How to Overcome 3 Common
Inventory Replenishmemt
Challenges
This white paper explains the 4 different types of replenishment models
used by wholesalers and distributors to avoid making costly inventory
replenishment mistakes.
Additionally, this paper breaks down common carrying and order costs, and
is complete with cost analysis calculations to guide inventory replenishment
and procurement planning.
EazyStock is the Market Leader in Inventory Optimization Solutions for
Small & Mid Sized Businesses.
Contents
Understanding Customer Demand ..……………………………. 3
Overcoming Replenishment Challenges……...…………….... 4
Replenishment Models ……………………….…………………... 5
Choosing the Right Model ………………….…………………. 9
Breaking Down Carrying & Order Costs .…………………….. 10
Calculation Models & Examples ….......……………………….. 15
Conclusion ………………………….......……………………….. 17
How to Avoid Making Costly Inventory Replenishment Mistakes.
THE CUSTOMER IS KING. DO NOT
MAKE THE KING WAIT…
“Sorry, we are out of that item.” How often have you
heard that during a shopping trip? Even popular ecommerce websites are littered with inventory out-ofstock notices on top selling items. Despite businesses
pushing demand-driven mantras, companies tend to be
better connected to their suppliers than their
customers. When stock balances hit zero, a company
has essentially failed to manage their inventory
correctly.
They have not replenished their inventory in time to
avoid shortages and backorders. The reason behind
the problem could be poor demand forecasting, lack of
inventory control of stocked items, and errors in
systems or manual methods controlling when and how
much to order what products.
“Rising customer
demands ranks as the
third highest supply
chain challenge behind
cost containment and
visibility, and two out
According to a recent study by IBM, rising customer
demands ranks as the third highest supply chain
challenge behind cost containment and visibility, and
two out of every three companies struggle to accurately
identify customer needs.*
companies struggle to
accurately identify
customer needs.”
While having out-of-stock items means that some
shelves and warehouse racks are empty, the irony is
that there are billions of dollars wasted each year in
excess stock. And most businesses struggle to find an
optimized balance between the two costly challenges.
of every three
IBM Report, Smarter Supply Chains
of the Future
It is not just retail stores that need to worry about properly managing inventory levels and
costs. In fact, inventory management processes are found everywhere in the business
world. Maintaining inventories is necessary for any company dealing with physical
products, including manufacturers, wholesalers, suppliers, distributors and retailers.
In the US alone the manufacturing and trade inventory on-hand was estimated at $1.812
trillion in June of 2015. With that much inventory on-hand, it begs the question, how much
of that inventory is excess stock or even obsolete stock?
How to Avoid Making Costly Inventory Replenishment Mistakes.
* IBM, Smarter Supply Chains of the Future
3
OVERCOMING 3 COMMON
REPLENISHMENT CHALLENGES
Many wholesalers, manufacturers, retailers and eCommercers rely on their enterprise
resource planning (ERP) system to help them decide when to replenish, procure or
purchase their inventory of products and how much of each product to reorder. They
are relying on the system to alleviate customer service problems and improve
profitability.
Unfortunately, most inventory planners and buyers do not have 100% visibility into
what the actual customer demand is for all the items they carry in inventory. As a
result, the reordering processes in their ERP system is setup incorrectly or is missing
critical functionality required for an optimized inventory mix and accurate
replenishment parameters.
When the shelf or warehouse rack is empty, it is usually too late to place a new order.
In inventory management, a company must pay special attention to three things:
1.  Know precisely what to reorder
2.  Know when to reorder items
3.  Know exactly how much to reorder
The what, when and how of inventory
replenishment is vital to keeping costs contained
and inventory levels under control. The key is to
find the optimal time when an item must be
reordered and at the necessary quantity to
ensure a continuous balance of inventory to meet
demand while ensuring inventory isn't piling up in
stock locations. The goal is to minimize total
warehousing and order costs while carrying just
enough to prevent a shortage of inventory.
Many companies will use an ABC Analysis model to classify inventory items according
to their customer demand and inventory turnover ratios to ensure they are tracking
what items need to be ordered, when they should be ordered and how much should
be placed for that order.
