Determining the optimal level of service (product availability)

The level oI product availability is measured using CSL (cycle Service Level) or the Iill rate. A
company can use a high level oI product availability to improve its responsiveness and thus
attracting the customers, which in turn, increases the revenue. However, a high level oI product
availability requires large inventories and hence increased costs. ThereIore the company must
strike a balance between the level oI availability and the cost oI inventory.

In this note, we Iocus on the products that are ordered repeatedly and saIety stock (SS) is used
to increase the level oI availability and decrease the probability oI stocking out between
successive deliveries.

Most saIety stock decisions are based on a more or less arbitrary level oI protection (95 CSL
in the textbook examples is a case in point). +RZGRZHVHWWKLVOHYHO? II the inventory control
manager increases the level oI saIety inventory, more orders are satisIied Irom the stock,
resulting in lower backlogs (or unmet demand). This decreases the backlogging cost (or lost
sales cost). However, the cost oI holding inventory increases. The manager must pick a level oI
saIety inventory that minimizes the backlogging (or lost sales) cost and the holding cost.

The Iollowing analysis (approximation) shows how to minimize cost by considering the cost
and saving oI a one-unit change in the saIety stock level.

Suppose that we considered reducing saIety stock (SS) by one unit. :KDWZLOOLWVDYH? II SS is
lowered the entire inventory curve moves down, indicating a lower average inventory. The
saving is thereIore C
H
(holding cost per unit per unit). :KDWZLOOLWFRVW? The answer depends on
the expected number oI times per year we are out oI stock. Each time we were out oI stock last
year, iI SS had been lower we would have had greater shortages. Thus, lowering SS by one unit
will cost us one more unit oI shortage Ior each out-oI-stock condition; hence the average cost
per year is

(1 shortage) * (Expected number oI stockouts per year) * (cost per unit short, C
B
)


II the cost is less than saving, we should reduce SS. II cost exceeds the savings, SS should be
higher. ThereIore, at the optimal SS, the cost oI marginal change should equal saving, or

(Expected number oI stockouts per year) * (cost per unit short, C
B
) C
H

Thus, the saIety stock level SS should be set in such a way that average annual number oI
stockouts is numerically equal to C
H
/C
B
.

The probability oI stockout per cycle is then equal to
Expected number oI stockouts per year
(D/Q)
where the denominator represents the number oI ordering cycles in a year. D is annual
demand and Q is EOQ.

The optimal cycle service level, CSL
*
, i.e. the probability oI no stockouts during a cycle, thus,
can be given as

CSL
*
1 |(C
H
/ C
B
)*(Q/D)|

To apply this result to J&G Distributors, suppose the shortage cost Ior the inexpensive part
#4915082 is estimated to be C
B
$0.015 per unit, because oI the expediting required to procure
the item iI it is needed when out oI stock. For this part, C
H
$0.12 * 0.25 per unit per year; D
60000 units, Q 6325. We have now, C
H
/ C
B
2, i.e. the optimal service level should have on
an average 2 stockouts per year and CSL oI (1 2*6325/60000) 0.79. Compare this with
arbitrarily set value oI 0.95. Is J&G carrying more inventory than it should?

Alternatively, iI there is a mandate Irom the management to have a target CSL oI 0.95, the
implicit backordering cost (C
B
) is 0.06325 per unit short. Please veriIy.