Abstract: The Department of Defense currently has a $9 billion inventory excess. This paper argues current procurement and inventory management methods — such as min/max ordering — are the cause of this excess. Demand driven dynamic replenishment — already used with success in Naval Aviation Enterprise and the airline industry — offers a proven method to reign in procurement costs, contain inventory and simultaneously increase parts and material availability.

The change in supply chain logistics

that could allow the Department of

Defense to reign in procurement costs

and contain inventory excess while also

boosting material availability

Demand driven dynamic replenishment

Introducing the Theory of Constraints (TOC) approach to Supply Chain Management

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A SigNifiCANT ExCESS iN A TiME of ThrifTIn the face of impending cuts in government spending, the challenge for DoD budget managers is to find innovative methods that will provide high levels of readiness with less funding. The logistics budget for the various needs of the military services is one of the largest items in the DoD budget and, as such, continuously receives the scrutiny of the public, the press and Congress. One article cites a Pentagon Inspector General report, “DoD has inadequate policies and procedures addressing the use of DoD inventory….”1 A second article observes, “The Pentagon admits that it has at least $9 billion worth of excess items in inventory. These include spare parts for obsolete systems, perishable items that won’t be used before their expiration date and supplies that exceed the projected requirements.”2 The second article’s observation of excess inventory is a symptom of the first article’s observation of DoD’s inadequate policies and procedures.

Any procedure that allows $9 billion in excess inventory is clearly inadequate as described above. Selling the excess, as the second article goes on to suggest, “earning pennies on the dollar,”3 would have very little monetary effect since excess inventory represents sunk cost. Two of the three categories of excess cited, obsolescence and expiration, can be minimized but not eliminated. The third category, supplies that exceed projected requirements, can be eliminated. These excesses result from the current policies and procedures that attempt to manage material from the early identification of planning requirements to material issue at point of use. The current policies and procedures need to be changed in order to lower inventory and improve availability. The question to be answered is: how do you change the policy and procedures to buy the right material and throw away less of it?

AN iNhErENT MANAgEMENT CoNfliCTThe inherent conflict in the management of the inventory systems is between meeting the material demand and maintaining low inventory cost. if the two motives of this conflict are not balanced, high levels of inventory result yet demand is not met. Current acquisition methods do not resolve this conflict. Certain elements of the current methods actually contribute to the imbalance between the two motives.

1 Aerospace Daily and Defense Report, “Pentagon Struggles to Manage Increase in Logistics Contracts”, Michael Fabey, July 06, 2011.

2 Defense News, “Our View: Tackle Inventory Problem-Now”, 27 May 2012.

3 ibid

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one element of the current approach to inventory management is the minimum and maximum ordering system (Min/Max) which operates with rules that increase the chances of not meeting the demand. The object of the Min/Max system is to meet demand for all material required in the process and to carry the minimum amount of inventory to cover demand during the time it takes to order, move, and issue the next unit of material after the minimum stock level is reached. What the system attempts to avoid with minimum inventory is a condition where there is zero stock on hand. This zero stock on hand condition is referred to as a “stock out” condition. If we assume that the signal to reorder is instantaneous, then the time to order, move and issue is the time to replenish the stock to some non-zero level. This interval is called replenishment lead time.

The maximum level of each order is merely the maximum number of units that are expected to be consumed between order cycles. The maximum attempts to adjust order quantities for the delay induced by the acquisition process and for the expected maximum variable demand during the total delay in restocking. The maximum determines the order quantity for each order. Order size, in general, is the maximum minus the minimum plus backorder quantity. In this system, the minimum threshold is intended to avoid stock outs and the maximum threshold is intended to keep inventory cost down. The system operates on two simple rules: “reorder when the amount of stock is equal to or below the minimum” and “set order quantity to attain the maximum.”

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Min/Max Inventory

Figure 1. Typical inventory level fluctuations with a Minimum and Maximum replenishment system.4

figure 1 depicts typical results from minimum and maximum ordering rules. This graph is for initial inventory of 90 units with a demand average of 10 units per week with a standard deviation of 1.67 units and a constant replenishment time of 4 weeks. The portion of the line below at zero represents periods of stock out condition when demand cannot be met and demand accumulates in backlog. The inventory excursions of this graph occur with the Min/Max system if the initial levels are inadequate or if demand changes after the levels are set.