There are 4 different replenishment models that wholesalers and distributors should
consider when executing replenishment.
How to Avoid Making Costly Inventory Replenishment Mistakes.
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1
FIXED ORDER POINT
REPLENISHMENT
The question about when to place an order can be answered by specifying a definite
quantity and definite date. An order is made either if inventory has fallen below a
defined level (reorder point system) or if a predetermined period, Fixed Order Cycle
(FOC) system, has expired.
The answer to the question about how much to order can also be based on two
criteria. The ordered quantity is either a pre-determined Fixed Order Quantity (FOQ)
or a variable quantity, which supplements the inventory in each case up to a certain
order level.
Fixed Order Cycle (FOC) Variable Order Period Fixed Order Quan7ty (FOQ) Fixed replenishment Order Point or MAX/MIN Variable order quan7ty Periodic Replenishment On-­‐demand Fixed replenishment is the simplest model where both the ordering period and
quantity is fixed. This model is not advised to be used in general. The only situation
where it could be applicable is when demand is constant over time and there is a low
acquisition cost for the item. For most companies this replenishment model will not be
sufficient.
Fixed Inventory Replenishment Model
How to Avoid Making Costly Inventory Replenishment Mistakes.
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2
ORDER POINT MIN/MAX
REPLENISHMENT
Order Point or Minimum / Maximum (MAX/MIN), is a model that is suitable when
the demand is highly variable over time. The inventory manager needs only two
values to specify the desired inventory management policy:
•  A threshold, named reorder point, which defines if any reorder should be made.
•  A quantity, named reorder quantity, to be reordered
The prerequisite is that inventory levels are monitored well so ordering is done in
time. Moreover, we assume that the delivery lead-time is constant even though the
order periods are not.
An order is initiated if the inventory has dropped to a reorder point or a reorder level.
The quantity to be ordered is pre-determined to a fixed quantity. The reorder point is
specified in such a way that demand can be met from the existing inventory during the
delivery lead-time.
Minimum / Maximum Inventory Replenishment Model
How to Avoid Making Costly Inventory Replenishment Mistakes.
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3
PERIODIC
REPLENISHMENT
Periodic replenishment is a model where a maximum replenishment is executed
when reaching a reorder date in a fixed cycle. The order quantity is measured so that
it corresponds to demand during the order cycle and the replacement period minus
stock on-hand.
The inventory is replenished to its fullest extent during each new delivery. This model
is only relevant if the demand is constant. If the demand varies too much it required
very high safety stock levels, which can cause large carrying cost inflation and result
in diminished profit margins.
Periodic Inventory Replenishment Model
How to Avoid Making Costly Inventory Replenishment Mistakes.
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4
ON DEMAND
REPLENISHMENT
On-demand replenishment is a model where an order is initiated if the inventory has
dropped to a reorder point. The order point is determined in such a way that demand
can be met from the existing inventory during the delivery lead time. The quantity to
be ordered is variable, enabling it to supplement the inventory up to the level required
to meet forecasted demand.
For high-value materials, the reorder point system with variable order quantities tends
to be better suited if the costs of permanent control are lower than the savings from
the lower safety stocks compared with the fixed order cycle system.
On-Demand Inventory Replenishment Model
How to Avoid Making Costly Inventory Replenishment Mistakes.
8
CHOOSING THE RIGHT MODEL
If you reorder a product at the right time and quantity, you will protect your target
customer service levels and ensure customer demand is being met. Another way to
look at it is that the amount you order helps determine your company’s profitability
since customer orders mean more revenue and ideally larger profits for the business.
The objective of most supply planners and purchasers is to buy every item at the
lowest total cost per unit. In order to maintain profits, costs and delivery lead-times
need to be efficiently managed.
Outside of the overwhelming number of variables that influence procurement activities
there are two main factors that need to be evaluated to analyze the total summation
of replenishment costs:
1.  Carrying Costs - This is the cost of maintaining inventory in your warehouse
before it is sold, transferred, or used.
2.  Ordering Costs - This is the cost of issuing, receiving, and paying for a line item
on a supplier purchase order.
Supplier
Lead-Times
Inventory On Hand
Customer Demand
Transportation
& Logistics
Insurance Costs
?
