Design for the Supply Chain
EQUATIONS
for Online Educational Course
http://design4X.com
Instructor: Dr. Mark Martin
1
© design4X 2005
© design4X
http://design4X.com
1
Agenda
» Introduction
•
•
Design for the Supply Chain
Pre-Test
» Step 1: Know Your SC
•
•
•
•
Think About It
What is a Supply Chain?
Knowing your SC
Apply It
» Step 2: The Costs of SC
•
•
•
•
•
•
•
•
•
Commonality
Postponement / LPD
Shipping Logistics
Apply It
» Summary
•
•
•
Example - DVD-RW
dfSC
Assessment
Think About It
Costs and the Supply Chain
Types of Inventory
Calculating SS Inventory (optional)
Apply It
» Step 3: Designing for the Supply Chain
•
•
Think About It
The Five dfSC Strategies
32
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32
What does inventory cost?
» Annual inventory costs = (20% to 30%) x (Cost of goods of the inventory)
» Scenario: Macro Calculation
•
•
•
•
•
•
Sales: $1 billion (company or division)
Net profits: $60 million (6%)
Average Inventory: $100 million (10% of sales)
Cost of that inventory per year: 30% ($30 million)
Super engineer arrives: Reduces inventory by 20%
Savings: up to $6 million
Company profits just increased by 10%!
© design4X
37
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Many companies often assign an annual inventory cost factor of between 20% 30%. This is an estimate of all the costs associated with inventory - opportunity,
storage, material handling, insurance, theft, and obsolescence.
So let’s run a quick calculation, imagine this: You’re division does $1 billion in
sales. A good net profit for a company this size might be $60 million (or 6% of
sales). Let’s say the company has $100M dollars of inventory, and assuming a
30% annual inventory cost factor, it’s costing the company $30 million per year.
Now, if you can reduce inventory by 20% (which is not undoable), then you’ve
saved $6 million. That’s 10% of the company’s net profit. Imagine being able to
increase your company’s net margins by 10%. If you’re a public company, this
could add up to 10% to the stock price.
37
What does inventory cost?
» Micro Calculation
• How much does inventory cost per unit?
• For a final assembly or component in incoming inventory
- Measure inventory in “Weeks of Supply”
- Inventory Cost per Unit (ICU)
Inventory Cost per Unit (ICU) = X * c * ( h / 52)
X = average # of weeks of inventory kept in stock
c = cost of goods per unit
h = annual holding cost % (typically taken at somewhere between 20% - 30%)
- Example:
X = 3 weeks of inventory
c = $100
h = 30%
ICU = (3 weeks of supply) * $100 * (30% / 52) = $1.73
38
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We just finished a “macro” calculation of how much inventory can cost the
company. Now let’s do a micro-calculation and calculate how much inventory can cost for a
particular component or product – anything from a printer, a car, a power supply, or even small
components such as a pump or a resistor.
Let’s calculate our costs in terms of weeks of supply of a product. In other
words, let’s find out how much it costs to keep X weeks of supply of something in stock. One
week of supply of the product is defined as the average weekly sales of the product. So if you sell
1000 units a week on average, and you keep 2000 units of inventory in stock on average, you
have two weeks of supply. This micro-calculation is simple, multiply the number of weeks of
inventory, X, by the cost of goods of the product or component, c.
You then multiply this number by the annual holding cost percentage, as
mentioned before, many companies use between 20%-30%. This is divided by 52 to get it in
terms of weekly percentage costs. This is how much your company is paying per unit in inventory
costs. As you can imagine, this can add up quickly. Imagine you had a product, such as a printer,
that costs $100 and an annual holding cost of 30%. If average sales are 1000 units / week, and the
company has 3000 units in inventory (in FGI, in-transit, and in distribution centers. That’s 3
weeks of inventory of just the product.
Your cost per unit is 3 weeks of supply x $100 x 30% annual holding cost / 52 =
$1.73 per unit! That’s just the cost of holding the final goods inventory! Now, imagine that you’re
also keeping 3 weeks of inventory of the power supply for that product on hand. If that power
supply costs $10, then that is costing you an additional $0.17 per unit, and the same goes for all
the other components. You can see that if you could cut that inventory in half, you would start to
see some significant savings. This is where this course can help. By designing for the supply
chain, you can reduce inventory and save money.
