The role of Safety Inventory in a Supply Chain

Safety inventory: Inventory carried for the purpose of satisfying demand that exceeds the amount forecasted in a given period.
Safety Inventory Is Carried because
Demand is Uncertain.
A Product Shortage may result if actual demand exceeds the forecast demand.
Safety inventory is the average inventory remaining when the replenishment lot arrives.
Role of Safety Inventory
Average inventory is therefore cycle inventory plus safety inventory
There is a fundamental tradeoff:
Raising the level of safety inventory provides higher levels of product availability and customer service and thus the margin

captured from customer purchases.

Raising the level of safety inventory also raises the level of average inventory and therefore increases holding costs. However,
both the increased variety of products and the greater pressure for availability push firms to raise the level of safety inventory
they hold.
Very important in high-tech or other industries where obsolescence is a significant risk, where the product life cycles are
short and demand is very volatile (where the value of inventory, such as PCs, can drop in value).

Two Questions to Answer in Planning Safety Inventory

What is the appropriate level of safety inventory to carry?
What actions can be taken to improve product availability while reducing safety inventory?

Ex: Compaq and Dell in PCs, in 1998, when prices dropped. Compaq carried 100 days of inventory compared to Dell which carried only 10 days of
inventory. Declining prices hurt Compaq much more, given the extra inventory that it carried. Compaq did not make any profit in the first quarter of
1998. A key to Dells success has been its ability to provide a high level of product availability while carrying very low levels of safety inventory in its
supply chain.
Forecasts are rarely completely accurate
If average demand is 1000 units per week, then half the time actual demand will be greater than 1000, and half the time actual demand will be

less than 1000; what happens when actual demand is greater than 1000?
If you kept only enough inventory in stock to satisfy average demand, half the time you would run out.
Determining the Appropriate Level of Safety Inventory
Measuring demand uncertainty
Measuring product availability
Replenishment policies
Evaluating cycle service level and fill rate
Evaluating safety level given desired cycle service level or fill rate
Impact of required product availability and uncertainty on safety inventory

Appropriate level of safety inventory is determined by:

a. supply or demand uncertainty
b. desired level of product availability
Higher levels of supply or demand uncertainty require higher levels of safety inventory given a particular desired level of product availability.
When a new Palm (PDA) model is introduced in the market, demand is highly uncertain, and the retailer B&M thus carries a much higher level
of safety inventory relative to demand. As the markets reaction to the new model becomes clearer, uncertainty is reduced and demand is easier
to predict.
Higher levels of desired product availability require higher levels of safety inventory given a particular level of supply or demand uncertainty.
If B&M targets a higher level of product availability for the new Palm model, it must carry a higher level of safety inventory for that model.

Measuring Demand Uncertainty

 Demand has a systematic component and a random component. The goal of forecasting is to predict the systematic component and estimate the
random component.
The estimate of the random component is the measure of demand uncertainty
Random component is usually estimated by the standard deviation of demand or forecast error.
Notation:
D = Average demand per period
S = standard deviation of demand per period
D
L = lead time = time between when an order is placed and when it is received
Uncertainty of demand during lead time, and not just a single period, is what is important
Measuring Product Availability
Product availability: a firms ability to fill a customers order out of available inventory.
Stock out: a customer order arrives when product is not available.
Product fill rate (fr): fraction of the products demand that is satisfied from product in inventory. Assume that B&M provides Palms to 90% of
its customers from inventory (10% lost to competitors), it achieves a fill rate of 90%.
Order fill rate: fraction of orders that are filled from available inventory, also, like fill rate measured over a specified number of orders. In the
case of B&M, a customer may order a Palm along with a calculator. The order is filled from inventory only if both the Palm and the calculator
are available through the store. It tends to be lower than fr because all products must be in stock for an order to be filled (for single product
situations, the two are same).
Cycle service level (CSL): fraction of replenishment cycles that end with all the customer demands being met. It is the probability of not having
a stockout in a replenishment cycle.
A replenishment cycle is the interval between two successive replenishment deliveries.

 If B&M manages inventory such that the store does not run out of inventory in 6 out of 10 replenishment cycles, the store achieves a CSL of
60%.
Replenishment Policies
Replenishment policy: decisions regarding when to reorder and how much to reorder. These decisions determine the cycle and safety inventories
along with fr and CSL. It takes the following two forms.
Continuous review: inventory is continuously monitored and an order of size Q is placed when the inventory level reaches the reorder point
(ROP). B&M managers orders 600 Palms when the inventory falls below 400. Size of the order remains constant, time between orders may
fluctuate given variable demand.
Periodic review: inventory is checked at regular (periodic) intervals and an order is placed to raise the inventory to a specified threshold (the
order-up-to level). Every Saturday, employees at B&M check film inventory and the manager orders enough so that the available inventory
and the size of the order total equals 1,000 films. Time between orders is fixed, size of each order, can fluctuate, given variable demand.

