Safety Stock and Service Levels in Periodic Review Inventory Systems

Author(s): W. C. Benton
Source: The Journal of the Operational Research Society, Vol. 42, No. 12 (Dec., 1991), pp. 1087-
1095
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J. Opi Res. Soc. Vol. 42, No. 12, pp. 1087-1095 0160-5682/91 $3.50+0.00
Printed in Great Britain. All rights reserved Copyright ? 1991 Operational Research Society Ltd

Safety Stock and Service Levels in Periodic Review

Inventory Systems
W. C. BENTON
Ohio State University, USA

The management of requirement (purchased-parts and components) uncertainty in MRP systems is a

serious problem for manufacturing firms. When manufacturing service levels fall below a predetermined
service level, safety stock must be increased in order to adjust to the competitive environment. This
paper presents the results of a set of simulation experiments in which we investigate some of the com-
plexities of safety stock requirements, lot sizing performance and the marginal safety stock requirements
associated with various service level policies. The results of the experiments have empirically shown that
the marginal units of safety stock required for various service level policies follow a predictable (measur-
able) pattern. The research also indicates that the economic advantages of well-known dynamic lot sizing
procedures are diminished by the presence of requirements uncertainty. Another important finding is the
interaction between service level and 'lumpy' requirements. High levels of the coefficient of variation and
the economic time between orders resulted in larger orders, reduced safety stock and high service
levels. In general, the overall findings from this research will hopefully provide the decision maker with
an in-depth understanding of the measurement and impact of various service level policies.

Key words: inventory management, safety stocks, service levels

INTRODUCTION

A common element of all manufacturing processes is materials flow. The materials flow is initiated
by the arrival of purchased raw materials that are inspected and placed into storage. The raw
materials are then transformed through appropriate operations. Next, the transformed raw
materials are integrated with purchased subassemblies or processed chemicals until the materials
are transformed into finished products, or end items. Whether or not this transformation process
is explicitly or implicitly accomplished, materials flow is an intricate function in every manufactur-
ing firm.
The manufacturing planning system is the mechanism by which the material flows are planned
and controlled. The two key questions in any manufacturing planning system are how much of what
material flows, and when should the materials arrive.
The purpose of this study is to examine the impact of requirement uncertainty in a periodic
review manufacturing environment. In this research we experiment with the lowest level (Stage 1)
in a multi-stage production system (see Figure 1). Of course, lot sizing decisions are made at Stage
0 that directly impact Stage 1. In this research, the behaviour at Stage 1 will be reflected using
various empirical factor settings. This approach is worthy of study because materials managers
can experience various upstream situations that cannot be easily corrected in the short run.
Materials managers only have the requirements schedule that must be used to service the manu-
facturing operation. This research will specifically illustrate some of the trade-offs facing materials
managers.

Stage 0 A.

Stage 1 B C

FIc. 1. A multi-stage production system.

Correspondence: W. C. Benton, Academic Faculty of Management Sciences, The Ohio State University, 177S College
Road, Columbus, Ohio 43210, USA.

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 Journal of the Operational Research Society Vol. 42, No. 12

Some companies have modified their software to guarantee a predetermined service level for
component parts and materials. Other firms have incorporated several conditions under which the
safety stock level is automatically tracked. Answers to the following questions must be used as input
to the service level decision making process: (1) what is the environmental impact of various service
level/safety stock policies? and, (2) what are the marginal units of safety stock associated with
increasing the required (competitive) level of service (say, 93%, 95%, 97% and 100%) from one
level to another?
We first illustrate the conditions under which safety stock is replenished at Stage 1. Some general
considerations in setting and using safety stock to protect against stockouts are discussed. Next,
the research plan for the study is presented. Within the research plan section, the safety stock model
is presented along with the experimental factors. The results are described. Finally, the conclusions
from the study are reported.

SAFETY STOCK AND SUPPLY UNCERTAINTY

Safety stock is sometimes required for a purchased item in a manufacturing system to protect
against supply uncertainty. However, when safety stock is present, a circumstance such as that
illustrated in Figure 2 can occur. In this case, even though there is a planned closing inventory of
ten units in period 4, a net requirement of ten units is generated because the required safety stock
is 20 units, which is the quantity necessary to achieve a given customer service level. Because the
lead time is three periods, the order should be released now to provide the replenishment of safety
stock in the fourth period. The question that many operating managers ask is, 'Should an order
be released to replace safety stock?' and 'If it is released how much safety stock does it take to
achieve a given protection level?'

