The Stock Reward Function
The classic way of thinking about replenishment consists of establishing one target quantity per SKU. This target quantity typically takes the form of a reorder point which is dynamically adjusted based on the demand forecast for the SKU. However, over the years at Lokad, we have realized that this approach was very weak in practice, no matter how good the (classic) forecasts.
Savvy supply chain practitioners usually tend to outperform this (classic) approach with a simple trick: instead at looking at SKUs in isolation, they would step back and look at the bigger picture, while taking into consideration the fact that all SKUs compete for the same budget. Then, practitioners would choose the SKUs that seem to be the most pressing. This approach outperforms the usual reorder point method because, unlike the latter, it gives priority to certain replenishments. And as any business manager would know, even very basic task prioritization is better that no prioritization at all.
In order to reproduce this nice “trick”, in early 2015 we upgraded Lokad towards a more powerful form of ordering policy known as prioritized ordering. This policy precisely adopts the viewpoint that all SKUs compete for the next unit to be bought. Thanks to this policy, we are getting the best of both worlds: advanced statistical forecasts combined with the sort of domain expertise which was unavailable to the software so far.
However, the prioritized ordering policy requires a scoring function to operate. Simply put, this function converts the forecasts plus a set of economic variables into a score value. By assigning a specific score to every SKU and every unit of these SKUs, this scoring function offers the possibility to rank all “atomic” purchase decisions. By atomic, we refer to the purchase of 1 extra unit for 1 SKU. As a result, the scoring function should be as aligned to the business drivers as possible. However, while crafting approximate “rule-of-thumb” scoring functions is reasonably simple, defining a proper scoring function is a non-trivial exercise. Without getting too far into the technicalities, the main challenge lies in the “iterated” aspect of the replenishments where the carrying costs keep accruing charges until units get sold. Calculating 1 step ahead is easy, 2 steps ahead a little harder, and N steps ahead is pretty complicated actually.
Not so long ago, we managed to crack this problem with the stock reward function. This function breaks down the challenges through three economic variables: the per-unit profit margin, the per-unit stock-out cost and the per-unit carrying cost. Through the stock reward function, one can get the actual economic impact broken down into margins, stock-outs and carrying costs.
The stock reward function represents a superior alternative to all the scoring functions we have used so far. Actually, it can even be considered as a mini framework that can be adjusted with small (but quite expressive) set of economic variables in order to best tackle the strategic goals of merchants, manufacturers or wholesalers. We recommend using this function whenever probabilistic forecasts are involved.
Over the course of the coming weeks, we will gradually update all our Envision templates and documentation materials to reflect this new Lokad capability.