Setting the Optimal Safety Stock

Transcription

1 Setting the Optimal Safety Stock Setting safety-stock is about increasing the stock levels to create a buffer for managing unforeseen fluctuations in demand and supply. Many companies do this poorly relying on simplistic, traditional methods of either having no safety stock, or opting to have a flat number of days coverage, or just a set quantity of stock. The implications of incorrectly setting safety stock are that it costs the company due to the costs of holding sufficient stock or conversely, the costs of not being able to meet customer demand. This paper discusses the concept of setting the optimal safety stock, by finding the balance between the customer service level and the cost of maintaining that service level.

2 Setting your safety-stock Ideally, you should set the stock at such a level that means you will be able to cater for each and every demand/supply fluctuation. In theory, to do that you would need to set the service level at 100% (i.e., every order will be fulfilled). However, setting the service level at 100% can get costly because the amount of stock you would need to carry. This is expensive not only in terms of capital cost for holding stock but also the handling cost and potential write-off costs (when products expire or become redundant). Common solutions for setting optimal safety stock Optimally setting safety stock involves balancing the cost of holding/supplying the extra stock against the cost of not being able to meet demand. This is something that most companies do poorly they tend to either have no safety stock, or they opt to have a flat number of days coverage, or just a set quantity of stock. Some companies do manage to lift the level of sophistication by including a set service level and possibly considering the supply lead-time and/or forecast errors as illustrated below. Safety Stock = Safety Factor (service level) * 1.25 * MAD (forecast error) * SQRT Lead-time. However, is that really good enough in a very competitive world where managing the cost and the service levels are of critical importance? This paper discusses the concept of setting the optimal safety stock, by looking at the cost of holding and supplying that extra stock versus the cost of missing sales. Considering the different cost components We ll start by looking at the different cost components that we need to consider. Shortage cost cost of missing demand (sales) Safety-stock cost cost of holding the safety stock Cycle Stock cost cost of holding the stock (above safety stock). Fixed Order Cost cost of placing another supply order. The sum of these cost components is the total inventory cost, which is what needs to be minimized. To do this you need to find the optimal point at which you balance the cost of missing sales against the cost of holding the stock. 2

3 1. Shortage Cost The shortage cost is the cost of losing a sale, which, while it s difficult to determine the exact dollar cost of a lost sale, there is no denying there is certainly a cost associated with it. So how do you calculate this shortage cost? This involves three components: Shortage Quantity (missed demand) Shortage cost by unit Lost sales factor Missed demand First of all when looking at lost sales it s important to understand what is the estimated number of ordered units that will not be fulfilled. The service level by definition says that at a service level of 95% you will miss out on 5% of the projected demand. Shortage cost by unit Then we have to look at the shortage cost by unit. There are different methods to calculate the shortage costs depending on your business and whether you calculate shortage costs for Finished Goods or Semi Finished Goods. For finished goods it is important to understand whether a missed demand will result in 1, a backorder, 2, a lost sale, 3, a lost customer. The shortage cost could be set based on gross margin (price-cost), product cost, or a set cost. Lost sales factor The last component of the shortage cost calculation would be the Lost Sales Factor. This is a subjective factor that is used to adjust the total cost. This factor takes into consideration the intangible impact of missing the sale. For example the lost sales factor in a situation where a customer would reasonably expect to wait a few days before going to a competitor might be between 0 and 1. On the other hand, where the sale is lost forever, and additionally where there may be further implications such as future lost sales due to poor delivery performance, or even penalties, the lost sales factor would be above 1. The higher the factor is the bigger impact we will have on losing a sale and hence we would end up with an optimal service level that is higher and consequently higher safety stock.. How to set the right value would probably involve workshop discussions, however the key point is to recognise that there is a cost for losing a sale that is vital to consider when setting the optimal safety-stock levels. 3

4 2. Safety-stock cost The safety stock cost component is the just the cost of holding the safety stock, that is typically: Product cost x Interest rate x Safety stock quantity The challenge is to define the safety stock quantity. The safety stock quantity is impacted by a number of factors that must be considered: Demand variation. This is pretty straightforward - The more variation you have in the demand, the more safety stock you will need. However the demand variation could either be measured against the average demand or against the forecast. So you will either be looking at the demand fluctuations or you will be looking at the variation against your forecast (forecast error). Supply Lead-time. The longer the supply lead-time is, the longer into the future you need to predict (horizon); and the longer the horizon, the greater the uncertainty. Safety Stock Figure 1 Uncertainty related to long planning horizons 4

