Service level and cost: two opposing forces

"We must never run out of stock" is a goal that sounds good to a manager. But a 100 percent service level does not exist in practice, and chasing it demands unlimited stock. Raising service level from 95 to 99 percent may be a barely noticeable difference for the customer and a sharp rise in stock and cost for the company. These two opposing forces should be calculated in advance and chosen between deliberately.

What service level means

The term is understood in two ways, so agree on which one you mean:

• cycle service level: the probability of not running out of stock between two deliveries. 95 percent means that in one cycle out of twenty a shortage is possible;
• fill rate: the share of the quantity ordered that was shipped at once.

These are not the same figure: shortages can be frequent but small, or rare but large. When you write down a target, state which measure you mean.

Why 99 percent costs far more than 95

Safety stock depends on the swing in demand and on the chosen level. The higher the level, the faster the required stock grows, because you are covering ever rarer situations.

An example, with illustrative figures. The standard deviation of demand over the lead time is 100 units and the cost is 200,000 so'm a unit. Approximate safety stock under a normal distribution:

• for 90 percent: about 128 units, or 25.6 million so'm;
• for 95 percent: about 164 units, 32.9 million so'm;
• for 99 percent: about 233 units, 46.5 million so'm;
• for 99.9 percent: about 309 units, 61.8 million so'm.

From 90 to 95, each percentage point needs about 7 units of stock. From 95 to 99 it is about 17 units per point, and from 99 to 99.9 about 84 units per point. Real demand does not follow a normal distribution perfectly and the figures are approximate, but the pattern holds: the last percentages are the most expensive.

The extra cost is not limited to the price of the goods: every additional unit takes up space and raises the risk of loss, damage and obsolescence. Moving from 95 to 99 percent increases stock in this example by about 42 percent (from 164 to 233 units), while the customer meets a shortage in one cycle out of a hundred rather than one in twenty. For a regular customer that difference may matter; for a casual buyer it is barely noticeable.

Do not set one level for all goods

A single blanket target of "97 percent" makes two mistakes: it spends extra money on unimportant goods and gives too little protection where it matters. Set the level by item:

• high-margin or critical goods, and items regular customers wait for: 98 to 99 percent;
• the core range: around 95 percent;
• slow-moving, replaceable or low-profit goods: 85 to 90 percent, or made to order.

The optimal level is where the cost of one extra unit of stock equals the cost of one lost sale. With a high margin and cheap storage the level will be high; with a low margin, or goods that are expensive or age quickly, it will be low. For perishable food or medicines, for example, a high level can leave surplus stock that passes its expiry date.

Ways other than stock

Raising service level through stock alone is not necessary. There are often cheaper ways:

• shorten the lead time or its variability: agree terms with the supplier, speed up transport;
• improve the forecast: get orders from large customers in advance;
• offer a substitute or ship the order in part;
• promise the customer an exact date: "not tomorrow, but on Friday" is often better than a plain "no".

How to reach a decision

1. Measure the actual current level for each group: what share of orders went out complete and on time.
2. Calculate how much stock and money one extra percentage point requires.
3. Estimate what one point of shortage is worth in lost margin and lost customers.
4. Stop where the two figures meet, and review the level twice a year.

Conclusion

Service level is not a free gift but a decision whose price can be calculated exactly. The OmborExpert specialists compare customer requirements with the cost of stock for each product group and help set a well-founded level for the company.