Inventory Distribution Model
This project represents the investigation into the interactions
associated with an endeavor to reengineer an inventory management
and distribution operation.
Supporting Analysis
Architecture of the System
Part of the reason we often have such difficulty effecting
the chances we set out to make has to do with our limited understanding
of the systems we set out to change. We have a very pronounced
tendency to zero in on one or two factors which we consider to
be the root of the problem we face, or the controlling factors
of the change we wish to effect. Yet, we so often fail to realize
the extent of the interconnections and interactions within the
system we attempt to change.
The following diagram represents the major interactions which
are part of the supplier / distribution system associated with
the LAA Group.
The standard response to diagrams of this type generally borders
on something akin to horror, and the comment is that it's so complicated.
It is our unwillingness to understand and work with the complexity
of systems which dictates that we perceive them as complicated,
and subsequently become the victim of them.
The components of the above diagram are described as follows:
Current Sales
Represents the current level of sales in units and $.
Current Sales is directly dependent on Demand. As Demand increases
Current Sales will increase as long as there is Inventory available
to fulfill the Demand.
Lead Time
The current delivery delay among the suppliers varies from
1 month to 5 months in some cases. The overall average delay
is figured to be 4 months.
The belief is that by carrying the inventory in central location
and accepting forecasts once a month, accepting orders every
two weeks, and shipping every two weeks, via Air Freight, the
average delivery delay could be cut to 2 weeks.
Demand
Demand is consider to drive Current Sales. As it is believed
that Demand is depressed because of less than adequate availability
then an increase in Perceived Availability will allow demand
to rise back to the appropriate market level. Perceived availability
will not influence Demand to actually grow, but rather just return
to it's potential level based on market size.
This would tend to imply that as Perceived Availability increases
Demand will approach some predefined limit and not grow beyond
that limit unless some other factor enters into the puzzle.
Desired Sales
Represents the desired level of sales in units and $. This
is the driving element in the whole equation.
Inventory
Inventory is the total level of inventory held in all the
countries based. This is a result of increased based on shipments
received and decreases based on Current sales.
Orders
Orders represent the total of orders placed against suppliers
to replace current sales and satisfy future current inventory.
There are a couple questions regarding the interplay of Service
Level and Delivery Delay and Orders. I am uncertain as to whether
there is a direct influence between Orders and Service Level
and Delivery Delay or whether Service Level and Delivery Delay
operate on Orders via Required Inventory and Sales Forecast.
I have to ponder this one some more.
Perceived Availability
Perceived Availability represents the degree to which the
market believes the Inventory is available to meet their needs.
To the extent there is Perceived Availability then the market
produce Demand for the product. To the extent the market does
not believe the Inventory is available it will attempt to fill
its need via some alternative product.
Required Inventory
Required Inventory is the future inventory it is believed
must be in place to respond to future demand at a point in time
in the future equivalent to the Delivery Delay time.
Sales Forecast
Sales Forecast is the estimate of the sales expected in the
future period equal to the delivery delay. This is essentially
the amount of inventory that must be on hand at that time in
the future to satisfy the Demand that will be experienced in
that time period.
Service Level
Service Level is the percentage of the order received when
the shipment arrives. Typically Service Level has been between
40% and 60%. For model calculations we have been using 50% as
the typical average Service Level.
The Service Level is a function of the structure of the system
and the operation of the suppliers to the system.
Shipments
Shipment represents the fulfillment of a prior order at the
end of the Delivery Delay period.
The Shipment will consists of that quantity of ordered material
based on the Service Level for the particular supplier.
Structural Change
The difference between Current Sales and Desired Sales, with
Desired Sales being greater than Current Sales, provides the
motivation for structural change based on the believe that structural
change will influence the improvement in certain elements of
the system which will result in future decreases in Inventory
and increases in Current Sales.
It is believed that by inventorying in a central location
and air freighting products to the individual locations, with
the same level of demand, the total inventory in the system can
be reduced. This based on the added belief that by carrying inventory
in a centralized location Service Level and be increased and
Delivery Delay can be reduced.
