Welcome to this chapter on supply management!
In this management course, we will look at the 3 characteristics that you absolutely must know on the subject of supply management.
Concretely, here are the points that I will cover in this course:
- The cost of supply management
- How to optimize supplies?
- How to create a procurement program?
- Conclusion on Supply Management
The cost of supply management
The cost of managing supplies is made up of two elements: the cost of carrying inventory and the cost of placing orders.
The cost of carrying inventory
The cost of holding inventory, also called holding cost, is the sum of all costs, whether direct or indirect, directly related to the possession of an asset.
Here are some concrete examples (non-exhaustive list) of expenses that constitute the cost of ownership:
- loan interest
- remuneration of handling personnel
- storage room rent
- the insurance
- protection costs
- depreciation of the premises
- cleaning costs
- the cost related to heating consumption
- costs associated with the preservation of property
- administrative costs
- equipment
In summary, owning stock involves mastering its financing as well as its management.
The major drawback of carrying cost is that it is totally dependent on the average inventory of the business unit.
Average stock and orders
The average stock formula used in 99% of Management exercises in BTS MCO is the following :
Average stock = (Initial Stock + Final Stock) / 2
The initial stock corresponds to the company's stock in start of period which is usually at the beginning of the year. The ending stock is the stock that the business unit has at end of period.
Mechanically, the average stock decreases when the number of orders increases. Conversely, the more the number of orders decreases, the more the average stock increases.
The pace of orders therefore has an impact on the average stock level.
You will notice that the formula for average inventory is different from that found in the chapter on inventory management.
When the company wants to make forecasts and does not have the elements necessary to calculate the average stock, it can still calculate it using forecasts of its consumption for the period and the number of orders expected for the same period.
Here is the formula that allows you to calculate the average stock without knowing the initial stock or the final stock:
Average stock = Expected consumption for the period / (2 x N)
I would like to point out that by "consumption" you should understand "use". As for the "N" in the formula, it is the variable number of orders. So everything is clear in this formula for you now (well I hope so).
To conclude this part on the cost of possession, I will take two examples of average inventory calculations.
Example No. 1
The company places a single order at the beginning of the period for its annual consumption. Amount of the order: €800.
Let's calculate the average stock using both formulas.
So for the first formula we have: (800 + 000) / 0 = €2
And for the second we have: 800 / (000 x 2) = 1 €
Example No. 2
Miladra places 4 orders during the year for an annual consumption of €800. So Miladra places 000 orders of €4 each.
Let's calculate the average stock using both formulas.
So for the first formula we have: (200 + 000) / 0 = €2
And for the second we have: 800 / (000 x 2) = 4 €
These two examples clearly show you that the rate of orders has consequences on the average stock.
Average inventory and carrying cost
Above, we saw that the cost of ownership was calculated in value. In fact, this is not always the case. Indeed, it is generally accepted that storage costs are proportional to the value of the stock.
The cost of ownership is therefore expressed as a percentage of the average stock.. This percentage greatly facilitates forecast calculations.
So we can calculate using the following formula the Ownership rate :
Holding rate = Holding cost in value / Average stock in value
Example of using the possession rate
The costs associated with holding Miladra's stock amount to €60 and its average annual stock is €000.
Applying the possession rate formula we have:
Ownership rate = 60 / 000
Possession rate = 0,06 or 6%
This rate will be used to assess the cost of ownership for the future year.
The cost of placing an order
The cost of placing an order, also called launch cost, is the sum of all costs (preparation, shipping and follow-up) associated with placing an order.
Here are some concrete examples (non-exhaustive list) of expenses which constitute the cost of award:
- shipping
- study fees
- personnel expenses (business manager, secretary, etc.)
- telecommunication costs
- stationery costs
- supplier visit costs
What is the cost of supply management?
The cost of managing supplies is nothing more or less than the sum of the cost of carrying inventory and the cost of placing orders.
Cost of supply management = Cost of ownership + Cost of handover
Management cost and number of orders
We will see in the following table how the management cost behaves when the orders vary:
| Number of orders | Cost of passing | Cost of ownership | Management cost |
|---|---|---|---|
| 1 | €12 x 1 = €12 | €1 x 000% £60 | 12 € + 60 € £60 |
| 4 | €12 x 4 = €60 | €100 x 000% £6 | 60 € + 6 € £6 |
| 150 | 12 € x 150 = 1 € | [€800 / (000 x 2)] x 150% = 160 € | 1 € + 800 € £1 |
From the results, it can be stated that the more the number of orders increases, the more the cost of supply management decreases.
How to optimize supplies?
Preventing shortages
In terms of stock, when we use the term shortage, this implies that we are talking about a stock shortage.
Out of stock is when an item can no longer be sold temporarily because it is out of stock. The item usually for sale is unavailable.
In this case, the business unit suffers not only a loss of turnover but also a loss of margin.
