The Financial Implications of Order Lead Times, Order Frequency, and J.I.T.
Charles J. Bodenstab, October 1997

Many suppliers are beginning to offer "Just in Time" (JIT) inventory and delivery programs as they manage to get their own inventory situations under tighter control. This situation can be a boon to you, the distributor, providing that you have a full understanding of the implications of better delivery programs, and you have the systems in place to take advantage of these opportunities. Additionally, the suppliers will often want a slight price increase (and hence a lower gross margin to you) in return for this better service, making the need to capitalize on the new program that much more critical.

I ran a series of simulations to explore this issue further, which are summarized in the table below. The technique of simulating the average amount of inventory needed is similar to the process that I cover in my book "A New Era In Inventory Management" on page 68. The product used in the example has the following characteristics:

Monthly sales volume 400 units
Mean Average Deviation * 50
Cost $30/Unit
Desired Fill Rate 95%

* MAD - which is a measure of it’s variability - a MAD of 50 is an item with fair, but not great predictability

Summary of Various Simulations of Inventory Needed

The above table displays the inventory needed strictly to meet the 95% fill rate, and does not consider lot sizing, pallet requirements, EOQ considerations, discounts being take, etc., to say nothing about the dead stock which constitutes from 20 to 40% of most distributors inventory. Moreover, it assumes the use of a system such as MARS-IW with its strong reorder point calculations. Accordingly, even case #1 above, with the 30-day order frequency, would yield about 19 turns which is well beyond what most distributors enjoy. Consequently, it is the relative performance between the examples that is pertinent for this discussion.

With this qualification in mind, the table highlights a number of issues, but the most significant relates to the order frequency. Note how the amount of inventory needed responds much more aggressively to the reduction in order frequency than to lead time. This phenomena is very logical, since, as the frequency of reordering is increased, most of the product is driven into the pipeline, whereas lead time actually means the product arrives faster and is in your warehouse.

All of this analysis and discussion is academic however, unless you are using an inventory management system that will optimize the opportunities that are being offered to you. Manual reordering, aided only with some printed report that must be visually scanned, can make only some "gut feel" improvement, and will certainly fail to drive the inventory back into the pipeline. Simplistic systems, with their weak reorder point calculations and safety stock determinations will also fail to capitalize on the new opportunities.

The need to take advantage of the improved lead times and order frequency becomes particularly apparent when you consider the economic implications of giving up gross margin to the vendor. If we use the above example, where the product costs $30 a unit and moves at 400 units per month, a drop of 1% point is worth $120/ month in gross margin loss. To offset just this 1% drop in gross margin we would have to drop inventories of that item by 267 units (assuming an 18% carrying cost of inventory). That is greater than the full spread between the best and worst case in the example above.

On the other hand, if the above example were managed by a manual or simplistic system, you would be getting about 6 to 9 turns (if you were lucky) which equates to having about 800 to 530 units in inventory. Now we are talking about a potential reduction of at least 300 units, if not 500 to 700 under the most aggressive of circumstances.

The bottom line of this discussion is that: