The Origins of Order Point
What was inventory management like before MRP?
Before MRP was introduced, the most popular inventory management approach was called Order Point. The main limitations were within companies — that is, the market often wanted more than a company could build. Everything that was produced could and would be sold. Therefore, the main question was how to effectively meet market demand. There were few SKUs in the assortment, products were not complex, and product lifecycle was long. Sometimes, items were produced for decades without any modifications.
What did that mean for inventory management? Companies had a few SKUs, with a stable demand and BOM (Bill of Material) that created a predictable demand for components. These uncomplicated, stable, linear systems were much easier to manage and optimize it. That is when the concept of EOQ (Economic Order Quantity) came up, which often became a part of the Order Point system.
Understanding Economic Order Quantity (EOQ)
If we assume that Demand, Ordering, and Holding Costs are known and do not change over a period of time (usually a year), we could calculate the point where Total Holding Cost will be minimized. That’s the logic behind the classic version of EOQ. Modern EOQ implementation practices typically use more complex formula extensions that add more variables to the equation. But the initial assumption — that Demand and Cost are known and do not change — remains.
In our VUCA world, the number of SKUs in assortment, product, and supply chain complexity is growing, while product lifecycles are shortening and customer demand is anything but known and stable. Unfortunately, we use formulas for a world that no longer exists. Usually, the results of the implementation of EOQ logic in modern manufacturing enterprises leads to enlarged production batches, which makes a company misuse its production capacity and materials. The most common results are higher OOE (overall operations effectiveness), less agile production planning and increased inventory levels.
The good news? After a typical EOQ project, there is room for improvement with DDMRP. (Learn how Kormotech moved from EOQ’s implementation to DDMRP).
But first, let’s take a look at how Order Point and EOQ work.
EOQ and Order Point
How does the order point work? Take a look at the figure below, which shows the EOQ & Order Point. The idea is straightforward. When total inventory levels, plus items that are “on order,” reach a certain level, a new supply order is generated. How much should we order? Look at the EOQ.
How is the order point calculated? This is usually the consumption over lead time plus safety stock level. So, the batch could be delivered before safety stock consumption if we assume that there is no demand or supply variability (point 2).
In real life, customer demand will always be higher or lower than expected (points 1 and 3) or the supplier/production could be late (point 4). It’s the job of the safety stock to cover such fluctuations.
Again, because it’s so simple and looks like common sense, the approach is still quite popular, and it’s still used in many companies.
The Limitations of Order Point
Fixed Order Point and Safety Stock levels are good for linear, stable, and predictable environments. How many of these could you find today? As a result, it leads to bimodal inventory distribution (too little of the right and too much of the wrong) and overall too much stock.
Usually, bimodal inventory distribution in this approach is caused by:
- No connection to capacity. Even if it is calculated in some cases, it is fixed for a long period, plus it tends to lead to excess batch sizes.
- Assortment list and BOM changes. Order Points and EOQs become obsolete faster than they are actually recalculated in practice.
- High promo or seasonality undermines the effectiveness of this approach and usually causes workarounds.
- No use of actual client’s orders. If there’s no visibility, Service Levels decrease, or companies must increase stock to compensate.
- Lack of adaptation to constantly changing customer needs and production plans.
The last bullet was one of the key reasons why the Order Point approach was replaced with the spread of MRP technology. It is in its name, “Material Requirements Planning,” that requirements are directly recalculated from current production plan with the use of the Bill of Material.
This makes companies think that they will produce only what is really needed to cover the customer demand — and purchase raw materials only when and in the quantities they need to cover the production schedule. They opened the door to dependent planning through the Bill of Material, which was supposed to lead to higher ROI. And it did, back in the days. But the more volatile and unpredictable the environment becomes, the less efficient MRP becomes. But this is a topic for another story.
How DDMRP Buffers Can Help
DDMRP buffers are based on a similar mechanism to reorder points, but they correct their limitations to make them efficient in a more variable world: dynamic adaptation of levels, consideration of relevant customer demands, visual management, consideration of BOM links, etc. Intuiflow’s DDMRP buffers go even further by implementing artificial intelligence, dynamic multi-level adaptation and capacity constraints, for agile and resilient planning in the VUCA world.