Attempting to mask these problems by manually adjusting orders provided by Min/Max systems in an ad hoc fashion as consumption trends are discovered becomes a woeful, never-ending game of catch-up. The standard deviation of demand in this example is actually relatively small, and the standard deviation of the replenishment time is zero. With larger standard deviations seen in actual practice, stock out conditions would occur more frequently.

ExACERbATION ThROuGh “buLk-buyING” AND LONG-RANGE FORECASTSIn addition to Min/Max ordering, another element of the current inventory management system is the procurement practice of “buying in bulk” which attempts to reduce inventory costs through large orders of material. Each price and delivery interval is negotiated separately for each line item based on forecasted information on the potential future use of the line item. The result of this procedure is over stocking in a mix that does not match actual production demand. Excess stock due to buying in bulk often increases loss due to obsolescence and expiration. Over stocking of non-essential parts also ties up money that could be used elsewhere.

4 Sproull and Nelson, Epiphanized, 2012, North River Press, Great barrington, MA. Modified from Appendix 5.

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In addition to the specific problems cited above, a general underlying problem for the current inventory system is that, in operation, the acquisition policies based on reducing the cost of inventory decouple the order process from the demand. in cases where the production process manager experiences or predicts demand changes, it is difficult for him to justify and excite order level changes due to acquisition policy inflexibility. Demand information must be transmitted across functional organization boundaries against varying functional motives. Stock outs are a critical event for the production manager, but not necessarily for the acquisition manager. The production manager is concerned with production throughput, the acquisition manager with inventory cost. The resolution of this conflict requires methods that integrate cost savings activities without impeding production throughput. An airline example discussed later in this article illustrates the effect of policy that does not consider throughput and illustrates one potential win-win solution.

Another underlying problem in the current supply chain operations is the use of forecasting software at central ordering organizations to plan orders over long periods of time, like the budget year. The software models use historical demand information to create supply ordering plans and budgets to achieve a planned flow of material into the supply chain. buying supplies in bulk, discussed above, is a specific use of forecasting information. The execution of the forecasted plan “pushes” material into the points of use at local inventory locations. These push systems require accurate predictions of the line item demand, the destination locations and when the line items will be required. The complexity of the models and the inability to achieve accurate predictions are reasons why demand forecasting methods do not generally meet the local inventory demand requirements.5 The forecasting method can predict the total need across the entire inventory system but cannot predict or meet local demand at each point of use in the inventory system. The central system may have the required material, but it is rarely at the point of use when needed.

Another element of the current inventory management system is the practice of locating parts close to the point of use and independently managing orders for each local inventory. The idea is to have parts available to quickly meet local demand. however, once a line item is pushed out into the extremity locations of the supply chain, it becomes costly to move that line item to another peripheral location where it is stocked out. The result is excess inventory at some points of use while out of stock conditions exists at others. When orders are managed at the point of use, the orders are less frequent and order quantities are highly variable, resulting in a sporadic flow of material.

Inventory systems that use the Min/Max system, forecasting and holding inventory at point of use are insensitive to stock out conditions. This insensitivity causes loss of

5 Schragenheim, Amir. 2010. “Supply Chain Management,” Theory of Constraints handbook. Cox and Schleier, Ed. New york: McGraw hill, Chapter 11.

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opportunity in the form of production delay, missed deliveries, reduced sales, lower profit, reduced capacity, reduced customer satisfaction, lower future bookings and real dollar loss from ordering material that is never used. in DoD inventory systems, use of these methods, motivated by the desire to control inventory costs, results in losses which parallel those of commercial systems. Material shortages result in weapons systems that are not mission ready. Excess inventory is never used. And there are high material losses due to obsolescence and expiration. Unavailability of critical items results in low customer satisfaction and motivates the practice of unauthorized local purchasing or “buy around” activities. Also prevalent in high shortage inventory systems are hoarding activities such as “gunny lockers” for scrounging often used by the military to improve parts availability.

