 351 21 Active 2 16,994 695 Excess Excess Excess 1 4,097 121 2 26,879 385 3 0 0 Slow No Total Value 53,458 1,507 IQR Ratio 32.4% 47.5%
Moving Moving 1,738 18 3,400 267
Total
372
17,689
4,218
27,264
1,756
3,667
54,965
32.9%

page 86 / July 2008
ABC / XYZ CLASSIFICATION Examples
July 2008
EXERCISE 1 A
Description: Unit-Cost: Qty on-hand: Inventory Value: Usage Value: Months with Usage:
SOME-1094-102K049-126/89 6.10 3,800 23,161 22,552 7 (=Frequency)
What quantity will be forecasted?
page 88 / July 2008
EXERCISE 1 B
Classification = BY
page 89 / July 2008
CONCLUSION EXERCISE 1
The Arithmetic Mean is an in-appropriate tool to use as an order quantity and/or monthly forecast for items with irregular demand. In this situation the Median ( = the middle value! ) should be used instead, because it excludes extreme high and/or low values! Stock is normally available for components going into parent items. Lead times could be 2 to 3 weeks. These items are normally purchased and/or manufactured with an assemble-to-order policy.
page 90 / July 2008
EXERCISE 2 A
RICS-5043-30-1 20.67 1,106 22,864 364,734 12 (=Frequency)
page 91 / July 2008
EXERCISE 2 B
Classification = AX
page 92 / July 2008
For items with regular demand, either the Arithmetic Mean or the Median could be the proper tool for calculating monthly order quantities and/or forecasts. A good practice in forecasting is, to eliminate extreme values. One method could be excluding the highest and lowest value! Stock is normally available and lead times are short and predictable. These items are purchased and/or manufactured with a make-to-stock policy.
page 93 / July 2008
EXERCISE 3 A
603W035-53/239(S5) 8.58 1,400 12,006 5,146 2 (=Frequency)
page 94 / July 2008
EXERCISE 3 B
Classification = CZ
page 95 / July 2008
For items with one-time or very irregular demand, either the Arithmetic Mean or the Median are in-proper tools for monthly order quantities and/or forecasts. These items should be treated with discrete and not with statistical forecasting. Could build stock in anticipation of a known (=discrete) potential order with a high probability. In nearly all cases, this items are purchased and manufactured with a make-to-order policy. Stock is normally not available and lead times are long!
page 96 / July 2008
CHAPTER C
MISLEADING INVENTORY TURNS
July 2008
MISLEADING INVENTORY TURNS INTRODUCTION

Adam Hinton, controller UK, wrote me an E-Mail on the 10th of July 2006 with the following content regarding the inventory performance for Dulmison UK for June 2006: Erwin, Q3 Dulmison COS (cost-of-sales) was $1,146K; annualized COS equals $4,582K; current inventory $447K; stock turns 10.25. He concluded, that inventory turns is a misleading figure because much of the Dulmison UK inventory was slow moving and most of the sales were from drop shipped projects [from Thailand]. The UK got a credit for the cost-of-sales although there was no inventory activity because of the drop-shipments. The next slide illustrates the unfavorable month-of-supply distribution and why inventory turns or DOH (days on-hand) were misleading.
page 98 / July 2008
MISLEADING INVENTORY TURNS INTRODUCTION CHART
page 99 / July 2008
MISLEADING INVENTORY TURNS 1A

Ottobrunn, Jordan Products, July 2004 Gross-Inv: 3 COS: Daily COS: Days: Inv Turns: $450,054 $1,625,663
(Jul04: $502,659, Jun04: $480,792,May04: 642,212)
$1,625,663 / 90 ~ $18,063 $450,054 / $18,063 ~ 25 360 / 25 ~ 14.4
Based on inventory turns pretty good performance. But is there a further potential for inventory reduction?
page 100 / July 2008
MISLEADING INVENTORY TURNS 1B
Although inventory turns were pretty high with 14.4 there is another inventory reduction potential of at least $74K!
MISLEADING INVENTORY TURNS 2A

Shannon, Cable Accessories, July 2004 Gross-Inv: 3 COS: Daily COS: Days: Inv Turns: $1,527,221 $5,882,663
(Jul04: $1,922K, Jun04: $1,623K,May04: $2,338K)
$5,882,663 / 90 ~ $65,363 $1,527,221 / $65,363 ~ 23 360 / 23 ~ 16
Based on inventory turns pretty good performance. But is there a further potential for inventory reduction?
MISLEADING INVENTORY TURNS 2B
Inventory turns of 16 were misleading. In fact we have a big obsolescence reserve problem of around $500K!
CHAPTER D
PRACTICAL APPLICATION OF INVENTORY MANAGEMENT
July 2008
INVENTORY REDUCTION APPROACH
Management Input
3-Years Inventory Targets: 50-Days-Reach Inventory or 7.2 WW Inventory Turns Manufacturing Sites: 4+ Turns Distribution Sites: 6 8 Turns Sales Inventory Sites: 12 Turns
Classification of Sites
Inventory Control Tools
ABC/XYZ Analysis Month-of-Supply Obs Reserve Procedure Push / Pull Strategy Inventory Ratios
Sites classified as 'Distribution Inventory' must have a kitting operation and sites classified as 'Sales Inventory' have no kitting operation only pick & pack!
INVENTORY POLICY for Global Energy Published 6th February, 2008

Further to our e-mail in June 2007, it has become necessary to issue a further reminder and re-statement of the Inventory Policy for Global Energy Division as follows: No supplying site is allowed to ship more than 2 MOS (months-of-supply) to ordering sites based on minimum order quantities for purchased and manufactured parts. Supplying sites producing or purchasing minimum lot sizes over 2 MOS have to keep the excess inventory if this does not affect negatively their inventory targets. As of December 2007 CZ parts (no usage and no demand in the last 12 months) accounted for [3.2%] of our usage and [19.6%] of worldwide gross-inventory. This has to be reversed. Ordering sites should refuse receipts over 2 MOS if this will hurt their inventory targets. To avoid unnecessary inventory build-up in our supply-chain, orders have to be placed directly to supplying sites. No inventory build is allowed for potential projects with questionable accounts. It is mandatory to have an order before. The key objective is to cut our worldwide shipping inventory (not released due to customer inflicted reasons) by half down to $2.5M to $3M. Urgent action is needed now. We expect all sites and functions to fully support these measures. Energy management will consider taking appropriate disciplinary action against anyone who fails to comply with this policy. Any business requirements which need to deviate from this policy will be approved by Olaf Happe on an exception basis.
Tony Gatt / Joe Lane / Olaf Happe

INVENTORY CYCLE I
1.Accounting View of Inventory Intercos M&P RM WIP Obsolescence Reserve Net-Inventory and DOH GIT FG COGS
ABC is VALUE Component ABC
4. ABC / XYZ Analysis Revenue Recognition

XYZ is TIME Component Q XYZ T
X A
Z
Make-to-order, Tender Management, Discrete Forecasting Make-To Order, cumulative lead time
$%
A
#%
B C
Reorder-Point
3. Month-of-Supply Analysis 2. Approximated DOH
INVENTORY CYCLE II
1. The Accounting View of Inventory splits inventory into raw material, work-inprocess, and finished goods. The focus here is added-value from receiving material into the warehouse till the shipment to the customer as finished goods. For inventory control this view is not sufficient for corrective actions. 2. Calculating Approximated DOH breaks down inventory into product lines and/or groups separating the good from the bad performers. The bad performers have to be broken down further. 3. A Month-of-supply Analysis of inventory (=aging!) should be done to detect the scope of the problem for the bad performers. A good inventory distribution must be right-skewed. 4. Last but not least a combined ABC/XYZ Analysis is needed to find the items representing the bread-and-butter business also called standard products. Here we determine our inventory strategy, e.g. make-to-order or make-to-stock, safety stock, lot sizes etc.
Trade Sales FY 2006

XYZ ABC A Data Parts Parts % Sales Sales % Margin Margin% Parts Parts % Sales Sales % Margin Margin% Parts Parts % Sales Sales % Margin Margin% Parts Parts % Sales Sales % Margin Margin% X 2,103 5.5% 310,208,124 44.1% 148,498,509 49.2% 1,195 3.1% 18,226,298 2.6% 7,783,244 2.6% 489 1.3% 1,501,919 0.2% 552,783 0.2% 3,787 9.8% 329,936,340 46.9% 156,834,535 51.9% Y 1,526 4.0% 154,469,291 22.0% 60,404,177 20.0% 2,386 6.2% 32,236,584 4.6% 14,366,248 4.8% 2,569 6.7% 6,215,043 0.9% 2,461,219 0.8% 6,481 16.8% 192,920,919 27.4% 77,231,644 25.6% Z 1,329 3.4% 97,954,126 13.9% 35,165,566 11.6% 4,416 11.5% 55,049,545 7.8% 22,182,658 7.3% 22,519 58.4% 27,448,623 3.9% 10,568,462 3.5% 28,264 73.4% 180,452,294 25.7% 67,916,686 22.5% Grand Total 4,958 12.9% 562,631,541 80.0% 244,068,252 80.8% 7,997 20.8% 105,512,427 15.0% 44,332,150 14.7% 25,577 66.4% 35,165,586 5.0% 13,582,464 4.5% 38,532 100.0% 703,309,553 100.0% 301,982,866 100.0%
TED trade sales of $703M in USD TBR06 in FY2006 for competency 13005 (only Energy). We sold around 40K discrete products but around 60% of our products in class CZ generated only 3.9% of sales with only 3.5% of margin. For our repetitive business in class AX, AY, BX, and BY we only needed ~20% items but generating ~75% of sales.
Total Total Total Total Total Total
Trade Sales FY 2006 C Items
Looking at C-items from an inventory point of view it can be shown that these items account for the majority of slow-moving and/or dead-stock inventory. Most fo these items have a low inventory value but the cumulative impact goes into the millions!
FY2007 Inventory Reduction Approach
ADR-049 December 2006: Purchased outside Vendor Manufactured in-house Purchased within Tyco
$48,129 $33,801 $28,500
43% 31% 26%
MONTHLY INVENTORY REPORTING

1. 2. 3. 4. All reported inventory is based on Hyperion and valued in USD TBR (Tyco-BudgetRate) for FY2007. Reported inventory represents Net-Inventory. Net-Inventory consists of raw-material plus work-in-progress plus finished goods plus goods in-transit minus obsolescence reserve. Inventory turns or DOH (days on-hand) are based on Hyperion total trade COS (other and standard cost-of-sales) and are used as corporate performance measure. Depending on the Interco shipments per site DOH for worldwide benchmarking might be based on total shipments Interco and Trade shipments at cost from TED (Tyco Electronics Data warehouse). Total cost-of-sales for Zibo is based on feedback from local controllers.
5.
6.
WW Inventory by Region Jan07
$19,231 13.8% $4,427 3.2%
$89,023 64.1%
$13,984 10.1%
TOP10 Ottobrunn U.K. USA Shannon Gevrey Wyong Axicom Canada Corp-India
$138,908 $30,173 $15,429 $15,070 $13,911 $11,254 $11,504 $5,587 $3,261 $1,978
107 56 126 107 131 68 126 55 53 116
$12,243 8.8%
MONTHLY HYPERION INVENTORY REPORTING
Monthly Hyperion inventory reporting (=accounting view!)
MONTHLY INVENTORY REPORTING TOP 10
MONTHLY INVENTORY BY COMPETENCY
MONTHLY INVENTORY PROJECTION

