Managing the Frequency of Purchase Orders
Over the past several months, we have been reviewing the critical components of determining when to order a product and how much to order. This month we continue our discussion with the order cycle (also known as the review cycle).
In order to avoid stockouts, you must reorder products when you still have enough stock remaining in inventory to satisfy customer demand during the anticipated lead time. You also might want to keep some safety stock just in case you sell or use more than you forecast or there is a delay in receiving a replenishment shipment. The result is the “order point” formula:
Order Point = (Anticipated Lead Time * Forecast Demand/Day) + Safety Stock
Often you can’t order just one item by itself. You must place a certain size order to get the discounts or terms that allow you to competitively sell the vendor’s products. This is known as a target order requirement. An order cycle (also known as a review cycle) is the amount of time it takes for you to sell or use enough of a supplier’s products to meet their target order requirement.
We have often observed that many organizations have used the same order cycles for many years. One of our clients used a 30 day order/review cycle with one of their major suppliers because “that is the way we’ve always ordered products from that vendor.” But after a quick analysis we discovered that they could place an order every 14 days that met the vendor’s target order requirement. Using a 30 day order cycle was causing them to not only overstock products but also had a detrimental effect on customer service. That has resulted in more out of stock situations and delays in delivering products to customers.
Overstock – Because they were only placing an order with the vendor every 30 days, they had to order a minimum of a 30 day supply of each item ordered from the vendor, even if the economic order quantity (EOQ) for a particular product represents only a 14 day supply. After all, ordering a 14 day supply of a product every 30 days will not result in great customer service. But they could order a 14 day supply every 14 days. Not only will this avoid overstocking (i.e., ordering a 14 day instead of a 30 day supply) but because the EOQ is your lowest “total” cost quantity for an item you will maximize your profitability! Note – we will begin our discussion of the EOQ in November’s newsletter.
Detrimental Effect on Customer Service – What if a customer orders a non-stock or special order in this vendor line or you experience an unusually large sale of one of the vendor’s products? It might be several weeks before you can include these items on the next replenishment order you place with the vendor. Your customer has to wait longer for delivery.
It is critical that you calculate and maintain accurate order cycles for each supplier. Divide your purchases from the vendor over the past 12 months (including non-stock products) by the vendor’s target order requirement. The result is the projected annual number of purchase orders you can place with the vendor. For example if you ordered $250,000 worth of material from the vendor over the past year and the vendor has a $5,000 target order requirement you will probably be able to place 50 orders with the vendor each year or about one every seven days:
$250,000 ÷ $5,000 = 50 Purchase Orders
365 Days ÷ 50 Orders = 7.3 ≈ 7 Day Order Cycle
Accurate order cycles are critical to achieving the goal of effective inventory management. Next month we will continue our discussion of order cycles examining problems associated with unrealistically short order cycles.