Service Levels and Contribution Analysis

In my last posting, I wrote about Pareto's Law and ABC Analysis (also called "Contribution Analysis".) Once the Inventory Manager understands the ABC's of his or her product portfolio, there are many practical applications.

One such practical application is with regard to Service Levels. Service Levels can be defined in myriad ways, but one of the most common is fill rate vis-a-vis customer orders. Another is a simple % in-stock calculation. In its simplest form, if customers, for example, order 100 widgets, and we are able to fulfill quantity 98 on time, our fill rate is said to be 98%. Now, there are a number of variants to this simple example that are designed to make the service level statistic more meaningful, but for the sake of illustration I have chosen the simplest example that I could conjour up.

Much to the chagrin of the Marketing and Sales Departments, it is statistically impossible to reach and maintain 100% service levels. The graphical relationship between service levels (on the horizontal axis) and inventory investment (on the vertical axis) is hyperbolic. It shows that as the firm approaches 100% service levels, the inventory investment required to achieve an extra 1% in service levels increases exponentially. The curve never reaches 100%. So, the firm that is obsessed with chasing the 100% service level Pot of Gold at the end of the rainbow can ruin its cash flow through over-investment in inventory. 

The idea behind ABC (Contribution) Analysis is to stratify service level goals by contribution code. Typically, the goal structure looks something like this:

"A" items =>Service Level Goal = 98%
"B" items => Service Level Goal = 95%
"C" items => Service Level Goal = 90%

This says, in essence, that the firm is willing to live with a 90% fill rate on "C" items as they are of little relative importance to the business as a whole. The firm will strive for high service levels for "A" items, due to thier importance to the business.

Firms employing this recognize the very real tradeoff that exists between financial needs and sales or customer service needs. It makes no sense to increase inventory investment by 50% in order to realize a 4% increase in sales. And believe me, I have sat in my fair share of Senior Management meetings where this arguement was made repeatedly. As the guardian of the inventory asset, the Inventory Manager cannot allow himself or herself to get talked in to this high-risk approach.

Firms ought to do some benchmarking, to try to determine what the competition is able to do. If best practice in the industry is that "A" items typically see a 99% service level, then you must judge whether or not that is achievable given current pricing structures and profitability scenarios. On the other hand, if you can achieve 98% due to superior inventory management expertise when the competition achieves 95%, and you can still beat or meet the competition on price, you have achieved a significant competitive advantage.

Moreover, the spirit of continous imprvement is that you can, and should improve service levels overall incrementally. But be careful not to blow your brains out in the process.

It can be done!

Cheers