Why do service levels have a powerful impact on profitability?
"I need a 100% service level" – a typical expectation of both management and commercial departments. Purchasing & operational divisions however, have a much better understanding of service levels and appreciate that attaining 100% is a utopia. In practice, determining an appropriate service level is an extremely complicated undertaking.
Service level optimisation
For many businesses, the criteria for setting service levels is unclear and as a consequence, service level targets are set as a given figure (based on a quick and vague analysis). Furthermore, the quality of the service level is difficult to measure as the effects only emerge after a certain period of time. It is only when an inappropriate service level has a negative impact on safety stock for example, that the service levels are reviewed and quickly adjusted (without any real analysis). Thus, service levels are not reviewed regularly. Should this worry you? Only if you think that service levels are a powerful instrument that have the potential to impact both your profit margins and overall business performance.
Do service levels really have such a powerful influence on your margin? And can a well-thought out service level provide your organisation with a valuable asset?
When describing a service level in its purest form, you are describing your company's goal. It is a translation of your business strategy to your inventory strategy: you are deciding to what extent you want to satisfy your customer's needs based on your stock capacity.
The service level is an operational translation of the maximum profit you want to generate.
When defining a service level, a number of components have to be taken into consideration including turnover, capacity, customer demand and cost. These components and their relations can be defined on an article level. For example, knowing that the cost component has an exponential character, an appropriate service level on an article level can result in a large margin boost at an assortment level.
Finding an optimal service level thus results into a margin boost on an article level, which in turn leads to a large margin increase at an assortment level. In addition to this, the insight into your assortment's margin performance can also lead to further opportunities to increase margins over time.
Insight into internal processes
The advantage of a well-adjusted service level goes beyond margin increases as a thorough analysis also provides greater insight into your internal processes. By internal processes, we mean the processes that should mitigate both the supply chain factors and the demand chain factors.
A service level reflects your ability to meet demand and the capacity you are willing to use to satisfy this demand. If it is based on the right criteria, it should fit with your company's strategy and the capacity of its processes. If your capacity is not based on the right criteria, it may not have the desired effects. This occurs because certain supply and demand influences are not taken into account and as a consequence, this can cause a margin decrease. In that case, simply increasing or decreasing your service level can make the issue even worse.
Your service level should be a reflection of your internal processes and the maximum profit they could possibly generate. From the service level and its effects, we can derive:
- To what extent the internal processes can handle the service level
- What this process input means for every individual article
You should ask yourself which element you want to change; the inventory process or the service level. Either way, one should be adapted around the other. However, there is a risk that you adapt the wrong one, which can lead to a decrease in quality of both elements. This in turn can have severe consequences!
In conclusion, the right determination of your service level can have a considerable effect on your margin, but it can also give your insight into the extent to which your internal processes and their capacity can be improved and aligned to your organisational goals.
How to get started?
The determination of a quantitative fact, based on quantitative data only, requires a formula. The correct determination of a quantitative fact, based on more than quantitative data alone, requires a perspective. The correct perspective.
With regards to the perspective of a service level, we mainly mean the way the cost and turnover components are approached. We should look at the relevant process input for each article. Superficial quantitative criteria like turnover (ABC analysis) and the cost of safety stock should also be taken into consideration. However, we have to accept that there are also other, less quantifiable criteria in play. For instance; think of the actions your customers will take in the event of stock outs, is the expected turnover guaranteed?
The quantification of the appropriate service level is a company-dependent exercise, in which we should be able to determine the process input per article. Quantifying these criteria is not an easy thing to do. However, it is possible!
Would you like to have a more elaborate guide about how to determine the right service level for your organisation? In the near future we will publish a whitepaper including an extensive exercise helping you to determine your service level in a more pragmatic way.