The Illusion of Service Levels in the 90th Percentile

How good is good? If your company is crowing about order fill rates of 98 percent, recognize you have an opportunity. For a number of reasons, accepting such service levels means missing significant net profits and customer satisfaction. Customer satisfaction is the bellwether of future opportunity. Failure to exceed customer expectations limits your company’s ability to grow its market share.

The environment caused by shortages creates a Catch-22. The more shortages, the more rushing to fill orders causes a hectic environment. The more hectic, the less a firm is able to avoid shortages. Expediting product is expensive and becomes more commonplace as the vicious cycle repeats itself. For all the efforts companies put forth and for all their money spent, consumers still find shelves empty more often than less. Why do things get worse the harder we work?

Let’s begin with how we measure shortages. The typical mechanism is to measure the amount of goods on backorder. Companies that are reasonably well run experience shortages of 2-3 percent, when measured in this fashion. That is, 97-98 percent of the time orders are filled from stock, which meets the customer need.

Does this measurement give us an accurate picture? Consider these points:

  • Do customers always complain when they don’t find what they’re looking for?
  • When they do complain, is an entry made into the system documenting that an order was missed?
  • If so, is the magnitude of an order that was not placed always known?
  • If a customer requests a new item that your company must make or source, do lost sales get counted, even if no order is ever placed?
  • Is the shortage measurement different if a customer buys a competitive product once, as compared to never buying your product again?
  • What is the impact on the measurement of shortages if a reseller of your product drops the product permanently because they find it too difficult to depend on you?Most of the situations described above are not captured in shortage reports. In other words, our shortage measurements are way too low. How many orders are we really missing?Companies that solve their shortage problem by having inventory in the right place at the right time find that sales increase 20 percent or more when they were only measuring shortages in the 2-3 percent range. That means conventional shortage measurements are understating the actual impact on sales by 7 to 10 times!The financial impact is tremendous. The majority of companies could produce or sell more if only they had customers willing to buy. Most companies have the capacity to handle more sales with their existing staff and facilities. Much, if not all, of a 20 percent increase could be handled without an increase in operating costs.

    Let’s calculate the improvement in net profits. Subtract from the 20 percent sales increase the cost of raw materials to get gross profit. Let’s say raw materials are 75 percent of the extra goods sold (or 15 percent). The difference is five percent gross profit. From the five percent gross profit, subtract other truly variable costs like freight or commissions. Few companies spend more than 40 percent of their gross profit on these items. Assuming you do pay out 40 percent, the remaining contribution to net profits is an additional three percent of today’s sales. If we further assume that net profits were two percent of sales, we are discussing a change that multiplies net profits by 250 percent! What would such an increase in return do to the value of your company’s stock?

    (All percentages are of today’s sales)


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    What caused the “Catch 22” in the first place? Why do things get worse the harder we work? Today, business concentrates too much on cutting costs. We read about layoffs and automation in the papers every day. Companies slash the capacity they historically used to respond to urgent customer needs. The results are short term profits. Long term, there is less ability to serve and retain customers. Profits decline, calling for more cost cutting. Obviously, we created the cycle.

    Companies need to understand the importance of increasing sales and customer satisfaction and how to increase fill rates while reducing overall inventory levels. Of course, reducing operating expense is important. It is just far less important than increasing the contributions from sales and reducing inventory levels.

    Vistage member Henry F. Camp is president of Shippers Supply Co., based in Louisville, KY.

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