Determining Optimal Level of Safety Stock-

When to Order When Out of Stock Costs are Known

Lead Time: The time between ordering and
receiving of inventory is called the lead time.
Stock out: Variations in lead time and demand
often cause stockouts, that is, situations where
the inventory is insufficient to meet demand.
Safety Stock: It is the extra inventory held as a
protection against stockouts. Safety stock has two
effects on the costs. It will decrease the cost of
stockouts, but will increase the cost of carrying
this additional inventory.
Example. A television set manufacturer obtains speakers
from another source. He has calculated that the EOQ for
this item is 3600 with an average of 50 speakers per day
and the lead time is 6 days. He has also estimated that
the cost of a stock out is Rs 50 per speaker. The
inventory carrying cost is 20% of the cost of inventory
and has been calculated as Rs 12 per unit annually. The
stockout cost represents the cost of inconvenience, the
cost involved in reprocessing sets when the speakers
arrive and the cost of holding sets without speakers. Past
records for the usage of this item during the lean period
are as shown on the next slide.

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Safety Stock Level Example contd

Usage during No. of times this Usage probability Cumulative If a manufacturer maintains a reorder level
reorder period quantity was probability
used of 300 units, i.e., average lead time
150 3 0.03 0.03 consumption (average usage per day *
200 4 0.04 0.07 lead time) it means
250 6 0.06 0.13  With no safety stock demand will be met
300 68 0.68 0.81 81% of the time.
350 9 0.09 0.90
 The 0.19 probability of a stockout can be
400 6 0.06 0.96
reduced by maintaining a safety stock
450 4 0.04 1.00
over and above the lead time
Total 100
consumption.
How much safety stock should the manufacturer maintain? Page 4

Safety Probability of Numbers Expected annual cost (No. Total annual

stock stockout short short x probability of being stockout cost
Example contd short x shortage cost per unit
no. of orders per year)
0 0.09 when
Manufacturer should aim at minimizing the usage is 350 50
total cost of stockouts and carrying costs 0.06 when
usage is 400 100
of safety stock. 0.04 when
usage is 450 150 4125
50 0.06 when
usage is 400 100
0.04 when 1750
usage is 450 150
100 0.04 when 500
usage is 450 50
150 0 0 0 0

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Computing the total costs for different safety stock policies

Safety Costs of stockouts Annual carrying Total costs (Rs)

stock (Rs) costs (Rs)

0 4125 0 4125  Since the total cost for carrying a safety

50 1750 2350 stock of 100 units is the least, the
manufacturer should hold a safety stock
of 100 units
100 500 1700
 Reorder point = (Average daily use *
Lead time)+safety stock
150 0 1800
= 300+100
= 400

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Determining Optimal Level of Safety Stock-

Safety Stock Level When Out of Stock Costs are Not Known

 Service Level. Service level is the  Consider the previous example. The daily
probability of being able to fulfil orders demand is normally distributed with a mean of
50 and a standard deviation of 8 speakers. The
 A service-level policy of 95% for a lead time is 6 days. The average demand in six
particular item implies that the days is 300.
organisation wants to be able to supply  The standard deviation for six days must be
95% requests for that item. determined.
Note: Standard deviation cannot be added but
variance can be added.

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Safety Stock Level Safety Stock Level

 Standard deviation during the lead time is:
 If the organisation wants to maintain 95 %
Where σ is the standard deviation of daily demand service level, what should be the safety stock?
and L is the lead time.

Area under
the curve =
0.45
Area under
the curve =
m=300 x
0.05
σ=19.60

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Fixed Order Quantity System
• Order Quantity is fixed. (EOQ)
• Time of placing order varies
• Reorder point = Lead time
consumption + Safety stock
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Fixed Order Quantity System
 Disadvantages
 No records are maintained of stock levels
and usage rates
 Does not lend itself to ordering different
items simultaneously from the same
source
 Does not permit balancing of the work
load
 not suitable for items having very long
and highly variable lead times.
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Fixed Interval System (P System)
 Advantages
 Provides strict control on inventory
 Permits even distribution of load
 Permits the grouping of orders from a
single source
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Fixed Order Quantity System
 Advantages
 Highly automatic
 Simple, reliable and cheap to operate
 Lends itself to visual controls
 Records can be dispensed with.
 Suitable for items of low value (C
items)
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Fixed Interval System (P System)
• Interval between orders is fixed
• Quantity ordered varies.
• Stock position reviewed at fixed interval.
• Review period generally corresponds to
EOQ consumption period.
• Maximum stock level = Review period
consumption + Lead time consumption
+ Safety stock.
• Order quantity = Maximum stock level –
Stock in hand – Stock on order
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Fixed Interval System (P System)
 Disadvantages
 Requires skilled manpower
 Costly
 Order quantities may vary considerably
from period to period causing problems
for the supplier
 Quantity held is higher than that held in
the fixed quantity order system
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Reordering with Planned Stockouts Back Order Model
• A customer placed an order.
• The supplier was out of stock of that
particular item.
where V is the cost to maintain 1 unit on backorder status for
• The customer does not withdraw the one year
A is the annual usage
order. S is the cost per order
C is the cost per unit of the item
• The customer waits till the next i is the carrying cost expressed as a percentage.
Q is the EOQ in units.
shipment arrives.
• The supplier fills the customer’s order
when the next shipment arrives.
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Back Order Model Example

Mr. I M Car is a Maruti dealer. He
estimates that:
where B is the number of units backordered when the
EOQ arrives

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