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Defining customer service levels to keep customers and shareholders satisfied

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  1. Introduction
  2. Optimize inventory with service level targets
  3. How should customer service level be defined?
  4. Aligning service levels to working capital objectives
  5. Conclusion

If you need to release cash, particularly during a recession period or when sales are falling, you should look to your working capital. Optimization of your working capital will improve efficiency, liquidity and potentially investor ratios like the dividend yield, if the dividend payment can still be maintained.
One of the blockers or reasons not to reduce working capital is the potential effect on customer service levels. Any deterioration of customer service could jeopardize the initiative straightaway, have long-term consequences on revenue due to lost sales, and lead to counterproductive results such as overstock.

For this reason, any inventory and receivables optimization need to go hand in hand with optimal service level targets. Service level in this context means the probability that all customer orders arriving within a given time interval will be completely delivered from stock on hand, that is, without delay.

Often influenced by the sales department, too many companies pursue the same service level target for all their clients. Not only is this unrealistic, it is dangerous, for three different reasons. On a cost basis, margin can deteriorate due to a wide product portfolio, rush orders and express shipments offered to unprofitable and low profitability clients. On a cash basis, a high service level for all clients requires a correspondingly high inventory level of finished goods and components, with cash tied up unnecessarily and a high obsolescence risk. Finally, on a service level basis, there is a risk that low-profit customers will get a higher service than the profitable ones.

[...] Aligning service levels to working capital objectives Customer segmentation is the first step towards the definition of a differentiated service level strategy. Using annual net sales and operating profit, customers can be classified into 12 categories, ranging from the strategic customers down to the unprofitable ones. The second step defines service level targets by category based on a formal sales strategy. The final step is to translate such service levels through the supply chain in terms of inventory targets. This inventory model is a proven methodology for a quick and sustainable implementation. [...]


[...] The table explains how the service level target set for a customer helps to optimise both the inventory of finished goods sold and the inventory of the corresponding components. Optimising inventories of both the finished goods and components will cut costs, principally of cash tied up in inventory, also by optimising storage and production capacity, and finally in depreciation costs thanks to a lower obsolescence risk. As illustrated below, A1 customers are granted service level of 98 percent. That percentage defines the inventory of the finished goods sold to A1 customers. [...]

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