In general DoD operates an acquisition system displaced from demand. Functional procurement staffs follow department policies and rules motivated by cost cutting and by policies that are in place to meet audit requirements. The DoD system uses automated models for forecasting demand, uses bulk buys, uses a Min/Max system for replenishment and positions stock at point of use. The results, as observed in the quoted articles, are excess inventory and insensitivity to obsolescence and expiration. All of which result in significant increases to the cost of inventory.

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A NEW yET PROVEN ALTERNATIVE: DyNAMIC REPLENIShMENT ThEORyAn alternative inventory management approach which addresses the problems of the current inventory systems is a Theory of Constraints method called Dynamic replenishment (Dr). Dr uses an alternative to ordering to supply targets and to demand forecasts. orders are constructed as instantaneous responses to demand during short intervals. Where instantaneous response to demand is possible, such as production line operations, forecasting is not needed,6 except for budget planning. The Dr method constantly replenishes stock using real time response to demand and manages stock buffers to accommodate variation in demand and variation in replenishment time.

There are six basic features of a Dr implementation:

1 Stock is positioned at the highest level in the distribution system so that all available inventory can be used to satisfy demand at multiple points of use. Centralization of inventory also allows more frequent ordering because the central warehouse sums the demand usage of the various consumption locations. using this approach, larger order quantities are accumulated at the central warehouse sooner than at each separate location.

2 buffers are positioned at points of potential high demand variation and stocked and restocked at levels determined by stock on hand, demand rate and replenishment lead time.

3 Order frequency is increased and order quantity is decreased to maintain buffers at optimum levels and avoid stock out conditions which cause interruption to the flow of product.

4 Ordering is determined by buffer depletion. how much to order and where to distribute available stock are determined by buffer status.

5 buffer size is managed dynamically. buffer depletion data provide signals to determine when and by how much to modify buffer size.7

6 Order urgency is based on buffer depletion and is used to set ordering priorities. The DR order method accounts for buffer depletion and local demand information so the right mix of parts is ordered and parts are distributed to the priority locations.

for purpose of comparison figure 2 depicts inventory levels using a Dr approach. The differences with the DR method in this example are that orders are placed every week and order quantity is the demand for the past week. Stock out conditions do not exist in this example of the DR approach. Also, the maximum inventory level required to avoid stock out conditions is much less than the maximum inventory level would be with the Min/Max method.

6 Ibid. p269.

7 Camp, henry, TOC Distribution Webinar, TOCICO 2011.

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figure 2. Dynamic replenishment inventory levels with ordering to demand.8

figure 3. Transition from a Min/Max to a Dr inventory replenishment system.9

figure 3 illustrates the reduction of average inventory during transition between Min/Max and DR inventory replenishment systems. As seen in Figure 3, simple changes in frequency and size of replenishment orders address the flaws in a Min/Max system, significantly reducing inventory and stock out conditions.

Many other supply chain improvement activities are included in a Dr implementation. An end to end redesign of the inventory management process is often required. Initial gains, however, can be made with less than a complete overhaul of the system, such as changes to ordering methods discussed above. Any comprehensive approach to a supply chain redesign should include the consideration of the following: number of central warehouses in the system, the existing replenishment process including buffers and signals between warehouses and points of use10, and the lead times in the planning,

inventory

Time

8 Camp, henry, TOC Distribution Webinar, TOCICO 2011.

9 Demory, Erin F., henry Camp, The benefits of Moving from a Push to a Pull System, Charleston, SC, n.d.

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procurement and ordering processes. The approach should also consider supplier procedures including replenishment time, variation of replenishment time, procedures for expediting priority demand, contracts to support smaller, more frequent orders and cost effective shipping of small orders. Automatic replenishment software applications should also be redesigned to include new rules for buffer management and order frequency. Applications should include dynamic analysis of demand changes including early warning of impending stock out occurrences. Finally, electronic interface should be provided for suppliers to facilitate order placement and order status tracking.