Procurement
Managers
How to Avoid Making Costly Inventory Replenishment Mistakes.
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BREAKING DOWN THE COSTS
Carrying Costs
The cost of carrying inventory includes all of the costs you incur by stocking material
in your warehouse or in your store. These costs are split in four parts:
1.
2.
3.
4.
Capital costs
Storage space costs
Inventory services costs
Inventory risk costs
The annual amount of these costs is accumulated and divided by the average
inventory investment. The carrying cost is expressed as a percentage and the values
currently range on average between 15–20 percent.
1. Capital Costs
It is the largest component of the total costs of carrying inventory. It includes
everything related to the investment, the interests on working capital and the
opportunity cost of the money invested in the inventory.
One way to determine the capital costs is to use a WACC (weighted average cost of
capital). This is the rate a company is expected to pay on average to all its security
holders to finance its asset.
Typically, capital costs tend to be vastly underestimated by inventory buyers. A
common mistake to avoid is to reduce them to short-term borrowing rates since rates
can fluctuate over time and hurt profitability.
How to Avoid Making Costly Inventory Replenishment Mistakes.
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BREAKING DOWN THE COSTS
Carrying Costs
2. Storage Space Costs
Storage space costs are a combination of the warehouse rent or mortgage, lighting,
heating, air conditioning, plus the handling costs of moving the materials in and out of
the warehouse. These costs are dependent on your type of storage and if you have a
privately owned warehouse or use Third Party Logistics (3PL) providers.
3. Inventory Services Costs
Inventory service costs include insurance, IT hardware and applications, tax in some
countries, but also physical handling with the corresponding human resources and
management personnel. Also in this category are the expenses related to inventory
control and cycle counting.
The insurance that a company pays is dependent on the type of goods in the
warehouse as well as the inventory levels. The higher the level of inventory is in the
warehouse, the higher the insurance premium will be which can also eat away at
profit margins.
4. Inventory Risk Costs
This cost covers the risk that items might fall in value over the period they are stored
or that they become obsolescent.
Risks first include shrinkage, which basically is the loss of products between the
recorded inventory and the actual inventory. The difference is caused by
administrative errors (shipping errors, misplaced goods, systems not updated, etc.),
pilferage, theft (including employee theft), damage in transit or during the period of
storage (because of incorrect storage, water or heat damage, etc.).
Inventory risk costs also take into account the obsolescence factor, that is, the costs
occurring when items is no longer wanted by the market.
How to Avoid Making Costly Inventory Replenishment Mistakes.
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BREAKING DOWN THE COSTS
Ordering Costs
The ordering costs or cost of replenishing inventory is the cost incurred every time
you place an order. These costs can be split in two parts:
1. Cost for processing orders
It typically includes fees for placing the order, and all kinds of costs related to invoice
processing, accounting, or communication. When exchanging data electronically,
using electronic data interface (EDI) systems, inventory management system allowing
supply chain integration, etc., the ordering process costs are significantly reduced.
This is a fixed cost.
2. Inbound logistics costs
Is related to transportation and reception (unloading and inspecting). These are
variable costs.
One way to get an understanding of the cost per order, without diving into the details,
is to divide the total annual cost of purchasing stock line items by the number of
purchase order line items for stock products issued in the past year:
There are ways to minimize those costs, or more precisely, to determine the right
trade-off between carrying costs vs. volume discounts. Essentially, it is all about
balancing the cost of ordering too much and the cost of ordering too little resulting in
backorders or lost sales.
Basically, smaller order quantities typically lead to more orders, which means higher
ordering costs, but is also implies lower carrying costs. This is usually achieved
through the calculation of the Economic Order Quantity (EOQ).
How to Avoid Making Costly Inventory Replenishment Mistakes.
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BREAKING DOWN THE COSTS
Ordering Costs
Economic Order Quantity
The economic order quantity (EOQ) is a model that is used to calculate the optimal
quantity that should be purchased or produced to minimize the carrying cost and the
ordering costs.
Notice that the total cost is at its lowest at point where the tangent equals zero. We
can draw a straight line from this point through the intersection of the carrying cost
and ordering cost curves. This is the EOQ. Luckily, you do not have to develop graphs
to determine the optimal order quantity for every stocked product. The optimal
quantity can be calculated as follows.
