As a supply chain consultant, I often get asked about national benchmarks for inventory values. This is usually a request for total inventory value or the value per procedural suite (i.e., operating room or cath lab). While in most areas benchmarks are quite useful, it is my experience that managing to arbitrary inventory benchmarks potentially leaves money on the table or, worse, could put an organization at risk for a high percentage of stockouts.

Inventory benchmarks are by their nature an abstraction that usually buries many assumptions into the metric, including economies of scale, quality and reliability of local distribution, geographic area and other factors. For example:

• A high performer’s (low percentile) benchmark value could represent a large operating room or cath lab with significant economies of scale. The larger the department, the more the variability of demand for any one product can be reduced (for the same reason diversifying a stock portfolio reduces risk).

• A high performer’s benchmark value could be a hospital that is geographically close to the vendor’s distribution point. This could imply the facility experiences low lead times and potentially low lead time variability.

• A poor performer’s (high percentile) benchmark value could be a hospital in a remote area with less-than-ideal distribution. This could mean the facility experiences both high lead times and high lead time variability.

If inventory benchmarks may not be useful, what can materials managers do to quantify inventory opportunity? Simply put, maximum inventory value should be determined through a combination of the optimal reorder point (ROP) and the reorder quantity (ROQ).

Reorder points need to be based on four factors: Average Daily Demand, Variability of Daily Demand (measured as standard deviation), Average Lead Time (time from order to delivery) and Variability of Lead Time (again, measured as standard deviation). If one sets the ROP without taking the above four variables into consideration, the facility or department may carry too little inventory and suffer constant stockouts or carry too much inventory and tie up capital in non-productive assets.

"Standard deviation" is a statistical measurement of variability which can be defined as how wide the bell-shaped curve is. As the bell gets wider (increases in variability), the standard deviation numerically increases. While standard deviation requires some sophisticated math to calculate, every major spreadsheet and many scientific calculators will calculate it for you.

While a detailed explanation of statistics is out of the scope of this column, it is important to stress that accounting for variabilities of demand and lead time are extremely important. The higher the variability, the more inventory you will need to keep on-hand to ensure a high availability of product. If you only use averages, your inventory service level is 50 percent by definition.

Several solutions for ROP have been provided by operations research studies; however, over the years, I’ve developed a formula that accounts for variable demand and variable lead time with minimally complicated math (see figure 1). The benefit of this formula is that it recognizes both the effects of singular spikes in demand or lead time and the effects of overall trends. While the formula here yields a service level of 95 percent, it can easily be adjusted to change the service level up or down. It also has the benefit of being easy to implement in a spreadsheet, permitting inventory managers to download usage histories and lead times from their materials management information system into a spreadsheet, apply the ROP calculation, then upload the result back into the materials management information system.

While there are a few ways to calculate reorder quantities, the industry generally uses "Economic Order Quantity" or EOQ (see figure 1). It requires that the person calculating EOQ have access to the hospital’s carrying costs and reorder costs per purchase order line. This can be a bit of a challenge because it is my experience that few hospitals have these calculations easily (and accurately) available and it is calculated using estimates based upon industry "benchmarks."

It is important that hospital materials managers move beyond using arbitrary benchmarks for managing their inventories. By managing inventory to a maximum value of ROP + ROQ, hospitals can reduce the amount of capital tied up in non-producing assets without sacrificing service levels, product availability and patient care. If inventory benchmarks must be used, it is important to understand all of the assumptions buried in that benchmark. If you do, you will avoid setting your organization up for stockouts.