Period 1 2 3 4
Gross requirements 20 60 40 40
Scheduled receipts 50 100
On hand/20 50 90 50 10
Net requirements 10
Planned order release 100
Safety stock = 20 Lead time 3 Periods Order quantity 100

FIG. 2. MRP records indicating a safety stock replenishment order.

To begin to answer the questions, we will first consider the role of lower level safety stocks in
a manufacturing system under alternative circumstances. Suppose that the requirements per period
can be characterized by a mean and standard deviation. In this instance we could simply decide the
service level (fill rate) that manufacturing desires, determine the safety needed to provide that
service level and place one order for the mean requirements plus safety stock. In each period
thereafter, we could place an order for the mean demand. After some time, we would find that the
service level would average the desired level provided there were no changes in the requirements
distribution.
The service level issue may become considerably more complex as alternative lot sizing techniques
are used. For example, if more than one period's requirements are incorporated in the order that
is placed, the appropriate value of safety stock to be used becomes more difficult to determine.
If the number of periods of demand covered is constant, the statistical formula for determining
the standard deviation for several periods might be helpful in setting safety stock. On the other
hand, if the number of periods of demand is variable, then the difficulty of setting the appropriate
level of safety stock is increased. In addition, some lot sizing techniques, like the traditional EOQ,
produce orders that are not necessarily equivalent to an integer number of periods of requirements.
Such orders may substantially reduce the possibility of out-of-stock conditions simply because they
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 W. C. Benton -Safety Stock and Service Levels in Periodic Review Inventory Systems

plan to leave a quantity in stock at the end of the period before the next order arrives. On the other
hand, dynamic lot sizing techniques like the lot-for-lot (L4L), McLaren's Order Moment (MOM),
and least unit cost (LUC) all order the requirements for an exact number of periods, exposing the
item to an out-of-stock condition just before receipt of the next order. A more detailed discussion
of the alternative lot sizing techniques is provided elsewhere.'
As shown in Figure 2 we show how a 100 unit planned order release in period 1 is activated to
replace ten units of safety stock in period 4. Let R (t, t + i) be the requirement in period t + i as
projected at the start of period t. Let S(t) be the sum of inventory and scheduled receipts at the
start of period t. In Figure 2, S( 1 ) = 20 + 50 + 100. Thus, the general expression for the planned
order releases in period t, P(t) and the requirements R (t, t + i) is
k
P(t) = R(t, t + i) -S(t) (1)
i=O

Adding safety stock B to (1) we get

k
P(t) = R(t, t + i) + B-S(t) (2)
i=O

The size of the safety stock B depends on

B= arZ (3)
where Z is the number of standard deviations above the mean needed to implement the cycle
service level and ar is the standard deviation of demand during the lead time.
Applying (2) to Figure 2 we get
P(i) = (20 + 60 + 40 + 40) + 20 - (20 + 50 + 100)
= 160 + 20 - 170
P(1) = 10
To explore some of these complexities and address the problem of whether to place an order to
replenish safety stock to achieve a predetermined service level, we constructed a simulation model.
The experimental design and the environmental factors are described in the next section.

EXPERIMENTAL DESIGN

To evaluate the complexities of the service level-safety stock interaction, we developed and
solved 384 test problems. From the research of Berry2, McLaren3, Benton and Whybark4,
and Benton5 several factors have been shown to be important in evaluating MRP environ-
ments with rolling planning horizons. The relevant factors and experimental settings are described
below:
(a) Requirement lumpiness. This factor relates to the amount of 'lumpiness' in the requirements
for a part. Lumpiness is measured as the coefficient of variation, Cv, of the requirements.
(Cv = aiR where a is the standard deviation of the requirement and R is the average usage.)
For this study Cv will be set to Cv = 0.29 and Cv = 1.85 to represent high and low lumpiness
respectively (see Berry2, Benton and Whybark4, Benton5).
(b) The uncertainty measure (Q) is the standard deviation of the difference between projected
requirements and actual requirements. To generate the requirement uncertainty desired for this
research, a normal distribution of requirement errors around the planned requirement for each
period was used. In the formal simulation model, both the planned requirements and actual
requirements were normalized to maintain the average requirement level and to prevent a
consistent bias. The uncertainty settings used for the experiment are t = 40, and t = 80 (see
Benton5, Benton and Whybark4).
(c) The economic time between orders (TBO) reflects the economics of the item being considered,
e.g. a long time between orders indicates that the ordering cost is high relative to carrying
cost. The TBO is calculated by dividing the economic order quantity by the average usage. For
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 Journal of the Operational Research Society Vol. 42, No. 12

