Explaining What “Service Level” Means in Your Inventory Optimization Software

Customers often ask us why a stocking recommendation is “so high.” Here is a question we received recently:

During our last team meeting, we found a few items with abnormal gaps between our current ROP and the Smart-suggested ROP at a 99% service level. The concern is that the system indicates that the reorder point will have to increase substantially to achieve a 99% service level. Would you please help us understand the calculation?

When we reviewed the data, it was clear to the customer that the Smart-calculated ROP was indeed correct.  We concluded (1) what they really wanted was a much lower service level target and (2) we had not done a good explaining what was really meant by “service level.” 

So, what does a “99% service level” really mean? 

When it pertains to the target that you enter in your inventory optimization software, it means that the stocking level for the item in question will have a 99% chance of being able to fill whatever the customer needs right away.  For instance, if you have 50 units in stock, there is a 99% chance that the next demand will fall somewhere in the range of 0 to 50 units.

What our customer meant was that 99% of the time a customer placed an order, it was delivered in full within whatever lead time the customer was quoted.  In other words, not necessarily right away but when promised.  

Obviously, the more time you give yourself to deliver to a customer the higher your service level will be. But that distinction is often not explicitly understood when new users of inventory optimization software are conducting what-if scenarios at different service levels.  And that can lead to considerable confusion.  Computing service levels based on immediate stock availability is a higher standard: harder to meet but much more competitive.

Our manufacturing customers often quote service levels based on lead times to their customers, so it isn’t essential for them to deliver immediately from the shelf. In contrast, our customers in the distribution, Maintenance Repair and Operations (MRO), and spare parts spaces, must normally ship same day or within 24 hours.  For them it is a competitive necessity to ship right away and do so in full.

When inputting target service levels using your inventory optimization software, keep this distinction in mind.  Choose the service level based on the percentage of the time you want to ship inventory in full, right away from the shelf.  

Don’t blame shortages on problematic lead times.

Lead time delays and supply variability are supply chain facts of life, yet inventory-carrying organizations are often caught by surprise when a supplier is late. An effective inventory planning process embraces this fact of life and develops policies that effectively account for this uncertainty. Sure, there will be times when lead time delays come out of nowhere and cause a shortage. But most often, the shortages result from:

  1. Not computing stocking policies (e.g., reorder points, safety stocks, and Min/Max levels) often enough to catch changes in the lead time. 
  2. Using poor estimates of actual lead time such as using only averages of historical receipts or relying on a supplier quote.

Instead, recalibrate policies across every single part during every planning cycle to catch changes in demand and lead times.  Rather than assuming only an average lead time, simulate the lead times using scenarios.  This way, recommended stocking policies account for the probabilities of lead times being high and adjust accordingly.  When you do this, you’ll identify needed inventory increases before it is too late. You’ll capture more sales and drive significant improvements in customer satisfaction.