Governing Logic
- Return on Inventory Assets = Gross Profit($) / Sales($)
- Gross Profit = Sales($) - Cost of Goods Sold($) - Inventory
Carrying Cost($)
- Sales($) = Sales * (1 + GSV)
- Order Quantity = Target Inventory - Availability
- Target Inventory = Forecast * (Lead Time + Safety Stock +
Order Freq)
- Availability = On Hand + On Order - Backorder
- Safety Stock = 2 * Order Freq * ( (1 - Fcst Acc) / Fcst Acc
+ (1 - Service Level) / Service Level )
- Cost of Goods Sold = Product Cost * (1 + Landing %)
- Inventory Turns = Average Inventory On Hand / Yearly Sales
Initial Year Collected Data - 1995
- Sales - 5.84 million units
- Inventory On Hand - 4.99 million units
- Service Level - 60%
- Lead Time - 6 months
- Forecasting Accuracy - 25% (75% Inaccuracy)
- Sales per month distribution
- Jan = 0.048
- Feb = 0.070
- Mar = 0.095
- Apr = 0.080
- May = 0.073
- Jun = 0.073
- Jul = 0.073
- Aug = 0.078
- Sep = 0.098
- Oct = 0.098
- Nov = 0.106
- Dec = 0.109
- Product Cost = $.81
- LAC Landing Costs = 32%
Parameter Values and Projections
- Annual Growth Projections
- 1995 - 00.0% (actual base year)
- 1996 - 61.5%
- 1997 - 28.6%
- 1998 - 23.2%
- 1999 - 20.2%
- 2000 - 20.0%
- Inventory Carrying Cost = 20% of Product Cost per Year
- GSV = 43% of Product Cost
- LAC Forecasting Accuracy = 25%
- LAC Lead Time from Suppliers = 6 months
- LAC Service Level from Suppliers = 50%
- LAC Lead Time from MRDC = 1 month Ocean/.5 month Air
- LAC Service Level from MRDC = 85%
- MRDC Forecasting Accuracy = 70%
- MRDC Lead Time from Suppliers = 4 months
- MRDC Service Level from Suppliers = 85%
Simulation Runs
Initial Year Model Validation
For the model to be valid it must produce results which agree
with the 1995 actual values. The following 12 month run is with
no default parameter changes to produce correct 12 month sales
volume, dollars, and end of year inventory.
Projection Runs
A 36 month run with no growth shows the expected inventory
oscillation.
Note the stabilization of the yearly sales volume (line # 5)
after the 12th month. The dip in return on inventory assets in
month 13, 25, 37 are due to the lower sales volume which occurs
between December and January, while inventory is increasing.
The following graph is produced with the projected growth factors
turned on for the 2nd and 3rd years.
Note that inventory and yearly sales volume continue to grow
as sales increase, yet the return on inventory assets remains
at essential the same average level. This is because the ratio
of gross profit to profit does not change with the growth in sales.
MRDC Operation
When MRDC operation is turned on there are a number of options
that can be set at the same time that it is turned on. These have
to do with the expected supplier lead time and service level to
MRDC, as well as the MRDC lead time and service level to LACs.
In addition the expected alteration in forecasting accuracy has
a substantial effect on the inventory levels as does the method
of shipment from MRDC to LACs.
The following graphs represents the implementation of MRDC
operation in month 16, April 1996, with shipments to LACs by ocean.
Note that while annual sales is not affected there is a marked
decline in LAC inventory during the 16th thru 24th months. Along
with this there is a marked increase in return on inventory assets.
The return on inventory assets increases because the decrease
in inventory carrying cost more than offsets the increase in shipping
costs from MRDC via ocean once a month.
If MRDC decides to ship via air every 2 weeks the implications
are shown in the following graph:
Note that shipping by air every two weeks produces a lower
level of inventory the return on inventory assets drops because
the reduced inventory carrying costs are not enough to offset
the increase shipping costs for air.
Some of the above relationships are best seen in comparative
graphs, a number of which are provided below.
This graph represents resultant LAC inventory with (1) no growth,
(2) growth, (3) MRDC operation with growth and shipment via ocean
starting in month 16, (4) MRDC operation with growth and shipment
via air starting in month 16.
This graph represents resultant system (LAC + MRDC) inventory
with (1) no growth, (2) growth, (3) MRDC operation with growth
and shipment via ocean starting in month 16, (4) MRDC operation
with growth and shipment via air starting in month 16
Note the delay in the drop of the MRDC inventory until after
the orders in the pipeline are received and redistributed to the
LACs as they place orders.
