Operations Management / Supply Chain Management

Module 10.03 Key Concepts: Order Point Planning and Other Independent Demand Planning Processess

Economic Order Quantity and the other Lot Sizing methods mentioned earlier are used to determine how much to order.  Now we will explore alternative techniques for determining “when to place and order.”

A simple method is referred to as the Reorder Point approach.  This method requires information regarding the projected demand for a product and the lead time it takes to receive the product after an order is placed.  A little later we will bring in an enhancement required if safety stock is appropriate.  This approach can be utilized for manufactured or purchased products but is generally applied to purchased products.

The simple Reorder Point formula assumes that demand is constant and supplier lead times are always realistic and accurate.  Well, in practical day-to-day life, this is usually not the case.  Safety Stock can be used to protect against these variations in demand and supply.  The text authors propose something that sounds very complicated “Probabilistic Models for Safety Stock.”  In reality this is not that complicated.  Let’s bring this down to the basics.  Remember our previous excursion into the area of Demand Planning and Forecasting, and our evaluation of Forecast Accuracy / Demand Variation?  Also, remember when we talked about variation in the chapter on Quality Management?  Well, all these things come together here in what I might call Reorder Points considering Safety Stock.

There is generally a strong correlation between safety stock and customer service level.  The latter is generally specified by management and expressed as a percentage.  A table has been derived that shows the normal relationship between Service Level % and the variation expressed in terms of Standard Deviation or Mean Absolute Deviation,  The text provides a rather complicated mathematical approach but this table is quite useful and simpler to apply.

Service Level (%) Standard Deviation (Factor) Mean Absolute Deviation (Factor)
50 0.00 0.00
80 0.84 1.05
90 1.28 1.60
95 1.65 2.06
98 2.05 2.56
99 2.33 2.91

Based on the table, Safety Stock = Factor x Calc. Value (Std Dev or MAD)

The Reorder Point Formula can be enhanced with the addition of Safety Stock.

The authors present other options for use when data on demand during lead time is not available for example:

  • When demand is variable and lead time is constant
  • When lead time is variable and demand is constant
  • When both demand and lead time are variable

With Reorder Point Planning the quantity ordered is the same but the period between orders will likely be variable.  There are many valid reasons to change the approach and keep the time between orders the same but adjust the order quantity to maintain a certain target level.  For example, it may be beneficial to place an order once a week, once a month, or something similar.   Orders are thus placed at the end of a fixed period. Inventory counted only at end of period and the subsequent Order brings inventory up to target level.  The only costs considered are those attributable to ordering and holding.  In this case, lead times are expected to be known and constant. Items are expected to be independent of one another.

The Target Level can be manually assigned or derived from a general formula:  Target Level = Demand during Lead Time + Demand During Planning Period (i.e. 1 week) + Safety Stock.