Category Archives: Inventory

EOQ Part I: The Quantity You Can’t Depend On The Computer to Calculate!

I was reminded of this while reading Mr. Koray Köse’s great piece on how our supply chains are literally drowning in wannabes who mistake theory for expertise where he accurately and astutely noted that most of today’s so called “experts” could not pass his Economic Order Quantity (EOQ) exam question. And I totally agree. Because

1) Math (where competency in many Western nations decreases every year and where the US is literally becoming math stupid, as reflected in the latest OECD ranking which puts it 25 out of 31 “developed” countries that were globally measured with countries like Croatia coming in ahead of it).

2) No real understanding of supply chain or total supply chain cost!

3) Even less understanding that your EOQ (Economic Order Quantity) is not your suppliers EPQ (Economic Production Quantity) and for high cost/complex products, this can sometimes (but not always) be much more important (and impactful) than the classic EOQ formula would dictate.

Mr. Köse illustrates this deftly when he shared one of the questions he uses to gauge whether or not his MBA students truly understand EOQ. The core variant of the problem he shared with us was this:

  1. The purchasing manager for Spacely Sprockets orders mechanical gears from an industrial supplies distributor, Cogswell Cogs.
  2. Spacely Sprockets uses 5,000 gears per year.
  3. Annual inventory carrying costs are 20% and order costs are 3,400 per order.
  4. The following order discount price schedule is provided by Cogswell.
    • 0,200-0,999 $1300 / unit
    • 1,000-2,999 $1250 / unit
    • 3,000-4,999 $1200 / unit
    • 5,000+      $1175 / unit
    

    5. 

  5. Determine the optimal order quantity, total cost, and actual per unit cost (once order costs and inventory carrying costs are taken into account).
    6. 



Now, if you were a prepared student, you might have memorized the classic EOQ formula:


    

  • EOQ = √ ( (2 x ACPO x AUU) / (UC x CCP) )
    • 



where


    

  • ACPO = Acquisition Cost Per Order = 3,400
    • 

  • AUU = Annual Usage in Units = 5,000
    • 

  • UC = Unit Cost
    • 

  • CCP = Carrying Cost Percentage = 0.20
    • 



and this leaves you with


    

  • EOQ = √ ( 34,000,000 / (0.2 * UC) )
    • 



and you can work this out at each price break:


    

  • 1,300: √ ( 34,000,000 / 260 ) = √ (130,769) = 362
    • 

  • 1,250: √ ( 34,000,000 / 250 ) = √ (136,000) = 369
    • 

  • 1,200: √ ( 34,000,000 / 240 ) = √ (141,666) = 376
    • 

  • 1,175: √ ( 34,000,000 / 235 ) = √ (144,680) = 380
    • 



which indicates the first price bracket is the correct one for you, and you should be making 13.8, rounded to 14, orders every 26 days (and net a total volume of 5,068 units over the year) and, on average, you will carry each unit of inventory for 13 days.


    

  • unit cost: 5,068 * 1,300 = 6,588,400
    • 

  • inventory carrying cost: 13/365 * 0.2 * 6,588,400 = 46,931
    • 

  • order cost: 3,400 * 14 = 47,600
    • 

  • total cost: 6,682,931
    • 

  • unit cost: 1,319
    • 



But this is NOT an EPQ for the supplier, which means that you might be paying more than you need to. To figure that out, you have to analyze the costs at each breakpoint that is reasonable for you.


These are:


    

  • 362, your computed EOQ, with 14 orders per year
    • 

  • 1014, the first discount tier, at 5 orders per year every 73 days, with 36.5 days of inventory on average
    • 

  • 5,068, at the third discount tier, at 1 order per year every 365 days, with 183 days of inventory on average
    • 

  • … because you can’t hit the 2nd tier more than once
    • 



First run the calculation at 5,068, because your greedy executives only understand unit discounts:


    

  • unit cost: 5,068 * 1,175 = 5,954,900
    • 

  • inventory carrying cost: 183/365 * 0.2 * 5,954,900 = 595,490
    • 

  • order cost: 3,400 * 1 = 3,400
    • 

  • total cost: 6,553,790
    • 

  • unit cost: 1,293
    • 



You quickly see that you clearly want the discounts even if your inventory costs shoot up because 633.5K in savings is greater than 595.5K in expected inventory carrying costs.


But you’re not done yet. Now you have to run the calculation at 1,014 units an order over 5 orders, because it’s also a valid option and captures the suppliers first EPQ point:


    

  • unit cost: 5,068 * 1,250 = 6,335,000
    • 

  • inventory carrying cost: 36.5/365 * 0.2 * 6,335,000 = 126,700
    • 

  • order cost: 3,400 * 5 = 17,000
    • 

  • total cost: 6,478,700
    • 

  • unit cost: 1,278
    • 



which is your actual EOQ because it not only takes advantage of the supplier’s EPQ level but does so at the breakpoint that is closest to that given by your traditional EOQ calculation!