FY 2007 Sep07
Act
Actual Inventory FY2008 Oct07

Act
Inventory Forecast Jan08

Act
Inventory Plan FY 2008 Feb08

Plan
Nov07
Act
Dec07
Act
Feb08
Fcst
Mar08
Fcst
Apr08
Fcst
Mar08
Plan
Apr08
Plan
Sep08
Plan
NET-INVENTORY Ottobrunn 0973 Gevrey 0436 UK All Shannon 0964 Axicom 1294 India All Saudi 0993 Dubai 1369 USA FV 1083 Canada 0392 Brazil 1300 Mexico 0399 Wyong 1147 Thailand 1148 Hong Kong 0451 Shanghai 1006 Zibo 1149 Indonesia 1143 Singapore 1,014 Dul Malay ??? Rayenergo ??? Other Sites XXXX
M. Kessler C. Djane T. Burgess R. MacDonnell D. Stenz H. Dave H. Dave A. Wadhwa M. Dominguez M. Dominguez R. Leme R. Leme A. Morris Nok J. Wong H. Qiu H. Qiu A. Glennharto R. Tan S. Wan Yusuf D. Kryukov E. Opalla
BASE TED TED TED TED TED TED HYP HYP HYP TED TED HYP HYP TED HYP HYP TED TED HYP HYP HYP
133,333 31,740 11,356 12,622 10,766 6,061 3,742 984 2,666 11,589 2,798 1,797 1,143 10,557 6,076 1,014 2,323 1,114 758 762 713 1,647 8,517
81 50 59 62 94 49 128 50 70 83 50 63 74 106 137 32 73 64 50 53 60 81
136,171 33,305 12,105 12,937 10,691 7,084 4,165 1,193 2,838 12,152 3,211 1,896 861 10,719 5,501 1,194 2,753 1,242 1,025 999 675 1,574 8,051
144,014 34,102 12,491 12,825 10,934 8,225 3,795 1,113 3,351 13,827 3,259 1,658 867 11,414 5,184 1,490 3,749 1,294 1,231 940 834 1,912 9,519
142,416 33,977 12,586 12,519 10,864 8,225 4,021 1,131 3,114 13,859 2,656 1,769 966 11,230 5,143 1,385 3,230 1,477 1,158 977 728 1,658 9,743
144,467 35,111 12,328 12,898 11,159 7,863 4,143 1,226 2,995 15,305 2,138 1,977 1,048 11,254 5,166 985 3,754 1,419 1,194 1,028 728 1,747 9,001
99 63 75 79 126 58 156 104 66 124 32 90 59 95 114 28 97 82 53 71 141 87
145,510 35,000 12,200 13,000 11,500 8,000 4,200 1,250 3,100 14,700 2,200 2,230 1,200 10,900 5,700 1,200 3,800 1,500 1,200 1,100 750 1,780 9,000
145,550 36,000 12,200 12,600 11,500 8,000 4,100 1,200 3,200 14,300 2,200 2,000 1,350 11,000 5,500 1,200 3,800 1,500 1,300 1,100 750 1,750 9,000 Fcst DOH
144,000 35,000 12,200 12,400 11,500 7,000 4,350 1,450 3,200 14,300 2,200 2,100 1,250 10,900 5,500 1,300 3,800 1,500 1,400 1,100 750 1,800 9,000
138,937 31,694 11,545 11,536 11,700 6,350 5,663 2,730 3,400 14,000 3,180 2,100 1,450 9,100 4,900 1,393 3,576 2,177 1,164 950 750 1,577 8,000
138,002 31,903 11,774 11,487 11,700 6,350 5,700 2,580 3,400 13,500 2,379 2,000 1,200 9,000 4,900 1,681 3,680 2,229 1,172 980 800 1,588 8,000
139,611 32,037 12,298 11,662 11,700 6,500 5,658 2,430 3,100 14,000 2,461 1,900 1,250 9,000 5,200 1,680 3,732 2,488 1,216 900 750 1,648 8,000
132,790 30,756 10,883 11,000 10,000 6,700 5,161 2,200 2,900 11,036 2,800 1,650 1,100 9,000 7,000 1,450 3,732 2,851 1,356 780 600 1,837 8,000
Legend: * Fy2008 recost impact on inventory $2,588K! 3COS = 3COS = $131,000 $140,000
100 94
Monthly inventory reduction action meetings.

INVENTORY FORMULAS
The following formulas are used for Inventory Days-Reach and Turns. 1. 2. 3. Daily Cost-of-sales = COS last three months divided by 90 Days-Reach (DOH) = Net-Inventory divided by daily cost-of-sales Inventory-Turns = 360 / Days-Reach
Derivation:
DOH = 360 / Turns = 360 / (COS / INV) = 360 / ((4 3COS) / INV) 360 INV = = INV / (3COS / 90) 4 3COS INV = Daily COS
MONTH-OF-SUPPLY CALCULATION I
A good starting point for analyzing manufacturing inventory is a simple month-of-supply calculation. This ratio gives a good insight into the aging of inventory and highlights items where urgent review of order parameter is needed.
1. Dead-stock is all inventory with no usage in the last 12 months and no demand. 2. 1st Demand has as well no usage in the last 12 months but for the first time demand has been recorded.
MONTH-OF-SUPPLY CALCULATION II
The calculation is done in three steps: 1. Divide per item the last 12-month usage by the number of active usage periods. 2. Divide the current free qty on-hand by the monthly usage from point 1. 3. Classify the inventory in meaningful terms, see next slide for an example.
Example: Usage last 12 months = 600 pcs, Active periods = 6, and Qty OH = 500 pcs
Month of Supply = QtyOH 600 = 500 6 = 5 months
Usage last 12 months Active Periods
Quality of Inventory Percentage (QIP) % of Inventory < 3 MOS

QIP = =
(0 1M ) + (1 2M ) + (2 3M )
Total Gross Inventory
$14,803 + $18,447 + $11,767 $104,652 = 43%
QIP should be between 60 to 70%!

FY 2008 Inventory Reduction Plan Quality of Inventory Percentage (QIP)
The QOI percentage must be around 70%.
Approximated DOH
Approximated DOH by competency will be used to detect inventory reduction potential during monthly inventory reviews. A good inventory performance is right-skewed using month-of-supply and has a QIP between 60 to 70%!
MONTH-OF-SUPPLY APPLICATION I
Competency Code 5 Bowthorpe (13155) ENERGY CABLE ACCS (13041) INSULATORS (13040) SURGE ARRESTER (13037) COMPOUNDS (13054) COPPER (13061) RAYSULATE (13039) Dulmison Insulators (13074) MATERIALS (13055) B&H Products (13150) HARNESS COMPONENTS (13048) DULMISON FITTINGS (13072) HV Products (13234) HARNESSES (13049) SINGLE WALL TUBING (13043) Utilux (13181) SUCOFIT PRODUCTS (13149) Corrosion Protection (13007) Total % 0-1 M 108,688 445,180 214,742 114,659 14,845 16,621 3,758 4,173 9,393 0 0 623 89 0 0 0 932,772 9.38% 1-2 M 131,253 436,146 50,101 372 192,682 30,137 19,164 360 2-3 M 73,274 324,951 152,916 28,646 66,122 26,513 9,731 3-6 M 447,932 483,692 228,350 111,320 153,957 81,711 41,760 12,411 6-12 M 432,947 109,360 620,104 102,848 69,645 11,965 4,657 23,034 12-24 M 24-99 M 988,310 1,020,085 47,555 258,256 300,248 461,200 40,930 176,476 42,459 29,118 38,994 13,902 25,059 33,685 20,145 3,973 739 1,161 492 1st Demand Dead Stock Total % 62,482 466,451 3,731,422 37.53% 190,305 2,295,446 23.09% 184,685 2,212,347 22.25% 31,983 607,233 6.11% 24,261 593,090 5.97% 25,361 218,692 2.20% 6,562 161,157 1.62% 36,492 106,346 1.07% 9,393 0.09% 3,973 0.04% 1,901 0.02% 257 748 0.01% 623 0.01% 89 0.00% 69 0.00% 0 0.00% 0 0.00% 0 0 0.00% 62,482 966,357 9,942,529 100% 0.63% 9.72% 100%
69
860,954 8.66%
682,153 1,562,363 1,374,560 1,503,700 1,997,189 6.86% 15.71% 13.83% 15.12% 20.09%
Dead-Stock items had Zero Usage and Zero Demand and were active in the last 12 months. 1st Demand are all items with Zero Usage but First Time Demand.
MONTH-OF-SUPPLY APPLICATION II
2,500,000
Target
2,000,000
1,997,189
1,562,363 1,500,000 1,374,560
1,503,700
1,000,000
932,772 860,954 682,153
966,357
500,000
62,482 0 0-1 M 1-2 M 2-3 M 3-6 M 6-12 M 12-24 M 24-99 M 1st Demand Dead Stock
TYCOS OBSOLESCENCE RESERVE POLICY

Each site has to report their obsolescence reserve. This is normally done by finance quarterly. It's important to understand the impact of changing the obsolescence reserve. An increase of obs reserve from $500 to $1,000 has an immediate income impact because our operating income will be reduced by the resulting obs expense.
OBSOLESCENCE RESERVE EXAMPLE

Usage per year is 300 pcs; Quantity on-hand is 500 pcs. 1. Transactions in the last 6 months 500 pcs minus 300 pcs is 200 pcs. Obs Res is 200 pcs * 25% 2. Transactions in month 7 to 12 500 pcs minus 300 pcs is 200 pcs ObsRes is 200 pcs * 100% 3. No Transactions in the last 12 months 500 pcs minus 0 is 500 pcs Obs Res is 500 pcs * 100%
ORDER QUANTITIES GUIDELINES

Up to 2 month-of-supply Local planner/buyer
Between 2 to 6 month-of-supply
Local group leader, authorized by local Logistics Manager Worldwide Controller and/or Global Logistics Manager
Greater than 6 months-of-supply
STOCK BUILD APPROVAL When to Apply

Stock Builds should be used for items having irregular demand or for new product launches. For items with regular demand a stock build is only needed if violating our inventory policy not ordering and/or producing more than 2 months-of-supply of inventory. All values must be entered in K USD! The Requester of the stock build is normally a person from sales and/or product management. The Issuer of the stock build is the person filling out the form. It can be the same person as the requester but this depends on the decision of the local Supply-Chain-Manager granting access to this application. The issuer sends the stock build to the approver with the status Initialized. The issuer has the responsibility to maintain current stock builds. Old or completed stock builds should be closed as explained in the training. The Approver is the local supply-chain manager being accountable for the inventory performance. Depending on the total value (see as well approval level policy) the approver can approve/authorize the stock build if it does not violate his approval level policy. If the value for the stock build is higher than his approval limit the stock build is send to EMT members for authorization. As the time of writing this mail we identified the following approvers The Authorizers are Geert Quaegebeur and Olaf Happe.
STOCK BUILD APPROVAL List of Approvers February 2008

1147 Wyong Australia 1300 Braganza Brazil 0451 Hong Kong 1006 Shanghai China 1149 Zibo China 0436 Gevrey France 0973 Ottobrunn Germany 0464 India-Corp India 1144 India-Sys India 1143 Djakarta Indonesia 0964 Shannon Ireland 0468 Auckland New Zealand 9999 Moscow Russia 0993 Damman Saudi Arabia 1014 Singapore 1151-0862 Wohlen CH 1148 Bangkok Thailand 1369 Dubai UAE 0962 Witham UK 1441 Witham UK 1325 Aldrige UK 1083 Fuquay-Varina US 0392 Markham CA Ashley Morris Ruy Leme Jassica Wong Heidi Qiu Heidi Qiu Fabrice Chazee Michael Kessler Himanshu Dave Himanshu Dave Agus Glennharto Randal McDonnell Murray Green Dmitry Kryukov Himanshu Dave Ridhwan Tan Daniel Stenz Nutchanat Permpool Akash Wadhwa Troy Burgess Troy Burgess Troy Burgess Marco Dominguez Marco Dominguez ashley.morris@tycoelectronics.com rpleme@tycoelectronics.com jassica.wong@tycoelectronics.com heidi.qiu@tycoelectronics.com heidi.qiu@tycoelectronics.com fchazee@tycoelectronics.com mkessler@tycoelectronics.com hdave@tycoelectronics.com hdave@tycoelectronics.com agus@tycoelectronics.com rmacdonnell@tycoelectronics.com mgreen@tycoelectronics.com dmitry.kyrukov@tycoelectronics.com hdave@tycoelectronics.com ridtan@tycoelectronics.com dstenz@tycoelectronics.com nutchanat.pp@tycoelectronics.com akash.wadhwa@tycoelectronics.com troy.burgess@tycoelectronics.com troy.burgess@tycoelectronics.com troy.burgess@tycoelectronics.com marco.dominguez@tycoelectronics.com marco.dominguez@tycoelectronics
STOCK BUILD APPROVAL Intranet Link

You can enter/request a new SBA (Stock Build Approval) at http://deoworld1/energy-sba/sba-new.asp You can find an overview of all requested SBAs at http://deoworld1/energy-sba-masterlist.asp
STOCK BUILD APPROVAL Totals by Entity
Click on Org-ID to see a list of all Stock-Builds.

