DETERMINATION OF SAFETY STOCKS

FOR
FINISHED GOODS
And
THE BULLWHIP EFFECT

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SS (Safety Stock)

Purpose of Safety Stock

Protect inventory from excessive out of stock situations
2 major factors cause above situation
(a) Errors (deviations) from actual sales & fcstd demand
(b) Variations in manufacturing lead times.
Hence, a method for determination of SS shd be based on a
measure of the errors or variations. If no measurement is there, SS
may be too low or too high.
Sometimes ABC approach is used to set SS levels as per product
class. Important products (A & a few B class) therefore SS shd be
computed product by product instead of a flat rule.
Here important consideration should be the SERVICE LEVEL
A -98% B-95% and C say 90%. Exceptions: Life-saving Drugs, etc.
U/s the methods r designed to compensate for sales variations
around the average. No SS method exists to compensate for a
biased forecast, i.e. a forecast always on the low (or high side)
Eliminate the bias first.

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A SIMPLIFIED SAFETY STOCK COMPUTATION

This can be done in 3 steps
- Calculation of SS for forecast variation (2nd) -- ditto for lead time
variation (3rd) - Combination of the two. ---------- Method Fcst Variation: - Find the MAD (mean absolute deviation)
Use Sales forecast tracking e.g.
Period
Act Sales
Fcst
Variance Absolute Variance
Dec.
160000
103000
57000
57000
So on upto Nov.
August
109000
121000
- 12000
12000
Total
170000 say
MAD
14000
If service level 98% (safety factor 2.5) SS is 2.5 x 14000 = 35000
units
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 Lead Time variation

Compute MAD for LT errors (AFD actual finish Date (or Dlvy Dt.)
PFD (Planned FD (or Dlvry Date) Diff. in days - Absolute Dif.
AFD
PFD
Diff. in days Abs. Diff
Jan 15 Jan 10
5
5
Jan 31 Feb 10
(10)
10
Feb 20
Feb 18
2
2
Mar 25 Mar 20
5
5
April 10
April 5
(5)
5
Total
27 Avg 5
Step 2: Multiply the MAD by the safety factor and by the av. Demand
per month
Example: 98% service Sales Fcst av: 104000 units S Factor 2.5
Therefore, SS to cover lead time variation is: 2.5 x 104000/30 x 5 =
43300 units,

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 Combination of the 2 SS:

It is unlikely that deviation in lead time has an impact on sales
forecast error or vice versa. This means that the two factors are
independent and, there4fore, they will not happen statistically at the
same time.
That is why, in order to combine the safety stocks, we have to add
half of the smaller safety stock to the higher one.
In our example we have: SS for Fcst Variation 35000 and SS for LT
variation 43000. SO, total SS: 4330 + 35000/2 = 68000 Units.
For multiple distribution centres, the computation of Ss must be
done for each one of them. Indeed, sales FCST error is far higher
(in %) at a DC than it is for the total country. At the Central
Location, sufficient stock shd be held to cover the mfg. LT variatn.
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Minimum Stock & Safety Stocks

SS is a level below which we should not go. When most planning
systems are month by month, we do not know precisely when an
order will be mfd, we only know the month of production.
Also, in a long term m/m plan, capacities are not precisely
considered. We know that the capacity is enough for the month, but
when the time comes to schedule, we may find it impossible to
manufacture on time and maintain safety stocks bec ause of a
temporary bottleneck on one piece of equipment.
A third thing may impact on minimum levels: the sales forecast may
well be very irregular from one week to another.
Some companies are experiencing such irregularities as much as
80% of the sales made in the first week. In that case, it is obvious
that if we do not have a t least 80% of the months sales on top of
the safety stock, it is impossible to maintain inventories above SS
every day of the month.
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 So, perhaps, why cant we have at least the first two weeks sales on
top of safety stock.
In conclusion, we may have to add an additional cushion on the
safety stock in order to compensate for:
- irregularities of sales within the month
- tight capacities on some equipment and imprecise scheduling at
the time of planning
- Imprecision of dates when planning long term.

Minimum Stock = Safety Stock + Cushion

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Bullwhip Effect
Demand Amplification
Or Accelerator or Bullwhip Effect)
Caused by speculative over reaction to demand fluctuation due to
Over optimism or Panic.
Demand changes by the end-user create an accelerator effect in the
SC, which magnifies the size of demand changes on upstream SC
elements (W/S, WH, factories and the suppliers).
THIS IS OFTEN TERMED AS BULLWHIP EFFECT.
Case Study:
Early 90s P&G found large fluctuations in the raw-material
requirements for Pamper brand of diapers. It puzzled the Co.
because babies generally go through the diapers at a fairly constant
rate.
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 A study of the supply chain of the Pamper diapers revealed that that
there were only minor random variations in the retail sales. These
small variations were amplified by each individual stage in the SC
as the demand was transferred upstream. This resulted in large
swings at the raw material stage:
Demand Amplification The Bullwhip Effect
Demand for RM at the Supplier Plant
Demand for FG at the Mfg plant
Demand for FG at the Distbn centers
Dmand for FG at the Retail Stores
Each Retailer and each DC in turn adds a further safety margin
while requisitioning supplies from the plant.

