Whenever we think of cost for making a product the first thing that comes to our mind is Material Cost and undoubtedly it’s the heaviest cost incurred by any manufacturing company due to which we try to minimise it. Inventory is nothing but assets of organisation which requires investment. Every investment has a cost attached to it and if we invest huge in inventory we will have to lose an opportunity of investing these funds elsewhere and earn something but if we are low on investment in inventory we tend to loose on sales. Think of being a trader of any commodity you will definitely feel the above words. So now we not only have to think on how much to invest in inventory (HOW MUCH TO ORDER) but when to invest (WHEN TO ORDER). We hereby only discuss the TIME at which one should place an order i.e. WHEN TO ORDER.
In the age of technological transformation, where everything around you is getting connected to internet & gradually people have started to adopt to so many things that one couldn’t even imagine at the start of 20th Century. So many businesses are solely operating over the internet and goods, commodities, services and what not are sold just over a click and the interesting fact is that revenue is crossing millions with ease. So let me ask you this before we go ahead; have you ever ordered & received any product instantly or within an hour or so? If your answer is no, than how much time it generally takes? You might answer, it depends on the fact that how far the supplier is situated, or whether the goods ordered already manufactured or under process, or the availability & efficiency of staff in respect of the transport company all of which is calculated and considered in delivery time. All these reasons sum up for you not getting your products instantly. One more question which I would like to through up is – if in the above case you ordered medicines (please assume any commodity being necessity which you consume regularly). Would you order the tablet after consuming everything you had knowing that supplier would at least take a week to deliver? No ways. So next question that comes up is when to place the order for medicines? One week before what else. Frankly, the seriousness of the answer depends on the product ordered. Talking about medicines only, if we can’t skip them even for a day than your answer would require some help in regards to the trust you place upon the supplier, past delivery records to add on or just to be safe at your end, you would definitely place the order at least 10 / 12 / 14 days before the tablet exhaust. Medicine for you is similar to raw materials for a manufacturing company.
Another way to look at it may be from a trader point of view – Have you ever noticed a shopkeeper getting out of stocks and then ordering the required products? No, because it’s basic that the supplier will not & practically cannot deliver goods on immediate basis and thus would lose on sales and reputation both.
Lastly, if we talk in respect of a manufacturer producing variety of products & requiring numerous raw materials it becomes utmost important to procure every single raw material in required quantities and at proper time because they are procured from various other states and sometimes beyond national frontiers. So the TIME AT WHICH WE PLACE ORDER becomes essential part so that we don’t end up facing stock outs because this would be the worst situation for any company where the workers are coming to factory and they don’t have stocks to produce the goods. In order to tackle this we learn a concept of RE- ORDERING LEVEL also called as WHEN TO ORDER.
DEVELOPMENT OF CONCEPT
Few things to start with: 1. The company should know how many units should be ordered every time learnt from the theory of EOQ which can be EOQ itself or any other quantity which the firm might order at which the total inventory associated cost for them lower which is called as RE – ORDERING QUANTITY (ROQ) 2.The time when we place an order depends on the following two concepts:
The word consumption in general means the act of using or eating something. If we keep on consuming ice creams on a daily basis than it won’t take much time for us to be placing a new order for it. But for products which are hardly consumed we don’t even bother to order them for months. So one trigger that would help us calculate When To Order is the velocity with which the goods are consumed. Consumption for a manufacturing company stands in respect of raw materials that are consumed while producing the goods. Higher the consumption sooner will be the requirement of raw materials and vice versa. Moving ahead, consumption majorly depends upon the demand of a particular product. Since demand is never certain it is practically very difficult to predict that how many units we will consume in the coming month or so. To overcome this we take our past records as a base and categorise consumption into maximum, minimum & average. Maximum consumption refers to the highest quantity of raw materials consumed in a given period (may be a week, a month or a year) whereas minimum refers to the lowest and average being total consumption divided by the respective period. All these data are picked up from the past on a presumption that the same will continue in future.
The time lag between one orders and gets the goods is called as lead time/delivery time. This lead time is never constant and hence we categorize it as maximum, minimum & average lead time. Maximum lead time refers to the longest duration taken for delivering the goods in a given period (may be a week, a month or a year) whereas minimum refers to the shortest and average being total lead time divided by the respective period. All these data are again picked up from the past on a presumption that the same will continue in future.
DERIVATION OF FORMULA
RE ORDER LEVEL helps us to identity the level at which one should place order. Now if you to frame the formula than definitely your answer would be more than zero and the correct answer would be the level where the company does not face stock out. As a businessman we always think for the best and prepare ourselves for the worst. In the similar manner, ROL is computed using worse possibilities. Worst thing for a company would be that factories are consuming its maximum and suppliers are taking the maximum time for supplying and in this scenario to safeguard ourselves from any unforeseen circumstance i.e. shortage of goods we keep our ROL as follows:
ROL = MAXIMUM CONSUMPTION x MAXIMUM LEAD TIME + BUFFER STOCK (If any)
Buffer stock here represents the minimum level of stock the company should always have for meeting emergency supplies and therefore added to the above formula.
APPLICATION OF ROL
If stocks touch this level, time for “YOU” to be ordering goods. YOU here stands for purchase manager as he is solely responsible for ordering the goods. Do remember, that once we have set the ROL purchase managers should always order at that ROL only. He should not order before or after this level. Ordering before would increase carrying cost as we have already prepared for the worst and ordering after would make it risky for the company and there might be a chance that the company faces stock outs. In order to keep a check on him, we calculate two other stock levels one being maximum stock level and other being minimum stock level.
MAXIMUM STOCK LEVEL
This level helps the company to check whether the purchase manager has not ordered before stock touches ROL.
FORMULA = ROL – (MINIMUM CONSUMPTION X MINIMUM LEAD TIME) + ROQ
Explanation: If we order at ROL (which should always be the case) and want to know the maximum stock level it is very obvious that we will deduct the minimum consumption and take the minimum lead time of supplier and after we are done with this; the supplier would come up with the requisite stock i.e. ROQ which would be added up to get our answer.
MINIMUM STOCK LEVEL
This level helps the company to check whether the purchase manager has not ordered after ROL.
Formula: ROL – (AVERAGE CONSUMPTION x AVERAGE LEAD TIME)
Explanation:Explanation: If we order at ROL and want to know the minimum stock level we are reducing average consumption & average lead time because if we reduce maximum consumption and maximum lead time we would arrive at buffer stock which would not be much helpful to catch purchase managers.
AVERAGE STOCK LEVEL
Mathematically calculated as (MAXIMUM STOCK LEVEL + MINIMUM STOCK LEVEL) / 2
But a better way to calculate is = MINIMUM STOCK LEVEL + ROQ / 2
The most lucid way to understand this concept is to look at the meter of fuel engine in your bike, car or any transport vehicles. If the meter is towards “F” we hardly bother but as soon as it keeps on drifting towards the “E” we start thinking that when should we refill the fuel? Even after that also if we don’t refill the fuel the Blink of Fuel indicator is the last warning that the vehicle gives us to refill and at this time we should quickly refill our fuel. This is nothing but Danger level.
ROL is the best opportunity for the company to order whereas Danger level is the available opportunity to order and still be safe. At this time stock positions are very low and we tend to procure stocks by paying something extra in cash for speed delivery. This time is called as emergency lead time.
Formula: AVERAGE CONSUMPTION X EMERGENCY LEAD TIME
We have learnt various formulas as stated above but do remember businesses are never run by formulas but all these helps the businessman to make an informed and correct decision as these formulas don’t work under extreme cases.