TED INVENTORY AND USAGE
July 2008
WW INVENTORY AND USAGE REPORTING
Power-Cubes Level of Detail
I. II. III.
Screen on-line drill down for last completed month by region, competency, GPL, product code, Item number, measures in HTML format.
Intranet Reports
Separate IWR request for competency, GPL, product code. Worldwide items search. Site usage report for last completed month. TED details as above plus 12 month historical usage reports by site. Total 2 years history.
TED Catalog
WW INVENTORY REPORTING SET-UP
Codes
TED
ADR-049 Data feed Common front-end for worldwide inventory planning and control independent from current used systems, e.g. AMPICS, SAP, Mfg/Pro, or any Legacy Systems. Link between item-numbers and competency biz codes. Availability of 12 monthly usage data, quantity on-hand and unit-costs from Global-Cost-System for the last 2 years. Total outstanding customer requirements and supplies. Month-of-supply and weeks-of-supply ratios, calculated obsolescence reserve, stock on-hand etc.
NC IRL AUS BKK Otto
WW INVENTORY HYPERION VIA USAGE REPORT
The Intranet usage report includes obsolescence reserve and represents gross inventory minus work-in-process plus manufactured & purchased components!
GAP HYPERION TO ADR-049

S E P T EM B E R Gross-Inventory WIP excl M & P GIT Sub-Total Obs Reserve Net-Inventory 2005 ADR-049 Hyperion Hyperion
$75,753K $16,892K $1,924K $94,569K $10,112K $84,457K GAP $1,681K or 2%
Hyperion ADR-049
Net-Inventory
$86,138K
Hyperion
IWR REPORT SELECTION
Intranet web reports can be requested by competency, GPL, product code and part number. All worldwide usage reports can be downloaded into Excel as comma-separated format.
IWR REPORT NUMBER 1 SELECTION
With this report you can request a worldwide inventory/usage overview per discrete item number. All sites will be shown having either inventory and/or usage. To get results for all entities will enter Tycos product number (TCPN).
IWR REPORT NUMBER 10 SELECTION
Select inventory and usage information for ALL items per reporting organization and/or plant. In this case TELAG, entity 1151, is selected with plant code 0862 to get results for Axicom in Wohlen.
ADR-049 RESULTS I
ADR-049 RESULTS II
ADR-049 RESULTS III

ABC A Data Items Items% Usage Usage% Inventory Inv% Res25% Res100% Items Items% Usage Usage% Inventory Inv% Res25% Res100% Items Items% Usage Usage% Inventory Inv% Res25% Res100% Items Items% Usage Usage% Inventory Inv% Res25% Res100% X 69 2.50% 19,083,592 27.11% 1,596,775 16.06% 34,564 0 31 1.12% 667,003 0.95% 172,619 1.74% 7,056 0 75 2.72% 166,513 0.24% 98,749 0.99% 8,687 0 175 6.35% 19,917,108 28.29% 1,868,143 18.79% 50,307 0 Y 134 4.86% 26,752,108 38.01% 1,948,628 19.60% 16,520 0 173 6.27% 3,952,292 5.61% 748,739 7.53% 28,843 0 199 7.22% 621,558 0.88% 331,880 3.34% 33,754 881 506 18.35% 31,325,958 44.50% 3,029,246 30.47% 79,116 881 Z Grand Total 93 296 3.37% 10.74% 10,475,689 56,311,389 14.88% 80.00% 954,298 4,499,700 9.60% 45.26% 2,011 53,095 0 0 313 517 11.35% 18.75% 5,945,577 10,564,872 8.45% 15.01% 1,326,590 2,247,948 13.34% 22.61% 101,115 137,013 38,925 38,925 1,670 1,944 60.57% 70.51% 2,726,583 3,514,654 3.87% 4.99% 2,764,252 3,194,881 27.80% 32.13% 135,687 178,129 1,187,916 1,188,796 2,076 2,757 75.30% 100.00% 19,147,849 70,390,915 27.20% 100.00% 5,045,139 9,942,529 50.74% 100.00% 238,813 368,236 1,226,840 1,227,721
AX, AY and BX items account for around 66% of total usage. Represent typical candidates for statistical forecasting. CZ inventory (3.9% usage) make up 28% of total gross-inventory. Calculated obsolescence for CZ inventory $1,324K. Fully reserved $1,188K.
Total Total Total Total Total Total Total Total
???
ADR-049 RESULTS IV
Only competency 13005 (Energy products) is shown!
ADR-049 RESULTS V
ADR-049 RESULTS VI
ADR-049 RESULTS VII
This is a snapshot of the results of the new worldwide web-report. It shows per product line all entities carrying active parts (=usage and/or stock is greater zero!) with month-of-supply, total usage, stock submitted etc. Here the first item is dead-stock in Dubai but could be used up in the UK!
ADR-049 MONTHLY CUBE
This ADR-049 cube shows only data for the current month!
ADR-021 WEEKLY CUBE
The ADR-021 data feeds shows weekly gross-inventory (excluding WIP & GIT) by entity. Several weekly values are available.
ADR-049 FEBRUARY 2007 KEY ENERGY ENTITIES
ADR-049 IMPLEMENTATION STATUS February 2008

As of February 2008 nearly all Energy sites report their gross-inventory and usage via the ADR-049 data feed. Missing sites is
Rayenergo with $1.8M inventory.
Total net-inventory as of February 2008 $145M with DOH=99!
CHAPTER E
PROBLEMS WITH MINIMUM ORDER QUANTITIES
July 2008
MISUSE OF MINIMUM ORDER QTYS

An ordering site needs only 1 pc of an item from a supplying site. The supplying sites answer is that the mimimum order quantity for this item is 300 pcs. If the ordering site would accept this minimum order quantity it would have to create a reserve for the receiced quantity in excess of a yearly usage if it would follow strictly financial procedures. What is the apporach?
I need one piece!
You have to order 300 pcs!
PROBLEM OF MINIMUM ORDER QTYS

The typical purpose of a minimum manufacturing or purchase order quantity is to find an optimal level between set-up or order costs and inventory carrying costs. Advocats of mimimum order quantities normally claim that it doesn't make sense setting up a machine in order to produce only a few meters or pieces because the set-up time would be much greater than the run-time. Set-up time is regarded as a fixed element which is not modifiable. On the purchasing side quantities are bought taking advantage of discounts leading to lower unit costs, but at the same time the quantity ordered represents much more than the yearly demand. Financially, if followed strictly, a provison for an obs reserve must be done for all quantities in excess of a yearly demand.
CURRENT PUSH SYSTEM

Target Turns ----------TE Supplying Site MFG INV C/O 0 0 0 0 0 500 500 0 500 0 500 0 0 0 0 TE Regional Hub P/O INV C/O 0 0 5 500 0 5 500 0 5 0 500 5 0 495 0 Customer P/O INV 5 0 5 0 5 0 5 0 0 5
1 2 3 4 5
Customer places order Hub places min order qty Supplying Site produces min order qty Supplying site delivers min order qty Hub ships to end customer
Legend: P/O C/O MFG INV
Purchase order Customer Order Manufacturing order Inventory
In our existing push system, ordering sites have to procure minimum order qtys although their customer demand is much lower. This approach 'optimizes' the supplying site but sup-optimizes the worldwide supply chain. This system results as well in slow-moving and/or obsolete inventory at ordering sites and leads to irregular demand at supplying sites although demand could be stable at source.
EXAMPLE DATA PUSH SYSTEM
Supplying Site
Worldwide Yearly Demand: 1,200 pcs MinOrdQty: 500 pcs Inv Turns: 2.4
Ordering Site 1
Regional/Territory Yearly Demand: 120 pcs MinOrdQty: 500 pcs Inv Turns: 0.24
Ordering Site 2
....
Ordering Site N
....
Legend: MinOrdQty = EOQ etc.
PUSH SYSTEM AND IRREGULAR DEMAND

Ordering Site
ROP
ROP
ROP
Time Supply Site

EOQ EOQ EOQ
Time
Although the demand at the ordering site is quite regular demand at the supply site is showing an irregular demand pattern because of min order qtys.
Legend: * ROP is Reorder-Point * EOQ is Economic-Order-Quantity
EXAMPLE DATA PULL SYSTEM
Supplying Site
Worldwide Yearly Demand: MinOrdQty: Target Turns: 1,200 pcs 300 pcs 4
Ordering Site 1
Regional/Territory Yearly Demand: 120 pcs MinOrdQty: 10 pcs Target Turns: 12
Ordering Site 2
....
Ordering Site N
....
Legend: MinOrdQty = WW Demand / Target Turns
FUTURE PULL SYSTEM

Target Turns Customer places order --Hub places min order qty based on target turn 12 Supplying Site produces min order qty 4 Supplying site delivers purchase order 4 Hub ships to end customer 12 TE Supplying Site MFG INV C/O 0 0 0 0 0 10 300 0 10 0 290 0 0 290 0 TE Regional Hub P/O INV C/O 0 0 5 10 0 5 10 0 5 0 10 5 0 5 0 Customer P/O INV 5 0 5 0 5 0 5 0 0 5
1 2 3 4 5
Legend: P/O C/O MFG INV
Purchase order Customer Order Manufacturing order Inventory
The new modified supply chain, pull system, tries to optimize the worldwide supply chain. Minimum order quantities at both, the supplying and ordering site, are set-up in relation to inventory target turns. This approach avoids slow-moving and/or obsolete inventory at ordering and supplying sites. Remnants of min order qtys remain at supplying sites. Capacity is better utilized.
PUSH / PULL FUNDAMENTALS

Supplying Site Each minimum order quantity must be evaluated in relation to the yearly (=worldwide) usage. If the yearly (=worldwide) usage is 500 pc and the minimum order quantity is 100 pc then the resulting inventory turns would be 500/100=5! No minimum order quantity should be greater than the yearly (=worldwide) usage because the excess has to be put into obsolescence reserve. Supplying sites have worldwide visibility about total demand. Ordering Site Each order quantity must be evaluated in relation to their yearly (=regional) usage. If the yearly (=regional) usage is 120 pc and the target inventory turns are 4 the order quantity should be equal to 30 pc. No minimum order quantity should be greater than the yearly (=regional) usage because the excess has to be put into obsolescence reserve. Ordering sites have only visibility about their regional demand.
INVENTORY CONSOLIDATION
July 2008
CENTRALIZATION OF INVENTORY
It is not a good inventory strategy to have the same stock of inventory at different warehouses just in case for a future possible sale. It makes more sense to stock the fast-moving items decentralized near customers and slow-moving items at central warehouses. Offering the same lead time for the whole product portfolio is also too costly as described in the previous section because normally minimum order quantities are pushed to ordering sites for slow-moving parts. The approximated savings for centralization can be approximated by the same approach used for warehouse consolidation, e.g. going from 5 warehouses to 1. The formula used is known as the Square Root Law of Inventory. This law was proved mathematically by D. H. Maister in his 1975 article Centralization of Inventories and The Square Root Law in the International Journal of Physical Distribution.
THE SQUARE ROOT LAW OF INVENTORY

