Statistical Confidence in Safety-Stock Levels

In a properly structured and comprehensive safety-stock model, expediting, which relates to a statistical factor called “confidence” – is neither subjective nor unpredictable. Because confidence is a statistical factor, the level of common-cause expediting is quantifiable. Confidence is integral to statistics – as in political polls with their plus-or-minus ranges. However, confidence as it applies to safety stock may be a new thought for you. As this discussion progresses, you will see how critical confidence is to optimizing your business.

When you employ correctly-modeled safety stock and confidence – the statistical factor that determines expediting – as business strategies for achieving your service-level targets, more expediting means less safety stock, and vice-versa. Both of these service-level techniques have costs and risks, many of which are difficult to quantify objectively, but which are nonetheless significant. Clearly, your costs and risks of both service-level dimensions – safety stock and expediting – have a direct connection to determining and optimizing your profitable safety-stock and service levels.

Optimal Fill Rate Is Limited by Incremental Margin

Everyone agrees that the ideal service level would be a 100% fill rate, if there were no costs and risks associated with achieving and supporting that fill rate. Of course, if this were really true, you and your competitors would all be providing 100% service level, and no one could use service level as a competitive advantage. (By “100%,” we mean virtually 100%, since 100% is theoretically not achievable.)

In reality, the costs and risks of 100% service level are daunting and often prohibitive. In one sense, this is bad news. On the other hand, it offers you both market and financial advantages if you can provide a better service level than does your competition – with minimal safety-stock and expediting costs – so that you make a compelling margin on the incremental service level.

What are the competitive advantages of increased service level? They include:

  • revenue enhancement as a result of the market preferring your service level to that of your competition
  • Increased market share, and therefore increased volume
  • Premium pricing

These competitive advantages also provide cost reduction and avoidance, such as:

  • Minimizing late-ship penalties
  • Leveraging fixed costs and expenses against incremental revenue from increased market share

However, these service-level-driven competitive advantages also incur incremental costs, including:

  • Carrying costs on higher safety-stock levels corresponding to higher service levels (costs of capital, inventory service, storage and risk)
  • Premium freight (air vs. ground, next-day vs. standard, LTL, etc.)
  • Expediters (buyers, planners, logistics specialists, etc.)
  • Other short lead time and expediting costs (small-quantity and/or secondary-supplier pricing premiums, etc.)
  • More frequent replenishment (re-ordering costs, etc.)

Your financial analyst will have no trouble creating a holistic financial model that determines the point at which increased service level ceases to provide an acceptable incremental margin. The model is easy (see below for an example of the model inputs).

Assigning reliable, quantified values to some of the financial-model inputs above can be most challenging.

We will begin discussing an improved way of doing this in our next post.

NB: Of course, your marketing and sales teams can make a reasonable estimate of the potential for increased market share and premium pricing, and your financial analyst can easily calculate leverage at all contribution levels. Your accounting group can easily provide your current level of late-ship penalties. And your supply-chain organization knows reordering, expediting and inventory-carrying costs.