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Optimal Inventory Management for an Asset Retirement Event

Posted by SiewMun Ha

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5/19/15 10:47 AM

A discrete step reduction in future demand occurs in MRO inventory optimization when an asset is taken off line permanently. This might happen, for example, at a utility or oil and gas company when a plant is decommissioned, or maybe a mining company when a mine is shut down. What is the optimal way to manage MRO spares and inventory in such a scenario?


As it is undesirable to have leftover inventory that may have to be written off, one course of action would be to run down the inventory such that there is only a minimal quantity left when the asset is retired. A write-off cost is incurred by leftover inventory that has to be written off if it cannot be used on other active assets. Conversely, there is also a risk of incurring a stock-out if the run down is implemented too aggressively and the inventory falls to zero before the asset is retired.

Assuming that the business objective is to minimize both the write-off cost AND the stock-out risk, the aggressiveness of the run-down strategy becomes an important variable in determining the outcome of the process. The determination of this optimal run-down strategy requires a statistical analysis because of the uncertainty that typically exists in the demand pattern of MRO inventory.

A critical factor that must be considered in planning the run-down strategy is whether the item is shared with other active assets in the organization or if it is unique to the to-be-retired asset. If the item is shared with other active assets, then there is some leeway in managing the aggressiveness of the run-down strategy as any leftover inventory can be transferred to the active assets and stock-outs can be mitigated by obtaining the item from the same. However if the item is unique to the to-be-retired asset, then this leeway is eliminated. In such a case, additional considerations such as the item criticality and cost come into play.

If the item is critical (high stock-out cost) and inexpensive (low write-off cost), then it would be logical to run down the inventory less aggressively to minimize the high stock-out cost at the expense of the low write-off cost. On the other hand, if the item is not critical (low stock-out cost) and expensive (high write-off cost) then it makes sense to run down the inventory more aggressively to minimize the high write-off cost at the expense of the low stock-out cost.

How should an item be managed if it is both critical (high stock-out cost) AND expensive (high write-off cost)? Since both costs are high, erring on excessive OR inadequate run-down aggressiveness becomes expensive. The inventory manager must decide on the optimal trade-off between these two costs! It then becomes advisable to plan the optimal run-down strategy based on the quantified expected costs on both sides of the trade-off.

Consider, for example, a scenario where an inventory item that is unique to a soon-to-be-retired asset has a forecasted usage of U = 2 units per month, a unit price of $1,000 and a stock-out cost of $7,000 per stock-out occurrence. What is the optimal run-down strategy for this item?

The inventory manager controls the run-down aggressiveness by choosing when to halt procurement of the item with respect to the stock on hand (Q) and the time to asset retirement (T). The planned run-down usage rate is then defined by the ratio Q/T. Choosing Q and T such that U < Q/T makes the run-down less aggressive as the forecasted usage rate is less than the planned run-down rate. This decreases the expected stock-out cost and increases the expected write-off cost.

Conversely, choosing Q and T such that U > Q/T makes the run-down more aggressive as the forecasted usage rate is now greater than the planned run-down rate. This increases the expected stock-out cost and decreases the expected write-off cost. These costs may be quantified by a statistical analysis that accounts for the stochastic variation in usage relative to Q and T. The output of such an analysis for different combinations of Q and T are presented in Table 1.


Table 1: Expected Stock-Out and Write-Off Costs for Multiple Run-Down Strategies

With the expected write-off and stock-out costs quantified, the inventory manager is now equipped to plan her run-down strategy on an objective basis. Among the strategies analyzed, the Q/T = 20/8 combination provides the minimum total cost of $6,939. An inspection of Table 1 indicates that there is a significant degree of sensitivity in the total cost with respect to the Q/T combination with the cost rising by a factor of 2 to a maximum of $14,214 for Q/T = 20/10.

If the objective is to minimize the stock-out risk instead of the total cost, then the Q/T = 24/6 combination provides the best outcome with a stock-out risk of only 0.1% and corresponding expected stock-out cost of $9. Finally, if the objective is to minimize the leftover stock, then Q/T = 20/10 is the best choice with an expected leftover stock of only $1.78 units and a corresponding write-off cost of only $1,777.

An asset-retirement event injects additional complexity into the standard day-to-day MRO inventory-management process. Organizations that fail to properly address this complexity impose an avoidable burden on themselves through the sub-optimal tradeoff between write-off and stock-out costs. A comprehensive solution to this problem includes a combination of inventory segmentation based on uniqueness, criticality and cost and a detailed analysis of the critical and high-cost items to optimize the tradeoff between stock-out costs and write-off costs.

For more best practice advice, check out this Gartner report  Read More

Topics: inventory optimization

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