The square root law of inventory states that the total inventory can be approximated by multiplying the total inventory by the square root of future warehouses divided by the current number of warehouses. This formula can be used if an equal amount of inventory is kept in each warehouse and inventory control at each warehouse is based on EOQ principles.
I New
Notation:
WhseNew = I Old WhseOld
INew is centralized inventory in one or several locations IOld is total de-centralized inventory WhseNew is number of new centralized warehouses WhseOld is number of de-centralized warehouses
THE SQUARE ROOT LAW OF INVENTORY Multiple Warehouses Example

Example: * $5M total inventory in de-centralized warehouses * Total number of de-centralized warehouses is 5 * Total number of centralized warehouses is 2
I New
Whse New = I Old Whse Old 2 = $5M 5 = $3.16M
The total new inventory in 2 warehouses will be $3.16M or 37% less inventory!
THE SQUARE ROOT LAW OF INVENTORY Single Warehouses Derivation

The square root formula1) can be simplified if consolidation of inventory is done into one single warehouse.
I New = I Old = I Old = I Old = Whse New Whse Old 1 Whse Old Whse Old 1 Whse Old Whse Old
Take care that in the simplified version of this formula the average inventory is now used instead of the total inventory! To get the average inventory you have to divide the total inventory by the number of existing warehouses.
I Old Whse Old Whse Old
= I Average Whse Old

1) See Ronald H. Ballou, Business Logistics Management, 3rd Edition, 1992, Prentice Hall. He covers on pages 447 to 449 the square root formula for one single warehouse.
THE SQUARE ROOT LAW OF INVENTORY Single Warehouses Example

Example: * $5M total inventory in de-centralized warehouses * Total number of de-centralized warehouses is 5 * Total number of centralized warehouses is 1
I New = I Average Whse Old = $1M 5 = $1M 2.236 = $2.236M
At first the total inventory of $5M in 5 warehouses has to be divided by the total number of warehouses to get the average inventory of $1M per warehouse.
The total new inventory in ONE warehouse will be $2.236M or 55% less inventory!
CONSOLIDATION OF INVENTORY Non Average Inventory

The previous examples were applicable if average inventory per warehouse was nearly equal. If we relax this assumption the inventory impact for centralization of warehouses has to be modified. We now have to apply basic statistics for joint (independent) random variables. The variance of the sum of several independent random variables is equal to the sum of variances of the individual items! For two random independent variables the variance and standard deviation can be calculated as: Variance:
2 2 2 X +Y = X + Y
Standard Deviation:
2 2 X +Y = X + Y
CONSOLIDATION OF INVENTORY Non Average Inventory Example I

What is the reduction on safety stock if inventory is centralized. The table below shows the base data. Assume a lead time of 6 weeks. The service level should be 95%. Demand distribution is normal N(0,1). a) Using Microsoft-Excel we get the z-score.
z score = NORMSINV(P ) = NORMSINV(95% ) = 1.65
b) Weekly data from decentralized warehouses: Country Code Average Demand Standard Deviation TH 2,000 1,000 SP 3,000 2,500 HK 1,000 600 MY 1,500 1,000 ID 500 300
CONSOLIDATION OF INVENTORY Non Average Inventory Example II

c) Decentralized safety stock d) Centralized Standard Deviation
2 2 2 2 2 2 = TH + SP + HK + MY + ID
S/S = z LT TH = 1.65 1,000 6 = 4,042 SP = 1.65 2,500 6 = 10,104 HK = 1.65 600 6 = 2,042 MY = 1.65 1,000 6 = 4,042 ID = 1.65 300 6 = 4,042 Total Safety Stock is 21,826
2 = 1,000 2 + 2,500 2 + 600 2 + 1,000 2 + 300 2 2 = 1,000,000 + 6,250,000 + 360,000 + 1,000,000 + 90,000 2 = 8,700,000 = 8,700,000 = 2,950
e) Centralized Safety Stock
f) Safety Stock Reduction
S/S = z LT = 1.65 2,950 6 = 11,923
Old Safety Stock = 21,826 New Safety Stock = 11,923 Reduction = 9,903 45.4%
CENTRALIZATION OF WAREHOUSES Benchmarking
CHAPTER F
LOT SIZING MODELS
July 2008
INVENTORY CONTROL Basics

Inventory Control comprises all activities and techniques of maintaining the desired levels of items, whether raw material, work in process, or finished goods (APICS Dictionary, 11th Edition). The objective is to minimize total variable cost of a cost function over a specified time period; e.g. a year, month, week etc. The cost function may be represented by
Total Inventory Purchasing Setup Holding Shortage Transportation = + + + + Cost Cost Cost Cost Cost Cost
INVENTORY COSTS Definition

Purchasing / Manufacturing costs represent the actual price of the item. Setup / Ordering costs occur regardless of the of the quantity ordered. Ordering costs are salaries and expenses of processing and order and setup (changeover) costs are for start-up scrap, calibration, downtime etc. Holding costs is the cost of holding inventory, usually defined as a percentage of the dollar value of inventory per unit of time (generally one year). It includes finance costs and costs maintaining the inventory as taxes, insurance, obsolescence, spoilage, and space occupied. Shortage costs is the marginal profit that is lost when a customer orders an item that is not available. Transportation cost is caused by inventory that is in transit between locations.
APICS Dictionary, 11th Edition, 2005
INVENTORY COSTS Holding Cost and Average Inventory

Johnson1) described that inventory holding costs is assumed to be proportional to average inventory. If I(t) is the inventory at time t, the average inventory over a period (0,T) is defined as
Inventory I(t)
1 T I = I(t )dt T 0
If h is the holding cost for one unit of time, then the average holding cost over the interval (0,T) is h x AvgInv. The total holding inventory cost is of course T x h x AvgInv. It is crucial to understand time units, e.g. does h refer to one unit of time or to the total period T! Time T
The average inventory is now the shaded area under the inventory curve divided by T.
1) L.A. Johnson, D. C. Montgomery, Operations Research in Production Planning, Scheduling, and Inventory Control, Wiley, 1974
INVENTORY COSTS Example 1

Calculate with h=3 a) Total inventory, b) Average inventory, c) Holding cost per unit of time, and d) Total inventory cost for period T (here 1 year!) Q Total (=Area) Inventory The holding cost per unit of time h is normally calculated by multiplying the inventory carrying rate in percent by the product unit cost. The average holding cost per unit of time is then h=i*c and total holding cost H=h*T!
1,200
Avg Inv
12
Total
1 = 1,200 12 Inv 2 = 1,200 6 = 7,200
Avg Total Inv = Inv T = 7,200/12 = 600
Inv Cost = Avg Inv h Unit Time = 600 3 = 1,800
Inv Cost = Avg Inv h T Year = 600 3 12 = 21,600


Calculate with h=3 a) Total inventory, b) Average inventory, c) Holding cost per unit of time, and d) Total inventory cost for period T (here 1 year!) Q 600 0
12
Total 1 = 4 600 3 Inv 2 = 4 900 = 3,600
Avg
Total Inv Inv T 3,600 = 12 = 300 =
Inv Cost = Avg Inv h Unit Time = 300 3 = 900

Calculate with h=3 a) Total inventory, b) Average inventory, c) Holding cost per unit of time, and d) Total inventory cost for period T (here 1 year!)
Total
Q 2,400 900 600
1 1 1 1 = 800 3 + 2,400 3 + 600 2 + 900 4 Inv 2 2 2 2 = 1,200 + 3,600 + 600 + 1,800 = 7,200
800
12
Avg
Total Inv Inv T 7,200 = 12 = 600 =
Inv Cost = Avg Inv h Unit Time = 600 3 = 1,800
INVENTORY CONTROL Quantity and Timing

Rules have to be defined of 1. How much of an inventory item has to be ordered? 2. When an order should be placed? Two standard systems are in use 1. Fixed Order Quantity, Continuous Review, or Order Point System 2. Fixed-Time Period System or Periodic Review System.
INVENTORY SYSTEMS Overview

Inventory Systems Order Point Order Cycle Combined Review Period
variable fixed fixed
Order Quantity
( fixed ) (variable)
Triggered by
s t t, s
s, q t, q t, s, q
s, S t, S t, s, S
Notation: q is Fixed-Order Quantity s is Reorder-Point S is Fixed order up inventory level t is Fixed review period
ORDER-POINT SYSTEMS s,q and s,S

Stock Stock
s, q
s, S S
q1 q2 q3
q2 q1
t1
t2
t3
Time
t1
t2
t3
Time
q1 = q2 = qn and t1<> t2 <> t3 <> tn Inventory position checked continuously. At or below s (=reorder-point) constant quantity will be ordered.
q1 <> q2 <> qn and t1<> t2 <> t3 <> tn Inventory position checked continuously. At or below s (=reorder-point) variable quantity to fill target inventory S will be ordered.
ORDER-CYCLE SYSTEMS t,q and t,S

Stock Stock
t, q
t, S S
q2 q1 q3
q1 q2
q3
t1
t2
t3
Time
t1
t2
t3
Time
q1 = q2 = qn and t1= t2 = t3 = tn At constant intervals t a constant quantity q will be ordered. Irregular demand leads to strong fluctuating inventory.
q1 <> q2 <> qn and t1= t2 = t3 = tn Same as t,p policy but variable quantity q will be ordered to fill target inventory level S.
COMBINED SYSTEMS t,s,q and t,s,S

Stock Stock
t, s, q
q2 q1
t, s, S S
q1 q1
t1
t2
t3
Time
t1
t2
t3
Time
q1 = q2 = qn and t1= t2 = t3 = tn Similar to t,q policy but reorder point s is used to place order quantity q.
q1 <> q2 <> qn and t1= t2 = t3 = tn Similar to t,s,q policy. Inventory position is checked at constant intervals. Depending on s inventory filled up to target level S.
NOTATION
D d c Demand rate in units per year. Demand rate in units per period, e.g. week, month. Unit production or purchasing cost not including setup or inventory carrying costs in dollar per unit. K Constant setup (ordering) cost to produce (purchase) a batch in dollars. h t, j Q EOQ Holding cost per unit per time. Time indexes Lot size in units. Economic Order Quantity
CLASSIFICATION OF LOT SIZING MODELS Deterministic via Probabilistic

Lot Sizing Models
Deterministic
Probabilistic
Single Period or News Boy model Reorder-Point Models Periodic Review Models
Static Lot Sizing

Economic Order Quantity EOQ Economic Production Quantity EPQ EOQ with Shortage Resource Constraints Fixed Order Quantity
Dynamic Lot Sizing

Simple
Fixed Period Period Order Quantity Lot for Lot
Optimum
Wagner-Whitin
Heuristic
Silver- Meal Least Unit Cost Part Period Balancing Groff
Some lot size models will be described on the next slides.
CHARACTERISTICS OF LOT SIZES

