Control your service levels, don’t let them control you

Published on by Joannes Vermorel.

In retail, many companies don’t have much control over their service levels. In fact, many companies don’t monitor the service level where it matters the most: the physical store. Indeed, measuring in-store service level is a tedious exercise. Some companies - mostly panelists - specialize in doing this sort of measurements, but the cost is steep as there is no workaround for the extensive manpower involved in the process.

Taking a step back, why do we even need to measure the service level?

Wouldn’t it be more convenient if the service level was something obtained by design and defined through explicit settings within the inventory optimization software? This would certainly be a lot more practical. Service levels certainly don't need to be an afterthought of the inventory optimization process.

It turns out that, historically, the need to measure the service levels came from early inventory optimization methods such as the safety stock analysis that offer about no control on actual service levels. Indeed, the underlying models rely on the assumption that the demand is normally distributed and this assumption is so wrong in practice that most retailers gave up on this assumption in favor of ad-hoc safety stock coefficients.

Those ad-hoc safety stock coefficients are not bad per se: they are certainly better than relying on abusive assumptions about the future demand. However, the quantitative relationship between the safety stock and the service level is lost. Hence, retailers end-up measuring their service levels and tweaking coefficients until inventory stabilizes somehow. At the end, the situation is not satisfying because the inventory strategy is inflexible: safety stock coefficients can’t be changed without exposing the company to a myriad of problems, repeating the tedious empirical adjustments done originally.

However, with the advent of quantile forecasting, it’s now possible to produce forecasts that very accurately drive the service levels, even if the quantile forecasts themselves are not accurate. All it takes is unbiased forecasts, and not perfectly accurate forecasts.

Indeed, quantile forecasts directly and very natively address the problem of producing the reorder quantities it takes to cover target service levels. If a new and better quantile forecasting technology is found, then this technology might be capable of achieving the same service levels with less inventory, but both technologies deliver the service levels they promise by design.

This behavior is very unlike the case of classic forecasting allied to safety stock analysis where an improvement of the accuracy, while being desirable, leads to erratic results in practice. For example, for many low volume products, as observed in stores, shifting to a dumb forecasting model that always returns zero usually improves the accuracy defined as the absolute difference between the actual sales and the forecasted sales. Obviously, shifting toward zero forecasts for half of the products can only end with dismal business results. This example might appears as anecdotal but it is not. Zero forecasts are the most accurate classic forecasts in numerous situations.

Thus, in order to take control of your service levels, it takes an inventory optimization methodology where such a control is built-in.

Categories: Tags: quantiles inventory insights inventory optimization