Tuesday, August 3, 2010

Best Practice: Setting the Min -- Reorder Point (ROP)

By Dr. Barry Lawrence, Texas A&M University

Senthil Gunasekaran, Texas A&M University

Pradip Krishnadevarajan, Texas A&M University

The most difficult purchasing process to understand is setting the Reorder Point (ROP) also known as the “min.” The ROP will constitute the vast majority of the distributor’s inventory and will determine the most important critical success factor, customer service. Each product has an ROP that is often determined by some form of guesswork. Customer expectations have increased over the past 20 years along two axes: availability and selection. Increased availability means a larger ROP. Increased selection means more ROPs. Both mean more inventory. A larger offering leads to many slow-moving products. Slow-moving products often have ROPs that are very high, compared to sales, which leads to inventory increasing at a faster rate when adding new products.

The current No. 1 best-selling NAW Institute for Distribution Excellence book, Optimizing Distributor Profitability: Best Practices to a Stronger Bottom Line (available at http://www.naw.org/optimizdistprof), details best practices, their implementation, and ROI. These practices are valid in any economy, but the significance of one best practice versus another may change under different market conditions. Each month in this blog, we have introduced a best practice and how it can improve earnings and/or ROI under current economic conditions. We encourage you as you participate in this blog to ask questions, debate results, and offer your own experiences with such practices, so that we may further the knowledge of the community and the understanding of the science of distribution.

The book breaks business processes into seven groups (SOURCE, STOCK, STORE, SELL, SHIP, SUPPLY CHAIN PLANNING and SUPPORT SERVICES) based on various distributor asset categories. This month, we focus on STOCK as shown in exhibit 1.

Best Practice: Setting the Min (ROP)

The ROP is usually determined by one of two methods: an estimate made by a purchasing specialist or by the information system after receiving input from a purchasing specialist. The first process is static in that it does not change over time unless the purchasing person revisits it. In many distributor environments, this is impractical due to the large number of products. The second process is not static, since the system will change the ROP as the forecast and, perhaps, supplier performance changes. Both methods fall far short of what is possible from both a calculation and relationship management best practice standpoint, however.

We will explore the levels of best practice, the value they provide, and what differing members of the organization must do to achieve the best results.

The practice levels for “Setting the Min” are as follows:

COMMON practice: 1) Fixed percentage of safety stock 2) Multiplier set by planner 3) Standard days of supply 4) Service driven (expediting) 5) Static lead time by planner 6) No forecast error in ROP 7) same service level for all items.

GOOD practice: 1) Statistical replenishment 2) Lead time variability measurement 3) Demand variability measurement (forecast error) 4) Service levels driven by inventory stratification.

BEST practice: 1) Dynamic safety stock 2) Actual demand distributions 3) Multi-echelon inventory optimization 4) Service level determined by inventory stratification and financial constraints (service vs. cost matrix).

The common practices have a great deal of guesswork and tend to be slow to respond to market changes. Take for example the popular standard “days of supply.” The firm determines how many days of inventory it wants to carry and sets up rules that may or may not vary by product type or sales. When supply becomes uncertain due to products going on allocation or disruptions in shipping, customer service failures will occur until someone adjusts the rules. If the days of supply requirement was set high due to poor supplier performance or forecasting difficulty, the days of supply may not get adjusted at all when things improve, thus leaving the firm with too much inventory. All of the common practices lack responsiveness, which leads to customer service failures and/or excess inventory (usually both).

Good practice considers changes in the key inventory drivers, lead-time, and forecast performance, and ties the service level to inventory stratification. The ROP moves with changes in the inventory drivers and reduces or increases inventory thereby preventing stockouts while holding down inventory.

Best practice engages more of the firm’s resources to guarantee a high ROI. In addition to changing the ROP as business conditions change and products gain or lose popularity, best practice uses hub-and-spoke techniques to further reduce inventory. Best practice also treats all inventories as an investment that is measured against other opportunities before deployment. The role of ROP in the replenishment process is shown in exhibit 2.

A home products distributor improved its reorder point and resulting inventory levels in stages. At the beginning of the process, the firm had very large inventories with most products carried in all locations. Gross margin return-on-inventory investment (GMROII) for the entire firm was at 170%. The firm was under extreme pressure by ownership to increase its ROI. The company implemented inventory stratification, statistical reorder points, hub-and-spoke, and a new value proposition for the sales force to deliver.

The first step, inventory stratification, involved using a combination process, as described in the Optimizing Distributor Profitability book, to determine inventory status. The inventory management model is shown in exhibit 3.

“D” items were first removed from inventory resulting in an increase in GMROII to 220%. The next step was to improve forecasting and set dynamic ROPs. The process involved combination forecasting, which we’ve described in our previous blog posts. By tying forecasting improvement to a dynamic ROP (one that changes when forecast and supplier performance change), the firm was able to further improve its GMROII to 235% as safety stocks declined. No attempt was made to improve supplier performance.

The next step was multi-echelon inventory management. The firm first went about consolidating “C” item inventory into Regional Distribution Centers (RDCs). “C” items at branch level would be held at the RDC and removed from the branches. This process involved a great deal of inventory and increased GMROII to greater than 280% after implementation. The reduction was driven by the “square root rule of inventory” where inventories combined from multiple locations will reduce to the square root of the number sites the item is taken from times the average inventory per site.

An example: The firm combined three locations’ “C” inventories into one RDC. Each location had an average “C” inventory of $800,000. The new inventory eventually settled at the RDC at $1,385,000 (square root of 3 times $800K) from the original $2,400,000 (three sites at $800K), a reduction of $1,015,000. Hub-and-spoke essentially reduces the ROP to zero at the branch and moves it back to the RDC. The RDC is able to operate with far less inventory by sales volume since the larger volume leads to better forecasting and supplier performance. Safety stock also gets combined allowing for further reductions.

The final step was to develop a value proposition for the sales force. The changes might cause customers to become concerned that service would decline. The firm designed a value proposition built around reinvesting in “A” inventory. The sales force message was: “We are increasing our fill rates on our most important items (examples listed here) that you use the most. To do so, we will consolidate items you rarely or never use (more examples here). I’ll work with you on those items to make sure you can get them quickly when you need.”

The net effect was a reduction on inventory of $25,000,000 even after increasing “A” item inventory. The increase in “A” items more than compensated for the decreased inventory in “D” items. Fill rates increased as a result leading to an increase in sales. The company had calculated its inventory holding cost at 40%, so the overall impact of the program was a $10,000,000 increase in the bottom line. Earnings increased by nearly 80%.

The most important component was the value proposition delivered by the sales force. The firm had to invest in inventory training for salespeople as well as for operations people. Management had to go through a paradigm shift since they had never considered training the sales force on operations issues before.

The process included many tools (forecasting improvement, inventory stratification, value proposition development, etc.), but the key issue was tying all these things to the ROP. Many firms implement improvements without considering this all-important issue. How will it impact the min? Developing a plan for that process is key to all inventory improvement plans.

About this Blog

“Managing in an Uncertain Economy” is a blog created by the Council for Research on Distributor Best Practices (CRDBP). The mission of the CRDBP, created by the NAW Institute for Distribution Excellence and the Supply Chain Systems Laboratory at Texas A&M University, is to create competitive advantage for wholesaler-distributors through development of research, tools, and education. CRDBP encourages readers of this blog to send in comments and e-mail this blog to other interested parties.

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