For Deterministic lot sizes demand is constant and known. There is no uncertainty. Probabilistic (Stochastic) lot sizes can only be described by probability distribution, e.g. Normal or Poisson, because demand is uncertain and not constant. Static / Fixed order quantities (demand rates are fixed at all times) remain the same each time they are ordered unless the factors used in determining the quantity change. Dynamic (Discrete) lot sizing models change with each order because they deal with lumpy demand (known but allowed to vary over time!); not regular or continuous. The advantage in using them is that there will be no remnants from one order cycle to the next as with fixed or economic order quantities. Heuristic models achieve a low-cost solution which is not necessarily optimal.
VARIABILITY COEFFICIENT Formula

Dynamic lot sizes should be used if the variability of demand exceeds some threshold value, see Peterson-Silver (1979). A useful measure of the variability of a demand pattern is the variability coefficient VC. It is calculated by dividing the Variance of demand per period by the Square of average demand per period. N D2 j
j=1 N
VC =
Dj j=1
N
1. If VC < 0.2, use a simple EOQ with average demand as demand estimate. 2. If VC 0.2, use the Silver-Meal heuristic.
VARIABILITY COEFFICIENT Example

t/j dj 1 40 2 20 3 10 4 30 5 50 6 20
VC =
ND
j=1
2 j
VC =
1
Dj j=1
N
6 5,900 1 170 2 35,400 = 1 28,900 = 0.23
VC 0.2, use the Silver-Meal heuristic instead of the EOQ.
ECONOMIC ORDER QUANTITY Trail-and-Error Approach
One order per year results in lowest ordering but highest inventory costs!
D= K= c= i= h=
2,700 $50 $10 30% $3
units per year per order unit cost carrying charge per unit per year
ECONOMIC ORDER QUANTITY Incremental Analysis

Larger order quantities result in less set-up cost. Producing or ordering once per year results in lowest ordering costs but is offset by additional inventory carrying costs. The incremental gain in set-up reduction can be calculated as
D D ICSet Up = Q Q + Q K D(Q + Q ) DQ = Q(Q + Q ) K DQ + D Q DQ K = Q(Q + Q ) Q D = Q + Q Q K
Inventory carrying charge is a function of average inventory Q/2. Incremental increase in inventory carrying cost (regarded as a loss!) is then
Q + Q Q ICInv = h 2 2 Q + Q Q = h 2 Q = h 2
ECONOMIC ORDER QUANTITY Cost Elements Analysis
At the optimal order quantity the absolute values for setup and inventory (holding) cost of the first derivative (= slope of total cost curve) are equal to average order and inventory (holding) cost.
ECONOMIC ORDER QUANTITY Slope of total cost

Cost Total Cost
Total 1st Derivative
EOQ
Qty
At the optimal order quantity the absolute values for setup and inventory (holding) cost of the first derivative (= slope of total cost curve) are equal to average order and inventory (holding) cost.
ECONOMIC ORDER QUANTITY Assumptions

The simplest, oldest, and most widely used order quantity was developed 1913 by F. W. Harris. This formula is applicable if all decision parameters are known with certainty:
1. 2. 3. 4. 5. 6. Demand is known and constant per period, see picture below. Lead time is instantaneous or zero. Unit price is constant. There is no discount. Inventory holding costs are based on average inventory. Ordering or setup cost are constant and can be expressed as K+c*q No backorders are allowed. All demand will be satisfied.
Demand
Inventory
-d
Time
Time
ECONOMIC ORDER QUANTITY Basic Sawtooth Model

Qty
Cycle length: t=q/d

-d
2t
Time
At time zero an order quantity of q arrives and will be consumed during t with d units per unit of time. As inventory reaches t a new order of q is received immediately (lead time is zero) and will be consumed in the next cycle and so forth.
ECONOMIC ORDER QUANTITY Costs per Cycle / Unit of Time

1. Inventory per cycle
1 IC = q t 2 1 q = q 2 d q2 = 2d t = q/d
2. Holding cost per cycle

q2 H = h 2d h q2 = 2d
3. Total cost per cycle

TC = Order Cost + Holding Cost h q2 = K + cq + 2d
4. Total cost per unit of time

h q2 C = K + cq + divided by t 2d K c q h q2 = + + t = q/d t t t 2d d q = K + cd + h q 2
ECONOMIC ORDER QUANTITY Derivation of EOQ

5. Minimal cost with respect to q
q d C = K + cd + h q 2 dC Kd h = 2 + =0 dq q 2 q* = 2 K d h
Take the first derivative of C with respect to q and set it equal to zero. Because the second derivative of C is positive we reached a minimum. Note as well that q does not depend on the purchase/unit cost because they are constant for each quantity.
6. Economic Order Quantity (EOQ)

dC Kd h = 2 + dq q 2 d 2C 2 d K = > 0 Minimum! dq 2 q3
2 K d q* = h
ECONOMIC ORDER QUANTITY Optimal Cycle Length

7. Optimal cycle length
q = dt q t = d 2 K d h t = d 2 K d 1 t = 2 h d
t =
2 K hd
ECONOMIC ORDER QUANTITY Minimum Cost per Unit of Time

8. Minimum cost per unit of time
d q C = K + cd + h q 2 d q C = K + cd + h q 2
q = 2 K d/h
C = C =
Kd 2 K d/h h 2 K d/h + cd + 2 2 K d/h 2 K d/h
K d 2 K d/h h 2 K d/h + cd + 2 K d/h 2 h 2 K d/h h 2 K d/h C = + cd + 2 2 1 h2 1 h2 C = 2 K d + 2 K d + cd 2 h 2 h 1 1 C = 2 K d h + 2 K d h + c d 2 2
C = 2 K d h + c d
ECONOMIC ORDER QUANTITY Sensitivity Analysis

9. Sensitivity Analysis
d q K + h C q 2 = d q C K + h q 2 d q K + h q 2 = 2Kdh dK qh = + q 2Kdh 2 2Kdh = d K 2Kdh + q 2Kdh 2Kdh 2Kdh q + 2 q h 2 q 1 2Kdh q + 2 2q h 2 q q 2Kdh 2 h2
For this analysis we can skip the factor c * d (=total purchasing or manufacturing cost per cycle), because it is independent of the lot size q!
= =
C 1 q q = + C 2 q q
1 q 1 q = + 2 q 2 q
ECONOMIC ORDER QUANTITY Example - EOQ

D = 2,700 units per year; K = $50 per order; c = $10 unit cost; i = 30% carrying charge per year; h = $3 = c * i = $10 * 0.30 per unit per year Calculate the optimal quantity q, cycle time t, and total cost.
2 K d q = h
*
2 K t = hd
C = 2 K d h + c d = 2 50 2,700 3 + 10 2,700 = 810,000 + 27,000 = $27,900 per year
2 50 2,700 3 = 300 pcs =
2 50 3 2,700
= 0.111 years 52 weeks/year = 5.8 weeks 6 weeks
ECONOMIC ORDER QUANTITY Example - Sensitivity

What cost impact does it have if the actual purchased/manufactured quantity is 30% higher or 30% lower than the EOQ (Economic Order Quantity)?
Plus 30%
C 1 q q = + C 2 q q 1 1 1.30 = + 2 1.30 1 1 = (0.7692 + 1.30 ) 2 = 1.0346 3.5%
Minus 30%
C 1 q q = + C 2 q q 1 1 0.70 = + 2 0.70 1 1 = (1.4286 + 0.70 ) 2 = 1.0643 6.4%
Although the deviation (plus/minus) of the order quantity compared to the EOQ is quite big the cost impact is much lower. Due to the flatness of the total cost curve around the EOQ it is more cost effective to produce bigger lot sizes than smaller ones.
ECONOMIC PRODUCTION QUANTITY Inventory over Time

Qty
q = p t1 t1 = q q = td t = q Inv max = (p d ) t1 d p
Invmax q p-d -d
= (p d )
q p
d = 1 q p Inv max = d t 2 t 2 = Inv max d
t1
t2 t
2t
Time
For this model inventory builds up during the production cycle t1 but is consumed by d. The maximum inventory level is reduced by the factor (p-d) during production cycle t1.
ECONOMIC PRODUCTION QUANTITY Costs per Cycle / Unit of Time

1. Inventory per cycle
1 IC = Inv max t t = q/d 2 q 1 d = 1 - q p d 2 1 d q2 = 1 2 p d
2. Holding cost per cycle

1 d q2 H = 1 h 2 p d 1 d q 2h = 1 2 p d

1 d q 2h TC = K + c q + 1 2 p d K c q 1 d q2 h C= + + 1 t t 2 p dt d 1 d C = K + c d + 1 q h q 2 p divide by t t = q/d

TC = Order Cost + Holding Cost 1 d q 2h = K + c q + 1 2 p d
ECONOMIC PRODUCTION QUANTITY Derivation of EPQ

5. Minimal cost with respect to q
1 d q C = K + c d + 1 q h 2 p d dC Kd 1 d = 2 + 1 h = 0 dq q 2 p Kd 1 d = 1 h q2 2 p Kd q2 = 1 d 1 h 2 p q2 = 2 K d d 1 h p
Take the first derivative of C with respect to q and set it equal to zero. Because the second derivative of C is positive we reached a minimum. Note as well that q does not depend on the purchase/unit cost because they are constant for each quantity.
6. Economic Production Quantity (EPQ)

2 K d q = d 1 - h p
*
dC Kd 1 d = - 2 + 1 h dq q 2 p d 2C 2 d K = > 0 Minimum! dq 2 q3
ECONOMIC PRODUCTION QUANTITY Optimal Cycle Length

7. Optimal cycle length t*
t = q /d q = 2d K (1 d/p ) h
2 d K (1 d/p ) h = d 2d K = (1 d/p ) h d 2
t =
2 K (1 d/p ) h d
Keep in mind that the production period t1 = q / p (time to produce the lot size) is different to the (production) cycle time t = q / d (time between production runs)!
ECONOMIC PRODUCTION QUANTITY Minimum Cost per Unit of Time

8. Minimum cost per unit of time
C = = d 1 K + (1 d/p ) q h + c d q 2 dK 1 + (1 d/p ) 2 2 d K (1 d/p ) h dK q = 2 d K (1 d/p ) h
2d K h + cd (1 d/p ) h 2d K h + cd (1 d/p ) h
= = =
(1 d/p ) h
2d K
1 (1 d/p ) 2
2 d K (1 d/p ) h + cd 2dK (1 d/p ) h
(1 d/p ) h d K (1 d/p ) h 2 d K + + cd 2 2dK (1 d/p ) h 2 d K (1 d/p ) h

d C = 2 d K h 1 + c d p
22 d 2 K 2 h 2 = 2 d K h
(1 d/p )2 (1 d/p )
+ cd
ECONOMIC PRODUCTION QUANTITY Example

A heat-shrink tube has a yearly usage of 4,000 meters. The production capacity is 8,000 meters per year. Each setup requires cleaning of the equipment and inspection and calibration costs $25 per run. The cost to produce the tubing is $0.25 per meter and inventory holding cost is estimated as 40% annually. What should be the optimum production size? K=$25 /order; c=$0.25; h=i x c = 40% x $0.25 = $0.10 per meter/year; d=4,000 meters per year; p=8,000 meters per year
q* =
2 K d d 1 - h p 2 25 4,000 4,000 1 0.10 8,000
Production time is 0.25 years or 3 months. (t1=q/p=2,000/8,000=0.25) Cycle time is 0.5 years or 6 months. (t=q/d=2,000/4,000=0.5)
200,000 0.5 0.1 = 2,000 =
EOQ with Shortage Basics

Qty Inventory/ cycle
M q
t = q/d t1 = M/d t 2 = t t1 q M d d qM = d m =qM =
-d Backorders/ cycle
m t1 t t2
Time
In this scenario backorders are now allowed (=no lost sales!) but a shortage cost s must be paid proportional to the waiting time t2 till the order can be delivered.
EOQ with Shortage Cycle Costs