this research the TBO factor will be set to TBO = 2 and TBO = 6 (see, Benton5, Benton and
Whybark4).
(d) Emerging from research by McLaren3 is a promising dynamic procedure for deciding how to
make the ordering decision in MRP systems, McLaren's order moment6. The LUC dynamic
lot sizing procedure has also been shown as a robust and simple procedure4' .
(e) Finally, the service factor will reflect a predetermined service level policy based on fill-rate,
directly from the stock on hand. This factor is used to determine the necessary units of
safety stock needed in the system. The service factor settings used for the experiment are
SL = 93.99%, SL = 95.99%, SL = 97.99% and SL = 99.99%.
The above combinations of factors result in 96 (2 x 2 x 2 x 3 x 4) problems. With four
replications a total of 384 observations are provided for the experiment.
The experimental design is used to evaluate the differences in the average systems safety stock
needed to achieve various service level policies in a variety of manufacturing environments. A
secondary research question deals with the interaction of various service level policies with the
various experimental factors. The measurement criterion is the average cost and number of units
of safety stock needed to achieve alternative service level policies.

THE SIMULATION MODEL

The major function of the simulation model is to generate several periods of planned and
actual requirements, and to account for the safety stock levels that result from a specific service
level and lot size methodology. The simulated decision requires lot sizing of a single purchased
component part at the lowest stage of the manufacturing process. For this research, it is assumed
that once a lot is scheduled it will arrive on time, and no backorders are allowed. Lead times were
set equal to one period. The planned requirements were generated from a modified uniform
distribution and the requirement errors were generated from a normal distribution. The require-
ment uncertainty was measured by the standard deviation of the difference between the planned
requirements for a period (at the time it is included in a purchased lot) and the actual requirements
for that period. The simulation model provided for the calculation of lot sizes, safety stock levels,
and the evaluation of the lot sizing procedures. The simulation model was programmed in
FORTRAN 77. Once the simulator was determined to be running correctly, a preliminary study
was made to determine the run length. To determine the run length, the C, and S factors were set
at their maximum levels and TBO was set to 6 (i.e. a = 80, S = 99.99, C, = 1.85 and TBO = 6).
The service level for each lot sizing methodology was set to 99.99% by adding safety stock. Four
independent runs were made at each run length from 50 periods to 950 periods, in increments of
50 periods, for three and four replications. The safety stock for the traditional EOQ lot sizing
procedure was plotted and the means and the standard deviations for three and four replica-
tions were calculated and plotted at each of the 50 period run lengths for the EOQ procedure. The
safety stock estimates stabilize after 400 periods. The run length for this research was set at 450
periods.
To ensure that the start-up period was sufficiently long enough to provide stable, typical condi-
tions for the start of the data collection, two conditions were applied. The simulation was run for
50 periods before data was collected and, sufficient initial inventory was provided to ensure that
no stockout occurred before the first order is placed.
To solve the comparability problem, safety stock levels were set for each lot sizing procedure in
order to achieve (guarantee) a prespecified common level of service SL. A search routine was
incorporated into the simulation model to determine the level of safety stock needed to achieve
the. appropriate service levels. A drop in one unit of safety stock (B) results in a drop in the
predetermined service level. The search routine ensures an unbiased comparison in total systems
cost between the various service level policies. For a more detailed description of the routine see
Figure 3.
In the simulation model any order in the action bucket (net requirement) is released based on
the following calculation.
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 W. C. Benton -Safety Stock and Service Levels in Periodic Review Inventory Systems

Initialize high = 512

Low = 0
Safety stock (B) = 0
Midpoint = 0
Unit = 0

Run simulation

is uncertainty Yes

lNo

and3Service level sr r fl
Od 99.99?it no B needed

LL ; YeIit esg

==

B99thesafety9stock3. needed levels ear service

toevel preetie

R(t,t + i) = the reqireet in perio t| spoetda h tr fpro

Shr P(t) = schedulaned ordeepsfrthelentifre planing hoio

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 Journal of the Operational Research Society Vol. 42, No. 12

When an order has been released, the quantity is calculated separately. In the case of traditional
(fixed) order quantities, there is no possibility of recovering used safety stock so decreasing B
should simply be the same as decreasing the safety stock. To determine lot sizes for procedures that
determine quantities by adding the requirements for a specific number of periods, we evaluate the
planned on-hand inventory at the end of the period just before receipt of the order. Any deviation
from the desired service level position is incorporated in the order, after adjustment by B.

