How much should I make when demand is uncertain? How much should I order? How much is too much when inventory has a shelf life after which it is no longer usable or sellable?
These are uncertain times. For many industries, past sales are no longer valid in predicting future demand. At least not until the economy gets back to a new normal after the pandemic. Demand is way down, or even completely gone in some industries (such as foodservice and travel). Demand is way up or at record levels in other industries (such as PPE and cleaning products).
This is the first in a series of blogs on the topic of lot sizing to determine optimal batch quantity for production or ordering in uncertain times. I’ll explore some of the historical methodologies and some of the newer philosophies. My focus is on adapting these methodologies and philosophies for products with finite shelf life when demand is uncertain.
Economic Lot Sizing (ELS)
The long-standing approach to lot sizing that I learned years ago in Industrial Engineering school is Economic Lot Size (ELS), also known as Economic Order Quantity (EOQ). ELS is an old idea that has been around for over 100 years. With some modifications it still has tremendous potential, even alongside newer production philosophies such as Lean Manufacturing (LEAN), Theory of Constraints (ToC) and Demand Driven MRP (DDMRP).
ELS or EOQ was first developed by Ford Whitman Harris in 1913 to balance the costs of inventory against the costs of setup to minimize Total Cost. Today, some advocates of LEAN and ToC would argue that ELS is dead. Ideally, every operation should manufacture exactly what the downstream customer needs in “batches” of one unit. However, many factories still have significant costs for setup and changeover. Not the least of these is the opportunity cost when a factory is operating near capacity and changeovers take time away from producing needed products.
The other argument some people make against ELS is that holding costs don’t really change with increasing inventory. This is not even true where there is excess warehouse capacity because there is a cost to the working capital tied up in inventory. If your product has a shelf life, then expected cost of obsolescence increases with more inventory. If you use a 3PL that charges storage by the pallet, that certainly is directly proportional to inventory.
In supply chains where factories have significant setup costs, optimizing lot size is still an issue and ELS is a helpful concept. Figure 1 depicts a typical ELS model. For more information on the elements of the ELS model click here.
For most CPG and food companies, there are additional complications of uncertain demand and the risk of obsolescence. In a standard ELS model, both demand and obsolescence risk are assumed to be linear. In reality, demand may vary significantly and the risk of obsolescence for each unit produced increases as inventory increase. Future blogs will show how to adapt ELS for these situations.
What tools do you use for determining lot sizes for production or ordering? How do you consider the risk of obsolescence?
References
Erlenkotter, D. (2014). Ford Whitman Harris’s economical lot size model. International Journal of Production Economics, 155(C), 12-15. RePEc ID: RePEc:eee:proeco:v:155:y:2014:i:C:p:12-15. http://dx.doi.org/10.1016/j.ijpe.2013.12.008 Retrieved from https://escholarship.org/uc/item/4s8482p2
Joong “Joon” Hyun (2017) Hone Your Economic Order Quantity for Improved Results. APICS Magazine
Collin M. Seftel (2014) Rethinking EOQ. APICS Magazine