The Basics of Gordon Graham Inventory Management
By Bob Boyles, Principal
Smarter Distribution

You may not know it but today’s distributor owes a great deal to Gordon Graham. The Graham method of inventory management has become the standard by which all other inventory management methods are judged. The reason Graham methodology is so popular is simple it works. In this article we’ll review the basics of Graham methodology.

Graham theory is based on balancing two different and divergent measurements of inventory management, one being the reduction of stock outs and the second being the overall reduction in inventory investment. There are numerous other things to worry about when managing inventory but we’re going to focus on these two competing principles and see how Graham theory allows users to decrease their inventory investment at the same time that it allows them to decrease the number of stock-outs and those increase their service levels.

The Data

First things first, before you can make intelligent decisions you must have good data to work with. There are a few critical pieces of data that we’ll use in our formulas. If you lack these pieces of data your efforts should not be focused on fudging them and proceeding but collecting good data to base your work on. Seemingly small changes in the values of some of these data pieces can affect the outcome dramatically.

Lead-Time

Lead-time is defined as the length of time from when the purchase order is issued to the supplier and the material shows up on your dock. This piece of the puzzle is defined in the number of days. Be sure to exclude those purchase orders that were expedited and shipped via rush delivery and also exclude those purchase orders that were issued to non-standard vendors.

Demand

This is perhaps the most important piece of the puzzle and the one that is misunderstood most often.
Demand is the number of units sold per period. If you think that sounds pretty simple then you’d be wrong. Demand includes certain things and does not include others. Demand does not include

Order Cycle

The order cycle is defined as the number of times per year that your company qualifies for a “best purchase” quantity. This is also expressed in days.

Purchasing Cost

The purchasing cost will be used in the Economic Order Quantity (EOQ) formula. The purchasing cost is the dollar cost associated with issuing a purchase order.

Carrying Cost

Carrying cost will also be used in the EOQ formula and is the dollar cost associated with having material on the shelf in the warehouse.

The Formulas

There are numerous ways of expressing the mathematical formulas listed below. The ones we’re using here are the most common method of expressing these formulas and lead to a better understanding of their interaction than other representations. As you read the formula below notice how they build on each other, the safety stock number is included in the order point and the order point is included in the line point, etc.

Safety Stock

The safety stock will be used to cover variations in demand and supply to insure that the supplier does not run out of inventory. The formula is defined as:

Safety Stock = Demand per day X Lead Time X P Factor

The P factor is generally expressed as a percentage. So, as an example, I would take 50% of the daily demand multiplied by the lead-time expressed in days. Varying the P factor based upon the type of product is a basic tenet of what consultants do. However, using a P factor of 50% is recommended and will work for the vast majority of your products. I an ideal world safety stock is material that will never be sold and could thus be eliminated from but we don’t live in a perfect world. So your dollars tied up in safety stock can be thought of as an insurance policy against the variations in demand and variations in lead times. The sole purpose of safety stock is to reduce the number of stock outs and increase your service level.

Order Point

Order point can be thought of as the last point at which a purchase may be placed with out consuming some of the distributors safety stock. The order point is used so that purchase orders are issued after the on-hand level is less than the line point and prior to going below the order point. The formula is defined as:

Order Point = ( Demand per Day X Lead Time ) + Safety Stock

There are a lot of people out there that profess to be Graham experts and Graham adherents but when you start talking about the facts they begin to get hazy on the details. For example, if someone tells you to not order the material until it reaches the order point then they do not under stand the purpose of safety stock and the meaning of the order point.

Line Point

The Line point formula is where we begin to expand beyond the single line item and begin to look at the other products that can be ordered at the same time to make a “Line Buy”. A product line is defined as a group of products that can be purchased on the same purchase order. When we issue a purchase order we do not purchase just a single line item we purchase a group of items in order to make freight or meet vendor minimums.

Line Point = ( Demand Per Day X Order Cycle ) + Order Point

When a products on-hand falls below the line point then the product becomes “eligible” to be bought. Products are bought when the on-hand falls below line point and before it reaches the order point.

Surplus Point

The surplus point is the theoretical maximum that you should ever have on hand using the Graham theory.

Surplus Point = Line Point + 1 EOQ

Why is this the surplus point? Because you’ll order sometime when the quantity falls below the line point and the amount that you’ll order will be one EOQ. So the max is a line point plus one EOQ

Economic Order Quantity

The Economic Order Quantity or EOQ is defined as the optimal quantity to purchase. The formula attempts to balance the cost of ordering and the cost of carrying to achieve the lowest cost or ordering and handling for inventory.

Using Graham Theory

When you examine the formulas above you’ll quickly notice that the “when to order” is determined by the order point and line point and that the “how much to order” is determined by the EOQ. Graham theory is using purchase order timing to manage the level of inventory investment.

About Bob Boyles and Smarter Distribution:
Bob Boyles is principal of Smarter Distribution in Coppell, Texas, a strategic consulting business focusing on technology. He has served as an installation consultant for several distribution software companies. Reach him at (972) 304-1180, via e-mail at bob@smarterdistribution.com or on the Web at www.smarterdistribution.com

© Copyright 2003, Robert S. Boyles Jr. All rights reserved. This article cannot be reprinted or reproduced in whole or in part, without the express written permission of Robert S. Boyles Jr.