EXPERIMENTAL RESULTS

All factors had a significant main effect on systems safety stock. The ANOVA results are shown
in Table 1. The cell means for the average systems safety stock for the alternative service level
policies are shown in Table 2. The most significant differences were requirements uncertainty (Q)
(F = 436, p < 0.01) followed closely by the service level policy (F = 374.10, p < 0.01). An overall
safety stock requirement of almost 113 units was required to increase the overall service level by
207o (from 93.9907o to 95.9907o). The 113 units of safety stock represented 122%Vo (113/92) of the
average systems requirements. The amount of safety stock needed to ensure service levels of
97.9907o and 99.9907o is 258 and 417 respectively. (See Figure 4.)

TABLE 1. Analysis of variance for average systems safety stock

Factor effects
(source of error) F Level of significance (p)
Main effects
Coefficient of variation (Cv) 296.18 0.000*
Service level (SL) 374.10 0.000*
Lot sizing (L) 22.37 0.000*
Time between orders (TBO) 45.59 0.000*
Uncertainty (Q) 436.99 0.000*
Two-way interactions
Cv x SL 35.28 0.000*
Cv x L 0.572 0.565
Cv x TBO 1.70 0.000*
x
CV X 47.06 0.193
SL x L 3.10 0.006*
SL X t 52.56 0.000*
SL x TBO 5.33 0.001*
L x t 4.70 0.010*
L x TBO 1.91 0.149
X TBO 6.43 0.012
*
Significant (p 0.01)

TABLE 2. A verage systems safety stock

Overall
Service level mean SL = 93.99% SL = 95.99% SL = 97.99% SL = 99.99%
Mean (overall) 104.30 0.00 112.96 258 417
Lot Sizing Rule
MOM 0.00 125.16 281.32 474.32
LUC 0.00 118.47 272.19 437.32
EOQ 0.00 95.25 220.97 350.50
Uncertainty
= 40 0.00 69.92 161.57 259.30
= 80 0.00 156.00 354.42 575.13
Coefficient of variation
Cv = 0.29 0.00 147.25 340.38 548.69
CV= 1.85 0.00 78.67 179.45 289.58
Time between orders
TBO = 2 0.00 127.21 289.71 466.44
THO = 6 0.00 98.71 226.27 367.98

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 W. C. Benton -Safety Stock and Service Levels in Periodic Review Inventory Systems

100

98 -

a) 96 -
CD,
U,
94

92 l l l
0 100 200 300 400 500

Safety stock level

Average safety stock (B)

FIG. 4. A verage systems' safety stock.

Another finding of particular interest was the effects of the Cv (third strongest effect) and the
TBO (fourth strongest effect). Increases in the Cv and TBO factors resulted in larger lot sizes. The
resulting increase in cycle stock reduced the order frequency and exposure to stockouts. Increases
in Cv and TBO cycle stock served as surrogates for safety stock.
All of the two-way service level (SL) interactions were significant at the 0.01 level (see Table 1).
The most significant interaction was between the service level (SL) and the uncertainty factor (k),
(F = 52.56, p < 0.001) followed closely by the service level (SL) and the coefficient of variation
(Cv) (see Figures 5a and b). This result was expected since it increases the levels of requirement
uncertainty and requires more protection to achieve consistent service objectives. In addition,
increases in the coefficient of variation (Cv) (lumpiness of requirements) will result in fewer orders
for larger quantities and lower safety stock requirements needed to achieve the predetermined level
of service to manufacturing. To a lesser degree of significance, the interaction between service level
(SL) and the lot sizing procedures (L) is the result of the inferior performance of the LUC lot sizing
procedure (see Figure 5c). Moreover, the least unit cost lot sizing procedure is, on average, 2% more
expensive than the MOM and the EOQ procedure. There is no difference in the cost performance
between the MOM and EOQ lot sizing procedure. The interaction between SL and TBO is the result
of larger lot sizes, fewer larger-cycle stock and fewer exposures to stockouts between cycles (see
Figure 5d).
On the other hand, as more requirement uncertainty was experienced by the system, the safety
stock requirement increased (see Figure 4). This finding is consistent with the work by Benton
and Whybark4, Whybark and Williams6. Finally, in this experiment the static EOQ lot sizing
procedure required slightly less safety stock than the LUC or MOM procedure to achieve the
various service level policies. However, the cost performance for the MOM and EOQ were the same
for uncertain environments. The LUC procedure was on average, 2% more expensive than the
MOM and EOQ procedures.