No change effort is successful without appropriate activities to ensure new procedures are absorbed by the organization. Replenishment concepts implemented in DR change many organizational ideas related to acquisition of inventory. Maximizing throughput and minimizing stock outs are the focus of DR and at times works at odds with classical cost saving ideas. Required changes in behavior are paramount to a successful Dr implementation. For example, the organization must be willing to release stock between points of use, must agree to cease the practice of prematurely drawing stock and hoarding it, and must implement a strong communication system between production and acquisition allowing decisions based on throughput requirements rather than inventory cost.

Depending on the size of the acquisition system and how independent that system is from the production system, making changes to the acquisition system can be a significant challenge. As an example, the effort to establish long term contracts that allow frequent, small orders could be extensive and time consuming. however daunting such policy changes may appear, the potential reductions in total inventory would certainly justify the efforts.

fiND oUT MorEWe hope you enjoy this paper. if you would like to learn more about the application of Demand Driven Dynamic Replenishment, we recommend a best Practice briefing.

This structured 40-minute conference call will give you a clearer idea of how DR has succeeded for large commercial organizations as well as Naval Aviation Enterprise, the clear inventory control and procurement advantages it offers, and how it could conceivably work for military applications.

Just call toll free 1-855-NOVACES to arrange yours today.

10 “Schmidt, Snyder and Shen, Centralization versus Decentralization: Risk Pooling, Risk Diversification, and Supply uncertainty in a One-Warehouse Multiple-Retailer System, May 27, 2008, NSF Grants DGE-9972780, DMI-0522725, DMI-0621433.

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DR IN ACTION: AVAILAbILITy uP, INVENTORy DOWN AT TuRkISh AIRLINES TEChNICrecently Dynamic replenishment principles were successfully applied to Turkish Airlines Technic’s aircraft parts inventory system. The inventory, in this case, supported its maintenance and repair function, which is of vital significance to its operations in addition to maintaining third party aircraft. The aircraft on the line were either company owned or contracted from other airlines. Production tasks consisted of both periodic maintenance and the correction of operational malfunctions. The inventory system managed consumable items and rotable pools of subassemblies for both types of repairs. Initially, the purchasing system supporting replenishment was the Min/Max type.

The existing inventory system was sometimes unable to provide parts to meet maintenance demand. Low parts availability may affect the cycle time to repair and deliver aircraft. long cycle times represented lost opportunities: loss of passenger revenue for the additional time that the company owned aircraft were down for maintenance, loss of potential external revenue from additional external aircraft maintenance and repairs that could be conducted with excess capacity, and loss of premium payments from from external customers for quick turnaround of repairs.

Turkish Technic was determined to improve cycle times and commenced analysis of their inventory system under the initial subjective conclusion that variation in supplier replenishment times for required repair parts was one of the major contributors to stock out conditions and that waiting for parts in stock out condition was the biggest component of long maintenance and repair lead times. For the first phase of DR implementation, about 1000 line items were selected from the 45,000 inventory items. These selected items were of high dollar value and had high consumption. The overall availability of these line items was 90.4% at the outset.

The general objective was to increase parts availability and reduce inventory. Analysis verified that wait time for parts out of stock was a significant nonproductive contributor to maintenance cycle time. however, the internal contribution to the replenishment lead time was larger than expected. The preliminary improvement phases were focused on ordering procedures for consumable inventory, deferring rotable demand to later phases of the improvement effort. Three critical actions were initially undertaken: establishing an internal pull replenishment system, maintaining targeted buffer inventory levels, and establishing supplier contracts and procedures consistent with DR system requirements.

Establishing an internal pull replenishment system included setting the order frequency of each line item to weekly. Decreasing these ordering frequencies resulted in an immediate reduction in inventory levels. Shipments were

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combined to avoid increases in transportation costs. iDEA’s Elucidate software was used to augment legacy inventory software. Elucidate automatically adapts targeted inventory levels based on changes in actual demand. The basics of an integrated automated ordering application were developed with the intention to connect the system directly to the suppliers in order to easily manage three times more orders. This ordering application might be implemented after the new ErP system is ready to use.

Maintaining targeted buffer inventory levels included several activities:

1 Dynamic buffer management,

2 Improvement efforts continued to reduce replenishment times,

3 Suppliers were assisted in expediting orders for line items with low on-hand levels, expediting decisions considered whether inbound orders were likely to arrive before stock out conditions occurred.