38
Agenda
» Introduction
•
•
Design for the Supply Chain
Pre-Test
» Step 1: Know Your SC
•
•
•
•
Think About It
What is a Supply Chain?
Knowing your SC
Apply It
» Step 2: The Costs of SC
•
•
•
•
•
•
•
•
•
Commonality
Postponement / LPD
Shipping Logistics
Apply It
» Summary
•
•
•
Example - DVD-RW
dfSC
Assessment
Think About It
Costs and the Supply Chain
Types of Inventory
Calculating SS Inventory (optional)
Apply It
» Step 3: Designing for the Supply Chain
•
•
Think About It
The Five dfSC Strategies
48
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48
Types of Inventory
» Pipeline inventory
• Mean lead time: L
• Mean demand: µ
Pipeline inventory
Punits = L ⋅ µ
52
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The concept of pipeline inventory is simple. When you order incoming
components from your supplier, they ship these parts to you. These parts are “in
the pipeline” and if you own them during this time, they are part of your pipeline
inventory.
The projected amount of this inventory is easy to calculate. It’s simply the
average demand of your product that you’ll be ordering from your supplier,
multiplied by the lead time to ship to your factory.
So, if it takes two weeks to ship, and your average weekly demand is 2000
components/week, you would expect that at any moment in time, you have 4000
components in the pipeline. Of course, this number might vary based on how
often the company places an order, what the minimum order quantities are for
your supplier, etc.
This pipeline inventory calculation works on the other end of the supply chain as
well. If you’re shipping 2000 units / week to your customers or retailers, and it
takes two weeks to ship. There are 4000 units in the pipeline. Of course, if your
customer pays for them once they ship, then in essence that pipeline inventory is
now owned by them, so it doesn’t figure into your cost calculations.
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Types of Inventory
» Pipeline inventory
» Cycle stock inventory for:
• Incoming
• FGI
Cycle stock inventory
CS =
1
2
µ
f
µ = average demand
(during time period)
f = delivery frequency
(deliveries during time period)
53
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The next inventory is called cycle stock. It varies with how frequently you receive incoming inventory,
and, how often you deliver FGI to your customers. Here’s the concept, if you get weekly shipments from your supplier,
then they are typically delivering the amount of product you expect you will need for that next week. So if you expect to
build 2000 units, you’ll order 2000 components. When the components arrive at the beginning of the week, assuming you
build on a steady schedule, the cycle stock for that component will decrease linearly until you use them all up at the end of
the week.
So what’s the average level of cycle stock inventory you have? Well, in our example you start out with
2000 units, and end up with zero units. Since the decrease is linear, then the average amount you have on hand is ½ of what
you started out with, or 1000 units. Now what happens if you decide to have the components delivered twice a week as
needed, then you’ll have 1000 components delivered each time. You’ll start out with 1000, and end up with 0, and your
average stock level would be ½ of that, or 500 units. If you decide to have delivery five times per week, that would be a
delivery of 400 units each time, and your average inventory would be 200. Do you see the pattern? To get the average
amount of cycle stock your company would keep, take the average demand during a time period, which is ½ mu, and
divide that by the delivery frequency during that time period.
The same is true on the other end of the supply chain, if you deliver to your customers once a week,
you are building up that inventory over that week and will have an average cycle stock inventory of ½ mu. If you deliver
more frequently, you’ll reduce the amount of inventory.
That’s part of what JIT manufacturing is doing, it’s delivering inventory more frequently, and thus
reducing your overall inventory levels. Then why not just deliver more frequently (say once a day, or even more
frequently). Some manufacturers do this. In automotive, some components are delivered, from suppliers, every four hours.
Of course, the reason this isn’t done by everyone is that more frequent shipments can cost more. There are more
transactions occuring, the logistics are more complex, shipping costs can be more expensive, and, if problems occur – such
as truck breakdowns, union strikes, or major catostrophes, natural or man-made, you risk not getting parts in time. These
are some of the trade-offs that must be considered when determining delivery frequency.
53
Agenda
» Introduction
•
•
Design for the Supply Chain
Pre-Test
» Step 1: Know Your SC
•
•
•
•
Think About It
What is a Supply Chain?