Constraints related to the volume of supply
Overstocking
In order to avoid stock shortages, the business unit may order a much larger number of items than its actual needs.
But this type of supply involves physical, financial and commercial constraints.
Indeed, the company may not be able to sell all of its inventory if customers are no longer there. In addition, the company will need to have a large space to store all the items while financially coping with the high cost of ownership.
Understorage
Conversely, if the company wants to order more often but in small quantities, the cost of placing the order is likely to be very high.
The business unit manager must therefore avoid stock shortages while controlling management cost elements.
Stock levels
Le minimum stock is the stock that allows you to last until the next delivery.
Le safety stock is the stock that allows you to deal with unforeseen events such as delivery delays or sharp increases in sales.
Le alert stock (or critical stock) is the addition of the minimum stock and the safety stock. It is a volume of stock that triggers an order. It is also called the reorder point.
How to create a procurement program?
A supply schedule is a forecast table which makes it possible to determine, based on forecast sales, order dates, delivery dates and quantities delivered for a specific future period.
Wilson Model
The Wilson model is used to determine the optimal quantity to order and the optimal number of orders calculated using the holding rate and the cost of placing. The objective of this model is to minimize the overall cost of supply management.
Here is the formula for the optimal number of orders to order:
with:
- N: number of orders to place
- C: consumption of the period
- PU: unit purchase price
- T: ownership rate
- P: cost of placing an order
And here is the formula for the optimal quantity to order:
with:
- Q: Optimal quantity to order
- C: consumption of the period
- N: optimal number of orders
Knowing that demand is certain and regular, we can determine the minimum management cost as follows:
- Consumption of the period: 36
- Cost of placing an order: €30
- Unit purchase cost: €2,60
- Ownership rate: 4%
- Optimal number of orders: 8
- Optimal quantity: 4 items
The optimal number of orders is 8 and the optimal quantity is 4 items.
Part 1 of the table:
| Number of orders | Average stock quantity | Average stock in value | Cost of ownership |
|---|---|---|---|
| 1 | 36 / (000 x 2) = 18 000 | 18 000 x 2,60 £46 | 46 800 x 0,04 £1 |
| 2 | 36 / (000 x 2) = 9 000 | 9 000 x 2,60 £23 | 23 400 x 0,04 = 936 € |
| 3 | 36 / (000 x 2) = 6 000 | 6 000 x 2,60 £15 | 15 600 x 0,04 = 624 € |
| 4 | 36 / (000 x 2) = 4 500 | 4 500 x 2,60 £11 | 11 700 x 0,04 = 468 € |
| 5 | 36 / (000 x 2) = 3 600 | 3 600 x 2,60 £9 | 9 360 x 0,04 = 374,40 € |
| 6 | 36 / (000 x 2) = 3 000 | 3 000 x 2,60 £7 | 7 800 x 0,04 = 312 € |
| 7 | 36 / (000 x 2) =2 € | 2 571,43 x 2,60 £6 | 6 685,72 x 0,04 = 267,43 € |
| 8 | 36 / (000 x 2) =2 € | 2 250 x 2,60 £5 | 5 850 x 0,04 = 234 € |
| 9 | 36 / (000 x 2) £2 | 2 000 x 2,60 £5 | 5 200 x 0,04 = 208 € |
| 10 | 36 / (000 x 2) £1 | 1 800 x 2,60 £4 | 4 680 x 0,04 = 187,20 € |
Second part of the table:
| Cost of placing orders | Cost of supply management | Economical quantity to order |
|---|---|---|
| 30 x 1 = €30 | 1 + 872 £1 | 36 000 / 1 = 36 000 |
| 30 x 2 = €60 | 936 + 60 = 996 € | 36 000 / 2 = 18 000 |
| 30 x 3 = €90 | 624 + 90 = 714 € | 36 000 / 3 = 12 000 |
| 30 x 4 = €120 | 468 + 120 = 588 € | 36 000 / 4 = 9 000 |
| 30 x 5 = €150 | 374,40 + 150 = 524,40 € | 36 000 / 5 = 7 200 |
| 30 x 6 = €180 | 312 + 180 = 492 € | 36 000 / 6 = 6 000 |
| 30 x 7 = €210 | 267,43 + 210 = 477,43 € | 36 000 / 7 = 5 143 |
| 30 x 8 = €240 | 234 + 240 = 474 € | 36 000 / 8 = 4 500 |
| 30 x 9 = 270 € | 208 + 270 = 478 € | 36 000 / 9 4 000 |
| 30 x 10 = 300 € | 187,20 + 300 = 487,20 € | 36 000 / 10 = 3 600 |
Interpretation of the table: When the company places 8 orders with a quantity of 4 items, the management cost is at its minimum. From 500 orders, the management cost starts to rise again.
When the company anticipates irregular sales, two methods can be applied to calculate order dates as well as delivery dates: the reorder point method and the calendar management method.
