Chapter 12

Managing Uncertainty in a Supply
Chain: Safety Inventory

• Understand the role of safety inventory in a supply chain
• Identify factors that influence the required level of safety

inventory
• Describe different measures of product availability
• Utilize managerial levers available to lower safety inventory and

improve product availability
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
• Three key questions

What is the appropriate level of product availability?
How much safety inventory is needed for the desired level of
product availability?
What actions can be taken to improve product availability while
reducing safety inventory?
Determining the Appropriate Level
• Determined by two factors

The uncertainty of both demand and supply
The desired level of product availability
• Measuring Demand Uncertainty

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 = ås 2
i
+ 2å rijs is j
i=1 i=1 i> j
DL = DL s L = Ls D
The coefficient of variation

cv = s / m
Measuring Product Availability
• Product fill rate (fr)

Fraction of product demand satisfied from product in inventory
• Order fill rate

Fraction of orders filled from available inventory
• Cycle service level (CSL)

Fraction of replenishment cycles that end with all customer
demand being met
Replenishment Policies
• Continuous review
Inventory is continuously tracked
Order for a lot size Q is placed when the inventory declines to the
reorder point (ROP)
• Periodic review
Inventory status is checked at regular periodic intervals
Order is placed to raise the inventory level to a specified
threshold
Evaluating Cycle Service Level
and Fill Rate
• Evaluating Safety Inventory Given a Replenishment Policy
Expected demand during lead time = DL

Safety inventory, ss = ROP – DL
and Fill Rate
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

and Fill Rate
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
and Fill Rate
• 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)

and Fill Rate
Q = 10,000, ROP = 6,000, L = 2 weeks

D = 2,500/week, sD = 500
DL = DL = 2 ´ 2,500
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
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
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)
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

Evaluating Safety Inventory Given
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 so that
F(DL + ss, DL, sL) = CSL

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
Q = 10,000, CSL = 0.9, L = 2 weeks

D = 2,500/week, sD = 500
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
Desired Fill Rate
• Expected shortage per replenishment cycle is
ESC = (1 – fr)Q
• No equation for ss
• Try values or use GOALSEEK in Excel

Evaluating Safety Inventory Given Desired
Fill Rate
Desired fill rate, fr = 0.975

Lot size, Q = 10,000 boxes
Standard deviation of ddlt, sL = 707
ESC = (1 – fr)Q = (1 – 0.975)10,000 = 250

Desired Fill Rate
ESC = 250 = –ss ê1– Fs ç ÷ú + s L f s ç ÷
êë è s L øúû ès L ø
= –ss ê1– Fs ç ÷ú + 707 f s ç ÷
ë è 707 øû è 707 ø
250 = –ss[1– NORMDIST(ss / 707,0,1,1)]

+707NORMDIST(ss / 707,0,1,0)
• Use GOALSEEK to find safety inventory ss = 67 boxes
Desired Fill Rate
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
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
Reduce the supplier lead time L
Reduce the underlying uncertainty of demand (represented by
sD)
Benefits of Reducing Lead Time
D = 2,500/week, sD = 800, CSL = 0.95
ss = NORMSINV (CSL) ´ Ls D
= NORMSINV (.95) ´ 9 ´ 800 = 3,948
• If lead time is reduced to one week
ss = NORMSINV (.95) ´ 1´ 800 = 1,316
• If standard deviation is reduced to 400
ss = NORMSINV (.95) ´ 9 ´ 400 = 1,974

Impact of Supply Uncertainty
on Safety Inventory
• We incorporate supply uncertainty by assuming that lead time is

uncertain
D: Average demand per period

sD: Standard deviation of demand per period
L: Average lead time for replenishment
sL: Standard deviation of lead time
DL = DL s L = Ls D2 + D 2 sL2
Impact of Lead Time Uncertainty
on Safety Inventory
Average demand per period, D = 2,500