Knowing your SC
Apply It
» Step 2: The Costs of SC
•
•
•
•
•
•
•
•
•
Commonality
Postponement / LPD
Shipping Logistics
Apply It
» Summary
•
•
•
Example - DVD-RW
dfSC
Assessment
Think About It
Costs and the Supply Chain
Types of Inventory
Calculating SS Inventory (optional)
Apply It
» Step 3: Designing for the Supply Chain
•
•
Think About It
The Five dfSC Strategies
55
© design4X
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55
Calculating Safety Stock Inventory
» Pipeline inventory
Safety stock inventory
» Cycle stock inventory
SS units = k ⋅ σ 2 ⋅ (L + R )
σ pooled =
∑σ
2
i
i
» Safety stock inventory
• Variation in demand
• Variation in lead time
Safety stock factor: k
Standard deviation demand: σ
Mean lead time: L
Review period: R
Note: all time units must be the same
58
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So, let’s show you how to calculate safety stock inventory that your company
should keep. Here’s the math. And now on to the next section!
Just kidding, we’ll step through this to help you understand the details.
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Safety Stock Factor
Safety stock inventory
SS units = k ⋅ σ = k ⋅ σ 2
Safety stock factor: k
Std dev demand: σ
0.5
Cum
99% =
98% =
95% =
90% =
84% =
50% =
0.45
0.4
0.35
0.3
“k”
2.326
2.054
1.645
1.282
0.994
0.000
1
0.9
0.8
0.7
0.6
0.25
0.5
“k” is the safety
stock factor
0.2
0.4
0.15
0.3
0.1
0.2
0.05
0.1
0
0
-3
-2
-1
0
1
2
3
Safety Stock = 2.326 x 200 units = 466
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To understand our safety stock equation, let’s start off with a statistical
curve indicating the average demand for a product (let’s say for a weekly time period), and
the variation in that demand. We’re assuming you have some basic statistics under your belt,
so we won’t go into the details here of this Gaussian distribution.
The average weekly demand in this graph is indicated with the red line.
This being a Gaussian distribution, that means that if you kept this amount of stock on hand,
then 50% of the weeks you would have enough stock to meet demand, and for 50% of the
weeks, the demand would exceed this amount and you would “stock-out”.
Now, if you want to satisfy more than 50% of the demand, you’ll need to
keep more stock on hand. Any amount you keep above the average demand is called safety
stock. Let’s say you want to have enough stock on hand to meet demand for at least 95% of
the weeks. Or for 99% of the weeks. How do you calculate that?
It’s simple because we’ve assumed that weekly demand is a Gaussian
distribution. In that case, all you need to do is multiply the weekly standard deviation of
demand by a statistical factor called “k”, and that’s the amount of extra stock, above the
average demand, that you keep on hand. This k factor, or what we’ll call the “safety stock”
factor is shown in this table.
So, to meet 95% of the demand, you would multiply the standard deviation
by 1.645 to get the amount of safety stock needed. To meet 99% of the demand, you multiply
by 2.326. These numbers are statistical constants and are based upon statistical theory. So,
imagine you had a weekly demand of 1000 units, with a standard deviation of say 200 units.
If you want a 99% service level, then you would keep 2.326 x 200 units, or 466 units of
safety stock on hand. This is in addition to the 1000 units you’ll need to meet the average
expected demand.
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Leadtime and Review Period
» But what about those lead times!
» What do you do?
• Have enough safety stock
on hand to cover you during
that lead time
• How to calculate?
Adding together standard deviations
σ = σ 12 + σ 12 + σ 12 + σ 12
since all the sigmas are the same
σ = LT • σ 1 2
L T = leadtime for the part
σ = ( LT + R )σ 1 2
» Review period
» SAFETY STOCK
R = review period
Safety stock inventory
SSunits = k ⋅
(LT + R )⋅ σ 2
Safety stock inventory
SSunits = 2.326 ⋅
(4 + 2) ⋅ 2002
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= 1140
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So in our example we want to keep 466 units of safety stock on hand, at all times, to ensure that during
99% of the weeks we will be able to cover all demand. If one week we dip into the safety stock by a hundred units, then next
time we order, we need to order a hundred extra units above our weekly average demand order to bring that safety stock back
up to 466.
