How Safety Stock Absorbs Demand Volatility

By Jeff Bodenstab22 Sep 2015

Demand volatility is cited by Gartner, IDC and other analyst firms as the number one obstacle identified by corporate executives to achieving their supply chain goals. But companies can overcome this obstacle by positioning the right safety stock inventory across the supply chain to absorb such volatility.

Fixing forecasts is important.  But generating good forecasts is still difficult for even the best managed companies.  Surprisingly, there is an immediately available, relatively straight-forward alternative – fixing your inventory (safety stocks) to cope with the forecast uncertainty.

That’s because inventory planning and demand forecasting are two sides of the same coin.  Demand forecasts attempt to predict future demand. Safety stock compensates for forecast inaccuracy and demand fluctuations, covering the demand until the supply chain can replenish the gap.

In other words, safety stock is a demand buffer.  To be precise, safety stock actually buffers two uncertainties.  First, it absorbs demand uncertainty – the fluctuations in demand.  Second, it compensates for forecast inaccuracy – the inherent error in predicting the future.  These are different components, which when combined create the uncertainty that safety stock addresses.  And so, since effective inventory management mitigates many demand volatility and forecasting problems, the key to improved customer-service levels lies in both improved demand forecasting and inventory positioning.

Getting the Right Inventory Mix

Not all inventory is created equal.  Especially now that markets are more dynamic, and service level expectations are high, just pumping more inventory into the system rarely solves the problem.  In fact, adding inventory reactively, without a global perspective and optimized approach, almost always creates a disruptive supply chain; with excessive expediting, over-compensation and under-performing inventory.  As Tim Payne, Research Director for Gartner Research, says, “Responding to the customer can be achieved with cost overruns, excessive inventory and firefighting, but to respond profitably means understanding the sources of volatility and planning for them appropriately.”

The more effective approach is to optimally position inventory in the supply chain using inventory optimization.  Inventory optimization creates an optimized inventory portfolio driven by customer-service objectives.  With it, companies are able to guarantee the desired service level to the customer while maintaining a highly efficient mix of inventory in the pipeline.

Inventory optimization solutions (also known as Multi-Echelon Inventory Optimization or MEIO) rely on stochastic-based demand models that act as an ongoing mechanism for understanding the statistical nature of the demand uncertainty and forecast error.  This positions or “mixes” the inventory throughout the supply network to maximize customer service objectives.  Inventory optimization takes into account demand characteristics and supply variability when identifying the inventory targets that guarantee customer fulfillment.

Several trends are also making inventory optimization more attractive.  First, higher fill-rates at retail require more proactive inventory positioning, and increase the benefits of inventory optimization as companies push their processes harder to meet customer expectations.

Second, as supply chains become more global, longer lead times and higher transportation costs limit the ability to quickly respond to unforeseen changes in demand, e.g., longer lead times from Asia increase the size and importance of safety stocks.  Larger in-transit inventories put more pressure on getting the right inventory on the boat.

Finally, the increase availability of point of sale (POS) data allows suppliers to acquire more up-to-date and granular sales data, which can help optimize inventories and create a more automated replenishment process.  Properly incorporated into the process, more accurate and timely data can yield an improved inventory mix that drives higher customer service levels.

Immediate inventory optimization benefits include increased service levels and improved inventory turns, as well as additional operational improvements.  Perfect demand sensing is an important goal, but fixing your inventory buffers will likely improve your bottom line even faster.