Using a target service level to set safety stocks prevents optimisation. That is because the optimum service level is different for different items. Using the same target service level for all items tends to produce results which are far from optimal. This problem is particularly large for companies and other organisations for which customers usually submit orders rather than visiting the store. That is because, under those circumstances, the time taken to fill customer orders tends to be one of the most important measures of customer service.
Finding the optimum service level for an item involves weighing up the costs of shortages against the cost of avoiding shortages. Notice that this requires information concerning shortage costs. Shortage cost modelling is much easier than you probably think. Instructions for doing it will be given in a future article. Using such a model avoids the need to find optimum service levels. A single shortage cost model can be used for a large group of items, perhaps even your entire inventory. This greatly reduces the amount of work required to optimise safety stocks.
It is worth considering the implications of the definition of optimisation. It is maximisation of net benefit. That can only be achieved if all of the benefits are expressed in the same terms. There are costs involved in inventory control. Therefore, all of the benefits relevant to inventory control have to be expressed in monetary terms. Otherwise, inventory optimisation is not possible. Therefore, a high service level cannot be treated as being one of the benefits for the purpose of optimisation. Shortage costs have to be used as an alternative expression of that benefit. Service levels and shortage costs are closely related. The optimum service level for an item is strongly influenced by how costly shortages are. For the reasons given in this paragraph, optimisation of reordering criteria is achieved by minimising the total cost. Shortage costs are one of the most important types of cost involved.
You are probably still wondering how it is possible, without much difficulty, to do a good job of shortage cost modelling. Your thinking in that regard is probably influenced by the fact that some shortage costs are very difficult, or even impossible, to determine. A good example is the cost of the damage which shortages cause to your company’s reputation. Typically, there is one major shortage cost which is difficult, or even impossible, to determine. Surprisingly, this difficulty is beneficial. That is because it results in there being a parameter which you can set, arbitrarily, to control the overall service level and total investment in stock. Regardless of the value which you set for that parameter, the overall service level will be high in relation to the investment in stock. The parameter concerned should then be adjusted as required to achieve your company’s overall inventory objectives. Minimising total cost will then result in optimum minimum and maximum levels. You can then concentrate your efforts on the relatively small number of items for which it is costly to provide good service.
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