Now we’ve now clearly demonstrated why most of today’s so called experts couldn’t calculate EOQ with a computer because it’s not always the classic EOQ formula (or whatever pseudo-random formula happens to be in the forecasting system they try to use), or the supplier’s optimal EPQ level (if that leads to a significantly high storage cost for you — JIT is a core tenet of lean for a reason, inventory is costly, and while you need a safety stock, too much not only presents too much obsolescence risk but shoots your carrying costs way up), but usually somewhere in between (where the optimal curves intersect closest to their respective minima). Good luck doing that if you can’t do math, don’t know supply chain, and think Chat-GPT holds the answer to everything.


What we didn’t demonstrate is why, in reality, you often need a computer to calculate it (and that comes down to the inventory carrying costs which are often much more involved than Finance believes) and your associated supply chain costs. The reality is that you might have to re-write your formulas, which really will require a computer to constantly calculate and recalculate your true inventory carrying costs, but the reality is that you will only be able do this AFTER you understand what the proper order volumes should be (because you need to check that you worked out the formulas and calculations right for your supply chain)! We might tackle this in another article, because the only way to get costs way down is to help Finance and Operations understand the true costs and how to tackle them (because if you’re still running on an average ICC of 20%, or even worse, 25% to 30%, someone, somewhere, is performing pretty poorly in their profession).

					

		
		
	


	

				

			
						

				When Managing Supply, Don’t Forget …
			

								


				

			
… sometimes supply comes from within the four (virtual) walls of your business. This is one fact that is overlooked by many S2P suites which are setup to acquire external goods and services (and, specifically, finished goods and services that typically fall into indirect categories.


When we are talking about MRO, the goods and services you need might be in a storage room in another building. If we are talking about consumables, like what you might need for a new hire, everything you need might be one floor down, left behind by another hire who, after the probation period, didn’t work out.


Inventory and Asset Management are key to successful Supply Management, and to successful Procurement. One should NOT buy what one does not need. This is the other form of demand management — which is two parts. The curbing of need for consumables (less paper for the printer, less usb drives when there are secure network share folders, etc.), and the re-use of what you have. Laptops or cell phones less than 6 months old should never go unused or reassigned. Expensive MRO replacement parts can often be couriered from site to site for $40 — why spend $5000 ordering another 4-pack to fix the production line and have your minimum “3” on hand when another facility still has 8 in storage.


When you are upgrading your e-Pro / P2P / S2P system, keep this in mind. Either find one that includes inventory management or integrates with an inventory management system, and you’ll save a lot.


But to truly win, make sure it supports end-to-end asset management. It’s not just expensive hardware that often collects dust in storage closets, is also expensive assets. Like expensive snowblowers that are bought, put in the basement, forgot about when the business gets a new, better, facilities contractor and the internal maintenance team doesn’t have to do it anymore instead of being sold or sent to another facility. Expensive 3-D software licenses that are not transferred to another engineer, and then bought again 6 months later when a new hire needs them. Patent or other IP library that could be licensed by sales to a partner for extra revenue. Etc. This last part is key. Not only are unused assets costing the company money (because thy were bought to fulfill a need, which is not being met by them, but costing the company money if they can be licensed, rented, or, in the case their value becomes limited, sold.


So when you are upgrading your e-Pro / P2P / S2P system, keep this in mind too. Make sure it’s inventory and asset management or integrates with an inventory and asset management, and you will not only save a lot, but help the organization generate value.

					

		
		
	


	

				

			
						

				What’s the right level of safety stock?
			

								


				

			
Severe weather events and transportation disrupting natural disasters are on the rise, and the only thing that we can be sure of is they are going to keep coming fast and furious in the near future. We don’t know when, where, or what extent the impact will have, but we know it’s coming.


The resulting disruptions to your supply chain will last days, weeks, or months. And if the part of your supply chain that is disrupted is one supplying a critical component that is sole-sourced or in a supply shortage, any and all products it is used in will be in jeopardy once the inventory runs out. As a result, JiT inventory is becoming a thing of the past. However, too much inventory on hand is NOT a good thing. You want a balance between JiT and everything you need for the planned production run. And that balance could be anywhere from a few extra days (for inventory that can be obtained from another source on short notice) to a a few months (for something otherwise hard to get).


But how do you figure out the right stock levels? It’s not just rarity. After all, stock costs money and ties up working capital … capital that likely has better uses. After all, early supplier payments can bring cost reductions. Investments can bring recurring cast. R&D can develop new, more profitable, products for sale. And so on.


So how do you determine the right level of safety stock? Expand the working capital optimization model to allow for a variable disruption cost based upon variable stock levels, each of which has an associated investment cost (in the form of tied up working capital), and determine the stock levels from the investment that optimizes working capital.


Again, the right level of safety stock falls out of working capital optimization.

					

		
		
	


	

				

			
						

				Demand Control: Reduce, Reuse, Recycle, Redefinition and … Requisition Everything!
			

