MANAGING UNCERTAINTY IN A

SUPPLY CHAIN: SAFETY

INVENTORY

Prof. Debadyuti Das

FMS, DU
The Role of Safety Inventory
• Safety inventory is carried to satisfy demand that exceeds
the amount forecasted

• Raising the level of safety inventory increases product availability

and thus the margin captured from customer purchases.
• Raising the level of safety inventory increases inventory holding
costs.
The Role of Safety Inventory
The Role of Safety Inventory
• Three key questions
1. What is the appropriate level of product availability?
2. How much safety inventory is needed for the desired level of
product availability?
3. What actions can be taken to reduce safety inventory without
hurting product availability?
Factors affecting the level of Safety
Inventory
• The desired level of product availability
• The uncertainty of demand
• The uncertainty of supply
• Inventory replenishment policies
Determining the Appropriate
Level of Safety Inventory
• Higher levels of uncertainty require higher levels of safety
inventory given a particular desired level of product
availability

• Higher levels of desired product availability require higher

levels of safety inventory given a particular level of
uncertainty
Measuring Product Availability
• Product availability: a firm’s ability to fill a customer’s order
out of available inventory
• Stockout: a customer order arrives when product is not
available
• Product fill rate (fr): fraction of demand that is satisfied from
product in inventory
• Order fill rate: fraction of orders that are filled from
available inventory
• Cycle service level: fraction of replenishment cycles that
end with all customer demand met
Measuring Product Availability
1. Product fill rate (fr)
– Fraction of product demand satisfied from
product in inventory
2. Order fill rate
– Fraction of orders filled from available inventory
3. Cycle service level (CSL)
– Fraction of replenishment cycles that end with
all customer demand being met

replenishment cycle – the interval

between two successive
replenishment deliveries
 Measuring Demand Uncertainty
• Demand has a systematic component and a random
component
• The estimate of the random component is the measure of
demand uncertainty
• Random component is usually estimated by the standard
deviation of demand

D = Average demand per period

sD = Standard deviation of demand (forecast
error) per period
Lead time (L) is the gap between when an order
is placed and when it is received
Evaluating Demand Distribution
Over L Periods
L L
DL = å Di sL = å i + 2å rijs is j
s 2

i=1 i=1 i> j

DL = DL s L = Ls D

The coefficient of variation

cv = s / m
Measuring Supply Uncertainty
• Orders not arriving on time or orders not arriving
complete.
• Described by the uncertainty in lead time.

L = Average lead time

sL = Standard deviation of lead time

DL = DL s L = Ls D2 + D2 sL2
Replenishment Policies
1. Continuous review
• Inventory is continuously tracked
• Order for a lot size Q is placed when the inventory declines to the
reorder point (ROP)

2. Periodic review
• Inventory status is checked at regular periodic intervals
• Order is placed to raise the inventory level to a specified threshold
Determining the Appropriate Level of
Safety Inventory
• Evaluating Safety Inventory Given a Replenishment
Policy

Expected demand during lead time = D x L

Safety inventory, ss = ROP – D x L
Determining the Appropriate Level of
Safety Inventory
Average demand per week, D = 2,500
Standard deviation of weekly demand, sD = 500
Average lead time for replenishment, L = 2 weeks
Reorder point, ROP = 6,000
Average lot size, Q = 10,000

Safety inventory, ss = ROP – DL = 6,000 – 5,000 = 1,000

Cycle inventory = Q/2 = 10,000/2 = 5,000
Determining the Appropriate Level of
Safety Inventory
Average inventory = cycle inventory + safety inventory
= 5,000 + 1,000 = 6,000

Average flow time = average inventory/throughput

= 6,000/2,500 = 2.4 weeks
Determining the Appropriate Level of
Safety Inventory
• Evaluating Cycle Service Level Given a
Replenishment Policy

CSL = Prob(ddlt of L weeks ≤ ROP)

CSL = F(ROP, DL, sL) = NORMDIST(ROP, DL, sL, 1)

(ddlt = demand during lead time)