Importance of the Level of Product Availability

Product availability measured by cycle service level or fill rate. Also referred to as the customer service level
Product availability affects supply chain responsiveness
Trade-off:
High levels of product availability increased responsiveness and higher revenues
High levels of product availability increased inventory levels and higher costs

Product availability is related to profit objectives, and strategic and competitive issues (e.g., Nordstrom, power plants, supermarkets, ecommerce retailers)
Factors Affecting the Optimal Level of Product Availability
Cost of overstocking
Cost of understocking
Possible scenarios
Seasonal items with a single order in a season
Continuously stocked items
Demand during stockout is backlogged
Demand during stockout is lost
The cost of overstocking (Co) = the loss incurred by a firm for each unsold unit at the end of the selling season.
The cost of understocking (Cu) = the margin lost by a firm for each lost sale because of stockout.
The relationship between the cost of overstocking and the cost of understocking determine the optimal level of product availability.
Understocking and Overstocking
Understocking
Cannot cope with unexpected changes in demand
Production line may have to stop therefore firm is paying an idle labour force
Cannot meet customers orders so they may choose to go elsewhere
Increased administration costs if firm is frequently re-ordering
Overstocking
High costs of storage and maintenance
High insurance costs
Possible need for security measures
Large amount of space needed
Money is tied up in stock which could be used elsewhere
Stock may deteriorate or become obsolete

 Safe disposal incurs extra cost

Parkas at L.L. Bean
Cost per parka = c = $45
Sale price per parka = p = $100
Discount price per parka = $50
Holding and transportation cost = $10
Salvage value per parka = s = 50-10=$40
Profit from selling parka = p-c = 100-45 = $55
Cost of overstocking = c-s = 45-40 = $5
The level of product availability is measured using the cycle service level of the fill rate. The service rate = The amount of
customer demand satisfied from available inventory. The level of product availability supply chains performance.
A high level of product availability large inventories costs for the supply chain.
Balance between the level of availability and the cost of inventory.

The Role of Transportation in a Supply Chain

Transportation refers to the movement of products from one location to another as it makes its way from the beginning of a supply chain to
the customer.
Factors to consider:
1.

Carrier (party that moves or transports the product)

Vehicle-related costs, Fixed operating costs, Trip-related costs
Often incurs huge investments (new fleets, etc)

2.

Shipper (party that requires the movement of the product between two points in the supply chain)
May need to balance Transportation costs with Inventory and Facility costs

3. Consignee (party that receives the shipment)

May have certain responsiveness needs

We should also consider:

4.

The owners of the infrastructure (Ports, highways, railroads)

5.

Government and/or bodies that set worldwide transportation policy

Transportation Modes

Trucks
Rail
Air
Water
Pipeline (highly limited by geography and product)
Package Carriers (still using trucks, but the focus is on delivery of a few packages).

Rail
Cheapest of the land-based modes
Uses less fuel, so also greener
Key issues:

Scheduling to minimize delays / improve service

Off-track delays (at pickup and delivery end)
Yard operations
Variability of delivery times.
Rail does not and cannot reach everywhere.

Air
Fastest mode, often used for global transit of expensive items
Use is growing (14% per year in US, see usage in Europe in graph below)
Key issues:
Complex: Location/number of hubs, Location of fleet bases/crew bases,
Schedule optimization, Fleet + Crew assignment, yield management.
Expensive
Most energy/emissions intensive.
Carriers:
Expensive
Rapid and reliable delivery
Small and time-sensitive shipments
Preferred mode for e-businesses (e.g., Amazon)
Consolidation of shipments (especially important for package carriers that use air as a primary method of transport).

Water
Ocean, inland waterway system, coastal waters
Limited to certain geographic areas
Very large loads at very low cost
Lowest energy/emission intensity per ton-km, though some concern about port pollution
i. Slowest
e. Also subject to bottlenecks at Ports
f. Dominant in overseas trade (autos, grain, apparel, etc.)
a.
b.
c.
d.

Pipeline:
High fixed cost
Primarily for crude petroleum, refined petroleum products, natural gas
Best for large and predictable demand
Would be used for getting crude oil to a port or refinery, but not for getting refined gasoline to a gasoline station

Intermodial:
Use of more than one mode of transportation to move a shipment to its destination
rail/truck, water/rail/truck or water/truck
Grown considerably with increased use of containers
Increased global trade has also increased use of intermodal transportation
More convenient for shippers (one entity can provide the complete service)
Key issue involves the exchange of information to facilitate transfer between different transport modes

The role of IT in a supply Chain:

Information is a key supply chain driver because it serves as the glue that allows the other supply chain drivers to
work together with the goal of creating an integrated, coordinated supply chain. It provides the foundation on
which supply chain execute transactions and managers take decisions.
IT consists of:
Hardware
Software
People(who gather, analyze, execute upon information)
Information must have following Characteristics:

Information must be accurate

Information must be accessible in a timely manner
Information must be of right kind
Information must be shared

Information is used to make wide variety of decisions about each supply chain drivers. They are:

Facility
Inventory
Transportation
Sourcing
Pricing and revenue management

References:
1. Logistics and Supply Chain Management : Strategies for Reducing Cost and Improving Service (Financial Times Management) -Christopher Martin;
2. Introduction to Supply Chain Management -- Robert B. Handfield, Ernest L. Jr. Nichols

3. Advanced S u p p l y C h a i n M a n a g e m e n t : How to Build a Sustained Competition -- Charles C. Poirier

4. Supply C h a i n M a n a g e m e n t : The B a s i c s a n d B e y o n d ( The S t . Lucie Press/Apics Series on Resource Management) ~
5.
6.
7.
8.
9.

William C. Copacino / Published 1997

Basics of Supply Chain Management James E. Hill,/ Published 1974
Introduction to Supply Chain Management ~ Robert B. Handfield, Ernest L. Jr. Nichols / Published 1998
Quick Response in the Supply Chain Eleni Hadjiconstantinou(Editor), Eleni Hadjiconstaninou (Editor/Published 1999)
Global Cases in Logistics & Supply Chain Management David H. Taylor (Editor / Published 1997)
Logistical Management: The Integrated Supply Chain Process Donald J. Bowersox, David J. Closs / Published 1996