Safety Stocks: More about the formula

https://michelbaudin.com/2012/07/23/safety-stocks-more-about-the-formula/

In a previous post on 2/12/2012, I warned against the blind use of formulas in

setting safety stock levels. Since then, it has been the single most popular post in
this blog, and commands as many page views today as when it first came out.
Among the many comments, I noticed that several readers, when looking at the
formula, were disturbed that three of the four parameters under the radical are
squared and the other one isn’t, to the point that they assume it to be a mistake. I
have even seen an attempt on Wikipedia to “correct that mistake.”
I was myself puzzled by it when I first saw the formula, but it’s no mistake. The
problem is that most references, including Wikipedia, just provide the formula
without any proof or even explanation. The authors just assume that the eyes of
inventory managers would glaze over at the hint of any math. If you are willing to
take my word that it is mathematically valid, you can skip the math. You don’t
have to take my word for it, but then, to settle the discussion, there no alternative
to digging into the math.
A side effect of working out the math behind a formula is that it makes you think
harder about the assumptions behind it, and therefore its range of applicability,
which we do after the proof. If you don’t need the proof, please skip to that
section.

 Math prerequisites
 Proof of the Safety Stock Formula
 Applicability

Math prerequisites
As math goes, it is not complicated. It only requires a basic understanding
of expected value, variance, and standard deviation, as taught in an introductory
course on probability.
In this context, those who have forgotten these concepts can think of them as
follows:

 The expected value E(X) of a random variable X can be viewed, in the broadest
sense, as the average of the values it can take, weighted by the probability of
each value. It is linear, meaning that, for any two random
variables X and Y that have expected values,
and, for any number a,

 Its variance is the expected value of the square of the deviation of individual
values of X from its expected value E(X):

Variances are additive, but only for uncorrelated variables X and Y that have
variances. If

then

 Its standard deviation is

Proof of the Safety Stock Formula

Fasten your seat belts. Here we go:

As stated in the previous post, the formula is:

Where:

 S is the safety stock you need.

 C is a coefficient set to guarantee that the probability of a stockout is small
enough.

 The other factor, under the radical sign, is the corresponding standard
deviation.

 μL and σL are the mean and standard deviations of the time between deliveries.
 μD and σD are the mean and standard deviation rates for the demand.
is the standard deviation of the item quantity consumed
between deliveries, considering that the time between deliveries varies.
μD and are the mean and variance of the demand per unit time, so that the
demand for a period of length T has a mean of , a variance of , and
therefore a standard deviation of . See below a discussion of the
implications of this assumption.
Note that the assumptions are only that these means and variances exist. At this
stage, we don’t have to assume more, and particularly not that times between
deliveries and demand follow a particular distribution.
If is the demand during an interval of duration T, since:

we have:

If we now allow T to vary, around mean μL with, standard deviation σL , we have:

and therefore:

and

That’s how the variance ends up linear in one parameter and quadratic in the
other three!

Then:

QED.

Note that all of the above argument only requires the means and standard
deviations to exist. There is no assumption at this point that the demand or the
lead time follow a normal distribution. However, the calculation of the
multiplier C used to set an upper bound for the demand in a period, is based on
the assumption that the demand between deliveries is normally distributed.

Applicability
The assumption that the variance of demand in a period of length T
is implies that it is additive, because, if , then

But this is only true if the demands in periods and are uncorrelated. For a
hot dog stand working during lunch time, this is reasonable: the demands in the
intervals between 12:20 and 12:30, and between 12:30 and 12:40 are from
different passers by, who make their lunch choices independently.
On the other hand, in a factory, if you make a product in white on day shift and in
black on swing shift every day, then the shift demand for white parts will not
meet the assumptions. Within a day, it won’t be proportional to the length of the
interval you are considering, and the variances won’t add up. Between days, the
assumptions may apply.

More generally, the time periods you are considering must be long with respect to
the detailed scheduling decisions you make. If you cycle through your products in
a repeating sequence, you have an “Every-Part-Every” interval (EPEI), meaning, for
example, that, if your EPEI is 1 week, you have one production run of every
product every week.
In a warehouse, product-specific items don’t need replenishment lead times
below the EPEI. If you are using an item once a week, you don’t need it delivered
twice a day. You may instead receive it once a week, every other week, every three
weeks, etc. And the weekly consumption will fluctuate with the size of the
production run and with quality losses. Therefore, it is reasonable to assume that
its variance will be where T is a multiple of the EPEI, and it can be
confirmed through historical data.

You can have replenishment lead times that are less than the EPEI for materials
used in multiple products. For example, you could have daily deliveries of a resin
used to make hundreds of different injection-molded parts with an EPEI of one
week. In this case, the model may be applied to shorter lead times, subject of
course to validation from historical data.