The Role of Safety Inventory in a Supply Chain

Safety inventory is inventory carried to satisfy demand that exceeds the amount forecast. Safety inventory is required because demand is uncertain, and a product shortage may result if actual demand exceeds the forecast demand. Consider, for example, Bloomingdale’s, a high-end department store. Bloomingdale’s sells purses purchased from Gucci, an Italian manufacturer. Given the high transportation cost from Italy, the store manager at Bloomingdale’s orders in lots of 600 purses. Demand for purses at Bloomingdale’s averages 100 a week. Gucci takes three weeks to deliver the purses to Bloomingdale’s in response to an order. If there is no demand uncertainty and exactly 100 purses are sold each week, the store manager at Blooming­dale’s can place an order when the store has exactly 300 purses remaining. In the absence of demand uncertainty, such a policy ensures that the new lot arrives just as the last purse is being sold at the store.

However, given demand fluctuations and forecast errors, actual demand over the three weeks may be higher or lower than the 300 purses that were forecast. If the actual demand at Bloomingdale’s is higher than 300, some customers will be unable to purchase purses, resulting in a potential loss of margin for Bloomingdale’s. The store manager thus decides to place an order with Gucci when the store still has 400 purses. This policy improves product availability for the customer because the store now runs out of purses only if the demand over the three weeks exceeds 400. Given an average weekly demand of 100 purses, the store will have an aver­age of 100 purses remaining when the replenishment lot arrives. Safety inventory is the average inventory remaining when the replenishment lot arrives. Thus, Bloomingdale’s carries a safety inventory of 100 purses.

Given a lot size of Q = 600 purses, the cycle inventory, the focus of the previous chapter, is Q /2 = 300 purses. The inventory profile at Bloomingdale’s in the presence of safety inven­tory is shown in Figure 12-1, which illustrates that the average inventory at Bloomingdale’s is the sum of the cycle and safety inventories.

This example illustrates a trade-off that a supply chain manager must consider when plan­ning safety inventory. On one hand, raising the level of safety inventory increases product avail­ability, and thus the margin captured from customer purchases. On the other hand, raising the level of safety inventory increases inventory holding costs. This issue is particularly significant in industries in which product life cycles are short and demand is volatile. Carrying excessive inven­tory can help counter demand volatility but can really hurt if new products come onto the market and demand for the product in inventory dries up. The inventory on hand then becomes worthless.

In today’s business environment, it has become easier for customers to search across stores for product availability. If Amazon is out of a book, for example, a customer can easily check to see whether barnesandnoble.com has the title available. The increased ease of searching puts pressure on firms to improve product availability. Simultaneously, product variety has grown with increased customization. As a result, markets have become increasingly heterogeneous and demand for individual products is unstable and difficult to forecast. Both the increased variety and the greater pressure for availability push firms to raise the level of safety inventory they hold. Given the product variety and high demand uncertainty in most high-tech supply chains, a sig­nificant fraction of the inventory carried is safety inventory.

As product variety has grown, however, product life cycles have shrunk. Thus, it is more likely that a product that is “hot” today will be obsolete tomorrow, which increases the cost to firms of carrying too much inventory. Thus, a key to the success of any supply chain is to figure out ways to decrease the level of safety inventory carried without hurting the level of product availability.

The importance of reduced safety inventories is emphasized by the experience of Nord­strom, Macy’s, and Saks during the 2008-2009 recession. Nordstrom outperformed the other two chains by moving its inventories about twice as fast as its competitors. In 2008 (2009), Nordstrom carried an average of about 2 (2) months, Macy’s carried about 4 (4.15) months, and Saks carried about 4.24 (4.67) months of inventory. A key to Nordstrom’s success has been its ability to provide a high level of product availability to customers while carrying low levels of safety inventory in its supply chain. This fact has also played an important role in the success of Zara, Walmart, and Seven-Eleven Japan.

For any supply chain, three key questions need to be considered when planning safety inventory:

1. What is the appropriate level of product availability?
2. How much safety inventory is needed for the desired level of product availability?
3. What actions can be taken to reduce safety inventory without hurting product availability?

The first question is discussed in detail in Chapter 13. The remainder of this chapter focuses on answering the second and third questions, assuming a desired level of product avail­ability. Next, we consider factors that influence the appropriate level of safety inventory.

Source: Chopra Sunil, Meindl Peter (2014), Supply Chain Management: Strategy, Planning, and Operation, Pearson; 6th edition.