Ask a sales director what service level the company needs and the answer is usually "100%". Ask the finance director how much inventory the company should hold and the answer is "less". Both are right about what they want and both are missing the curve that connects the two.
Why the last points are so expensive
Safety stock protects against the variability of demand during the replenishment lead time. With normally distributed demand it equals a service factor z times the standard deviation of demand over that lead time. The service factor grows slowly at first and then very fast: the tail of the distribution is long.
Moving from 90% to 95% costs 28% more safety stock. Moving from 95% to 99% costs 42% more, and the last step to 99.9% another 33%, to avoid a stock-out in one replenishment cycle out of a thousand instead of one out of a hundred. Whether that is worth it depends entirely on what a stock-out costs for that item.
Choose the service level item by item
- Critical items, with high margins, demanding customers or no substitutes, deserve high service levels.
- Long-tail items, with low volume and erratic demand, are often cheaper to make to order or to serve from a central warehouse.
- Substitutable items can run lower, because a stock-out often becomes a sale of a neighbouring product.
The right question for the leadership team is not "how much inventory?" or "what service level?" but "what does one more point of service earn, and what does it cost?". The frontier answers it, item by item, in money.
Bartor S.
Founder
