In an inventory model that might include Safety Stock, several terms and concepts come into play. These concepts are as follows:
Demand history – A history of demand broken down into forecast periods. The amount of history needed depends on the nature of your business. Businesses with a lot of slower moving items will need to use more demand history to get an accurate model of the demand. Generally, the more history the better, as long as the sales pattern remains the same.
Forecast – Consistent forecasts are also an essential part of the safety stock calculation. If you don’t use a formal forecast, you can use average demand instead.
Forecast period – period of time over which a forecast is based. The forecast period used in the safety stock calculation may differ from your formal forecast periods. For example, you may have a formal forecast period of four weeks while the forecast period you use for the safety stock calculation may be one week.
Lead time – the amount of time from the point at which you determine the need to order to the point at which the inventory is on hand and available for use. It should include supplier or manufacturing lead time, time to initiate the purchase order or work order including approval steps, time to notify the supplier, and the time to process through receiving and any inspection operations.
Lead-time demand – the forecasted demand during the lead-time period. For example, if your forecasted demand is 5 units per day and your lead time is 10 days your lead time demand would be 50 units.
Lead-time factor – a necessary value used to compensate for the differences between lead time and forecast period. The standard deviation was based on the forecast period, a factor is necessary to increase or decrease the safety stock to allow for this variance. A formula you can try is lead time factor = square root (lead time divided by forecast period).
Minimum Reorder Point – For slow moving products and especially if the lead time is short, you may want to program in a minimum reorder point which is the equivalent of one average sale.
Order cycle – (Replenishment Cycle) The time between orders of a specific item. Most easily calculated by dividing the order quantity by the annual demand and multiplying by the number of days in the year.
Order cycle factor – Longer order cycles result in an inherent higher service level you will need to use a factor to compensate for this. A formula you can try is Order cycle factor = square root (forecast period divided by the order cycle).
Reorder Point – the inventory level which initiates an order. Roughly, the reorder point equals the Lead Time Demand plus the Safety Stock.
Standard deviation – Term used to describe the spread of the distribution of numbers. Standard deviation is calculated by 1) determining the mean (average) of a set of numbers, 2) determining the difference of each number and the mean, 3) squaring each difference, 4) calculating the average of the squares, and, 5) calculating the square root of the average.
Knowlege of the above concepts and terms can better prepare you for inventory management at the highest level and will help you in your planning for boom periods and crunch periods that occur as the economy and business practices change over time. To learn how item replenishment plays a role in your business, contact KCSI today.