Determining the Appropriate Level of
Safety Inventory
Q = 10,000, ROP = 6,000, L = 2 weeks
D = 2,500/week, sD = 500

DL = D ´ L = 2 ´ 2,500 = 5,000
s L = Ls D = 2 ´ 500 = 707

CSL = F(ROP, DL, sL) = NORMDIST(ROP, DL, sL, 1)

= NORMDIST(6,000, 5,000, 707, 1) = 0.92
Determining the Appropriate Level of
Safety Inventory
• Evaluating Required Safety Inventory Given a
Desired Cycle Service Level

Desired cycle service level = CSL

Mean demand during lead time = DL
Standard deviation of demand during lead time = σL
Probability(demand during lead time ≤ DL + ss) = CSL
• Identify safety inventory ss so that

F(DL + ss, DL, σL) = CSL

Determining the Appropriate Level of
Safety Inventory
DL + ss = F –1(CSL,DL ,s L ) = NORMINV (CSL,DL ,s L )
or
ss = F –1(CSL,DL ,s L ) – DL = NORMINV (CSL,DL ,s L ) – DL

ss = FS–1(CSL) ´ s L = FS–1(CSL) ´ Ls D

= NORMSINV (CSL) ´ Ls D
Determining the Appropriate Level of
Safety Inventory
D = 2,500/week, sD = 500, CSL = 0.9, L = 2 weeks

DL = DL = 2 ´ 2,500 = 5,000
s L = Ls D = 2 ´ 500 = 707

ss = Fs–1(CSL) ´ s L = NORMSINV (CSL) ´ s L

= NORMSINV (0.90) ´ 707 = 906
Evaluating Fill Rate Given a
Replenishment Policy
• Expected shortage per replenishment cycle (ESC) is the
average units of demand that are not satisfied from
inventory in stock per replenishment cycle
• Product fill rate

fr = 1 – ESC/Q = (Q – ESC)/Q
Evaluating Fill Rate Given a
Replenishment Policy

ò
¥
ESC = (x – ROP) f (x) dx
x=ROP

é æ ss öù æ ss ö
ESC = –ss ê1– Fs ç ÷ú + s L f s ç ÷
êë è s L øúû ès L ø

ESC = –ss[1– NORMDIST(ss / s L ,0,1,1)]

+s L NORMDIST(ss / s L ,0,1,0)
Evaluating Fill Rate Given a
Replenishment Policy
Lot size, Q = 10,000
Average demand during lead time, DL = 5,000
Standard deviation of demand during lead time, sL = 707

Safety inventory, ss = ROP – DL = 6,000 – 5,000 = 1,000

ESC = –1,000[1– NORMDIST(1,000 / 707,0,1,1)]

+707NORMDIST(1,000 / 707,0,1,0) = 25

fr = (Q – ESC)/Q = 110,000 – 252/10,000 = 0.9975

Key Point

Both fill rate and cycle service level

increase as the safety inventory is
increased. For the same safety
inventory, an increase in lot size
increases the fill rate but not the cycle
service level.
Impact of Desired Product Availability and
Uncertainty
• As desired product availability goes up the required safety
inventory increases

