How to Set Performance Targets
in Inventory Control
Dr. Everette S. Gardner, Jr.
1
How to Set Performance Targets
in Inventory Control






Clean up the parts list
Develop a basic forecasting system
Use the forecasts to classify parts (ABC+)
Decide what to stock
Decide where to stock it
Divide the inventory into control groups:


2
JIT, MRP, EOQ, Annual buy
Develop benchmark performance measures
Clean Up the Parts List

Code substitute items


Delete obsolete items (no longer used in current
product line)


3
Do the part numbers apply to other customers or
products?
Review items with no recent demand


Ensure historical demand recorded against primary
items
Stocking rules usually depend on demand in the last 6
months or the last year
Negotiate with vendors to return parts for credit
Water Filtration Company:
Status of 23,192 inventory items
2,200 obsolete
9%
7,526 with no hits
in 12 months
33%
6,336 active items
27%
4
2,928 substitute
items
13%
4,202 with
inadequate
demand to stock
18%
The Importance of Forecasting

Forecasts determine production and inventory
quantities



5
MRP: Master schedule
EOQ: Order quantity, leadtime demand, safety stock
JIT: Requirements to internal and external suppliers
The Importance of Forecasting (cont.)

Better forecast accuracy cuts inventory
investment. Example:



6
Forecast accuracy is measured by the standard
deviation of the forecast error.
Safety stocks are usually set at 3 times the standard
deviation
If the standard deviation is cut by $1, safety stocks
are cut by $3
Forecasting Tools for Inventory Control

Simple exponential smoothing



Weighted-moving-average technique for stable items
Highly recommended for repair parts demand
Trend-adjusted exponential smoothing


Estimates and projects growth (or decline) in demand
Types of growth




7
Exponential
Linear
Damped
Both models are easily modified to handle
seasonal demands
Origins of the Damped Trend

Reference


Operational requirement


Gardner & McKenzie, Management Science, 1985
Automatic forecasting system for military repair and
maintenance parts
Theory

Lewandowski, IJF, 1982 (M1-Competition)
Trend extrapolation should become more
conservative as the forecast horizon increases.
8
The Damped Trend
1) Error = Actual demand – Forecast
2) Level= Forecast + Weight1(Error)
3) Trend = (Previous trend) + Weight2(Error)
4) Forecast for t+1= Level + Trend
5) Forecast for t+2 = Level + Trend + 2 Trend
.
.
9
Automatic Forecasting with the Damped Trend

Constant-level data


Consistent trend


Forecasts emulate Holt’s linear trend
Erratic trend

10
Forecasts emulate simple smoothing
Forecasts are damped
Automatic Forecasting with the Damped Trend
In constant-level data, the forecasts emulate simple
exponential smoothing:
36
35
34
33
32
31
30
29
28
27
26
11
Automatic Forecasting with the Damped Trend
In data with a consistent trend and little noise, the
forecasts emulate Holt’s linear trend:
60
55
50
45
40
35
30
25
20
12
Automatic Forecasting with the Damped Trend
When the trend is erratic, the forecasts are damped:
50
45
40
35
30
25
20
13
Saturation level
Automatic Forecasting with the Damped Trend
The damping effect increases with the level of noise in
the data:
50
45
40
35
30
25
20
14
Saturation level
11-Oz. Corn chips
Monthly Inventory and Sales
$2,500,000
$2,000,000
Actual Inventory
$1,500,000
$1,000,000
$500,000
$0
15
Sales
Damped-trend performance
11-oz. Corn chips
$500,000
Outlier
$450,000
$400,000
$350,000
$300,000
$250,000
$200,000
16
Actual
Forecast
Investment analysis: 11-oz. Corn chips
17
Forecast annual usage
Economic order quantity
Standard deviation of forecast errors
$4,138,770
$318,367
$34,140
Nbr. shortages
per 1,000
Probability Safety
order cycles of shortage stock
100.0000
0.1000
$43,758
50.0000
0.0500
$56,167
1.0000
0.0010
$105,510
0.0100
0.0000
$145,601
0.0001
0.0000
$177,496
Order
quantity
$318,367
$318,367
$318,367
$318,367
$318,367
Maximum
investment
$362,125
$374,534
$423,877
$463,968
$495,863
Safety stocks vs. shortages
$200,000
$180,000
Target
Safety stock
$160,000
$140,000
$120,000
$100,000
$80,000
$60,000
$40,000
$20,000
$0
0
10
20
30
40
50
60
70
Shortages per 1,000 order cycles
18
80
90
100
Safety stocks vs. forecast errors
$200,000
Safety stock
$150,000
$100,000
$50,000
$0
($50,000)
($100,000)
($150,000)
($200,000)
19
Forecast errors
11-Oz. Corn chips
Target vs. actual packaging inventory
$2,500,000
$2,000,000
Actual Inventory
from subjective
Actual Inventory
forecasts
from subjective
forecasts
$1,500,000
$1,000,000
$500,000
$0
Target maximum
inventory based on
damped trend
20
Month
Monthly Usage
How to forecast regional demand


