The Problem Statement
Understanding the dynamics of inventory behaviour is an important step towards determining the correct supply method and therefore impacting directly the inventory performance. Inventory performance must be measured against the objective of its ability to buffer against uncertainty, protect customer service or product availability and to shorten lead-time. There are two basic supply methods, which are widely used and they are called make to stock and make to order. The basic characteristics of each supply methods are:
Supply Method: Make to Order (MTO), main characteristics are:
- Inventory will only be purchased or made when it is matched with a customer sales order
- The quantity of the customer sales order will be equal to the quantity of the purchase order or production order
- Fulfilment takes place with the lead-time committed by the factory or supplier and depends heavily on the load of a factory or the raw material procurement lead times
- Fulfilment of demand can either be:
A direct shipment to the customer from the factory or supplier
A time limited storage of the quantity in a warehouse before shipment to the customer from the warehouse of the full quantity, such shipment can be: (1) a single shipment, (2) multiple shipment consuming the available quantity in full
- There is nearly zero risk with this supply method if the quantity is equal to that of the customer order
Supply Method: Make to Stock (MTS), main characteristics are:
- Inventory will be purchased based on a forecast in quantity necessary meet demand, prevent out of stocks and avoid excess
- The fulfilment takes place with only the warehouse and shipping lead time
- The sum of Cycle Stock and Safety stock for a defined period is the total MTS inventory purchased
- Cycle Stock is the quantity of inventory maintained will be based on a sales or purchase forecast reflecting expected sales
- Safety Stock is the quantity of inventory to be added to protect the available inventory against demand or supply variations as well as service level targets
- The resulting purchase order will be received and managed in full at a warehouse
- There is a moderate degree of risk with this supply method
Next to those to basic supply methods, there are numerous derivations used in practice such as assemble to order, which assemble a product from component stock. Every material flow across all industries can be subdivided into 2 parts only, a customer specific material flow and a generic material flow. Where the two meet is called the customer order decoupling point (CODP). The concept is based on the research towards defining order fulfilment strategies and was published by Hans Wortmann of the University of Groningen.
The main question of many practitioners: How do I determine the assignment of a supply method to the behaviour of an item, product, material or component and where does a material flow need to be de-coupled to manage the risk associated with inventory is the best possible fashion? One approach is using the coefficient of variance and apply it to items, components or materials.
What is The Coefficient of Variance?
The coefficient of variance, or CoV, is defined as the standard variation divided by the mean.
Applied to inventory the CoV is calculated as follows:
With the variable I being the actual inventory level in a period, and n being the number of period considered. In practice, at least 10 periods should be considered for a robust and executable result.
Application to Inventory Management
The result of the coefficient of variance calculation should generally be organised in three bands. Bands are defined as follows:
Band 1: CoV = 0% to 50%; meaning that the variance moves by a maximum of 50% around the mean
Band 2: CoV = 51% to 100%; meaning that the variance moves by a maximum of 100% around the mean
Band 3: CoV = 101% and above; meaning that the variance moves by more than 100% around the mean
Each item considered is hence assigned based on its coefficient of variance to a single band. One item cannot be in multiple bands within a pre-determined horizon. Item behaviour can change over time based on the life cycle stage from launch to maturity to decline or the way a company choses to offer the fulfilment, and hence the assignment of an item to a band must be reviewed with a certain regularity.
As a practical rule, the assignment of a supply method to a band is done as follows:
Band 1: Make to Stock, can be managed automatically through techniques such as VMI, Kanban, etc
Band 2: Make to Stock, can be managed through a forecasting and constrained based supply planning process
Band 3: Make to Order, limited automation and requires human oversight of proposed supply quantities
Improved Inventory Performance
Very few companies can operate effectively using only one supply method. Therefore, analysing the item base and applying the corresponding supply method to the correct item behaviour is extremely important. Measures are then used to manage inventory performance. Those measures indicate to the practitioner if the desire level of inventory performance is attained. The main measures used for the tracking and reporting process are:
- Customer service level or product availability, measures the % of demand fulfilled
- Inventory Turn, measure the historical inventory performance (lagging indicator)
- Forward Coverage, measures the future inventory exposure (leading indicator)
By associating the correct supply method to the item behaviour using the CoV and then using measures to control the performance provides the base for improved inventory performance. In practice, the CoV is only one indicator of how a certain supply method should be assigned, other important indicators are for example the value of the item or component. Such as cross check avoids the expensive items or components are replenished automatically as a make to stock item.