Fill Rate Safety Inventory

97.5% 67
98.0% 183
98.5% 321
99.0% 499
99.5% 767
Key Point

The required safety inventory grows

rapidly with an increase in the desired
product availability.
Key Point

The required safety inventory

increases with an increase in the lead
time and the uncertainty of periodic
demand.
Impact of Desired Product Availability and
Uncertainty
• Goal is to reduce the level of safety inventory
required in a way that does not adversely affect
product availability
1. Reduce the supplier lead time L
2. Reduce the underlying uncertainty of demand
(represented by sD)
Impact of service level on safety stock
• Service level is the probability that all orders will be filled
from stock during the replenishment lead time or during
the reorder cycle.
• A retailer has specified a service level of 95 percent. This
implies that during 100 such reorder cycles, we can
expect stock out situation in about five cycles.
• A firm keeping a higher level of safety factor is in a
position to provide higher level of customer service.
• Service level increases as the level of safety inventory
increases.
• The marginal increase in service level in the initial period
is higher than that in the later period.
Impact of service level on safety stock
Impact of demand and supply uncertainty
on safety stock
• Variability in demand and lead time has an important
bearing on the amount of safety stock to be kept by a firm.
• The absolute value of lead time also has an impact on the
amount of safety stock to be maintained.
• Reduction in variability of supplier lead time provides
highest benefits to the firm in terms of minimizing safety
stock requirement.
• Reduction in variability of demand is not a significant driver
in minimizing safety stock requirement.
• Reduction in average lead time does not have much
impact in minimizing safety stock requirement.
Impact of demand and supply uncertainty on
safety stock (Consider SL = 97.8%, i.e. Z = 2)
Average S.D. of Average S.D. of Safety Safety Remarks
demand demand lead L.T. stock stock
time in days
100 30 15 5 1026 10.3 Base case

100 30 15 0 232 2.3 No supply

uncertainty
100 0 15 5 1000 10 No demand
uncertainty
100 15 15 5 1006 10 Reduce demand
uncertainty
100 30 15 2.5 526 5.3 Reduce supply
uncertainty
100 30 7.5 5 1003 10 Reduction in lead
time
Key Point

A reduction in supply uncertainty can

help to dramatically reduce the
required safety inventory without
hurting product availability.
Impact of Aggregation
on Safety Inventory
• How does aggregation affect forecast accuracy and
safety inventories

Di: Mean weekly demand in region i, i = 1,…, k

si: Standard deviation of weekly demand in region i,
i = 1,…, k
rij: Correlation of weekly demand for regions i, j,
1≤i≠j≤k
Impact of Aggregation
on Safety Inventory
k

in decentralized option
å S
Total safety inventory = F –1(CSL) ´ L ´ s
i
i=1

k
D = å Di ; ( ) = ås i2 + 2å rijs is j ;
C k C
var D
i=1
i=1 i> j

s DC = var DC( )
DC = kD s DC = ks 2 + k ( k – 1) rs 2

Simplified to s DC = k s D
Impact of Aggregation
on Safety Inventory

on aggregation
å
Required safety inventory= F –1(CSL) ´ L ´ s C
S D
i=1

Holding – cost savings on

aggregation per unit sold

FS–1(CSL) ´ L ´ H æk ö
= ´ ççås i – s D ÷÷
C

DC è i=1 ø
Impact of Aggregation
on Safety Inventory
• The safety inventory savings on aggregation increase
with the desired cycle service level CSL
• The safety inventory savings on aggregation increase
with the replenishment lead time L
• The safety inventory savings on aggregation increase
with the holding cost H
• The safety inventory savings on aggregation increase
with the coefficient of variation of demand (sD/D)
• The safety inventory savings on aggregation decrease
as the correlation coefficients increase
Impact of Correlation on
Value of Aggregation
Standard deviation of weekly demand, sD = 5;
Replenishment, L = 2 weeks; Decentralized CSL = 0.9
Total required
safety inventory,ss = k ´ Fs–1(CSL) ´ L ´ s D
= 4 ´ Fs–1(0.9) ´ 2 ´ 5
= 4 ´ NORMSINV (0.9) ´ 2 ´ 5 = 36.25 cars
Aggregate r = 0
Standard deviation of
weekly demand at central outlet, s D = 4 ´ 5 = 10
C

ss = Fs–1(0.9) ´ L ´ s DC = NORMSINV (0.9) ´ 2 ´10 = 18.12

Impact of Correlation on
Value of Aggregation

Disaggregate Aggregate
r Safety Inventory Safety Inventory
0 36.25 18.12
0.2 36.25 22.93
0.4 36.25 26.88
0.6 36.25 30.33
0.8 36.25 33.42
1.0 36.25 36.25
Impact of Aggregation
on Safety Inventory
• The Square-Root Law
Impact of Correlation on
Value of Aggregation
• Two possible disadvantages to aggregation
1. Increase in response time to customer order
2. Increase in transportation cost to customer