In other words, a 95% service level means that the company expects to meet customer demand in 95 out of 100 cases, without having to face a shortage of inventory. In the context of supply chain management and inventory management, service level refers to a company's ability to meet customer demand without running out of stock. Supply chain service levels are a fundamental indicator that determines the percentage of products delivered from an order compared to the total order, with the objective of meeting demand and meeting customer requirements. In simpler terms, achieving high service levels in the supply chain requires effort in all processes. For example, a 95% fill rate implies that the company successfully delivered orders on time and, in total, 95% of the time, creating a positive experience for the consumer.
Type I service level refers to the likelihood of completely avoiding a shortage during a supply cycle. For example, if you have 100 deliveries scheduled for next year, a service level of 95% would mean that only in 5 of those 100 cases could there be a shortage of products in the warehouse between deliveries. Companies often set their Type I service-level objectives. Based on demand and delivery schedules, the volume of products needed from suppliers is calculated. For example, if a company seeks a 95% Type I service level for product A with weekly deliveries, it may need 100 units of the product.
If the same product requires a 99% service level, the volume of weekly deliveries would increase. The fill rate refers to the part of the demand that we can reliably cover using available stock during the replenishment period. For example, if the total demand for a product was 100 units per month, but only 70 units were available in the warehouse and were being sold, the Type II service level would be 70%. Usually, we know satisfied demand and can forecast unmet demand. Calculating the number of products we could have sold over a period depends on the company's forecasting system or methodology.
For example, one of the simplest methods for estimating demand is to look at the average daily sales. If there were no products in the warehouse for 5 days and the average daily sales were 3 units, the unmet demand would be 15 units. The use of service level metrics allows for the individualized management of multiple products and product categories. First, it helps to evaluate the effectiveness of inventory management in the past, by understanding how well demand has been met and how much money has been lost due to scarcity.
Second, it helps influence future demand by setting different service levels for different product categories. This opens the door to more effective inventory management and planned revenues. The following graphic illustrates the amount of additional inventory a company must maintain if it wants to improve its level of service. Safety stocks are calculated based on the standard deviation of demand. If we look at the red curve (type I service level), it can be seen that its increase leads to a significant increase in the safety stock. Its purpose is to ensure that there is no stock of any product between deliveries.
Therefore, even a 1% increase in the Type I service level can result in a substantial increase in safety stock levels. When using Type I and Type II service levels for inventory management, it is critical to distinguish between the two and to understand the specific purposes for which they are calculated. Suppose we plan to keep 15 units of a product and we want to determine the level of Type I service we can achieve. To do this, we need to find out the likelihood that we will face a shortage. A shortage will occur if the demand is 16 units (probability of 0.26%), 17 units (probability of 0.28%) or 19 units (probability of 2.79%).
Therefore, the type I service level with an inventory of 15 units would be 96.67% (a shortage may occur in 3.33% of cases, equivalent to 2.79%, 0.28% and 0.26%). We can also solve the inverse problem: determining how much inventory is needed to ensure a specific Type I service level (for example, 95%). Without inventory, we would face a shortage in 87.63% of cases. With one unit, we would cover a service level of 87.89% (87.63% if demand is zero and 0.25% if demand is for a single unit).
With 5 units in stock, we would cover 91.84% of cases (adding up the demand probabilities of 0, 1, 2, 3, 4 and 5 units). In our calculations, our goal is to understand the percentage of demand that will not be met in different sizes of inventory. To do this, we first need to calculate the expected demand. Each possible level of demand must be multiplied by its probability of occurrence and then summarized.
In most retail sectors, service levels are set as a goal above 95% to ensure customer loyalty. However, the closer we get to 100% of the service level, the more costly it will be to close the gap as returns decrease. Let's take a look at this graph. We have our service level on the x-axis and the inventory on the y-axis.
Notice how a 2% increase in service level, for example, from 85 to 87%, requires a much smaller inventory expansion than the same 2% improvement, going from 95 to 97%. The cyclic service level is also commonly known as the service level and is a metric that indicates the probability of having enough stock to meet demand (expressed as a percentage).For example, if a particular SKU has a service level of 70%, there is a 70% chance that demand will not exceed the available inventory.