Ahh, but what happens if the standard lead time is longer, say, 4 weeks? For the next 4 weeks, until you
get that safety stock back up to 466 you have less than 99% chance of being able to meet the weekly demand. In fact, with
366 units on hand, that corresponds to a safety stock factor of 366/200 = 1.83, which just puts us slightly above a 95% service
level.So what are we to do? Well, we can account for that longer lead time in our calculations. If it takes 4 weeks to get parts
in, we want to calculate the standard deviation of demand during that time. We can do this by adding together the weekly
deviations.
Now here’s where the statistics training comes in, when you add standard deviations together, you don’t
simply add them linearly. You first add their variances, which is the standard deviation squared, then you take the square root
of that. Now, since the standard dev are the same for each week, this simplifies to the number of weeks of lead time,
designated as L-T, times the sigma squared, square root of all that.
And one other thing, what if you only check on inventory, or order every couple of weeks, then there
might be another couple of weeks before you get those parts on order. That would be a total of 6 weeks for our example. To
account for that, we include this review period in the std. dev calculation. In our equation, we designate it as R. Of course, if
the review period is continuous and you order as soon as your safety stock is tapped into, then R=0.
As an example of all this, imagine the you have a four week leadtime for the part and a two week review
period. The standard deviation of demand over that 6 weeks, is the square root of six times the standard deviation of the
weekly demand. For our previous part, the standard deviation was 200 units over a week, for six weeks, it is 6 x 200 squared,
square root, which gives a standard deviation of 490. If you multiply this by the safety stock factor for 99% service levels,
which is 2.326 you require a safety stock of 1140 – quite a jump over the 466 units you required with just a one week LT, and
no review period.
60
Reducing Safety Stock Inventory – Rough Cut Analysis
» Scenario: 9 power supplies for product line
» Strategy: Create a common PS (go from nine to 1 PS), you could reduce
inventory by 66%!
» In fact, the formula for this calculation,
with the stated assumptions, is
% inventory reduction
1
1
% reduction = 1 −
= 1−
= 66%
n
9
n= original # of unique parts
reduced to 1 common part
Assumes: Sales volumes are approximately equal for each part;
Demands are independent and uncorrelated; Leadtimes are known
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61
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So, this is all interesting (well, sort of), but what does this matter to you? Well, as
mentioned before, safety stock inventory costs the company money, and if you
can reduce the standard deviation of demand, you can reduce inventory. Creating
commonality does this. Now, we’re going to “boil” down the previous equations
to show you how commonality can impact inventory.
Imagine you had nine different types of power supplies you were using in your
products.
Assuming that the sales volumes were about the same, as well as the variations in
demand, and assuming these variations are independent, if you could create a
common PS (go from nine power supplies to one), you could reduce inventory by
66%! That means if you originally needed to keep 1000 units of safety stock
inventory for the nine different power supplies, you’d only need 340 units of
safety stock inventory for the one common power supply.
The formula for this calculation is pretty simple. To calculate the % reduction in
SS inventory you take
1 – 1 / sqrt n, where n is the number of original components. That’s it.
61
Reducing Safety Stock Inventory – Rough Cut Analysis
» Start off with n components
% inventory reduction
Design down to f components
» The lower you can make f,
the larger the reduction
in inventory.
f
n
% Reduction
% reduction = 1 −
f
Assumes: Sales volumes are approximately equal for each part;
Demands are independent and uncorrelated; Leadtimes are known
62
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Of course, going from numerous components down to 1 is often difficult
However if we start off with n components and design down to f components,
instead of one, again with all the previous assumptions, the basic equation is:
1 – the square root of the new number of components f, divided by the square
root of the original number of components n.
The lower you can make f, the larger the reduction in inventory.
62
Reducing Inventory
» Pipeline inventory
Pipeline inventory
Punits = L ⋅ µ
» Cycle stock inventory
Cycle stock inventory
CS =
1
µ
2
» Safety stock inventory
• Variation in demand
• Variation in lead time
Safety stock inventory
SSunits = k ⋅
(LT + R ) ⋅ σ 2
63
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We’ve now shown you how to determine the amount of inventory that a company
might expect to have on hand—pipeline, cycle stock, and safety stock
inventories. Obviously, your company will differ based on the policies you use
and a host of other factors. However, what you see from these equations is how
you, as an engineer can start to reduce inventory – especially in terms of safety
stock. If you can reduce the leadtime of the product, then you can reduce the
company’s inventory requirements.