Standard deviation of demand per period, sD = 500
Average lead time for replenishment, L = 7 days
Standard deviation of lead time, sL = 7 days
Mean ddlt, DL = DL = 2,500 x 7 = 17,500
Standard deviation of ddlt s L = Ls D2 + D 2 sL2
= 7 ´ 5002 + 2,5002 ´ 72
= 17,500
Impact of Lead Time Uncertainty
on Safety Inventory
• Required safety inventory

ss = FS–1(CSL) ´ s L = NORMSINV (CSL) ´ s L
= NORMSINV (0.90) ´17,500
= 22,491 hard drives
sL sL ss (units) ss (days)
6 15,058 19,298 7.72
5 12,570 16,109 6.44
4 10,087 12,927 5.17
3 7,616 9,760 3.90
2 5,172 6,628 2.65
1 2,828 3,625 1.45
0 1,323 1,695 0.68
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
Safety Inventory
k
Total safety inventory in = å FS–1(CSL) ´ L ´si
decentralized option i=1
k
DC = å Di ; ( )
var DC = ås i2 + 2å rijs is j ;
k
i=1
i=1 i> j
s DC = var DC ( )
DC = kD s DC = k s D
Safety Inventory
k
Require safety inventory on
aggregation = å FS–1(CSL) ´ L ´ s DC
i=1
Holding-cost savings on aggregation per unit sold
FS–1(CSL) ´ L ´ H æ k ö
= ´ ççås i – s D ÷÷
C
DC è i=1 ø
Safety Inventory
• The safety inventory savings on aggregation increase with the

desired cycle service level CSL
replenishment lead time L
holding cost H
coefficient of variation of demand
• The safety inventory savings on aggregation decrease as the
correlation coefficients increase
Safety Inventory
• The Square-Root Law

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 = 36.24 cars
Aggregate r = 0
Standard deviation of weekly
demand at central outlet, s DC = 4 ´ 5 = 10
ss = Fs–1(0.9) ´ L ´ s DC = NORMSINV (0.9) ´ 2 ´10 = 18.12
Disaggregate Aggregate
r Safety Inventory Safety Inventory
0 36.24 18.12
0.2 36.24 22.92
0.4 36.24 26.88
0.6 36.24 30.32
0.8 36.24 33.41
1.0 36.24 36.24
• Two possible disadvantages to aggregation

Increase in response time to customer order
Increase in transportation cost to customer
Trade-offs of Physical Centralization
• Use four regional or one national distribution center
D = 1,000/week, sD = 300, L = 4 weeks, CSL = 0.95

• Four regional centers
Total required
safety inventory, ss = 4 ´ Fs–1(CSL) ´ L ´ s D
= 4 ´ NORMSINV (0.95) ´ 4 ´ 300 = 3,948

Trade-offs of Physical Centralization
• One national distribution center, r = 0

Standard deviation of weekly
demand, s DC = 4 ´ 300 = 600
ss = Fs–1(0.95) ´ L ´ s DC
= NORMSINV (0.95) ´ 4 ´ 600 = 1,974
Decrease in holding costs = (3,948 – 1,974) $1,000 x 0.2

= $394,765
Decrease in facility costs = $150,000
Increase in transportation = 52 x 1,000 x (13 – 10) = $624,000
Information Centralization
• Online systems that allow customers or stores to locate stock
• Improves product availability without adding to inventories
• Reduces the amount of safety inventory

Specialization
• Inventory is carried at multiple locations
• Should all products should be stocked at every location?

