Friday, May 16, 2008

Replenishment Policies and Inventory Planning

The two processes of replenishment and inventory are closely related. The inventory planning process establishes the optimal inventory levels that must be maintained to meet expected service levels for demand fulfillment. What does that exactly mean? To understand we need to explore the replenishment (or re-ordering) process. In doing so, we will also establish the decision parameters an inventory planning process provides for the replenishment to work at its most optimal levels.

Replenishment or Reordering

Reordering or replenishment process needs to define review period for reordering, and an ordering quantity. Then it needs the inventory parameters to determine whether an order for replenishment should be placed at the time of review or not. Based on how the review period and order quantities are defined, there are a few options to drive the reordering.

Continuous Review and Periodic Review

These terms refer to the frequency of review to determine when orders must be placed for replenishment.

In the continuous review process, the inventory levels are continuously reviewed, and as soon as the stocks fall below a pre-determined level (usually called, reorder point, or reorder level), replenishment order is placed. As more and more companies start using sophisticated IT systems to track their inventories in real-time, the continuous review method becomes a viable and optimal way to plan for replenishment.

Under periodic review, the inventory levels are reviewed at a set frequency. At the time of review, if the stock levels are below the pre-determined level, then an order for replenishment is placed, otherwise it is ignored till the next cycle. This method provides a viable process alternative to the continuous review by segmenting the merchandise into review buckets. This makes it easier to manage when the process is manual, or the number of items involved is extremely large, or when constraints on ordering-day exist.

Order Quantity and Order up-to Level

These terms refer to the process that is used to determine how much is ordered when a replenishment order is placed.

In the first process, the “order quantity” is fixed. If the review determines that an order should be placed, then the order for a pre-defined quantity for that item-location combination is placed for replenishment. The order quantity for all replenishment orders is fixed in this method, though order day may vary or may be fixed depending on the review method.

The second process defines a pre-determined “order up-to level” instead. The actual order quantity is determined as the difference between the on-hand stock on the review day, and the pre-determined “order up-to level”. The order quantity in this process will differ from one order to another depending on the on-hand quantity on the day of the review.

Between these two sets of parameters, four basic reordering process options become available.

Options for Re-ordering Process

Based on the above two parameters, the reordering process can be deployed in the four basic ways. The diagrams below depict these variations of the process.

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Inventory Planning

The two key inputs to optimally run the reordering processes above are the inventory safety stock and reorder levels. These parameters control two of the most critical factors in a supply chain, the amount of inventory, and the ability to maintain favorable service levels.

And both of these are defined by the inventory planning process. As the demand and supply patterns change, the optimal inventory levels required to guarantee imagedesirable service levels also change.

Due to inherent variability in the demand and supply streams at any supply chain node, the ability to service demand directly depends on the safety stock. The relationship between the two is exponential that means that a 100% guarantee to fulfill demand will, in theory, require an infinite amount of safety stock to be maintained.

A good inventory planning process helps define these levels, discriminating between products that require higher service levels versus those that don’t. It helps in maintaining user defined service levels that guarantee desirable fill-rates to fulfill the demand. It also reviews them frequently to make changes to the safety stock recommendations to adjust to the new demand/supply picture.

Here is a quick synopsis of the inventory planning or optimization process that determines the optimal inventory levels to meet a desired service level.

Inputs to Inventory Optimization

As shown in the picture, the inventory planning process takes the following inputs.

  • Desired Service Level -- this is normally a user provided input. The desired service level depends on the item in question, its sales attributes, demand, profitability and associative relationship to the other items. Users normally define groups of items that have similar attributes to define and manage the service levels.
  • Demand -- this is the historical and projected demand for the item at the location. Note that the demand at a location like store will be the POS (point of sale) history, while demand at a distribution center is simply the requests that stores placed on the DC. If the store requests on the DC are not available, one could use the outbound shipments as an approximation of such demand.
  • Supply -- this is the historical and projected supply of the item at the location. The supply at a location like store will be the shipments history from DC, and/or vendors; and supply at a distribution center is generally the inbound shipments from vendors.
  • Supply Lead-time -- this is the historical lead-time of the supplies. The lead-time may vary for every PO/transfer order that is fulfilled even for the same item/vendor/distribution center combinations. This time-series data provides the variability of such lead-time and helps the inventory optimization engine to determine the probability that a specific projected supply will be realized on the need date. image
Process of Inventory Optimization

The inventory planning process determines the variability of the historic data to determine the optimal inventory levels. Most algorithms uses statistical methods, and are therefore computationally intensive.

  • The process pre-processes the time-series data for demand, supplies, and supply lead-time to compute the mean and standard deviation of these series.
  • It then computes the optimal inventory levels (safety stocks) that will be enough to guarantee the target service levels.
Outputs of the Inventory Optimization

The process can recommend the following decision parameters that are then the inputs to the reordering process itself.

  • Recommended safety stock levels.
  • Reorder levels,
  • OUTL (order up-to levels), and
  • Order quantities for the fixed order quantity scenarios above.

8 comments:

  1. this is really useful for my studies. thank you so much! :)

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  2. What is the difference between inventory policy, replenishment policy and ordering policy?

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  3. Thanks a Lot for explaining the replenishment concept in a easy and precise way.

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  4. do you have an article defining the days-of-supply required to maintain varying service levels? e.g., to remain 99% in-stock, you need 100 days of supply; to be 95% you need 50%, to be 90% you need 20 days. do you need to know the demand variability to use a chart or equation like this? thanks

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  5. I have a question. How do you calculate the reorder point if you have continuous replenishement(if you can order every month).
    If the reorder point is safety stock + demand lead time, I get an extremely high number. Of course it would mean you wouldn't have to order every month, but if you can, couldnt you set your reorder point lower?

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