1. Inventory cost per cycle
IC = M t1 h 2 M M = h 2 d M2 = h 2d t1 = M/d
2. Shortage cost per cycle

BC = m t2 qM s t2 = ;m =qM 2 d 1 qM = (q M ) s 2 d (q M )2 s = 2d

TC = Order Cost + Holding Cost + Shortage Cost h M 2 s (q M ) = K + cq + + 2d 2d
2
EOQ with Shortage Total Cost per Unit of Time

C= TC t = q/d t 2 d cqd h M 2 d s (q M ) d = K+ + + q q 2dq 2dq d h M 2 s (q M ) = K + cd + + q 2q 2q
2
d h M 2 + s q 2 2Mq + M 2 = K + cd + q 2q
)
M 2 (h + s ) sq d + sM C = K + cd + 2q 2 q
d h M 2 sq 2 2Mqs M 2s = K + cd + + + q 2q 2q 2q 2q d h M 2 + s M 2 sq = K + cd + + Ms q 2q 2
EOQ with Shortage Partial Derivation of M

5. Partial derivation for M
C= C = M s= M= M 2 (h + s ) sq d + sM K + cd + 2q 2 q 2 M (h + s ) s = 0 2q 2 M (h + s ) 2q s q h+s
6. Modifying M-term for q derivation

s q h +s M s = q h +s M= M2 s2 = q 2 (h + s )2
EOQ with Shortage Partial Derivation of q

7. Partial derivation for q
d M 2 (h + s ) sq C = K + cd + + sM q 2q 2 d K M 2 (h + s ) s C = 2 + =0 q 2q 2 2 q d K s s 2 (h + s ) = q2 2 2 (h + s )2 2 d K s2 =s q2 h +s 2 d K s (h + s ) s 2 = q2 h +s 2 d K sh + s 2 s 2 = q2 h+s h+s q 2 = 2dK sh 2dK h + s q2 = h s
M2 s2 = q 2 (h + s )2
q =
2 d K h +s h s
EOQ with Shortage Solution for M

8. Solution for M
M= s q h+s q= 2dK h +s h s
1/2
s 2dK (h + s ) = h+s h s1/2 2dK (h + s ) = 1/2 s h h +s s =
1/2
M =
2 d K s h h +s
2dK 1/2 1 s h (h + s )1/2
M is the up-to inventory level after receiving the order quantity.
EOQ with Shortage Cycle Length

9. Optimal Cycle Length
t = q d 2 d K h+s h s = d 2 d K h+s = 2 hd s
t =
2 K h +s hd s
EOQ with Shortage Maximum Shortage Quantity

10. Maximum Shortage Quantity
m = q M = = = = = = 2dK h + s 2dK s h s h h +s 2dK h 2dK h
(h + s ) (h + s ) 2dK s s (h + s ) s s (h + s ) h (h + s )2 2dK s2 (h + s ) s s (h + s ) h
Multiply the 1st square root by (h+s)/(h+s) and the 2nd square root by s/s and simplify further!
2dK 2 (h + s ) s 2 h s (h + s ) 2dK [(h + s ) s] h s (h + s ) 2dK h h s (h + s )
m =
2 d K h s h +s
2dK h2 = s h (h + s )
Because m represents backorders it is actually a negative value!
EOQ with Shortage Maximal Shortage Time

Because of the difficulties to calculate shortage costs Neumann (Produktions- und Operations Management, Springer-Verlag, 1996) recommends to use the maximal shortage time instead. This shortage time determines how many days a customer must wait till goods are delivered. 11. Maximal Shortage Time
q M = d 2d K h /d = s h+s = = 2d K h s d2 h +s 2 K h ds h + s
12. Shortage Cost Derivation

2 K h ds h + s 2 K h 2 = d s (h + s ) 2 K h s (h + s ) = d 2 2 K h 0 = s2 + s h d 2 =
EOQ with Shortage Shortage Cost

The shortage cost is now the positive part of the quadratic equation!
s2 + s h 2 K h =0 2 d
2
h h 2 h K s= + + 2 d 2 2
Note: The standard quadratic equation in normal form is shown on the right p=h and q=-2hK/d2
x 2 + px + q = 0 x1,2 p p = q 2 2
2
EOQ with Shortage Example I

We deliver to a key account customer a special type of HV connectors. In order not to loose this customer management decided that in case of shortage the maximum waiting time is 2 days. Order cost are $200 and the unit-cost is $30. Holding cost is $1 /unit/day.Yearly usage with 250 working days is 1,000 units. K=$200 /order; c=$30; h=$1 /unit/day ; =2 days; Daily usage d=5 units (1,250/250) 1. Shortage Cost s: 2. Optimal Order quantity q:
h h 2 h K s= + + 2 d 2 2 1 1 2 1 200 = + + 2 5 22 2 = 0.5 + 0.25 + 20 =4

Shortage cost s is$4 per unit per day.
2
q = =
2d K h +s h s 2 5 200 1+ 4 1 4
= 2,000 1.25 = 50
Optimal order quantity q is 50 units per order.
Example taken from Neumann, Produktions- und Operations Management, 1996, Springer
EOQ with Shortage Example II

3. Optimal Inventory Level M: 4. Optimal Order Point m:
M = =
2 d K s h h+s 2 5 200 4 1 1+ 4
m = =
2d K h s h+s 2 5 200 1 4 1+ 4
= 2,000 0.8 = 40
= 500 0.2 = 10
Optimal up-to inventory level M* = 40 units.
A new order should be placed if backorders reach minus m* = 10.
EOQ with Shortage Example III

5. Optimal Cycle Length t:
t = =
2 K h +s hd s 2 200 1+ 4 1 5 4
= 80 1.25 = 10
Each 10 days, after reaching (minus) 10 units backorders, a new order for 50 units should be placed filling inventory up to 40 units. If the lead time would be for example 7 days the reorder-point would be m* + LT x d = -10 + 7 x 5 = 25 units. More details for reorder points will follow in later sessions.
LOT SIZING TOURNAMENT
July 2008
ECONOMIC QRDER QUANTITY (EOQ)

The most popular order quantities in practice is the Economic Order Quantity or EOQ because of its simplicity. Optimal results can only be reached if following assumptions are met.
EOQ = =
2 Demand OrderCost Holding Cost 2 D K h
1. 2. 3. 4. 5. 6.
Item demand is constant. Lead time is constant. Cost per unit is constant, no discounts. Holding cost is based on average inventory. Ordering cost is constant. No shortages are allowed.
Demand
Inventory
-D
Time
Time
EOQ Example
t/j dj 1 40 2 20 3 10 4 30 5 50 6 20
EOQ =
2 D K h
K=$50; h=$1/unit/period Average Demand d = 40+20+10+30+50+20 = 170 / 6 = 28.3 ~ 29
EOQ =
2 29 50 = 53.85 54 1
2 20 54 48 38 8 3 10 4 30 5 50 54 12 6 20 54 46
t/j dj EOQ End Inv
1 40 54 14
For holding costs only ending inventory is considered!
EOQ Example Results

60 50 40 30 20 10 0 1 2 3 Demand 4 Lot size 5 6 54 54 54 54
Lot Q(1) Q(2) Q(5) Q(6) Total Cost
Qty 54 54 54 54
Setup 50 50 50 50 200
Holding 14 94 12 46 166
Cost 64 144 62 96 366
SILVER-MEAL HEURISTIC (SM)

This method is quite similar to the least unit cost approach, but instead of minimizing the unit cost for a lot it minimizes the cost per period over the number of periods the lot will cover.
C(1) = K C(2) = K + hd 2 2 K + hd 2 + 2hd 3 C(3) = 3 K + hd 2 + 2hd 3 + ... + (j 1)hd j C(j) = j
If Cj Cj-1 stop and set lot Q = d1+d2+d3++dj-1. Start calculation again at period j.
SILVER-MEAL Example
t/j dj 1 40 2 20 3 10 4 30 5 50 6 20
Cj Cj-1
Stop!
K=$50; h=$1/unit/period t=1; j=1: C(1) = (50+0*1*40)/1 = 50 t=2; j=2: C(2) = (50+0*1*40+1*1*20)/2 = 35 t=3; j=3: C(3) = (50+0*1*40+1*1*20+2*1*10)/3 = 30 t=4; j=4: C(4) = (50+0*1*40+1*1*20+2*1*10+3*1*30)/4 = 45 C(4) C(3) , Q(1) = d1+d2+d3 = 70 t=4; j=1: C(1) = (50+0*1*30)/1 = 50 t=5; j=2: C(2) = (50+0*1*30+1*1*50)/2 = 50 C(2) C(1), Q(4) = d4 = 30 t=5; j=1: C(1) = (50+0*1*50)/1 = 50 t=6; j=2: C(2) = (50+0*1*50+1*1*20)/2 = 35 Q(5) = d5+d6 = 70 End of horizon, STOP! STOP!
STOP!
SILVER-MEAL Example Results

100 90 80 70 60 50 40 30 20 10 0 1 2 3 Demand 4 Lot size 5 6 30 70 70
Lot Q(1) Q(4) Q(5)
Qty 70 30 70
Setup 50 50 50 150
Holding 40 0 20 60
Cost 90 50 70 210
Total Cost
LEAST UNIT COST (LUC)

This method is similar to the Silver-Meal method but instead of dividing the cost over j periods it is divided by the total number of units d1+d2+d3++dj.
C(1) = C(2) = C(3) = C(j) =
K d1 K + hd 2 d1 + d 2 K + hd 2 + 2hd 3 d1 + d 2 + d 3 K + hd 2 + 2hd 3 + ... + (j 1)hd j d1 + d 2 + d 3 + ... + d j
If Cj Cj-1 stop and set lot Q = d1+d2+d3++dj-1. Start calculation again at period j.
LEAST-UNIT COST (LUC) Example

t/j dj 1 40 2 20 3 10 4 30 5 50 6 20
Cj Cj-1
Stop!
K=$50; h=$1/unit/period t=1; j=1: C(1) = (50+0*1*40)/40 = 1.25 t=2; j=2: C(2) = (50+0*1*40+1*1*20)/60 = 1.17 t=3; j=3: C(3) = (50+0*1*40+1*1*20+2*1*10)/70 = 1.29 C(3) C(2) , Q(1) = d1+d2 = 60 t=3; j=1: C(1) = (50+0*1*10)/10 = 5 t=4; j=2: C(2) = (50+0*1*10+1*1*30)/40 = 2 t=5; j=3: C(3) = (50+0*1*10+1*1*30+2*1*50)/90 = 2 C(3) C(2), Q(3) = d3+d4 = 40 t=5; j=1: C(1) = (50+0*1*50)/50 = 1 t=6; j=2: C(2) = (50+0*1*50+1*1*20)/70 = 1 C(2) C(1), Q(5) = d5 = 50 Q(6) = d6 = 20 End of horizon! STOP!
STOP!
STOP!
LEAST-UNIT COST (LUC) Example Results

80 70 60 50 40 30 20 10 0 1 2 3 Demand 4 Lot size 5 6 20 40 50 60
Lot Q(1) Q(3) Q(5) Q(6)
Qty 60 40 50 20
Setup 50 50 50 50 200
Holding 20 30 0 0 50
Cost 70 80 50 50 250
Total Cost
PART PERIOD BALANCING (PPB)

This method, sometimes called the Least Total Cost (LTC) method , chooses a lot size which makes the holding and set-up costs as nearly equal as possible. Its derived from the fact that for the economic order quantity the set-up cost is equal to the holding cost for that lot size!
d ( j 1) K
j=1 j
K d j ( j 1) h j=1
d ( j 1)
j=1 j
is called part-periods!
For each step compare holding cost with set-up cost.