Required level of safety inventory
Affected by coefficient of variation of demand
Low demand, slow-moving items, typically have a high
coefficient of variation
High demand, fast-moving items, typically have a low
coefficient of variation
Impact of Coefficient of Variation on
Motors Cleaner
Inventory is stocked in each store
Mean weekly demand per store 20 1,000
Standard deviation 40 100
Coefficient of variation 2.0 0.1
Safety inventory per store 132 329
Total safety inventory 211,200 526,400
Value of safety inventory $105,600,000 $15,792,000
Inventory is aggregated at the DC
Mean weekly aggregate demand 32,000 1,600,000
Standard deviation of aggregate demand 1,600 4,000
Coefficient of variation 0.05 0.0025
Aggregate safety inventory 5,264 13,159
Value of safety inventory $2,632,000 $394,770
Savings
Total inventory saving on aggregation $102,968,000 $15,397,230
Total holding cost saving on aggregation $25,742,000 $3,849,308
Holding cost saving per unit sold $15.47 $0.046
Savings as a percentage of product cost 3.09% 0.15%
Product Substitution
• The use of one product to satisfy demand for a different product

Manufacturer-driven substitution
 Allows aggregation of demand
 Reduce safety inventories
 Influenced by the cost differential, correlation of demand
Customer-driven substitution
 Allows aggregation of safety inventory
Component Commonality
• Without common components

Uncertainty of demand for a component is the same as for the
finished product
Results in high levels of safety inventory
• With common components

Demand for a component is an aggregation of the demand for
the finished products
Component demand is more predictable
Component inventories are reduced
Value of Component Commonality
27 PCs, 3 components, 3 x 27 = 81 distinct components

Monthly demand = 5,000
Standard deviation = 3,000
Replenishment lead time = 1 month
CSL = 0.95
Total safety inventory = 81´ NORMSINV (0.95) ´ 1´ 3,000

required
= 399,699 units
Safety inventory per
common component = NORMSINV (0.95) ´ 1´ 9 ´ 3,000
= 14,804 units
• With component commonality
• Nine distinct components
Total safety inventory required = 9 x 14,804 = 133,236

Number of Finished Safety Marginal Total Reduction

Products per Inventory Reduction in in Safety
Component Safety Inventory
Inventory
1 399,699
2 282,630 117,069 117,069
3 230,766 51,864 168,933
4 199,849 30,917 199,850
5 178,751 21,098 220,948
6 163,176 15,575 236,523
7 151,072 12,104 248,627
8 141,315 9,757 258,384
9 133,233 8,082 266,466
Postponement
• Delay product differentiation or customization until closer to the

time the product is sold
Have common components in the supply chain for most of the
push phase
Move product differentiation as close to the pull phase of the
supply chain as possible
Inventories in the supply chain are mostly aggregate
Postponement
Value of Postponement
100 different paint colors, D = 30/week, sD = 10, L = 2 weeks,

CSL = 0.95
Total required safety

inventory, ss = 100 ´ Fs–1(CSL) ´ L ´s D
= 100 ´ NORMSINV (0.95) ´ 2 ´10 = 2,326
Standard deviation of base

paint weekly demand, s DC = 100 ´10 = 100
ss = Fs–1(CSL) ´ L ´ s DC = NORMSINV (0.95) ´ 2 ´100 = 233

Impact of Replenishment Policies
on Safety Inventory
• Continuous Review Policies

Mean demand during lead time, DL = DL

Standard deviation of demand during lead time, s L = Ls D
ss = FS–1(CSL) ´ s L = NORMSINV (CSL) ´ Ls D ,ROP = DL + ss

Impact of Replenishment Policies on
Safety Inventory
• Periodic Review Policies

Lot size determined by pre-specified order-up-to level (OUL)
T: Review interval
CSL: Desired cycle service level
Safety Inventory
Probability(demand during L + T ≤ OUL) = CSL
Mean demand during T + L periods, DT +L = (T + L)D

Std dev demand during T + L periods, s T +L = T + Ls D
OUL = DT +L + ss
ss = FS–1(CSL) ´ s D+L = NORMSINV (CSL) ´ s T +L
Average lot size, Q = DT = DT
Safety Inventory
Evaluation Safety Inventory for a Periodic
Review Policy
D = 2,500, sD = 500, L = 2 weeks, T = 4 weeks
Mean demand during T + L periods, DT +L = (T + L)D

