A product has a reorder point of 110 units, and is ordered four times a year on average. The following table shows the historical distribution of demand values observed during lead time

Question

Demand Probability
100 .3
110 .4
120 .2
130 .1

Managers have noted that stockouts occur 30 percent of the time with this policy, and they question whether a change in inventory policy, to include some safety stock, might be an improvement. The managers realize that any safety stock would increase the service level, but they are worried about the increased costs of carrying the safety stock. Currently, stockouts are valued at $20 per unit per occurrence, while inventory carrying costs are $10 per unit per year. What is your advice? Do higher levels of safety stock add to total costs, or not? What level of safety stock is best?

Answer 1

Action Safety stock cost Stockout cost Total cost
ROP=110 (SS=0 ) 0 = $0 .2 × 10 × 20 × 4 = $160
.1 × 20 × 20 × 4 = $160
$0 $320 $320

ROP=120 (SS=10 ) 10 × $10 = $100 .1 × 10 × 20 × 4 = $80
$100 $80 $180

ROP=130 (SS=20 ) 20 × $10 = $200 0 = $0
$200 $0 $200

The cheapest inventory policy has 10 units of safety stock. The managers should not be concerned about carrying cost only, but should consider that, while carrying costs rise, stockout costs fall.