PART PERIOD BALANCING (PPB) Example

t/j dj 1 40 2 20 3 10 4 30 5 50 6 20
h d j (t 1) K
j=1
K=$50; h=$1/unit/period t=1; j=1: $1*0*40 = 0 < K t=2; j=2: $1*0*40+$1*1*20 = 20 < K t=3; j=3: $1*0*40+$1*1*20+$1*2*10 = 40 < K t=4; j=4: $1*0*40+$1*1*20+$1*2*10+$1*3*30 = 130 > K
STOP!
40 is closer to K=50 than 130! Q(1) = d1+d2+d3 = 70 t=4; j=1: $1*0*30 = 0 < K t=5; j=2: $1*0*30+$1*1*50 = 50 = K STOP!
50 is equal to K=50! Q(4) = d4+d5 = 80 Q(6) = d6 = 20 End of horizon!
PART PERIOD BALANCING (PPB) Example Results

100 90 80 70 60 50 40 30 20 10 0 1 2 3 Demand 4 Lot size 5 6 20 70 80
Lot Q(1) Q(4) Q(6)
Qty 70 80 20
Setup 50 50 50 150
Holding 40 50 0 90
Cost 90 100 50 240
Total Cost
GROFF HEURISTIC I
It is based on the feature of the economic order quantity that at the optimal lot size the incremental reduction of set-up costs per period equals the incremental increase of holding costs per period. The incremental reduction of set-up or order cost per period can be shown by comparing average costs per period. Example: K=$100; h=$1/unit/period
K =
K K j j +1 K(j + 1) Kj Kj + K Kj = = j(j + 1) j(j + 1) K = j(j + 1)
K =
100 100 4 4 +1 = 25 20 = 5 or K j(j + 1) 100 100 = = =5 4(4 + 1) 4 5 =

GROFF HEURISTIC II
The lot size is increased by the requirement of another period till the increased holding costs equals roughly the decreased set up cost.
h d j+1 2
Increased holding cost
h d j+1 2
K j ( j + 1)
K j ( j + 1)
Decreased set up cost
h d j+1 2
>
K STOP! j ( j + 1)
If in period j the incremental increase of holding costs is greater than the incremental decrease of set-up costs then choose order qty Q as d1+d2+dj-1!
GROFF HEURISTIC Example

t/j dj 1 40 2 20 3 10 4 30 5 50 6 20
h d j+1 2
>
K STOP! j ( j + 1)
K=$50; h=$1/unit/period t=1; j=1: ($1*20)/2 = 10 < $50/(1*[1+1]) = 25 t=1; j=2: ($1*10)/2 = 5 < $50/(2*[2+1]) = 8.33 t=1; j=3: ($1*30)/2 = 15 > $50/(3*[3+1]) = 4.17 Q(1) = d1+d2 = 60 t=3; j=1: ($1*30)/2 = 15 < $50/(1*[1+1]) = 25 t=3; j=2: ($1*50)/2 = 25 > $50/(2*[2+1]) = 8.33 Q(3) = d3 = 10 t=4; j=1: ($1*50)/2 = 25 > $50/(1*[1+1]) = 25 t=4; j=2: ($1*20)/2 = 10 > $50/(2*[2+1]) = 8.33 Q(4) = d4 = 30 t=5; j=1: ($1*20)/2 = 10 < $50/(1*[1+1]) = 25 Q(5) = d5+d6= 70 End of horizon!
STOP!
STOP!
STOP!
GROFF HEURISTIC Example Results

80 70 60 50 40 30 20 10 0 1 2 3 Demand 4 Lot size 5 6 10 30 70 60
Lot Q(1) Q(3) Q(4) Q(5)
Qty 60 10 30 70
Setup 50 50 50 50 200
Holding 20 0 0 20 40
Cost 70 50 50 70 240
Total Cost
WAGNER-WHITIN
This method analyzes all possible combinations to find the optimal lot sizes. For example it is possible to produce lot-for-lot or produce 1 lot for period 1 and a second lot in period 2 covering requirements from period 2 to period 6.
To start with a matrix is calculated showing the cost impact of all different lot sizes.
c j = K + h
t = +1
(t ) d
Be aware that a sum from a higher index to a smaller, e.g. from 2 to 1 is defined as zero!
Wagner-Whitin is included because it is common to use it for benchmarking!

WAGNER-WHITIN Example I
t/j dj 1 40 2 20 3 10 4 30 5 50 6 20
c j = K + h
t = +1
(t ) d
K=$50; h=$1/unit/period 1. Calculate cost matrix 2. Determine minimum cost per period
\t 1 2 3 4 5 6 1 50 70 90 180 380 480 2 3 4 5 6 50 60 120 270 350 50 80 180 240 50 100 140 50 70 50
\t 1 2 3 4 5 6 ft
1 50
70 90 180 380 480 100 110 170 320 400 120 150 250 310 140 190 230 190 210 240
50
70
90
140 190 210
For example, in period 3 add minimum cost of $70 from period 2 and in period 5 add minimum cost of $140 from period 4.
WAGNER-WHITIN Example II
t/j dj 1 40 2 20 3 10 4 30 5 50 6 20
c j = K + h
t = +1
(t ) d
K=$50; h=$1/unit/period 3. Derive optimal order quantities
\t 1 2 3 4 5 6 ft
1 50
70 90 180 380 480 100 110 170 320 400 120 150 250 310 140 190 230 190 210 240
Start
50
70
90
140 190 210
Q(1) = d1+d2+d3 = 70; Q(4) = d4 = 30; Q(5) = d5+d6 = 70
WAGNER-WHITIN Example Results

80 70 60 50 40 30 20 10 0 1 2 3 Demand 4 Lot size 5 6 30 70 70
Lot Q(1) Q(4) Q(5)
Qty 70 30 70
Setup 50 50 50 150
Holding 40 0 20 60
Cost 90 50 70 210
Total Cost
LOT SIZE Benchmarking

Method Wagner-Whitin Silver-Meal Groff Part-Period Least-Unit EOQ Qty Q(1)=70, Q(4)=30, Q(5)=70 Q(1)=70, Q(4)=30, Q(5)=70 Q(1)=60, Q(3)=10, Q(4)=30, Q(5)=70 Q(1)=70, Q(4)=80, Q(6)=20 Q(1)=60, Q(3)=40, Q(5)=50, Q(6)=20 Q(1)=Q(2)=Q(5)=Q(6)=54 Setup 150 150 200 150 200 200 Holding 60 60 40 90 50 166 Cost 210 210 240 240 250 366
Comparing the different dynamic lot sizing methods with each other and with the EOQ the worked-out examples match with different simulations in textbooks. Wagner-Whitin, although tedious to calculate, shows normally the lowest costs, followed by Silver-Meal. Here both methods generate the same costs! For time-varying demand Silver-Meal and Groff are normally used. It is obvious as well from this simulation that the EOQ should not be used for time-varying demand.
CHAPTER G
SAFETY STOCK CALCULATION
July 2008
REASONS FOR SAFETY STOCK

One of the biggest problems in inventory management is random variability in the demand rate and/or lead time because it is unpredictable. Running out of stock has a very negative impact on customer service: Loss of goodwill, expediting costs from vendors, special set-up costs in manufacturing etc. To absorb shortages companies maintain safety stock. The objective is to balance the additional costs of holding safety stock with the expected cost of shortages. Obtaining accurate shortage costs is very difficult. Therefore management accepts a reasonable service level in the form of safety stock. Two major forms of safety stock are common: cycle-service level and unit-service level. Both will be covered in detail. Safety stock is all inventory held in excess of average, expected demand during lead time to reduce the risk of stock outs because of random variation of either lead time and/or demand.
DETERMINISTIC INVENTORY SYSTEMS

Quantity In a deterministic inventory system all parameters are predictable, e.g. demand rate or usage per period, lead time, no shortages etc. No safety stock is needed!
Order Quantity
Demand Rate
Time
Lead Time
PROBABILISTIC INVENTORY SYSTEMS

50 100 150 Relative Frequency Distribution
Order Quantity
ROP
200 250 300
Safety Stock Time Stock out
Lead Time
PROBABILISTIC INVENTORY SIMULATION

Period Demand INV Avg Demand INV <Avg Demand INV >Avg 0 0 1,000 0 1,000 0 1,000 1 100 900 100 900 0 1,000 2 100 800 150 750 200 800 3 100 700 50 700 150 650 4 100 600 200 500 50 600 5 100 500 0 500 250 350 6 100 400 120 380 50 300 7 100 300 0 380 150 150 8 100 200 50 330 200 -50 9 100 100 50 280 150 -200 10 100 0 70 210 50 -250 AVG 100
79
120
1,150 950 750 550 350 150 -50 -250 =Avg
Projected Inventory
300 250 200 150 100 50 0 -50
Average Forecast Error
10
<Avg
>Avg
Avg Fcst
< Fcst
> Fcst
SAFETY STOCK DEFINITION

In deterministic inventory models the reorder point is equal to lead time demand or ROP = d * LT. If, however, demand during leadtime is normally distributed, demand will be greater than the mean 50% and less than the mean 50% of the time. To provide for a service level greater than 50% a safety stock must be added, see the picture on the right. One popular method relates safety stock to usage rates or time supply, e.g. Two weeks of Supply. But the variability of supply and demand, not the average rate, should determine the amount of safety stock. Both methods will be described on the next slides.
SAFETY STOCK BASICS I

How safety stock is calculated is important to discover excess inventory. If safety stock is based on time supply, e.g. one monthly usage as safety stock, there is room for improvement because a time supply calculation could be misleading. Lets consider two items, A and B, both with an average monthly usage of 1,000 pcs a month. Item A has a standard deviation of 100 pcs and B of 300 pcs. The safety stock is set on time supply with 250 pcs ( = one week! ), the service level should be 95% (is equal to a z-score of 1.65) and demand during lead-time is normally distributed. Statistically, safety stock is a function of a safety factor, which reflects the desired service level, and the variability of the forecast error during lead-time. Safety Stock = Std Deviation * z-score
SAFETY STOCK BASICS II

Monthly usage 2 weeks-of-supply Standard deviation 500 Statistical safety stock
600
Part A 1,000 250 100 165
Part B 1,000 250 300 495
495
StatisticalSafetyStock = StdDev z score
400 300 200 100
300 250 165 100 250
0 Part A
2 weeks-of-supply Standard deviation
Part B
Statistical safety stock
For part A we would carry too much safety stock of 85 pcs (250 minus 165) and for part B too less safety stock minus 245 pcs (250 minus 495) for a target service level of 95%.
SAFETY STOCK BASICS III

With the statistically calculated safety stock we not only avoid excess inventory, we can shift inventory from items with low variable demand to items with higher variable demand with the same investment. If done properly, this could increase service and decrease investment. The figure below illustrates the statistical approach for item A.
1,250
Statistical Safety Stock Actual Usage
1,000
Time
SAFETY STOCK INVESTMENT

There is a trade-off between desired customer service level and inventory investment. Increasing safety stock in a way to achieve a 100% service level has disastrous results on the cash-flow of a company. The figure below shows the relation between desired service level and inventory investment. To increase the service level from 90% to 96% by only 6%, the incremental investment in safety stock will be (1.75-1.28)/1.28 = 36.7%!!!
90%
Percent Increase S/S Investme
80% 70% 60% 50% 40% 30% 20% 10% 0% 90% 92% 94% 96% 98% 99%
Compared to 90% Service Level 90% 92% 94% 96% 98% 99% Z-Factor 1.28 1.41 1.56 1.75 2.06 2.33 Safety Stock Increase 0.0% 10.2% 21.9% 36.7% 60.9% 82.0%
Desired Service Level
SAFETY STOCK INVESTMENT EXAMPLE

