Safety Inventory Analysis: Why and How?

By Hadley, Scott W. | Strategic Finance, September 2004 | Go to article overview

Safety Inventory Analysis: Why and How?


Hadley, Scott W., Strategic Finance


WOULDN'T YOU LIKE TO KNOW how the stock market was going to behave tomorrow, whether or not there's going to be an accident on your way to work, and if your flight is going to be delayed--and for how long? It goes without saying--we live in a world fraught with uncertainty!

To deal with uncertainty, more often than not you build some buffer into your life. For instance, you keep extra money in the bank just in case the car needs major repairs. You plan to arrive at the airport 90 minutes early just in case there's a traffic jam, and you schedule your meeting for two hours after you are due to land, just in case.

Companies also buffer against uncertainty. Perhaps the most common buffer companies use is safety inventory--carrying extra inventory just in case demand exceeds the forecast, just in case manufacturing has a breakdown, and just in case a supplier delivery is late or short in quantity.

"A Modern View of Inventory" in the July 2004 issue of Strategic Finance outlined the various roles of inventory and described techniques for computing target inventory levels. This article zeroes in on actual computation techniques to determine safety inventory levels. I'll explain a new one that addresses inventory uncertainty and compare it with common calculation techniques. A sample data set will demonstrate that the new technique far outperforms other methods, so you can use it to drive business value by achieving your customer service goals with less inventory. Let's begin.

THE ROLE OF SAFETY INVENTORY

Safety inventory protects against inventory uncertainty by ensuring there is enough product available to maintain desired service levels. Many factors contribute to inventory uncertainty, but three main elements give rise to the differences between planned inventory and actual inventory levels: demand deviations, supply deviations, and inventory accuracy. Traditionally, the analysis of safety inventory levels has focused primarily on demand and demand uncertainty, while supply uncertainty and inventory accuracy aren't typically addressed explicitly in the analysis of safety inventory.

What causes the deviations? Actual demand differing from forecast demand is the most common source of demand deviations. Supply deviations, however, arise for a variety of reasons, including:

* Late delivery,

* Short shipments,

* Production delays,

* Production yield differing from planned, and

* Substandard materials and production.

Finally, discrepancies between actual inventory and inventory records in corporate systems occur frequently and are often significant. Since computer systems generally initiate the operations and activities impacting inventory (e.g., procurement, production planning, logistics), it's necessary to account for inventory accuracy when computing safety inventory levels.

WHAT DO WE MEAN BY SERVICE LEVEL?

Most companies measure and manage service levels using a number of different definitions. Each of the service-level definitions focuses on how well you are able to satisfy specific demand as requested by the customer (e.g., meet the delivery dates, deliver the quantity requested). You can specify a number of different targets for each definition, but it's important to realize that each target must have a specified time frame, such as per hour, per day, per week, per month, per quarter, per year. The longer the time period, the easier it is to achieve a given level.

Some common service-level measures include line fill rate, order fill rate, demand fill rate, and 100% coverage rate, which are described in Table 1.

Table 2 shows how a company may set the following service-level targets for a specific product. Notice that there are two different demand fill-rate targets: one based on a monthly fill rate and the other on an annual fill rate.

Carrying safety inventory helps companies improve in each of these measures. …

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