21
Forecast total units with the damped trend
Forecast regional percentages with simple
exponential smoothing
Regional sales percentages: Corn chips
50%
40%
30%
East
South
North
20%
West
10%
0%
Mar
22
Jun
Sep
Dec
Mar
Jun
Sep
Dec
Target Inventory Analysis

Actual inventory based on subjective decisions:
$182.6 million

Target inventory based on the damped trend and
EOQ/Safety stocks:
$135.0 million

Projected savings:
$47.6 million
23
Water Filtration Company:
Inventory Classification
Active Items (some demand in past year)
Class Limits
Total nbr.
of items
Percent of
items
A
> $36,000
364
4%
$11,743,610
60%
B
$600 - $35,999
4,232
46%
$7,316,999
38%
C
< $600
4,668
50%
$365,605
2%
9,264
100%
Class
Totals
24
Total sales
forecast
$19,426,214
Percent of
forecast
100%
Water Filtration Company:
Inventory Classification
Class
Active Items
Number
of items
Definition
364
1.51%
Active items: Sales $600-$35,999
4,232
17.6%
C
Active items: Sales < $600
4,668
19.42%
Z
Zero forecast items: no hits in 6 mon.
1,548
6.44%
D
Disposal items: no hits in 12 mon.
11,526
47.95%
Buys not based
X
One-time buys
146
0.61%
on demand
N
New items: established in last 12 mon.
968
4.03%
Miscellaneous
F
Free (no-cost) items
27
0.11%
P
Problem items (missing data)
560
2.33%
24,039
100.0%
Slow Movers
A
Active items: Sales > $36,000
B
Percent
of items
Totals
25
What to Stock?

Compare costs



26
Cost to stock = (Avg inventory balance x holding rate)
+ (number of stock orders x transportation cost)
Cost to not stock = Number of customer orders x
transportation cost
Transportation costs for not stocking may be both inand out bound, depending on whether we choose to
drop-ship from the vendor
What to Stock? (cont.)

Simplify decisions using “hit” rules


A “hit” is one customer order for any number of units.
Cost comparisons usually result in minimum number of
hits that must occur before it is economical to stock.
Example:



27
Class A
Class B
Class C
6 hits in 6 months
4 hits in 6 months
3 hits in 12 months
Water Filtration Company:
Inventory Status as of July, 2009
Class
Definition
Minimum
hits to stock
Excess
stock qty.
Nbr items
stocked
Nbr
items not
stocked
Total
A
Active items: Sales >
$36,000
6 in 6 mon.
> 6 mon.
290
74
364
B
Active Items: Sales $600 $35,999
3 in 6 mon.
> 6 mon.
3,108
1,124
4,232
C
Active items: Sales < $600
4 in 12 mon.
> 12 mon.
2,938
1,730
4,668
Z
Zero forecast items: no hits
in 6 mon.
-
All
-
1,548
1,548
D
Disposal items: no hits in 12
mon.
-
All
-
11,526
11,526
X
One-time buys
-
All
-
146
146
N
New items: established in
last 12 mon.
-
Same as
ABC
170
628
968
6,506
16,776
23,452
Totals
28
Where to Stock?

Centralized order entry is mandatory

Apply the hit rules by location



29
This automatically tailors the range of stock to the
customer base at each location
Must designate who suppliers whom when a hit occurs at
a non-stocking location
Recognize that consolidating stocks makes
dramatic reductions in total inventory investment
Who Supplies Whom?
Stocking
Warehouses
30
LA forecast
FL forecast
CA/OR forecast
LA + CA/OR
FL only
0
1
LA + FL
2
LA + CA/OR
LA + FL
0
CA/OR only
3
FL + CA/OR
0
LA + FL
CA/OR only
Effects of Consolidating Inventories:
Manufacturer of Communication Systems
Investment
(millions)
6.5
5.5
4.5
3.5
2.5
1.5
1
2
3
Number of Warehouses
31
4
Monthly Item Migration Processing
Original Class
Result of monthly review
Action
N (new items)
Enough hits in last 6 months to
stock.
Generate forecast, change N
to A,B, or C
At least 1 hit in last 6 months,
but not enough to stock
Generate forecast, change N
to A, B, or C
No hits in last 6 months, but
hits occurred 7-12 months ago
Set forecast = zero, change
N to Z (zero forecast)
No hits in last year
Change N to D (disposal)
A, B, or C
(active items)
No hits in last 6 months
Set forecast = zero,
Change A, B, or C to Z (zero
forecast)
Z (zero forecast)
No hits in last 12 months
Change Z to D (disposal)
1 or more hits
Change Z to A, B, or C
1 or more hits
Generate forecast,
Change D to A, B, or C
D (disposal items)
32
Control
System
33
Inventory
Class
Production
Schedule
Lead-time
Behavior
JIT
A, B
Level
Certain
MRP
A, B
Variable
Reliable
EOQ/Safety
Stock
A, B
Variable
Variable
Annual buy
C
Any
Any
The Economic Order Quantity (EOQ)

