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The Concept Of Service Level: Some Things To Understand

Today, in the supply chain, the service level cycle (or simply “service level”) is the expected probability of not reaching a stock-out situation during the next replenishment cycle and is therefore also the probability of Don’t lose sales.

The duration of the cycle is, implicitly, the lead time or delivery time. Service level can also be defined as the probability of being able to meet customer demand without facing back orders or a lost sale.

In its application, it can contribute to various reports such as a level of repair analysis report. While a 100% service level—that is, serving all customers all of the time—might seem desirable, it is generally not a feasible option.

The service level cycle should not be confused with the fill rate, which represents the fraction of demand that is served without delays or lost sales.

In fact, the concept of service level is only relevant in situations where future demand is uncertain; otherwise, reaching 100% service level is simply a matter of proper scheduling.

When future demand is uncertain, the only theoretical way to avoid out-of-stocks is to go for infinite inventory. Therefore, in practice, the inventory manager must settle for an imperfect inventory commitment.

This commitment is measured precisely through the concept of service level.

The service level represents the probability of not reaching a shortage situation, that is, a lack of stock that would prevent orders from being delivered to customers within the agreed period.

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What Is Service Level In Logistics

The service level, also called the service level cycle, is an indicator that indicates the probability of having sufficient stock to supply the demand.

In this way, if the service level of a given reference is 90%, this means that there is a 90% probability that the demand for said product does not exceed the available offer or, in other words, that theoretically 90 of every 100 customers will see their demand satisfied in the expected times.

In this sense, the concept is closely linked to customer satisfaction, since high levels of service ensure practically total coverage of the generated demand, that is, that the majority of customers who wish to buy a product will find it and be able to acquire it.

Likewise, this parameter has a direct relationship with the optimal stock and inventory management.

The reason is that a correct administration of resources is essential to guarantee the desired level of service and avoid situations of stock out of a reference, which would mean not being able to send certain orders to certain customers, who would probably look for that same article in the competition.

Service Level As Financial Compensation

The service level such as the asset level of service balances the risk of stockouts against inventory costs. Retailers or manufacturers try to satisfy as many customers as possible, as this maximizes their sales.

However, at the same time, keeping a corresponding inventory is costly and risky: the products are expensive to produce or purchase, the products need space to be stored, they expire, become obsolete, etc.

In the end, the more inventory you have, the higher the costs and risks. It can only be worth it up to a point. In fact, the main challenge of inventory control is striking the right balance between costs: having enough to sell, but not too much, so that inventory costs don’t end up costing you more than the profit from additional sales.

From a business perspective, the service level represents a trade-off between the cost of inventory and the cost of out-of-stock.

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Diminishing Returns With High Service Levels

In most retail sectors, specialized or not, aiming for high levels of service is the norm, typically above 95%. In particular, high levels of service are one of the key factors in strengthening customer loyalty.

However, achieving higher service levels is a classic case of diminishing returns where the additional marginal effort, i.e. the additional inventory in the current case, leads to lower returns, i.e. eliminating smaller fractions of out-of-stocks. 

Optimization Of Service Levels

After all, the service level marks the trade-off between opportunity costs and operating costs. Optimizing service levels to maximize overall returns is complex and industry-specific.

The challenge is often compounded because the analysis is sensitive to the time being considered: reducing inventory levels results in the immediate availability of additional cash, while it takes years to see lower customer churn (hence higher sales) obtained through less frequent stock-outs.

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