2.The formula assumes that the order cost is fixed.
Your actual order cost may vary due to efficiencies related to the supplier. This could include extra costs at your end due to the supplier being inefficient, losing paperwork, hard to contact, requiring follow up, and order expediting. Or the costs could be less due to acceptance of blanket orders, use of electronic methods, and so on. A blanket approach could result in significant overstocking and the calculated ROQ should be reviewed for any orders of a significant value.
3.The formula assumes that the demand is constant.
We have already seen an example where the demand varies significantly over time. If the calculation is performed when the demand is high, the calculated ROQ value will be high and you will be overstocked.
4.The formula assumes one delivery per order, no allowance for scheduling or batching.
Not all orders are delivered in one delivery and each delivery costs you money in terms of workload.
When faced with determining the factors used to calculate the ROQ, it is suggested that values are used that minimize the order quantity rather than maximize the order quantity as this is the lesser of two evils.
If you overestimate, you will spend too much on stock and unnecessarily tie up money or, worse, spend money on items that might never be used. This type of error is rarely addressed because it does not automatically trigger any action. However, if you underestimate your ROQ — and assuming that your ROP is appropriately set — then you will only end up ordering more frequently and this can trigger the need for a review. You can then set the ROQ at a more appropriate level. The effect of different order costs is shown below.
1. Assume that:
Order Cost = $100
Demand = 1,000 per year
Item Cost = $10
Holding Cost = 25%
= 283
Therefore, the ‘economic’ ROQ is 283 items.
This means that this item will be ordered, on average, 3.5
times per year (1,000 per year/ 283 per order).
2.Let’s look at the impact of changing the Order Cost. Assume that:
Order Cost = $50
Demand = 1,000 per year
Item Cost = $10
Holding Cost = 25%
= 200
Therefore, if the order cost is really $50 per order the ‘economic’ ROQ is only 200 items – approximately 30% lower than if the order cost is $100. This means that this item will be ordered five times per year (1,000 per year/ 200 per order).
A Word on Monte Carlo Simulation
Monte Carlo simulation is a complex analytical technique that uses random numbers as input variables and applies them to a known function (or formula). It is reportedly named after the random inputs that occur in table games, such as roulette, at the casinos in Monte Carlo.
With inventory analysis, it removes the constraint of having to make assumptions about the frequency or level of demand as these would be randomly generated values. When used in a computerized simulation, the technique can run through a high number of cycles to demonstrate under which scenarios supply would not be available. From this perspective, it appears to be an attractive option for inventory review and is widely used in the academic analysis of inventory management.
The technique does, however, suffer from the same shortfall in practice that limits most analytical approaches — it does not easily enable consideration of the entire materials and spares inventory management process. Instead, it focuses solely on the mathematical evaluation of the ROP and ROQ settings.
Do You Hold Too Much Inventory?Check Your Stock Turn Ratio
There are a number of measures that get used for tracking inventory performance. One of the most popular measures is stockouts. A stockout occurs when there is demand for an inventory item but there is no stock.
It is essential to measure the availability of stock. After all, that is why the investment is made in the first place. However, measuring stockouts can be a limiting way to measure inventory as it only measures one dimension of inventory, that is, availability. This approach is limiting because one way to ensure a low number of stockouts is to overinvest in inventory so that stock is always available no matter what. This is sometimes referred to as ‘just in case’ inventory.
What Is a ‘Stock Turn’?
Because inventory requires a significant financial investment and that investment involves significant ongoing costs, it is also important to measure the financial performance. Tracking the value of inventory is important for cash management purposes. However, an additional financial measure that often gets overlooked is the stock turn ratio.
The stock turn is calculated by dividing the annual usage of the inventory (in dollars) by the value of the inventory held (also in dollars).
For example, if a company holds $5M worth of inventory and issues $2.5M worth of that inventory in a year, the stock turn ratio is 2.5/5.0 = 0.5. That is, the company turns over its inventory at the rate of one half per year. Obviously, the higher the stock turn ratio, the better.
What Stock Turns Tell You
Stock turns measures the efficiency of the inventory investment by telling you whether you have overinvested in inventory and whether you have the right mix of inventory. (Note, however, that it won’t tell you about specific inventory items.) For example, if the number of stockouts is low (which is good) and the stock turn ratio is also low (which is bad), you have an indicator that there may be an overinvestment in inventory. If the number of stockouts is high (which is bad) and the stock turn ratio is low (which is also bad), then you may have invested in the wrong inventory. That is, your money is tied up in stock that doesn’t turn over and you hold too little of the stock that is in demand.
Stock Turn Targets
An appropriate target for stock turns in your business will be influenced by a range of issues, some within your control and others outside of your control. For example, if you have spares that are imported from somewhere far away or you are in a remote and isolated area, then you are likely to hold more safety stock and, therefore, have a lower stock turn. Conversely, if you are located in a densely-populated area surrounded by similar industry and many suppliers, you should be able to achieve a high stock turn. But this isn’t the whole story because if your processes don’t adequately control decision making on materials and spares inventory stocking, you are also likely have a low stock turn.
Using Stock Turns as a Key Measure
The key thing to remember when using a stock turn ratio is that it must be applied across the entire inventory. You cannot ‘cherry pick’ elements of inventory.