Establishing supplier contracts and procedures consistent with Dr system requirements included communication with suppliers to make them aware of new ordering procedures and new expedite procedures. one prototype supplier was engaged to reduce their replenishment time. Contracts were modified for blanket purchase orders with longer terms, with smaller orders and with timely orders shipped to meet consumption. Transportation was managed to change the mix of parts being shipped to maintain full-truckload shipping.

In addition to supplier cycle time delays, one purchasing policy contributed significantly to lengthening replenishment lead time. For many orders placed, purchasing was required to research whether lower cost suppliers existed for the specific line item in the order. If a lower price could be found, the order was frequently shifted to the lower price supplier, to often one with longer

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replenishment times. In addition, the corresponding administrative delay due to the changing of purchasing contracts contributed to the internal component of the replenishment lead time. This policy, although based on cost savings motivation, frequently resulted in a negative impact on product throughput and drove Aog (aircraft on ground) emergencies. Delays resulting from this policy may have offset any cost benefit, since more inventory had to be held to cover the extended replenishment interval.

Now identified as a major contributor to replenishment lead time, re-engineering the price check activity to decouple it from the ordering procedure is being explored so that needed line items could be ordered without delay. In a future state, price checks will be conducted routinely, but apart from the ordering process to ensure cost savings. Changes to replenishment lead time due to changes in suppliers may be planned into future buffer modifications.

Only four months after the start of the second phase of DR implementation, initial purchasing process changes had been made and inventory data were collected. Overall availability had improved from 90.4% to 95.9% with $1.5 million less investment in inventory despite that fact that only a portion of Dr Strategy and Tactics has been implemented so far. These gains resulted from the application of simple changes to inventory policies. The continued application of Dr methods is projected to reduce replenishment lead times even further. Automated ordering and careful buffer management will continue to reduce stock out conditions and to reduce the cost of total inventory.

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ThE lESSoNS AND ChAllENgES for DoD ProCUrEMENTThe Dr theory and the solutions of the airline example have relevance to processes within the DoD supply chain. DoD acquisition contains many of the functions and undesirable effects of the classical inventory management systems discussed above. Solutions for these effects exist in industry inventory management practices as shown in the airline example. Dynamic replenishment methods are proven. The challenge is to determine how the methods may be applied in DoD and how to get started. in spite of the fact that the $9 billion in excess inventory represents a significant opportunity, retired united States Navy Vice Admiral keith Lippert, former head of the Defense Logistics Agency, said he is worried that it will take congressional hearings before key decision-makers in the Defense Department begin taking this problem seriously.11 Congressional action will certainly be required to change the policies in order to accomplish an overhaul of the entire acquisition system. however, Dr can be applied immediately within current DoD policy in processes such as maintenance and overhaul where demand is continuous. Work on changing these processes should start now. The application of Dr principles to broader global replenishment is dependent on the scale of inventory levels, demand rates and replenishment lead times and will require coordinated planning for a phased introduction into the entire supply system. Changes to some processes in the system cannot be made in isolation from related processes in the system, or we will run the risk that new conflicts will be created to replace the current cost and demand conflict. A long-term, methodical effort must consider the entire supply chain as a whole with its interlocking components.

The challenge involved in changing supply chain policy within DoD to accommodate DR methods is not trivial. Implementing DR requires changing the government’s approach to acquisition policy which is currently motivated by item by item cost savings and fraud avoidance. As in the airline maintenance example, cost control procedures have to be isolated from demand requirements. Other basic changes are also required. Contracting methods that allow large blanket purchases with flexible delivery quantities are needed. Acquisition of strategic reserves, which is not demand driven, and acquisition of currently demanded material have to be managed differently to simplify inventory management of demanded material. New expedite procedures for shortages of critical demand material need to be developed. New oversight methods to continuously avoid, identify and purge excess, obsolete and expired material are required to reduce

11 http://www.defensenews.com/article/20120527/DEFFEAT05/305270008/Our-View-Tackle-Inventory-Problem-8212-Now

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warehouse costs. New approaches need to be developed for disposal of excess material based on return on investment. Current automated systems need to be streamlined to give precedence to demand. And, finally, new approaches to fraud prevention must ensure throughput of material is not impeded and ensure stock is always available for issue.