StdDev z-score 0.00 0.84 1.28 1.64 2.33 100 Service level SL 50% 80% 90% 95% 99% Order Qty Safety stock 0 84 128 164 233 200 Avg Q 100 100 100 100 100 Average Inv 100 184 228 264 333 Service Level --50% to 80% 80% to 90% 90% to 95% 95% to 99% --30% 10% 5% 4% Inv Inc --84% 24% 16% 26%
AvgInv =
Q + z 2 Q = + z MAD 1.25 2 Q = + MAD SF 2
350 300
333 264 228 184 100
Average Inventory
250 200 150 100 50 0 50% 80%
Service Level SL in %: = NORMSDIST(z); N(0,1)

90% 95% 99%
Service Level
Z-Score: = NORMSINV(P); N(0,1)
DETERMINING SAFETY STOCK LEVELS

In practice there are two common methods how to calculate a safety stock for providing a desired customer service level. They are a) The cycle service level and b) The unit service level. Because of the simpler calculation the cycle service level is very popular. The cycle service level determines the probability of not running out of inventory during an order cycle. The unit service level or fill-rate determines the amount of stock which can be immediately satisfied.
Cycle 1 2 3 4 5 6 Demand 100 120 80 150 170 140 760 Backorder 20
5 25
In this example the cycle service level would be 67 % because there was a stockout during two cycles. The unit service level would be 97 % because only 25 units were backordered.
CYCLE-SERVICE-LEVEL VIA UNIT-SERVICELEVEL

Cycle-Service-Level Also called alpha or Type I service level. Represents an event oriented ratio. Probability of not incurring a stockout during an inventory cycle, e.g received orders can be completely filled from available stock. Applied when the likelihood of a stockout in percent and not its magnitude in pieces is important for the company. Unit-Service-Level Also called beta or Type II service level. Represents a quantity oriented ratio. Percentage of demand that are filled without incurring any stock-out, e.g. 100 short of 1,000 ordered means 90% service level. Applied when the percentage of unsatisfied demand should be under control.
CYCLE SERVICE LEVEL I

For a cycle service level the safety stock is calculated as depicted below:
SS = Z S LT / FP SS = Z 1.25 MAD LT / FP SS = MAD SF LT / FP
Table of Safety Factors:

Service Level 50.00% 75.00% 80.00% 84.13% 85.00% 90.00% 94.52% 95.00% 97.72% 98.00% Value Z 0.00 0.67 0.84 1.00 1.04 1.28 1.60 1.65 2.00 2.05 Safety Factor SF = Z x 1.25 0.00 0.84 1.05 1.25 1.30 1.60 2.00 2.06 2.50 2.56
Legend: SS Z S SF LT FP MAD
Safety stock Z-score from standard normal distribution table Standard deviation during lead-time Safety factor lead-time in weeks, months etc. Forecast period in weeks, months etc. Mean absolute deviation
CYCLE SERVICE LEVEL II

Month JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC TTL Past Demand 346 312 387 350 406 364 353 338 392 385 372 365 4,370 Average Absolute Demand Deviation 364 18 364 52 364 23 364 14 364 42 364 0 364 11 364 26 364 28 364 21 364 8 364 1 244
LT = 4 weeks, FP = 4 weeks Service Level = 95% Average Demand = 4,370 / 12 ~ 364 MAD = 244 / 12 = 20.3
SS = MADSF LT/ FP SS = 20.3 2.06 4/ 4 SS = 42

CYCLE SERVICE LEVEL WITH MS EXCEL

Jan-04 346 Feb-04 312 Mar-04 387 Apr-04 May-04 350 406 Jun-04 364 Jul-04 353 Aug-04 338 Sep-04 392 Oct-04 385 Nov-04 372 Dec-04 365
MAD = AVEDEV(Usage Jan04 to Dec04)
SF = z score * 1.25 = 1.65 * 1.25 = 2.06
MAD SF=95% 20.3 2.06
LT 4
FP 4
S/S 42
S/S = Safety Factor SF * Mean Absolute Deviation MAD *SQRT(Lead Time LT / Forecast Period FP)
EXPECTED NUMBERS SHORT I

The cycle service level only considers the probability of running out of stock, but doesnt answer how many units will be short. Lets assume that demand per month was estimated with the following probabilities, see sample data below:
Demand/ Month 12 13 14 15 16 17 18 19 Probability
0.25
0.10 0.15 0.15 0.20 0.20 0.10 0.05 0.05
Probability of Demand
0.20 0.15 0.10 0.05 0.00 12 13 14 15 16 17 18 19

Monthly Demand
Order Cost = $25 Carrying Rate = 25% per year Item Cost = $30 Holding Cost = $7.50 per unit per year
EOQ = 2 Yearly Demand Order Cost / Holding Cost EOQ = 2 15 12 25 / 7.50 EOQ = 35 units
EXPECTED NUMBERS SHORT II

Expected monthly demand is, see previous slide:
12 x 0.10 + 13 x 0.15 + 14 x 0.15 + 15 x 0.20 + 16 x 0.20 + 17 x 0.10 + 18 x 0.05 + 19 x 0.05 = 15
ROP 15 16 17 18 19 SS 0 1 2 3 4 P(D)=ROP 0.20 0.20 0.10 0.05 0.05 Numbers Short 0.75 0.35 0.15 0.05 0.00 Service Level 97.9% 99.0% 99.6% 99.9% 100.0%
Expected Numbers Short

D MAX D = ROP + 1
P ( D ) ( D ROP )
ROP = 15; SS = 0; E(Short) = (16-15) x 0.20 + (17-15) x 0.10 + (18-15) x 0.05 + (19-15) x 0.05 = 0.75 Service Level = 1 - E(Short)/Q = 1 - 0.75 / 35 = 1 - 0.021 = 0.979 = 97.9% ROP = 17; SS = 2; E(Short) = (18-17) x 0.05 + (19-17) x 0.05 = 0.15 Service Level = 1 - E(Short)/Q = 1 - 0.15 / 35 = 1 - 0.004 = 0.996 = 99.6%
It is very tedious to calculate the expected numbers short for a discrete distribution.
UNIT SERVICE LEVEL I

Its more convenient to approximate a discrete distribution with a continuous distribution to simplify the safety stock and reorder point calculations. If demand during lead time is normally distributed the expected numbers short for an average of zero and a standard deviation of one can be taken from a table, see the attachment and R.G. Brown, Decision Rules for Inventory Management, pp 95 - 103. If the unit-service level is P then there would be a shortage of (1-P) x D units, where D is the annual demand. If Q is the order quantity there would be D/Q orders per year. Because the table in the attachment is based on a standard deviation of one, E(z) must be multiplied by the standard deviation during lead time to get the expected numbers short per order.
UNIT SERVICE LEVEL II
Percentage Annual Number short Number of = short demand per order orders per year (1 P ) D = E (z ) LT D Q (1 P ) Q E (z ) =
LT
UNIT SERVICE LEVEL III

Example: Annual demand D = 1,000 units; Q = 200 units; Service Level P needed = 95%; Standard deviation during lead time = 25 and lead time LT = 15 days Determine the reorder point.
d=
1,000 units / year = 4 units / day 250 days / year
Shortage per order
ROP = d LT + z LT = 4 15 + z 25 (1 P ) Q = (1 0.95) 200 = 0.4 E (z ) = 25 LT
LT E (z ) = (1 P ) Q
10 = 10
25 0.4 = (1 0.95) 200
E (z ) = 0.4 z = 0 ROP = 4 15 + 0 25 = 60
The shortage per order is 10 and there are 5 orders per year ( 1,000 / 200 ) then the total shortage per year is 50 units. The service level is SL = ( 1,000 - 50 ) / 1,000 = 95 %
UNIT SERVICE LEVEL IV

E(z) 2.9005 2.8008 2.7011 2.6015 2.5020 2.4027 2.3037 2.2049 2.1065 2.0085 1.9110 1.8143 1.7183 1.6232 1.5293 z -2.90 -2.80 -2.70 -2.60 -2.50 -2.40 -2.30 -2.20 -2.10 -2.00 -1.90 -1.80 -1.70 -1.60 -1.50 E(z) 1.4367 1.3455 1.2561 1.1686 1.0833 1.0004 0.9202 0.8429 0.7687 0.6978 0.6304 0.5668 0.5069 0.4509 0.3989 z -1.40 -1.30 -1.20 -1.10 -1.00 -0.90 -0.80 -0.70 -0.60 -0.50 -0.40 -0.30 -0.20 -0.10 0.00 E(z) 0.3509 0.3069 0.2668 0.2304 0.1978 0.1687 0.1429 0.1202 0.1004 0.0833 0.0686 0.0561 0.0455 0.0367 0.0293 z 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00 1.10 1.20 1.30 1.40 1.50 E(z) 0.0232 0.0183 0.0143 0.0111 0.0085 0.0065 0.0049 0.0037 0.0027 0.0020 0.0015 0.0011 0.0008 0.0005 z 1.60 1.70 1.80 1.90 2.00 2.10 2.20 2.30 2.40 2.50 2.60 2.70 2.80 2.90
z = Number of standard deviations of safety stock E(z) = Expected number of units short for
Source: John A. Lawrence & Barry A. Pasternack, Applied Management Science, 1998
THE END
Thanks for your attention!

Inv How-To Manual V Erwin Opalla

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INVENTORY MANAGEMENT

HOW-TO MANUAL Version 2.3

page 2 / July 2008

MEASURE YOUR BUSINESS

page 3 / July 2008

FINANCIAL BASICS OF INVENTORY

page 6 / July 2008

CONFLICTING INVENTORY OBJECTIVES

Large lot sizes. Low unit cost.

Less space and low holding cost.

(Adopted from Tersine: Principles of Inventory and Materials Management)

page 7 / July 2008

page 9 / July 2008

page 10 / July 2008

page 11 / July 2008

MODIFIED DUPONT FORMULA

Return on Equity 20.5%

Equity Multiplier 2.281

Return on Assets 9.0%

Total Assets $2,198,740

Other Current Assets $320,760

page 12 / July 2008

MARGIN VIA TURNOVER

page 13 / July 2008

DUPONT FORMULA DETAILS

page 14 / July 2008

ROA (RETURN-ON-ASSET) EXAMPLE

After Inventory Reduction

page 15 / July 2008

CASH CONVERSION CYCLE

INVENTORY & CASH CONVERSION CYCLE

Cash Conversion Cycle (CCC) Cash Conversion Cycle (CCC)

page 17 / July 2008

INVENTORY & CASH CONVERSION CYCLE

page 18 / July 2008

MANAGING THE CASH CONVERSION CYCLE

page 19 / July 2008

MANAGING THE CASH CONVERSION CYCLE

page 20 / July 2008

CASH CONVERSION CYCLE REDUCTION

Inventory 70 days Payables 40 days

Receivables 80 days Cash Conversion Cycle 110 days Inventory reduction

Receivables 80 days Cash Conversion Cycle 90 days

OPERATING CYCLE 130 DAYS

OPERATING CYCLE 120 DAYS

page 21 / July 2008

CASH CONVERSION CYCLE FORMULAS

page 22 / July 2008

SAMPLE CALCULATION PROFIT & CASH

$766,030 $198,000 $964,030

Earnings Before Income Tax Income Tax Expense Net Profit

page 23 / July 2008

SAMPLE CALCULATION PROFIT & CASH CONT.

George W. Plossl, Production and Inventory Control Applications

page 26 / July 2008

page 27 / July 2008

You Can Never Plan the Future from the Past

I Know No Way of Judging the Future but by the Past

page 28 / July 2008

WHY TO FORECAST DEMAND

APICS Dictionary, 11th Edition

REGULAR VIS IRREGULAR DEMAND