5 Number of orders per year This is a factor that relates to the number of orders that will be placed to supply the required goods - The greater the number of orders, the greater the number of times the stock balance will come close to the safety stock and therefore a higher safety stock would be required (see below). Safety Stock Safety Stock Figure 2 Relationship between number of orders and Safety Stock Supply Lead-time Accuracy The same logic applies on the supply side as on the demand side - If the supplier sometimes delivers in 5 weeks and other times in 8 weeks you would need to cater for this uncertainty. Service Level Last but not least, the higher the service level is, the higher the safety stock - If you have the ambition to deliver 98% of all orders then you would need higher safetystock levels than if you only wanted to meet a 90% delivery accuracy. 3. Cycle Stock Cost Cycle cost is the cost of the holding the inventory that is not safety stock. This cost is simply: Product cost x Interest rate x Cycle stock qty When we are looking at the cost of holding stock we should not just look at the pure capital cost but also consider the fact that when there is more stock, there is generally more work associated with managing the stock. This is something that can be included in the interest rate we are using. 5

6 The cycle cost quantity is our average stock holding during the year. A simple way to look at this is just to look at the total annual demand divided by the number of times you will place the order (replenishment frequency) divided by two. See the following diagram. Figure 3 Cycle Stock Cost 4. Fixed Order Cost Every time you place a replenishment order (whether it is a manufacturing order, a distribution order or a purchase order) there will be an associated cost. So over the year if you place 20 orders versus 5 there will be a higher accumulated cost in the case where we are placing 20 orders. It might be difficult to precisely identify this cost, but the main thing is to recognise that there is a cost and that this is something that you need to consider. 6

7 Optimizing the safety-stock So when we are trying to optimize the safety stock, what we are really trying to do is to find the optimal mix of the right service level and replenishment frequency considering: the set sales price and cost the defined cost of losing a sale the current demand variation the supply lead time and variation the total annual demand the set interest rate There is no doubt that the best way to improve the overall safety-stock would be to improve the demand variation, the lead time, the supply lead time variation, etc. However, in any given situation, they are what they are and based on this situation what we need to do is to set the most optimal service level and replenishment frequency. Figure 4 Minimizing Total Inventory Costs So, we are really looking at a three dimensional problem where we are trying to minimize the total inventory cost (as defined above) by adjusting two variables (replenishment frequency and service level). 7

8 Figure 5 Cost and Service Levels change with Replenishment Frequency If we start looking at one of the dimensions we can see how the cost and service levels changes with the replenishment frequency (see above): The safety stock will increase with a higher number of replenishments (there will be more times over the year where we will be closer to the safety stock line as described above). The shortage cost will be the same regardless of the replenishment frequency as this is a direct relation to the service level. If we say that we will have a service level of 98% then that means by definition that we will miss out of 2% of the orders. The Cycle Stock Cost will drop with higher replenishment frequency. Basically the more often we buy, the less we need to hold in inventory. The fixed order cost is a direct cost that is related to each of the orders we are placing, so the higher the replenishment frequency the higher the fixed order cost. By adding up those costs we will get the total cost curve and we can see how the total cost changes with the replenishment frequency. In the picture to the right we can also see a different cost curve based on a different service level. 8

9 If we then present this problem in a three-dimensional graph where both the replenishment frequency and the service levels are variables we would get a picture as shown below. Figure 6 Optimal Safety Stock The aim of the game is now to find the optimum in this graph where the total inventory cost (considering shortage cost, cycle stock cost, safety stock cost and fixed order cost) is the lowest. Finding this point means that we have found the ultimate safety stock, a balance between the service level and the cost of maintaining that service level. 5. Conclusion Most companies are doing a poor job in maintaining the optimal safety stock. Experience tells us that the general approach of setting the safety stock is just a matter of setting a straight number of days coverage. However this is not good enough. The implications of setting the incorrect safety stock levels are that you underperform in terms of your ability to best serve your customers. Conversely you end up carrying too much stock which has implications not only from a cost of capital point of view, but also from a stock management point of view. A warehouse that is overfilled is harder and much more expensive to run. Carrying too much stock also means that we might have to write off stock due to expiration dates or because the stock has become redundant (no one wants it anymore and you are sitting on too much stock). At the end of the day, setting the right safety stock levels is important. For companies who haven t thoroughly looked into this there is a great potential that should not go wasted. 9