My  last blog introduced the factors to consider when determining  whether an item should be Make-to-Order (MTO) or Make-to-Stock (MTS).  This blog proposes a step-by-step process for evaluating those factors.

Service Considerations

There are there are typically two primary reasons for holding finished goods inventory of an MTS item:

• To assure service delivery requirements
• To provide cost savings

The first consideration is whether production can reliably supply product in time to meet customer demand.  Inventory is necessary in any of the following situations:

• If production output is uncertain,
• if it can take longer to produce than customers are willing to wait, or,
• if there is a competitive advantage to responding quickly to unexpected customer demand.

However, the inventory may not need to be held in finished products.  Are there intermediate components that lend themselves to being stored as Work in Process (WIP)?  If so, and if the WIP can reliably be turned into finished product in time to meet customer demand, this may present an opportunity to reduce or eliminate finished goods inventory.   

If production can reliably deliver product in time to meet customer demand (whether from WIP or raw materials), the next consideration is cost.  MTS items generally will have higher inventory costs and MTO items generally will have higher production costs.

Cost Considerations

Inventory costs are generally higher for MTS over MTO as MTS requires both safety stock and cycle stock.  Inventory costs include storage costs, cost of working capital, and risk of obsolescence.  Variability of supply and demand also impact cost as they affect the level of safety stock required. 

Production costs are generally higher for MTO over MTS as there are additional setup costs for production changeovers required whenever customer orders are received.   The cost trade-off for each item then comes down to comparing the incremental setup costs for MTO to the inventory costs for MTS.  

System Constraints

Once the analysis is complete at an item level, it is necessary to consider any system constraints that might impact the combined MTO/MTS decisions.  If production capacity is constrained, it may be necessary to limit changeovers, resulting in fewer MTO items.  Constraints on storage capacity or working capital might limit total inventory, resulting in more MTO. 

Heuristic for determining MTO vs. MTS.

Service considerations, cost considerations, and system constraints may be evaluated sequentially using this heuristic. First service and cost are analyzed at an item level (see figure 1), then system constrains are evaluated at an aggregate level (see figure 2).

A. Evaluate Demand and Service

1. An item should be MTS if either of the following are true:
   • There is an opportunity to a capture significant additional business by having inventory on hand.
   • Production is unable to reliably deliver product within customer order lead-time.
2. If neither of above are true, proceed to cost analysis.

B. Evaluate Cost Factors

1. Calculate MTS safety stock (SS) based on production and demand variability, considering backorder costs incurred for stock outs.
2. Calculate MTS Economic Lot Size (ELS), considering Setup costs and obsolescence risk (see my prior blog  Economic Lot Sizing with Variable Demand).
3. Calculate expected average inventory for MTS. 
   • I_MTS = SS + ELS/2
4. Calculate annual holding cost for MTS.
   • H_MTS = I_MTS * [storage cost/lb. + (standard cost/lb. * cost of capital) + Obsolescence risk]
   • Subtract holding costs for any unique ingredients with long lead-time that must be kept in inventory.
   • Obsolescence risk may not be linearly related to inventory levels for perishable items with variable demand. In this situation, the cost calculations are more complex. For more on this topic, see Economic Lot Sizing with Variable Demand.
5. Calculate the number of annual setups (Setups) that would occur if item were MTO.
   • S_MTO = number of weeks with shipments greater than 0 in past 52 weeks.
6. Calculate the number of additional annual setups for MTO
   • A_MTO = S_MTO – Annual demand/ELS
7. Calculate the cost impact for MTO
   • C_MTO = A_MTO x cost/setup – H_MTS
   • If C_MTO is less than zero, there is a savings for changing to MTO.
8. Rank items by cost impact for MTO (for use in steps 3 and 4)

C. Evaluate Capacity Constraints

1. Calculate total annual load by production line
   • L = Total lbs. / throughput rate + Total number of setups x time per Setup
2. If total annual load exceeds line capacity, shift one MTO item at a time to MTS until capacity constraint is solved. Start with items with smallest negative value for C_MTO.  Alternatively, if a secondary line is available at a cost impact, compare that cost to C_MTO.  Shift enough items to alternate lines or to MTS to balance load with capacity.

D. Evaluate Working Capital and Storage Constraints

1. If total expected inventory of raw materials, WIP, and finished goods exceeds working capital constraints or storage space constraints, shift one MTS item at a time to MTO until constraints are solved.  Start with items where C_MTO is zero or positive but close to zero, but exclude any items that require inventory for service reasons (test 1 above). Shift enough items to MTO to balance projected inventory levels with constraints.
2. If working capital and capacity constraints are both violated,
   • Attempt to solve for constraints using an optimization tool such as Excel Solver.
   • If optimization tool cannot satisfy both capacity and working capital constraints, either additional capacity is needed or working capital constraints need to be renegotiated.

Spreadsheet tool for determining MTO vs. MTS.

A spreadsheet template with some example data is available at: MTO-v-MTS-index-example. This spreadsheet covers the steps for 1 and 2 above for a preliminary determination of MTO or MTS. 

Columns AM through AU of the spreadsheet evaluate obsolescence risk for perishable items with variable demand. If the value in column AU is significant, a more detailed cost analysis is necessary before committing MTS. For more on this topic, see Economic Lot Sizing with Variable Demand.

Once completed, sort the spreadsheet by column to prioritize items when evaluating constraints in steps 3 and 4.

For assistance with these calculations or further customization, please contact info@shivesupplychainsolutions.com.