Last month we looked at the affect of the order quantity and at the elements that need considering when setting the order quantity. This month we will look at how to consider those elements and the methods used in industry to determine the order quantity.

We said that the two major costs to be considered were the inventory holding cost ; the cost of holding the manufactured or purchased material in stock, and the cost of obtaining that material. In the case of purchased material it is the order placement and processing cost which includes purchasing, goods receiving, incoming inspection and accounts payable. For manufactured items it is the cost of setting up the machines and processing the works order. It does not include the direct cost of obtaining or manufacturing the part as this would be incurred irrespective of the batch size.

The Theory

If you look in the good books it will tell you that the correct batch size is determined by the Economic Order Quantity formula. From a pure financial point of view this is correct.

EOQ = 

S = ordering or set-up cost

I = inventory holding cost

C = unit cost

Unfortunately there are a few assumptions made for this to be true. For example; the demand should be equal and regular, the physical size of the part is not considered, you have sufficient capacity, you have sufficient storage space and facilities. In the real world these may be a problem.

The concept is that we should build or purchase our parts in such a manner so as to incur the least total cost to the company over a period of time. The more we put into stock at anyone time the more it is going to cost us to store it from an inventory holding point of view. The more we make at one time the more we can spread the cost of setting up the machines and processing the order.

The first point tells us to order as few as possible at a time, but the next tells us to order as many as possible at a time. Obviously the correct batch size is one that is somewhere in between these two opposing points of view. What is firmly established is that the most economical batch size is when the holding cost equals the set-up cost. All the fancy methods of determining the batch size are based on this fact, but some take other considerations into account as well.

MRP Ordering Rules

Most MRP modules allow us to choose between several ordering rule options. Typically they offer; Fixed Order Quantity, Lot For Lot or Discrete Ordering and Period Order Quantity. Some also offer Periodic Ordering, Least Total Cost and Part Period Balancing. In addition there are order modifiers to make the order quantity generated practical. I will briefly outline the principle of each of these methods.

Fixed Order Quantity

When a net requirement is found MRP will create an order for this predetermined order quantity. This is usually fixed by the manufacturing process or equipment used to manufacture the part. MRP will consume any surplus in future periods before ordering again.

Lot for Lot (L4L)

MRP will generate a planned order equal to the net requirement for each period. One must be careful when using this method as if you have requirements for each day, MRP will plan an order for each day. It is common practice to use order modifiers with this method or to use the Period Order Quantity rule if orders are not wanted on a daily basis.

Period Order Quantity (POQ)

Using this method, the order quantity will be equal to the net requirement for a given number of periods. This method is often used in conjunction with the ABC classification. Blanket rules are determined for A's, B’s, and C's. For example, A items order 4 weeks supply, B items order 10 weeks supply etc.

When MRP finds a net requirement it then adds that periods requirement to the following periods requirement as per the number of periods specified. For example if 3 periods were stated for a part then MRP would add the net requirement for three consecutive periods together and plan an order for that quantity. To obtain the best results with this method, the EOQ should be calculated for the item and that quantity divided into the annual demand to determine the number of orders to be placed a year. That time period requirement is then entered into the system as the period order quantity requirement. This will result in the correct number of set-ups or order placements to be placed during the year but the holding costs will be reduced to a minimum as the actual quantity required during that period of time will be the quantity ordered.

Periodic Ordering

Periodic ordering is very similar to Period Order Quantity, except that POQ only starts counting the periods from a requirement whereas Periodic Ordering orders at the fixed frequency irrespective whether there is a requirement or not. This is extremely useful when a number of parts are bought from one supplier and you want them shipping together to reduce the transport cost.

Least Total Cost (LTC)

This dynamic lot sizing technique calculates the order quantity by comparing the inventory holding cost to the ordering/set-up cost for various lot sizes and selects the lot where these costs are nearly equal. One method of doing this is to add consecutive periods discrete quantities together and calculate the carrying cost. This is then repeated after adding the next periods requirement into the order quantity until the holding cost exceeds the ordering/set-up cost. The holding cost either side of the ordering/set-up cost is examined and whichever is the closest determines which order quantity is the one to use.

Part Period Balancing

This method which is also defined as a dynamic lot sizing technique, uses the same logic as the least total cost method, but adds a routine called look ahead/look back. In simple terms it first calculates the order quantity using the LTC method but then goes further forward combining periods together and regrouping the earlier periods to see if the overall result is less costly. This method tends to be extremely sensitive to minor changes and requires a very stable requirement else it recalculates all the order quantities and triggers further changes down to the lower level MRP items.

Order Modifiers

Order Modifiers, often referred to as batching rules, enable the system to modify the order quantity determined by one of the ordering methods into a practical usable quantity. For example, if the order method calculated the order quantity as 5 751, but the supplier sold his product in boxes of 1 000, the order needs modifying to 6 000.
 
 

The modifiers available are; minimum order quantity which increases the order quantity to a minimum of the stated quantity, maximum order quantity which limits an order to this quantity and then MRP will plan a second order for the remainder, multiple order quantity where the order quantity is increased to a multiple of the stated quantity.

Practical Applications

From experience I have found that the method most commonly used by companies who understand the costs associated with inventory and have implemented MRP or a computerised inventory control system is the period order quantity rule in conjunction with order modifiers. Usually they determine the period to be used by applying the ABC principle e.g. it items 4 weeks usage etc. This approach is simple to use, is understood by the material planners and very cost effective. If you are not currently using this type of approach may I suggest you investigate and estimate the savings you could make. We cannot afford high inventories if we want to be competitive and stay in business.
 

May 99