CONCLUSIONS

This research has isolated the systems safety stock requirements for various service level policies.
In addition, the research herein has empirically shown that the marginal units of safety stock
required for various service level policies follow a predictable and measurable pattern. This finding
is consistent with the theoretical safety stock/service level relationship7. The initial investment
in units of safety stocks to achieve a small (207o)service level improvement is generally very high.
Subsequent improvements in the service levels require larger and larger marginal units of safety
stock.
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 Journal of the Operational Research Society Vol. 42, No. 12

loG 100
99

98 98-

> 97->

(D 96 - 96

02 100o 200 300 400 500 600 0 100o 200 300 400 500) 600

Safety stock level Safety stock level

Uncertainty
(t) Coefficient of variation(Cv) = 0.29
-=-40-
- * Uncertainty () = 80
e.---- Coefficient of variation(Cv) = 1 .85

(a) Service level and uncertainty. (b) Service level and coefficient of variation.

92, E 1 l l 1 921 l l 1 f 1 1
100 2 z P 10^ 100 200 300 400 500
0 100 200 300 400 500 600 601 0
Safety stock level Safety stock level

98 98
Uncerainty 40e oen MM
@ Least UnitCost (LUC) Toeffiimento varitweenorder =T0 =29
- * UEcerantycOre Quatt (EQ ie ewe rer TO
o296 C 96-
U) C
(I) (a) Service level and uncetasinemtyo. (d) Service level and coficibewent ofvriatio.
~~~~~~~~~~~~~~~~U)
941 941

I I I I I
921 921 1
0 100 200 300 400 500 0 100 200 300 400 500
Safety stock level Sft tc ee
-in-----McLaren's Order Moment (MOM)
~~~~Least UnitCost (LUC) -i--- Time between orders (TBO)= 2
-u---- Economic Order Quantity(EOQ) -.-- Time between orders (TBO)= 6

(c) Service level and lot size method. (d) Service level and time between orders.

FIG. 5. Two-way service level interactions.

Moreover, increases in the Cv and TBO factors result in larger lot sizes, and more cycle stock,
which reduces the need for safety stock in the system. Finally, there is a subtle difference in the
cost performance of the three lot-sizing procedures. In other words, the economic advantages of
dynamic lot-sizing procedures (LUC, MOM) are diminished by the presence of requirement
uncertainty. As more requirement uncertainty is experienced by the system, the safety stock require-
ment increases. Managers operating in a highly uncertain environment should consider using the
traditional fixed order quantity EOQ procedure for purchasing component parts and raw material
because it is easily understood, requires slightly lower safety stocks and is familiar to manufacturing
users.
Another important finding of interest was the significant buffering effect incorporated in the
coefficient of variation and TBO environmental factors. High measures of coefficient of variation,
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 W. C. Benton -Safety Stock and Service Levels in Periodic Review Inventory Systems

and the economic time between orders resulted in reduced safety stock and high service levels.
Finally, the overall findings from this study will, hopefully, provide the decision maker with an
in-depth understanding of the measurement and impact of various manufacturing service level
policies.

REFERENCES

1. T. VOLLMANN, W. BERRY, and D. WHYBARK (1988) Manufacturing Planning and Control System. Homewood, Illinois.
2. W. BERRY (1972) Lot sizing procedures for material requirements planning systems: a framework for analysis. Prod.
and Inventory Mgmt 13(2), 19-23.
3. B. MCLAREN (1977) A Study of Multiple Level Lot Sizing Techniques for Material Requirements Systems. Ph.D.
Thesis, Purdue University.
4. W. BENTON and D. WHYBARK (1982) Material requirements planning and purchase discounts. J. OpsMgmt 2, 137-143.
5. W. BENTON (1985) Multiple price breaks and alternative purchase lot sizing procedures in material requirements
planning systems. Int. J. Prod. Res. 23, 1025-1047.
6. D. WHYBARK, and J. WILLIAMS (1976) Material requirements planning under uncertainty. Decision Sciences, 595-606.
7. R. BROWN (1967) Decision Rules for Inventory Management. Holt, Rinehart and Winston, New York.

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