Strategos, Inc.

3916 Wyandotte
Kansas City MO 64111 USA
816-931-1414

Lean Lot Sizing

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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Why Small Lots?

The Lean Manufacturing literature gives little guidance on lot sizing other than general
statements. This series of papers examines the lot-sizing problem in Lean Manufacturing
and offers a rational alternative to the slogans and edicts.
Small lot production (ideally one piece) is an important component of many Lean
Manufacturing strategies. Lot size directly affects inventory and scheduling. Other effects
are less obvious but equally important.
Small lots reduce variability in the system and smooth production. They enhance quality,
simplify scheduling, reduce inventory, enable kanban and encourage continuous
improvement.

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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The Economic Lot Size Model

An Old Theory Still Holds Value (Sort of)
Economic Lot Size (ELS) was first
developed about 1913. It balances the costs
of inventory against the costs of setup over a
range of batch quantities. In this model, the
Economic Lot Size (ELS) is where Total
Cost is minimum.
Economic Lot Size (ELS) is dead according
to some advocates of Lean Manufacturing
and Theory of Constraints. They contend
that every operation should manufacture
what the downstream customer needs
immediately in "batches" of one unit (One
Piece Flow). This may be correct in an ideal
world. Most factories are less than ideal. Where significant setup costs exist, batch
quantity is still an issue and Economic Lot Size provides important insights for rational
decisions.
The figure depicts a typical ELS model. This model calculates the total production cost
per unit over a range of batches. The batch quantity having the lowest unit cost is the
ideal or Economic Lot Size. This Total Cost typically forms a "U" as shown in the figure.
The model classifies total cost into three components: Setup Cost, Direct Cost and
Carrying Cost (Storage Cost). This facilitates calculation and aids understanding
Direct Cost
Direct costs are directly proportional to the amount produced.
Materials and direct labor are the most common. Accounting
systems usually capture these costs accurately and make them
readily available. In the figure, direct cost per piece is a
horizontal line for all batch quantities.
Setup Cost
Setup costs include the labor and material to ready a machine
for production. They may include the processing of work orders
or a first-article inspection. We amortize these costs over the
entire batch to derive the Setup Cost per piece. This cost is high
when batches are small and rapidly decreases with increasing
batch quantity.

Printing Press Setup

Setup (or make-ready) is
critical in the printing
industry.

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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Effects of Setup Reduction

The discussion, so far, assumes that setup
costs are fixed. Setup Reduction can often
bring setup cost and thereby lot sizes down
by a huge percentage.
The figures below show the effects of setup
reduction on the ELS analysis for Make-ToOrder (MTO) and Make-To-Stock (MTS)
environments. The effects for MTS are:

Make-To-Stock
Reduced Optimum Lot Size
Broader Range of Lot Sizes
Lower Total Cost Curve
Fewer Stockouts
Lower Inventory

Make-To-Stock Original Setup

In this analysis, an MTS machined part
shows an optimum lot size of 200 units at a
minimum Total Cost of $5.775.

ELS=200
Lowest Total Cost=$5.775
Lot Size Range at 3%= 110-450

However, the costs used in this analysis are

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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

Implications of This Analysis

If the original ELS is taken at face value (200 units), the minimum average inventory
would be 100 units. However, uncertainty of demand and other variations would dictate a
much larger average inventory.
With setup reduction the ELS is only 60 units. If this ELS is taken at face value, average
minimum inventory would drop by 70%. However, the range of lot sizes has increased
greatly and this leads to even more flexibility. Lot sizes from 20-200 units are now
feasible.
Taking the minimum lot sizes from the range both before and after setup reduction (110
and 20), the inventory reduction would be 80%.
One highly important but intangible benefit is the reduction of stockouts. For companies
that deliver from stock, a stockout represents more than just a lost sale. It can also lose
customers and affect many possible future sales.
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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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Make-To-Order Reduced Setup

With a 90% reduction in setup cost, the lowest Direct Cost is still $5.00 but now the
company can accept orders as low as 100 units without affecting profits or prices more
than 3%. An order of five units would require a 30% increase to cover setup cost. This
compares with a 420% increase required to cover the setup for five units in the original
scenario.

Implications of This Analysis

The conventional approach of volume discounting is counterproductive in several ways.
It encourages customers to order far more product than they may require. This adds a
great deal of unpredictability to a customer's orders and does not serve the customer's
needs. This is true even for high-volume customers. A steady flow of small or medium
size orders is far more predictable that large intermittent orders and complicates
scheduling.
The ability to reliably deliver exactly what a customer needs can often lock in important
customers if the competition cannot do the same. It may also command a higher base
price and increase profits.
The ability to satisfy small orders with no penalties may open entirely new markets for a
product that could not be effectively addressed without this ability. Alternatively, it can
deepen penetration of a small-order segment promoting both growth and profitability.
This is one of the connections between Manufacturing Strategy and Marketing Strategy.

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