Control point method
In the previous section, we assumed regular forecast sales. In the reorder point method, the supplier imposes the quantity on the business unit when placing an order.
Therefore, the company places an order when the alert stock is reached.
Alert stock = minimum stock + safety stock
Here is an example to illustrate this method.
The initial stock is 60 items. The alert stock is 250 items. The supplier requires ordering in batches of 300 items. The reference period is the week.
The sales forecasts (= consumption) are as follows: 140 in week 1, 110 in week 2 and 140 in week 3.
I will calculate the final stock at the end of the first week:
The theoretical final stock is: 60 (initial stock) – 140 (consumption) or – 80 items. This corresponds to a stock shortage.
You must therefore place an order for 300 items (quantity imposed by the supplier).
By placing this order, the final corrected (or actual) stock is: – 80 (theoretical final stock) + 300 (order) or 220 items.
Here's how to summarize the situation in a table:
| Element | Week 1 |
|---|---|
| Initial Stock | 60 |
| consumption | 140 |
| Theoretical Final Stock | - 80 |
| Delivery | 300 |
| Final Stock Rectified | 220 |
I will now calculate the final stock at the end of the second week:
The theoretical final stock is: 220 (final stock of week 1 which becomes the initial stock of week 2) – 110 (consumption of week 2) or 110 items. The value is positive so there is no stock shortage. But the stock quantity is less than the alert stock (250 items), so an order must be placed.
You must place an order for 300 items (quantity imposed by the supplier).
By placing this order, the final corrected (or actual) stock is: 220 (theoretical final stock) + 300 (order) or 520 items.
Here's how to summarize the situation in a table:
| Element | Week 2 |
|---|---|
| Initial Stock | 220 |
| consumption | 110 |
| Theoretical Final Stock | 110 |
| Delivery | 300 |
| Final Stock Rectified | 520 |
I will now calculate the ending stock at the end of week 3:
The theoretical final stock is: 520 (final stock of week 2 which becomes the initial stock in week 3) – 140 (consumption of week 3) or 380 items.
The value is positive so there is no stock shortage. In addition, this week 3, the quantity of the theoretical final stock is greater than the alert stock (250 items), so no order should be placed.
The actual final stock is therefore not modified..
Here's how to summarize the situation in a table:
| Element | Week 3 |
|---|---|
| Initial Stock | 520 |
| consumption | 140 |
| Theoretical Final Stock | 380 |
| Delivery | 0 |
| Final Stock Rectified | 380 |
Here is now a summary of the 3 weeks:
| Element | Week 1 | Week 2 | Week 3 |
|---|---|---|---|
| Initial Stock | 60 | 220 | 520 |
| consumption | 140 | 110 | 140 |
| Theoretical Final Stock | - 80 | 110 | 380 |
| Delivery | 300 | 300 | 0 |
| Final Stock Rectified | 220 | 520 | 380 |
And so on…
Calendar management method
The calendar management method consists of placing orders based on delivery dates imposed by the supplier. The quantity desired by the commercial unit is free.
I will take an example to illustrate this method of calendar management.
The safety stock is 135 items. The supplier requires delivery every 3 weeks.
| Element | Week 1 | Week 2 | Week 3 |
|---|---|---|---|
| Initial Stock | 60 | 385 | 275 |
| consumption | 140 | 110 | 140 |
| Need | 140 + 110 + 140 + 135 = 525 | - | - |
| Order date | 3 weeks ago | - | - |
| Quantity delivered | 525 - 60 = 465 | 0 | 0 |
| Final Stock | 60 - 140 + 465 = 385 | 385 - 110 = 275 | 275 - 140 = 135 |
Explanations Week 1 :
Need: The business unit has to cope with 3 weeks without delivery and therefore 3 weeks of consumption. This is why I add the consumption of weeks 1 to 3. In addition, the safety stock of 135 items must be taken into account.
Quantity to be delivered: this is the difference between the requirement and the initial stock
Final stock: initial stock – consumption of the week + delivery of the week
Explanation Week 2 :
Initial stock: this is the carryover of the final stock from the previous week.
Final stock: initial stock – consumption of the week
Explanation Week In 3:
same week 2
In week 4, the business unit is delivered and must plan for the week that begins and the two that follow as indicated in the following table:
| Element | Week 4 | Week 5 | Week 6 |
|---|---|---|---|
| Initial Stock | 135 | 475 | 315 |
| consumption | 100 | 160 | 180 |
| Need | 100 + 160 + 180 + 135 = 575 | - | - |
| Order date | Week 1 | ||
| Quantity delivered | 575 - 135 = 440 | ||
| Final Stock | 135 - 100 + 440 = 475 | 475 - 160 = 315 | 315 - 180 = 135 |
Conclusion
Future-proofing programs do not actually reduce the cost of managing supplies. They only help prevent stockouts.
There you have it, now you have mastered the chapter on supply management. You no longer have any excuse not to achieve your goal: Getting an excellent grade on the Operational Management test!
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