And, as we just showed you, by reducing the standard deviation of the demand
through commonality, you can also reduce safety stock inventory.
Ahh, but how to do that? In our section on commonality, we’ll show you
strategies on how you can reduce this standard deviation of demand.
63
Agenda
» Introduction
•
•
Design for the Supply Chain
Pre-Test
» Step 1: Know Your SC
•
•
•
•
Think About It
What is a Supply Chain?
Knowing your SC
Apply It
» Step 2: The Costs of SC
•
•
•
•
•
•
•
•
•
Commonality
Postponement / LPD
Shipping Logistics
Apply It
» Summary
•
•
•
Example - DVD-RW
dfSC
Assessment
Think About It
Costs and the Supply Chain
Types of Inventory
Calculating SS Inventory (optional)
Apply It
» Step 3: Designing for the Supply Chain
•
•
Think About It
The Five dfSC Strategies
111
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111
Computer Example – dfSC Strategies
2) Commonality
• Cost of inventory
- Assume you have 4 weeks supply of product
ICU (Inventory Cost per Unit) = 4 * $200 * 30% 52 = $4.62
• Going to one common manual and including SW reduces variety from
16 to 2
% inventory reduction = 1 −
f n = 1 − 2 16 = 65%
• Thus, inventory costs are reduced by $4.62 x 65% per unit
$4.62 * 65% = $3.00 That’s a $3 reduction in inventory costs!
116
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Let’s first calculate the cost of the inventory per unit if you stay with the 16
varieties. For this example, we’ll assume the company typically carries 4 weeks
of supply of the DVD’s in FGI in order to meet demand. The inventory cost per
unit is 4 weeks of supply times the $200 cost of goods, times an estimated 30%
annual holding cost, divided by 52. That equates to a $4.62 cost per unit for
holding that amount of inventory for 16 varieties.
Now imagine we choose to go with one common manual and include the Photo
archiving software in all the configurations. This drops the number of stock
keeping units from 16 to 2. And using our equation for inventory reductions this
would reduce the necessary finished goods inventory by 65%. Thus, by making
these changes we could reduce the inventory cost per unit by $3.
116
Computer Example – dfSC Strategies
2) Commonality
• Further savings available by going to a universal power supply
– Reduces to 1 variety
% inventory reduction = 1 − 1 16 = 75%
$4.62 * 75% = $3.46
• More savings from:
- Reduced complexity
- Reduced documentation
- Volume discounts
117
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Now let’s assume that you go to a universal power supply reducing the variety all
the way to one common product. That’s a 75% reduction in the safety stock
inventory costs – for a potential savings of $3.46. And there will also be savings
from reduced complexity and documentation, and increased volume discounts.
117
Computer Example – dfSC Strategies
3) Postponement / Late Point Differentiation
• Without postponement
- Keeping 16 varieties in stock means lots of inventory
• Implement process postponement
- Keep two varieties on hand (120 VAC, 230 VAC), add the appropriate manual
and software at the US and European DC’s
– Slightly more complicated distribution system
– Some extra labor
– Still have to have manuals in stock
» But can reduce stock of manuals, since manuals can be printed locally,
aren’t shipping paper overseas!
Safety stock inventory
SSunits = k ⋅
(LT + R )⋅ σ 2
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Now if you can’t reduce the number of varieties of final products through
commonality, there are other ways to reduce the amount of inventory you keep
on hand. One way is through postponement
Imagine that the company doesn’t want to create a common manual. Partly
because it’s environmentally unfriendly due to the extra size of the manuals
required, and also because the manual becomes too unwieldy for the customer.
How can we reduce inventory if we keep the different manuals? The answer is
through postponement. Rather than having 16 different varieties shipped from the
factory and trying to forecast demand for each of the 16 varieties that far in
advance, you can postpone the insertion of the manuals until later in the process
– then you ship just two varieties from the China factory, a 120 VAC version to
the America’s distribution center, and a 230 VAC version to the European
distribution center. The language-specific manuals are then inserted at the
distribution centers. This allows the company to pool the variation in the demand
and decrease the safety stock required.
Obviously, adding this new operation at your distribution centers (even if you
already have such centers) makes the distribution system more complicated and
adds extra labor – so you’ll need to weigh the savings against these costs.
118