Assessing Service Level Targets in Production and Inventory Planning*

In production and stock planning, the relationship between customer service, defined as the ability to meet demand for finished goods from in-stock inventory, and expected profits or expected costs can be represented by a simple reliability curve. The shape of this curve depends upon the parameters of the demand process, specifically the expected level of demand, standard deviation and correlation structure, as well as upon the capacities and initial state of the production and inventory system. A model is presented which explicitly determines this trade-off curve for a firm. The model is intended both as an operational model to aid managers in setting revenue and service targets which are compatible with the capacities and resources of the firm, and as a tool for exploring relationships between the parameters of the demand process and the constraints of the physical production and inventory system. The results illustrate that the level of risk depends strongly on the variability of the demand process, the cost structure, the capacities and initial state of the system and, to a lesser extent, the correlation in demand between succeeding periods. Results suggest that establishing service level targets consistent with the firm's strategic orientation must be done in consideration of both the characteristics of the demand process and the capacities of the production and inventory system. The model provides a tool for estimating the premium above unit cost which must be paid to provide a designated service level.