In addition to the cycle stock, the firm may also maintain an additional amount of inventory, called safety stock, to deal with the potential uncertainty in the replenishment situation. For example, as a given inventory cycle comes to an end, a replenishment order is launched, and the reorder lead-time begins. If the resupply is later than expected, or if the actual demand during the replenishment lead-time is higher than had been anticipated, then the on-hand inventory would be completely depleted, and the inventory system would experience a stockout situation. Demands that occur during the stock out would typically become either backorders (in the case where the customer or user will wait until the resupply arrives) or lost sales (in the case where the demand is lost to the system because the user will not permit the backorder). In commercial and industrial practice, backorders are commonly permitted. At the retail customer level in a system, stockouts usually result in lost sales. In either case, the stockout situation results in poor customer service and the attendant costs. In order to reduce the number of stockouts, and the associated backorders or lost sales, the firm can carry safety stock.
Note also that this safety stock represents a relatively “permanent investment” in inventory. It is only really needed at the end of a replenishment cycle, since that is where the stockout risk occurs. Unfortunately, to have it available at the end of the cycle, it must be available all through the cycle as well. What this means is that the average amount of safety stock on hand over time is very nearly constant. In the diagram below, we see an idealized representation (a so-called inventory saw-tooth) which shows how the on hand inventory level would rise and fall in a replenishment scenario with a highly consistent demand process. In this example, the chosen safety stock level is about half the order quantity; that is, it represents about a thirty-day supply. Thus the total inventory (cycle stock plus safety stock) would represent about sixty days worth of inventory on average, and the total inventory turn rate would therefore be about six times per year.
The safety stock acts as an insurance policy against the chance of stockouts. As such, the appropriate quantity of safety stock will depend on the relative risks and costs in a given situation. This chapter will also develop a set of probabilistic models that will help to determine a cost-effective safety stock strategy in a given situation.