How can you use master data to determine the order level?
To begin with, we are going to focus on the first question: When is the right time to place an order?
Is it when you sell the last unit? Or is it when you start to run a bit low? Or should this decision be based on something else?
Ordering at the right time is vital. If you order too soon, your warehouse will become clogged up with excess stock you don’t need. But on the other hand, if you order too late, you will face costly stock outs. If the product in question has extensive lead-times, the problem is only exacerbated!
Thankfully, there is a simple formula for working out the order level:
Average demand X (lead time + review time) + safety stock
However, to apply this formula, we need three key pieces of master data:
– The average demand you expect to see for the product in question during the supplier’s lead time
– The requirement for safety stock to cover volatility in demand and supply
– The lead time & the review time (Note: we will dive into this later)
So, let’s break this down:
Working out the average demand during the lead time
Obviously, we need enough inventory to satisfy demand while we wait for our next delivery to arrive. This is called the cover period.
So, we therefore need to know what the typical lead time would be. And we also need to know what the demand we are anticipating during this period. Typically, we base this on historic demand.
Working out the requirement for safety stock
Safety stock is necessary to accommodate variations in demand and supply. To anticipate the variation in supply, we need to look at the supplier’s track record for delivery reliability. Do they deliver when they promise or do deliveries always arrive late?
In terms of demand history and delivery reliability, we need a sufficient amount of data in order to make a good estimate.
You also need to understand the target service level.
Note: this is not a number that you can look up or calculate, but a criterion set by management to determine how high (or low) this should be.
Once the service level is clear, we can determine the requirement for safety stock in two main ways:
1. The number of times a product is out of stock
2. The number of units that are of out of stock
This safety stock criteria is therefore also a management variable, and to a large extent determines the level of risk.
Finally, the data to determine the order level is now visible! When the current stock falls below the order level, another order must be placed.