Despite the challenge in making these simple policy changes come to pass, the improvement in the inventory system responsiveness would justify the effort. Inventory costs would be reduced, weapon system availability would increase, warehouse space would decrease, and costs to dispose of excess material would decrease. As a secondary benefit, customer confidence in the inventory system would increase, reducing the incentives to buy material outside the system and to hoard material. The accumulation of $9 billion in excess material is a symptom that such a solution is long overdue. A critical hurdle for DoD managers is the acceptance that the current system is not working. it should not be surprising when incremental improvements yield diminishing results. Managers must be willing to challenge the status quo and to seek new methods to change how the supply chain performs. With the doomsday outlook for future DoD budgets, a creative, but proven approach is needed to successfully manage the supply chain with fewer dollars. if there are no funds to pay for the waste currently required to support high readiness, then readiness will most certainly decline with each declining budget. leadership from both Congress and the Department of Defense is required for the success of such an ambitious undertaking in a comprehensive manner, but initial progress can be made immediately within current policy by applying Dynamic replenishment. Dynamic Replenishment is an industry-proven method that reduces out of stock conditions while reducing excess inventory, thereby freeing up funds while sustaining force readiness.

ThE NExT STEP...We hope you enjoyed this paper. if you would like to learn more about the application of Demand Driven Dynamic Replenishment, we recommend a best Practice briefing.

This structured 40-minute conference call will give you a clearer idea of how Dr has succeeded for large commercial organizations as well as Naval Aviation Enterprise, the clear inventory control and procurement advantages it offers, and how it could conceivably work for military applications.

Just call (888) 317-3039 to arrange yours today.

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AboUT ThE AUThorS

Joe Boudreaux

Dr. boudreaux graduated from george Mason University with a degree in statistics. he was contract Program Manager for Defense logistics Agency’s Defense fuels Automated System (DfAS). he worked with Dr. Edwards Deming on the DoD prototype TQM implementation at North Island depot. he spent 15 years at Motorola and became a certified Lean Six Sigma Master black

belt. he worked with senior executives at Motorola to establish strategic direction for continuous improvement. he is currently contract Master black belt in DLA headquarters where he works with managers of DlA’s supply chain improvement projects.

Kevin Lehigh

Mr. lehigh graduated from Stanford University with an M.S. in Mechanical Engineering. he worked for 15 years in the aerospace industry at Martin Marietta and lockheed Martin. he received an M.b.A. in Project and Quality Management. he was a certified Lean consultant at IbM working with customers in high tech and aerospace industries. he was certified as a Six Sigma

black belt at Sun Microsystems where he improved the design and development of computer network storage systems. he worked in the intelligence and information systems field for Raytheon and National Security Agency. At DRS Defense Solutions, Inc. he was Director of Processes and Procedures and provided diversified products and logistics services to u.S. war operations in Iraq and Afghanistan and to Israeli and Saudi foreign Military Sales programs. he is currently a contract Master black belt at DLA headquarters where he works with managers of DLA Enterprise Continuous Process improvement projects.

Who WE ArENOVACES is a premier implementer of today’s most powerful process improvement and project management methodologies that strengthen operational capabilities and financial performance. We deliver Lean, Six Sigma and Constraints Management consulting and training to clients in the federal government, defense, healthcare, manufacturing, maritime and service industries. We are dedicated to advancing the science of process improvement and leverage research to provide the most effective solutions in the market.

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ThE NExT STEP...We hope you enjoyed this paper. if you would like to learn more about the application of Demand Driven Dynamic Replenishment, we recommend a best Practice briefing.

This structured 40-minute conference call will give you a clearer idea of how Dr has succeeded for large commercial organizations as well as Naval Aviation Enterprise, the clear inventory control and procurement advantages it offers, and how it could conceivably work for military applications.

Just call toll free 1-855-NOVACES to arrange yours today.