Question

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

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 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 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 (ss) cost	Stockout cost	Total cost
Reorder point:110 (ss=0)	$0	$160(0.2*10*20*4)+$160(0.1*20*20*4) =$320	=$320
Reorder point:120(ss=10)	$100(10*$10)	$80(0.1*10*20*4)	=$180
Reorder point:130(ss=20)	$200(20*$10)	$0	=$200

The managers should not be concerned about carrying cost only, but they should also consider that, while carrying costs rise, stockout costs fall. Hence, the best and cheapest level of safety stock is 10 units.