Controls



The EOQ



Increases with the order cost
Decreases with the holding rate
Do not treat order cost and holding rate as fixed
values. Instead, do what-if analysis to hit target
values for


34
Cost per order
Holding rate (% of inventory value)
Inventory investment on the balance sheet
Stock replenishment workload
Inventory tradeoffs for Class B items
Number of Class B active items
3,600
Sum of annual demand forecasts
$14,337,666
Sum of monthly demand forecasts
$1,194,806
Inventory carrying cost
Order
Cost
Maximum Investment
20.00%
Number of annual buys
EOQ in weeks of
stock
Total
Avg. per item
Total
Avg. per item
Min
Max
$5
$1,428,356
$397
28,567
7.9
2.6
14.9
10
2,020,000
$561
20,200
5.6
3.6
21.0
15
2,473,985
$687
16,493
4.6
4.5
25.8
20
2,856,711
$794
14,282
4.0
5.2
29.8
35
Communications Systems Manufacturer:
Target inventory values for fiscal 2009
Class
Control
System
A
JIT
1,412
$4,945,000
16,944
B
EOQ
3,999
$10,820,000
15,996
C
Annual Buy
8,688
$2,004,000
8,688
14,099
$17,769,000
41,628
Totals
36
Number of
Items
Maximum
Investment
Number of
Annual Buys
Water Filtration Company:
Inventory Values
Class
Definition
Nbr items
A,B,C
Active items: On-hand ok
A,B,C
Active items: On-hand excessive
A,B,C,Z
On-hand
Excess
On-order
5,754
$3,884,064
$0
$1,958,932
584
$887,048
$491,960
$23,220
Not enough hits to stock or zero
forecast
3,878
$943,950
$902,774
$27,398
D
Disposal items: no hits in 12
mon.
2,336
$458,968
$458,160
$121
X
One-time buys
12
$5,128
$5,128
$0
N
New items: established in last 12
mon.
404
$127,124
$121,534
$93,362
12,968
$6,307,626
$1,979,556
$2,103,033
Totals
37
Annual Purchasing Workload Estimates
New System:
Stock buys
Old System:
Stock buys
Nbr items
stocked
Annual
reorders
per item
Annual
reorders
per class
290
12
3,480
B(EOQ)
3,108
4
12,432
C(Ann.)
2,938
1
2,938
Total
18,850
Class
A (JIT)
Class
Nbr items
stocked
Annual
reorders
per item
Annual
reorders per
class
A(JIT)
290
12
3,480
B(EOQ)
3,108
12
37,296
C(Ann.)
2,938
12
35,256
Total
76,032
Old system
New system
76,032
18,850
?
11,624
600
600
?
1,600
76,632
32,674
Summary:
Workload comparisons
New system: Worst case estimate of
number of drop-ship buys
Nbr items
not stocked
Max# hits
for nostock item
Number
of dropship buys
74
11
814
B(EOQ)
1124
5
5,620
New items, one time buys
C(Ann.)
1730
3
5,190
Redistribution actions
Total
11,624
Class
A (JIT)
38
Stock buys
Drop-ship buys
Total
Monthly Inventory Performance Report
Lead-times
Lead-time exceptions
Average lead-time
4.5%
3.20
Stock Levels
Target
$19,900,878
Actual
$23,422,012
Excess
$3,521,134
Stock Status
Items in stock
Items out of stock
92.20%
7.80%
Items Out of Stock
With open order
82.2%
No open order
17.8%
Customer Orders
Percent shipped complete
94.3%
Warehouse Refusals
Percent occurrence
39
2.8%
Conclusions

Forecasting drives any inventory control
system
 Standard ABC classification doesn’t go far
enough
 Decision rules for what/where to stock must be
established early
40
Conclusions (cont.)

Performance measurement is essential to:
Justify a new system
 Tailor the system to the inventory
 Track progress

41
Conclusions (cont.)

The best inventory system is likely to be a
hybrid of:
JIT
 MRP
 EOQ
 Annual buy

42