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3916 Wyandotte
Kansas City MO 64111 USA
816-931-1414
By
Quarterman Lee, P.E.
Strategos, Inc.
28 April 2015
C O N S U L T A N T S E N G I N E E R S S T R A T E G I S T S
www.strategosinc.com
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The effects of small lots differ somewhat between Make To Order (MTO) and Make To
Stock (MTS) environments but they are important in either situation. We examine this in
a later section of this article.
Strategic & Systemic Issues
Production Linearity
Production linearity refers to the steadiness and repetitiveness of daily production output.
As Henry Ford understood, efficiency and quality come from producing the same
products, at the same rate, in the same way every day.
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This chart shows the effect of large and small lots on one particular workcenter's
production of a particular item.
A green line shows daily demand from the customer. It averages 50 units/day and does
not vary more than about 20%. The black line shows the actual production if units are
made in lots of 20 or about 0.4 days of demand. With this small lot size, required
production tracks demand and even smoothes the demand a bit. Output is quite linear.
A lot size of 200 units is about 4.0 days of demand. The purple line shows production
requirements. Here there are large, intermittent swings between 200 units and 0 units-very non-linear.
This kind of pattern complicates scheduling, precludes the use of kanban and generates
large inventories. The slightest glitch can cause stockouts.
Inventory
Batching has an even greater effect on inventory. This chart shows the theoretical
minimum inventory on hand downstream of the workcenter. A lot size of 20 units
generates an average inventory of 15 units.
A lot size of 200 generates an average inventory of 93 units with wide fluctuations. This
is a 600% increase!
Actual inventory would be much larger than shown here because of the uncertainty of
fluctuations, the difficulty of correcting a stockout and the need for coping with other
contingencies.
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Carrying Cost
Carrying or Storage cost is the average cost associated with storing an average production
unit for the average time it will be in inventory. These costs are more difficult to calculate
and we will not take up that procedure here. Storage costs are significant and often
represent 20%-60% of inventory value on an annual basis.
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Carrying Cost per piece (in the simplest case) varies directly with batch quantity. The
larger the batch, the more units will be in inventory, on average.
Practical Lot Sizing
There are problems with using ELS as the only determinate of lot size. ELS is only one of
several considerations.
Implications of the Total Cost Curve
Lot size examples in most textbooks show Total Cost curves that are sharp and narrow.
Such curves indicate a clear optimum. Yet, most real curves are flat and broad as in the
figure below.
There is a theoretical optimum where (dx/dy)=0.00. However, often, on both sides of this
optimum, large changes in lot size bring miniscule changes in cost. This indicates that
there is a range of realistic lot sizes rather than a clear optimum.
The accuracy of the costs used in this analysis is usually questionable. Direct Costs are
often accurate and easily obtained. Setup Costs are more variable but a reasonable
estimate can usually be made. Storage Costs are often buried in overhead accounts. They
must be found and allocated to production units. This makes the Storage Cost component
very approximate.
The flatness of the curve and uncertainty of the input costs suggests that the ELS analysis
should be a guide rather than an absolute decision tool. Nevertheless, it is quite a valuable
guide.
Most manufacturers have never done an ELS analysis. They determine batches by
instinct, tradition or guess. Thus, most batches are far too big. Occasionally, they are too
small.
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This initial analysis provides a range of lot sizes. Sometimes it is a very wide range. This
raises the question "What other criteria can help select the lot size within the ELS
Range?" Some general guidelines follow.
Lot Size Guidelines
Mostly, lot sizes should be at the low end of the ELS range. This reduces capital
requirements, smoothens production and makes scheduling more flexible.
When a particular machine is a "bottleneck" and needs to operate at maximum capacity,
set lot sizes at the upper end of the ELS range. This increases inventory buffers before
and after the bottleneck operation but it allows more time for production and less time for
setups.
When a piece of equipment must be staffed and maintained even when idle, and if the
equipment is not a bottleneck, set the lot sizes at or below the ELS range. This decreases
inventory but does not increase setup cost.
Given the fuzziness of the numbers, set lot sizes to a convenient unit such as "1-day of
production," "two containers" or some round number.
Bias your decisions towards the lowest reasonable lot size. The ELS does not capture
intangible costs of larger lots such as quality and scheduling flexibility. In addition, most
accounting systems under-estimate carrying costs.
Practical Lot Size
ELS analysis requires considerable time and effort. With hundreds or thousands of items,
an analysis of each one is impractical. Nor is it necessary. Analyze a few representative
parts and use the results for all similar items. The sample may be just 3-4 parts.
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Make-To-Stock
Reduced Optimum Lot Size
Broader Range of Lot Sizes
Lower Total Cost Curve
Fewer Stockouts
Lower Inventory
ELS=200
Lowest Total Cost=$5.775
Lot Size Range at 3%= 110-450
Make-To-Order
Lower Minimum Order Sizes
Higher Margins on Larger Orders
Faster Deliveries
inexact by nature. Particularly the storage costs that are usually elusive, part of overhead
and must be allocated by an inexact formula. In addition, there are many benefits in small
lots that have not been captured by this analysis. Recognizing these inaccuracies, we
might allow a tolerance on the total cost of, say, 3% and this is very conservative.
With a 3% tolerance there is a range of lot sizes available from 110 pieces up to 450
pieces. Given the advantages of small lots, the analysis would now indicate an optimum
lot size of about 110 units.
Make-To-Stock Reduced Setup
With a 90% reduction in setup cost, the
optimum batch becomes 20 units. Using a
3% deviation from optimum, the range
becomes 20-200 units.
ELS=60
Lowest Total Cost=$5.246
Lot Size Range= 20-200
In the short term, these kinds of improvements represent localized cost savings. In the
longer term, extended to other products, they can have major positive effects for facility,
finance and marketing strategies. They can increase growth while providing the capital
and space required for that growth.
Make-To-Order Example
Make-To-Order Original Setup
In an MTO situation, there is essentially no finished good storage. This analysis also
assumes no raw materials or WIP storage, although these can be significant in many
factories. The result is that there is no "optimum" lot size unless we take the customer's
order as the optimum.
The issue for MTO is the effect that setup costs have on pricing, volume discounts and/or
profits. With very large orders, the setup cost is amortized over so many units that the
total cost approaches the direct cost as shown in the chart above.
When customers want only a few items on an order, the setup cost adds significantly to
production cost. This requires either a price increase or reduced profit.
The chart shows how setup costs affect the total cost per piece. with a lot size of about
550 pieces setup represents 3% of direct cost and begins to affect total cost. At lots of 55
units, setup adds 30% to the direct cost and will require a significant price increase.
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