= (2 + 4)2,500 = 15,000
Std dev demand during T + L periods, s T +L = T + Ls D

= ( )
4 + 2 500 = 1,225
ss = FS–1(CSL) ´ s D+L = NORMSINV (CSL) ´ s T +L

= NORMSINV (0.90) ´1,225 = 1,570 boxes
OUL = DT +L + ss = 15,000 +1,570 = 16,570
Managing Safety Inventory in a
Multiechelon Supply Chain
• In multiechelon supply chains stages often do not know demand

and supply distributions
• Inventory between a stage and the final customer is called the

echelon inventory
• Reorder points and order-up-to levels at any stage should be

based on echelon inventory
• Decisions must be made about the level of safety inventory

carried at different stages
The Role of IT in Inventory Management
• IT systems can help

Improve inventory visibility
Coordination in the supply chain
Track inventory (RFID)
• Value tightly linked to the accuracy of the inventory information

Estimating and Managing Safety Inventory
in Practice
• Account for the fact that supply chain demand is lumpy
• Adjust inventory policies if demand is seasonal
• Use simulation to test inventory policies
• Start with a pilot
• Monitor service levels
• Focus on reducing safety inventories

Summary
• Understand the role of safety inventory in a supply chain
• Identify factors that influence the required level of safety

inventory
• Describe different measures of product availability
• Utilize managerial levers available to lower safety inventory and

improve product availability

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Managing Uncertainty in a Supply

Chain: Safety Inventory

• Identify factors that influence the required level of safety

• Describe different measures of product availability

• Utilize managerial levers available to lower safety inventory and

• Safety inventory is carried to satisfy demand that exceeds the

• Three key questions

• Determined by two factors

• Measuring Demand Uncertainty

The coefficient of variation

• Product fill rate (fr)

• Order fill rate

• Cycle service level (CSL)

• Evaluating Safety Inventory Given a Replenishment Policy

Expected demand during lead time = DL

Average demand per week, D = 2,500

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

Cycle inventory = Q/2 = 10,000/2 = 5,000

Average inventory = Cycle inventory + Safety inventory

Average flow time = Average inventory/Throughput

CSL = Prob(ddlt of L weeks ≤ ROP)

(ddlt = demand during lead time)

Q = 10,000, ROP = 6,000, L = 2 weeks

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

• Expected shortage per replenishment cycle (ESC) is the average

• Product fill rate

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

Lot size, Q = 10,000

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

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

Desired cycle service level = CSL

• Identify safety inventory so that

F(DL + ss, DL, sL) = CSL

DL + ss = F –1(CSL, DL ,s L ) = NORMINV (CSL, DL ,s L )

ss = F –1(CSL, DL ,s L ) – DL = NORMINV (CSL, DL ,s L ) – DL

Q = 10,000, CSL = 0.9, L = 2 weeks

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

• Expected shortage per replenishment cycle is

• Try values or use GOALSEEK in Excel

Desired fill rate, fr = 0.975

ESC = (1 – fr)Q = (1 – 0.975)10,000 = 250

250 = –ss[1– NORMDIST(ss / 707,0,1,1)]

• As desired product availability goes up the required safety

Fill Rate Safety Inventory

• Goal is to reduce the level of safety inventory required in a way

D = 2,500/week, sD = 800, CSL = 0.95

• If standard deviation is reduced to 400

ss = NORMSINV (.95) ´ 9 ´ 400 = 1,974

• We incorporate supply uncertainty by assuming that lead time is

D: Average demand per period

Average demand per period, D = 2,500

Mean ddlt, DL = DL = 2,500 x 7 = 17,500

Standard deviation of ddlt s L = Ls D2 + D 2 sL2

• Required safety inventory

• How does aggregation affect forecast accuracy and safety

Holding-cost savings on aggregation per unit sold

• The safety inventory savings on aggregation increase with the

• The Square-Root Law

Standard deviation of weekly demand, sD = 5;