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 As u will see, the AGGREGATE changes in demand overreacts and

adds its own safety margins to take care of perceived fluctuations in
future demand from downstream elements.
Human planners tend to overreact and amplify due:
- limited knowledge to the current inventory status of material in their
firm, while being oblivious of stocks with other stages
- they see and plan based on the actual amount ordered by their
direct customers, which might be significantly different from the
actual final customer demand; and
- their knowledge about firms past performance (mostly the
stockouts and overstock situations) gives rise to panic or overoptimism. Accentuated by presumed / or real insecurities.
A similar reaction comes when the sales go down at the retail levels.
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 Synchronous flow (absent in BW effect) requires fewer inventories =

reduced working capital = less plant assets to handle peak
requirements. Collectively this translates to improved ROCE.
The BW effect and Managerial Levers to mitigate it. In
summary they are:
1. Behavioral Causes: (Local perspective, delayed response,
overreaction and inadequate info. Sharing due to lack of trust)
- see problem through a wider (global) perspective, strive for Co.
wide optimization, share info at all levels, react and respond
realistically.

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Bullwhip effect
2. Fcstg based on order qtts. instead of actual customer demand.
WS depend on Retailers (they do not have access to Co. demand
data). So visibility across SC necessary Any SC has only one
point where end-use customer demand (called independent
demand) is satisfied. (a retail or a e-commerce est. B2C or B2B.
Only this stage needs to do fcstg. -- All upstream stages in the Sc
experience the derived demand which is tempered by the order
fulfillment and purchasing policies of other companies to the SC.
-- Answers: Aggregate the orders recd from the downstream cos.
(PULL SYSTEM) i.e. always base ordering decisions on the
aggregated ultimate customer demand derived from the PoS and
not on the ordering behavior of an immediate downstream partner.
Change from the decentralized (a more radical approach) to
centrally generating procurement plans for all stages of the SC.
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Bullwhip effect
3. Frequent changes in forecast due to frequent updating of
forecasts as the more recent data is made available.
Use a forecasting method that smoothens fluctuations. Toyota for
example uses simple exponential smoothing formula with a
smoothing constant = 0.2 forecast for the next week)
= 0.2* (this weeks actual demand + 0.8* (forecast for this week)
Differentiate between:
- Random demand fluctuations which are to be taken care by buffer
stocks
- Cyclical or seasonal demand which shd be taken into account by
the forecasting process and met through cycle inventory or variable
production
- Trends, which need to be addressed through capacity changes.
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Other Factors / Causes /and Ways to mitigate Bullwhip

Effect
Factors that accentuate:
- Long replenishment times (higher SS) - Use Lean Mfg/Distbn
techniques
- Ordering in Large Lots than demand arises Negotiate a blanket
order / schedule deliveries
- Price fluctuations / Sales promotions Retailers stock up thru
forward buying when prices are down (Offer cumulative volumebased discounts rather than lot-size base discounts)
- Shortage gaming (inflated orders in the face of rationing during
periods of shortages) (allocate products in short supply in
proportion to past sales)
- Sales Force Incentives (- Evaluation time) also Sale in to
Dist/Retailers than Sell-through (final customer) Incentive as per
Sthrough & overall supply chain efficiencies achieved.
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Building Blocks of SC Coordination

1. Use of Info & Communication tech. enables seamless integration
between different SC partners
2. Process orientation helps coordinate all the activities involved in
customer order fulfillment.
3. Advances Planning Systems (APS) incorporate long term, mid
term and short term planning levels. APS would assist ERP whilst
ASP takes planning tasks, ERP works as an execution and
transaction processing system. APS overcomes shortcomings of
ERP.

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SC Synchronization Techniques
Constraints Management & throughput analysis: identify the binding
constraint that currently puts upper limit on the flow rate (that is, on
the throughput), eliminate that constraint, aligning it to the new
throughput levels, and then go to the next constraint.
Sales & Operations Planning (S&OP) All operational functionaries
meet and resolve divergent issues to arrive at congruence.
Perfect Order fulfillment
Capacity Shifting involves adding/shifting resources or reducing
cycle times during peak periods
Aggregate Planning

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