This graph represents resultant LAC average inventory turns
with (1) no growth, (2) growth, (3) MRDC operation with growth
and shipment via ocean starting in month 16, (4) MRDC operation
with growth and shipment via air starting in month 16
The implication is that while shipments by air every 2 weeks
reduce inventory further than shipments once a month by ocean
within a 24 month period the average inventory turns will be essentially
the same, with both showing about a 100% improvement over the
implementation of MRDC operations.
Yet, inventory turns are not the most indicative representation
of improvement of the operation. It is possible to improve inventory
turns and make less money as a result. This is indicated in the
following graphs which refer to return on inventory assets.
This graph represents resultant LAC return on inventory assets
with (1) no growth, (2) growth, (3) MRDC operation with growth
and shipment via ocean starting in month 16, (4) MRDC operation
with growth and shipment via air starting in month 16
Note that the return on inventory assets for shipments via
air is about 5% below the return on inventory assets for shipments
by ocean.
This graph represents resultant system (LAC + MRDC) return
on inventory assets with (1) no growth, (2) growth, (3) MRDC operation
with growth and shipment via ocean starting in month 16, (4) MRDC
operation with growth and shipment via air starting in month 16.
The system return on inventory assets is about a percentage
point lower than the LAC comparative graph because of the inventory
carrying cost for MRDC. Note that the variance between shipping
via ocean and air.
Conclusions
From numerous simulation runs with varying input parameter
values such as Projected Sales Growth, Forecasting Accuracy, Lead
Time, Landing Cost, Service Level, Inventory Carrying Cost, etc.
there are several insights that come have become evident. These
are provided in the following conclusions.
- It is more cost effective to stock at MRDC and ship monthly
to the LACs via ocean than to ship every two weeks by air. This
option results in a slightly higher inventory maintained in the
LACs than if shipments are done every two weeks by air. The combination
inventory carrying cost for this higher inventory level combined
with the lower landing cost turns out to be more profitable than
the combination of inventory carrying cost on a lower level of
inventory combined with a higher landing cost. This difference
in terms of return on inventory assets is 4 to 5 percent in favor
of shipping monthly by ocean.
- With the initiation of MRDC operations it is expected that
the LAC orders in the pipeline will be routed to MRDC and the
LACs will place new orders on a monthly basis with MRDC. These
orders will be of significantly lower volume because of the lead
time reduction, forecast accuracy improvement and service level
improvement.
- With the initiation of MRDC operations for all LACs it will
take approximately 9 months for the system to stabilize. This
stabilization takes into account the amount of time it will take
for LAC orders in the pipeline to be delivered to MRDC and the
length of time it will take for the LACs to sell down current
inventories.
- It is recommended that MRDC operation begin one LAC at a
time to allow MRDC to develop its operational effectiveness.
It is understood that this may not be possible because of the
in place forecast / order management system. Whether the transition
is done one LAC at a time or all at once I would recommend the
preordering of additional inventory for MRDC to cover start up.
The absolutely critical portion of this solution is that the
LACs believe that MRDC will deliver at a service level higher
than the standard suppliers. If the LACs are not convinced of
this they will continue create oscillations in the system by
over, and later under, ordering. The only way they will come
to believe in the new MRDC service level is for MRDC to deliver!
Over time the MRDC inventory could be slowly reduced down to
more appropriate levels.
- Once MRDC has converted all LACs to source from MRDC the
next portion of the situation which should be worked on is the
reduction of lead times from MRDC suppliers, supplier service
levels, and the improvement of forecasting accuracy. These factors
are components of safety stock computations and will result in
a reduction of the inventory carried by MRDC, thus reducing the
inventory carrying cost and improving the overall system return
on inventory assets.
- The next stage is to work on the lead times and forecasting
accuracy for LACs. By improving the forecasting accuracy and
reducing the lead time the LACs inventory level my be further
reduced improving both the LACs and System return on inventory
assets. A key portion of this is finding a way to reduce the
shipping cost by air. This is the major determinant of the Cost
of Goods Sold which results in a reduced return on inventory
assets with shipments by air.
- Once this stage is completed the MRDC operation should be
concentrated on again to reduce inventory carrying cost, increase
forecasting accuracy, reduce lead times to LACs, and improve
service level.
This investigation was done in ithink 3.0. The ithink model
can be downloaded by clicking here [idm01.zip,
42k].
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Copyright © 2004 Gene Bellinger
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