THE ORDER QUANTITY

THE ORDER QUANTITY

BRIAN WILLCOX

ACTION MRPII

Who sets the order quantity in your company? How is the quantity determined? These are questions I often ask clients when working with them. Perhaps the most disturbing part of the answer is that in most cases no one is sure who set the quantity to be ordered or when it was set or even for which years program it was for.

The order quantity determines the company's average inventory which in turn determines one of a company's major costs, the cost of holding inventory. This is currently running at 35% per annum of the inventory value. For many companies this can mean that the size of the purchasing and manufacturing order quantities determines the size of the bank overdraft! Perhaps the first point to get sorted out is who in the company sets the order quantity. Usually it falls to the planning function to propose the order quantities as they know the overall requirements for a part. When this is done for all parts, it is then possible to establish the approximate stock holding for the future periods. Now the accountants can assess the financial implications and have their say on whether the company can afford or wants to afford that level of inventory. If the answer is that the stock holding is going to be too high, the company really has no choice but to reduce the batch sizes for purchased and manufactured parts. In the case of the finished goods store another alternative is to reduce the planned customer service level which will reduce the quantity of safety stock required. This decision would normally be taken at the executive level, and where a company has a "production planning" meeting, it would be at this meeting that the decision be taken.

Perhaps we should now look at the reason why the order quantity determines the average inventory and then look at the factors that should be considered when setting the order quantity.

Average Inventory

Average inventory is defined as half the batch size plus safety stock. Safety stock is determined from such factors as customer service level required, demand variability and replenishment lead time. Once the customer service level required is agreed, safety stock is then a calculated quantity and not a variable.

This means that the only figure we have a choice with is the order quantity. This is either our manufacturing batch quantity for the finished goods store, or the purchase order quantity for our raw material and piece part store.

The formula is;

average inventory = order quantity + safety stock
2

The assumption is made that at any point in time, the cycle stock (stock planned to be used which excludes safety stock) is on average half the receipt quantity: on average it is half way in between the receipt quantity and zero left.

The practical implications of this is that if you reduce your order quantity by half, you automatically reduce your average cycle stock by half. If you manufacture a part in your factory more frequently in smaller batches, your inventory goes down. I agree that there is an increase in the number of set-ups you do which increases the cost and consumes capacity. This tells us therefore that our average inventory tends to be controlled by our set-up cost. So if we want to reduce our inventory holding cost we must reduce our set-up cost so we can make smaller batches more economically.

Establishing the Order Quantity

There are many methods available to us these days in the inventory modules of our standard packages to calculate the order quantity. I must admit though that I often feel that some of them are theoretically wonderful but are only included as a feature because it is an easy little bit of programming and might impress unwary prospects who are considering buying the package. Not because the method is required or even used by anyone!!

In the ex stock environment, it is not uncommon to find the finished goods store replenished by a max - min or reorder point system, even though the material planning is calculated by MRP exploding the master schedule. In other cases manufacturing produce quantities in line with the Master Production Schedule which may or may not have been modified to take into account the current stock holding. Depending upon the manufacturing industry and the process used will depend upon how variable the order quantity can be. In the theoretical ideal world, the order quantity will exactly equal a demand. In the real world that may not be practical, but some companies have got their batch sizes down to one days requirement. This is not practical in all industries but it is amazing what some people are managing to do. Just consider how happy their accountants are with what that is doing to their average inventory and their costs. Obviously they have got their set-up down to a non important factor.

How should the planner calculate the batch sizes to propose? What are the factors to consider? In simple terms it is cost and capacity that must be considered. Capacity is a limitation we have to consider and we need to be realistic. If we want to do more set-ups, and we do not have surplus capacity we must reduce the set-up time.

The cost of set-up is another factor. In manufacturing it includes not just the cost of setting or preparing the machine but all the one off costs associated with processing an order.

For purchased parts its the cost of placing the order and processing the receipts. This is calculated by taking the total budget for the four departments involved in the process, namely; purchasing, goods receiving, incoming inspection and accounts payable, and dividing this by the number of orders placed or by the number of receipts. As three out of the four areas are involved in each receipt is more generally calculated by the cost of a receipt. This gives a realistic average cost of placing and processing a receipt.

The other cost factor is the cost of holding the inventory in stock when we have made it. This we say is currently at 35% per annum. This includes the lost opportunity cost of having the capital tied up in inventory, insurance, theft, damage, obsolescence and the cost of running the store.

These are real costs which need to be considered. So many companies just pick an order quantity because it is convenient without realising the costs they are incurring. The rules we use for establishing our order quantities must take these costs into account.

Next month I will be looking at the methods available in our systems and where they are commonly used.