Total Cost = Carrying Costs + Ordering Costs
Whereas:
Q = Order quantity
D = Demand of the year
Ch = Cost to hold one unit inventory for a year
Cp = Cost to place a single order
How to Avoid Making Costly Inventory Replenishment Mistakes.
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BREAKING DOWN THE COSTS
Ordering Costs
Remember that the optimal order quantity occurs at the point in the figure below
where the total cost curve is at a minimum. Which coincides exactly with the point
where the carrying cost curve intersects the ordering cost curve. This enables us to
determine the optimal value of Q by equating the two cost functions and solving for Q:
This model is built on the following assumptions:
•  Relatively uniform and known demand rate
•  Fixed item cost
•  Fixed ordering and carrying cost
•  Constant lead time
To illustrate how a business can use these calculations without the help of inventory
optimization software, let’s walk through an example.
How to Avoid Making Costly Inventory Replenishment Mistakes.
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BREAKING DOWN THE COSTS
Calculation Example
A regional distribution center (RDC) for a major auto manufacturer stocks
approximately 20,000 service parts. The RDC fulfills demands of dozens of
dealerships in the region. The RDC places orders with the distribution center (DC),
which is also owned by the auto manufacturer.
In this case the RDCs are not replenished automatically so each RDC manages the
inventory on its own regardless of the policies at the DC.
Let’s consider one part, a tail light, for a specific car model. The demand for this part
is almost steady throughout the year at a rate of 100 units per week. The purchasing
cost of the tail light paid by the RDC to the DC is $10 per unit. In addition, the RDC
spends on average $0.50 per unit in transportation.
A breakdown of the different types of costs is as follows:
The RDC calculates its interest rate to be 15% per year.
The cost of maintaining the warehouse and its depreciation is $100,000 per year,
which is independent of the amount of inventory stored there. In addition, the costs of
pilferage and misplacement of inventory are estimated to be 5 cents per dollar of
average inventory stocked.
The cost of invoice preparation, postage and time is estimated to be $100 per order.
The cost of unloading every order that arrives is estimated to be $10 per order.
Let us determine the optimal order quantity. The first task is to determine the cost
parameters.
How to Avoid Making Costly Inventory Replenishment Mistakes.
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BREAKING DOWN THE COSTS
Calculation Example (cont’d)
The carrying cost rate, I, is equal to the interest rate (.15) plus the cost rate for
pilferage and misplacement of inventory (.05). Therefore, I= .20. This rate applies to
the value of the inventory when it arrives at the RDC. This value includes not only the
purchasing cost ($10) but also the value added through transportation ($0.5).
Therefore, the value of Ch is $10.50*0.2=2.1. Finally, the fixed cost of order placement
includes all costs that depend on the order frequency. Thus, it includes the order
receiving cost ($10) and the cost of invoice preparation, etc. ($100). Therefore, Cp =
110.
We now substitute these parameters into the EOQ formula, and assume 52 weeks
per year, to calculate the optimal order quantity this spare part:
How to Avoid Making Costly Inventory Replenishment Mistakes.
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HOW TO GET STARTED
Contact EazyStock for a Demo & Analysis
Thank you for reading the white paper How to Avoid Making Costly Inventory
Replenishment & Procurement Mistakes. This white paper is knowledge article
produced by EazyStock, a cloud-based inventory optimization software.
With EazyStock, businesses have the ability to see exactly how much excess and
obsolete stock they are carrying in inventory and the associated costs via our free
inventory health check up and analysis. EazyStock is designed to take the complexity
out of supply chain management. Our team of inventory optimization experts can help
you measurably improve your demand forecasting, supplier planning, inventory
optimization, and inventory purchasing processes.
EazyStock customers report strong financial results within the first six months of
implementation, including the following:
•
•
•
•
•
Decrease inventory levels by 30%+
Decrease stock outs by 10-15%
Identify and address excess and obsolete inventory
Decreasing supplier lead times from 30-50%
Increasing planner productivity 10-20%
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How to Avoid Making Costly Inventory Replenishment Mistakes.
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