								


				

			
Part of good cost avoidance in Procurement is good demand management — reducing the consumption, and expenditure, on MRO, T&E, one-time buys for events, etc. We’ve covered the classic techniques in the past, which include:


Reduce: which can be accomplished by accurately predicting needs (and reducing waste) based on past use and current trends (and not maintaining volume levels on toner cartridges for a printer line being phased out)


Reuse: which can take the form of repurposing old equipment (as old developer workstations are probably just as powerful as the business user desktops used in the rest of the organization) or simply collecting unused/discarded collateral at an event and using it again next time


Recycle: where MRO inventory can be replenished by breaking down equipment (like workstations, production lines, etc.) that go out of service and harvesting still working parts that can be used in other equipment


Redefinition: where it’s not a need for more paper, but a need for second / bigger monitors so that people don’t need to print invoices / documents still submitted as (scans of) handwritten documents that can’t be OCR’d or that aren’t in a format the OCR recognizes or for tablets that allow executives to access their reports on the go


but a new type of demand management is popping up in the Procurement world, and it’s called:


Requisition Everything: where you have to literally submit a requisition to the procurement system so that all demand, and consumption, is tracked (and you can be visually guilted to control demand or utilization if you are consuming significantly more of a resource than your peer).


Now, this probably sounds very onerous to you and not worth it, but it all comes down to the implementation and user experience. At Coupa inspire, one company described an innovative method that they used to track and control demand on the factory floor (where workers would forget where they put their gloves, or realize they left them in the lunch room, and just go to the closest supply room or where workers would store extra tools or parts at their desks, just in case, leading to low stock signals and unnecessary ordering). They installed vending machines and when a worker needed something, they needed to go to the machine and punch in their id and slot number. Nothing was restricted (and no limits were placed), but every “requisition” was sent to the central Procurement system which not only updated MRO inventory but also tracked who used what, and allowed Procurement, and departments, to understand usage patterns better. This simple process reduced demand as it instilled the notion of cost consciousness and responsibility in the workers (who knew that their usage patterns could be analyzed and if they consumed considerably more than their peers, it would show), and didn’t really add any time or complexity to the process (as all the workers had to do was punch a few buttons) — especially since this process insured that the workers always knew where the stock was (which wouldn’t happen if it was moved around on the shelves).


Moreover, this technique is not limited to what fits in a vending machine — one could also use cheap RFID tags for larger items (of sufficient value) that would automatically be requisitioned when the tag left the store room (and be assigned to the right person using the employee record obtained from the entry control system when the person swipes their key card).


And, with micro-budgeting, it can be used to insure departments don’t go over their allotted new-hire budget unnoticed. New hire equipment can be kept in the secure storeroom, automatically tracked when retrieved, and automated re-orders made if stock gets too low. Plus, reusable equipment can be returned on employee departure, residual amortization amounts credited back to the micro-budget, and employees / departments who opt to use recycled equipment can be charged a deep discount against their micro-budget (and, more importantly, rewarded at annual recognition events as reuse stats can be tracked).


Now that almost everything can be automated, it might just be the time for Requisition Everything as the new method of employee-based demand management and cost control. Thoughts?

					

		
		
	


	

				

			
						

				Organizational Sustentation 59: Warehouse Management
			

								


				

			
This warehouse frightens me … still

Has me tied up in knots …


Dave Matthews Band


And, as per our damnation post, if your warehouse doesn’t frighten you, obviously you haven’t taken a really good look at it. The warehouse is responsible for inventory, and inventory is very costly … even when it is well managed. Many studies of inventory (carrying) costs have estimated inventory costs to be 25% of the value of the average inventory level (or more). That’s huge!


But this is not the only reason the warehouse is a damnation. It is also a damnation because the warehouse controls:


    

  • product availability

    and can take their time unloading product, packing product, shipping product, etc.
    • 

  • the final quality check

    and if they get lax, and don’t independently test the spinach, your company could be blamed for the next salmonella outbreak that is actually the fault of your supplier
    • 

  • overhead costs

    inventory, operations, etc.
    • 



So what can you do? Let’s start with the obvious:


JiT (Just in Time) Inventory


The less excess inventory on hand, the less inventory carrying cost, the less inventory for the warehouse to lose or damage, and the less overhead cost to consider.


VMI (Vendor Managed Inventory)


Sometimes your vendor can manage inventory better than you can, and if their revenue is dependent on good management, they are very incented to manage it well.


But that’s just the start. You can also:


Get (a) Lean (assessment). 


Identify the inefficiencies, and make sure something is done about them to keep efficiency up and overhead costs down. Make sure the organization is focused on lean transformation and continual process improvement.


Get external audits (on operations and inbound product). 


Not only to keep the warehouse in check but to help them identify areas for improvement.


Get the Warehouse Training. 


It’s not only Procurement that never has enough in the training budget, it’s the warehouse too. Management thinks that because it’s a manual job, it’s a low skill job and little training is required. Maybe, but considering that lean, six sigma, and kanban processes can greatly improve efficiency and minimize costs, it doesn’t hurt to make sure that the processes, and the labour implementing them, have all the knowledge they need to be as efficient and effective as possible.