Purchasing & Inventory Management Hook Up!
PurchTips – Edition # 116 December 27, 2006
By Charles Dominick, SPSM
Will Your Role Include Inventory Management?
A big trend is for organizations to blend their operational functions under the umbrella known as supply chain management. Often, the first two functions to merge are purchasing and inventory management.
So, as a purchasing professional, you must understand inventory management principles to remain valuable.
First, you must know how much inventory to have on hand to ensure continuity of supply in the event of an uncharacteristic increase in either demand and/or lead time. This quantity of inventory is called the safety stock. There is no universally used formula for determining safety stock quantity, but PurchTips Edition 86 suggested a risk averse calculation.
Second, you must know when to reorder materials for inventory. Generally, this point in time is determined when the quantity of materials in stock decreases to a certain level, called the reorder point. The reorder point is determined by the formula:
ROP = SSQ + (QUD x ALT)
ROP = Reorder Point
SSQ = Safety Stock Quantity
QUD = Quantity Used Daily
ALT = Average Lead Time (in days)
Third, you must know how much to order. A complex mathematical equation determines the Economic Order Quantity, or EOQ. The equation recognizes the tug of war between acquisition costs and inventory carrying costs: when you order bigger quantities less frequently, your aggregate acquisition costs are low but your inventory costs are high due to higher inventory levels. Conversely, when you order smaller quantities more often, your inventory costs are low but your acquisition costs are higher because you are expending more resources on ordering. The EOQ is the order quantity that minimizes the sum of these two costs.
Fortunately, inventory management systems calculate the EOQ for you. But if you want to see the EOQ equation, check out my blog post entitled Purchasing and Inventory Management.
EOQ = Economic Order Quantity
ACPO = Acquisition Costs Per Order
AUU = Annual Usage in Units
UC = Unit Cost
CCP = Carrying Cost Percentage
So, if you know that it costs you $150 in overhead per order, you use 5,000 widgets a year, you pay $200 per widget, and your Finance Department tells you that annual carrying costs are equal to 20% of the value of the goods in stock, you should order 194 widgets at a time.