Lot Sizing in Material Requirements Planning Systems
Manufacturing businesses need to balance the necessity of having stock to fill orders with the cost of storing too much inventory. How do they know how many units create that balance? In this lesson, we’ll explore lot sizing in MRP systems.
Material Requirements Planning
Adam owns a business that makes medical supplies. Its factories produce everything from heart rate machines to blood glucose monitors and more. In order to make these supplies, though, Adam has to order materials from his suppliers, like plastic and LED monitors to make glucose monitors.
But Adam needs to make products so that he can sell them. If he makes too many products, though, he’s stuck with a warehouse of inventory. How can he make sure that he manufactures just enough product and not too much?
Many business owners use a system called material requirements planning, or MRP, which is a computer-based system for coordinating materials purchasing, manufacturing, and delivery. With MRP, Adam can make sure that all parts of his business are coordinated and running efficiently.
As part of the MRP system, businesses have to calculate how much product they should manufacture. This guides their material purchasing decisions and also impacts how efficiently their business runs. To help Adam figure out how many glucose monitors to manufacture, let’s take a closer look at the lot sizing aspect of MRP.
Lot Sizing
Adam wants to implement material requirements planning in his business so that it will run efficiently. But, he still has a lingering question that he needs to answer for an MRP program to work: how can he make sure that he manufactures just enough glucose monitors and not too many?
Lot sizing involves determining the amount of an item that needs to be manufactured. Whether Adam needs to make 100 monitors every week or 1,000, lot sizing will help him determine the perfect lot size, or number of units. So, how does he approach lot sizing?
There are two basic approaches: static and dynamic:
Static lot sizing involves manufacturing the same quantity of items regularly. For example, if Adam decides that he needs to make 100 glucose monitors per week on average, a static lot sizing approach will allow him to make 100 monitors every single week. But what happens if the amount he needs varies from week to week? He ends up with leftover inventory (sometimes called safety stock) in the weeks where he sells less than he makes, and the safety stock can then be used in those weeks where he sells more than he makes.
All that sounds okay, but what if Adam doesn’t want a large safety stock and doesn’t want to store the extra monitors in his warehouse? What if, instead, he wants to produce just the right number of monitors each week to keep up with demand?
Dynamic lot sizing involves manufacturing different quantities of items based on what orders have been placed. For example, if Adam has a big order from a hospital one week and needs 150 monitors, then dynamic lot sizing will allow him to make 150 monitors that week. Then, the following week, if he only needs 50 monitors, that’s how many he’ll produce. Dynamic lot sizing does away with having a large safety stock (though Adam still might have some inventory set aside in his warehouse). It allows him to respond to the demand he’s seeing at the moment.
Of course, there’s a problem with this approach, too: Adam could run into trouble if he gets a big order and doesn’t have enough time to manufacture enough monitors. For example, if a client wants to order 300 monitors, but his factory can only make 150 monitors by the time the client needs them, then he’s out of luck. On the other hand, if he has a large safety stock (as he likely will with static lot sizing), he can make up the rest of the order from the inventory in his warehouse.
Methods
Okay, Adam understands the benefits and drawbacks of both static and dynamic lot sizing, but he still doesn’t know exactly how to figure out how many monitors to produce. Should he just take a shot in the dark? How does he calculate lot size?
There are several methods for lot sizing. Some of the most popular are:
Fixed Order Quantity
The first way that Adam can calculate lot size is the most basic. Fixed order quantity, or FOQ for short, involves setting a lot size and then calculating how often to restock. Adam might say that he wants a lot size of 200 monitors. His only question with FOQ is how often he needs to produce those 200 monitors. He’ll look at his company’s order history to answer that question, but the point is that he is setting a lot size and then figuring out how often to produce that lot size.
You’ll notice that, with the FOQ method, Adam is producing the same number of monitors over and over. This makes it a static lot sizing method.
Economic Order Quantity
FOQ is simple, but Adam worries that it doesn’t take into account the fact that it’s more economically sound to make monitors in certain quantities. For example, it costs him less per monitor to manufacture 500 monitors at a time than to manufacture 200 monitors at a time because the cost of materials plus the cost to set up the machinery in the factory to make the monitors is lower if it’s spread out over more glucose monitors.
Economic order quantity, or EOQ, involves lot sizing based on the cost of set-up and materials and the demand for the product. It is, essentially, like FOQ but with the added element of considering the cost of producing the product at different quantities. So, Adam might set his lot size at 500 glucose monitors and then adjust his timeline according to that.
Since it is based on, and similar to FOQ, EOQ is also a static lot sizing method.
Lot-for-Lot
FOQ and EOQ seem pretty straightforward, but Adam isn’t sure that static lot sizing is right for him. He’d rather change his lot size depending on what orders are coming in. Lot-for-lot, or L4L, is a dynamic lot sizing method that involves producing just enough units to fulfill orders and maintain a small safety stock.
For example, let’s say Adam wants to keep a safety stock of 150 glucose monitors in his warehouse just in case a client wants an order quickly. And, let’s say that he gets an order for 600 glucose monitors. He’ll then produce 600 monitors if he already has 150 in his warehouse.
On the other hand, if he used 100 of his safety stock last month, he’ll manufacture 700 monitors (600 to fill the order, and 100 to maintain his safety stock). With L4L, then, Adam is simply keeping up with demand and maintaining a small safety stock. Because the number he manufactures will change based on his orders, it is a dynamic lot sizing method.
Periodic Order Quantity
Adam likes the idea of the lot-for-lot method, but it sounds pretty stressful. It seems like he’d be scrambling to make his orders all the time. Isn’t there a better way, one in which he can plan but also be dynamic?
Periodic order quantity, or POQ, is a dynamic lot sizing method that involves producing enough units to fulfill orders over a specified time period and maintain a small safety stock. Let’s say that Adam knows that every March the orders from his various clients total about 1,500 glucose monitors. Then, in March, he’ll plan to manufacture 1,500 glucose monitors plus whatever he needs to maintain his safety stock.
In POQ, Adam could choose any time period to focus on: a week, a month, three months, or another amount of time. But the point is, he’ll figure out the lot size for that time period and manufacture that plus whatever he needs to maintain his safety stock. Because the lot size can (and probably will) change from period to period, POQ is a dynamic lot sizing method.
It’s important to note that in this lesson, we’ve talked about lot sizing in terms of how many units to produce (or manufacture). However, lot sizing also applies to purchasing materials. For example, Adam can use any of the lot sizing methods (such as POQ or FOQ) to determine how many LED screens he needs to purchase to fulfill his orders for glucose monitors.
Lesson Summary in this video
Lot sizing involves determining the amount of an item that needs to be manufactured. There are two basic approaches to lot sizing. Static lot-sizing involves manufacturing the same quantity of items regularly and usually results in a large safety stock of inventory. In contrast, dynamic lot-sizing involves manufacturing different quantities of items, based on what orders have been placed and results in a low safety stock of inventory.
There are many methods for lot sizing, including:
Fixed order quantity, or FOQ for short, which involves setting a lot size and then calculating how often to restock
Economic order quantity, or EOQ, which involves lot-sizing based on the cost of set-up and materials, as well as the demand for the product
Lot-for-lot, or L4L, which involves producing just enough units to fulfil orders and maintain a small safety stock
Periodic order quantity, or POQ, which involves producing enough units to fulfil orders over a specified time period, plus maintain a small safety stock
FOQ and EOQ are static lot-sizing methods, while L4L and POQ are dynamic lot-sizing methods.