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Calculating Safety Stock: Simpler Might Not be BetterInventory Optimization & Management
What is safety stock?
Safety stock is the extra stock you maintain to mitigate the risk of running out of raw materials or finished goods due to uncertainties in supply or demand. The purpose of safety stock is to ensure that once you have run through what you were expecting to sell during a certain time period (cycle stock), you are still prepared for additional demand.
Key Benefits of Safety Stock
In today’s world where customers are accustomed to instant gratification, safety stock is more than just a “nice to have”; it is a necessity. Carrying safety stock enables you to:
- Avoid stock-outs to keep customers happy and satisfied.
- Compensate for forecast inaccuracies and unforeseen variation in demand.
- Protect against unforeseen variation in supply.
- Prevent disruptions in manufacturing.
Having safety stock on hand is a no-brainer but determining how much safety stock to hold is the challenge. Planners tasked with managing safety stock often view it as a ‘no-win situation’. They feel pressure for the cost of holding too much but fear of holding too little.
Safety Stock Calculations
Because buying inventory involves tying up capital, it is extremely important to calculate safety stock levels as accurately as possible. Optimizing safety stock minimizes the number of disruptions while investing the lowest possible amount of capital in inventory.
Companies typically use one of the following three methods for calculating safety stock:
- Fixed calculation
- Time-based calculation
- Statistical calculation
In this post, we will examine each method and its pros and cons.
Fixed safety stock calculations
Some companies choose to set a fixed level of safety stock for their goods. This number is often based on the judgment of the planner or a simple calculation. Fixed safety stock calculations are often set on an aggregated level and not at the individual item level.
On the plus side, fixed safety stock calculations require no fancy tools. The problem with this method, however, is that it can lead to high inventory costs and/or stock-outs. This is because forecasts are not always accurate and demand is not always constant or similar for all items in the aggregated group. Simply put, not all items are equal, and for this reason, fixed safety stock calculations often fall short.
Time-based safety stock calculations
A time-based approach to setting safety stock levels involves calculating the stock required over a fixed period. In addition to the cycle stock, companies will decide to hold an added percentage of a day’s or a week’s average sales. For example, if the lead time for an item is two weeks, a company may decide to carry three or four weeks of safety stock for that item.
Time-based safety stock calculations are relatively easy to perform and can be completed with simple tools such as spreadsheets. The method can work well for many items, but holding an excess of high value, slow-moving items can tie up a lot of capital.
Statistical safety stock calculations
A statistical approach to setting safety stock levels uses multiple data elements and mathematical theories of probability. There are multiple formulas for statistical calculation and all of them will give better results than fixed safety stock or time-based methods. The formulas may consider the following parameters:
- Lead Time: Usually manufacturing or supplier lead time and possibly the variability of lead time as well. In situations when the product is not available from the supplier, it will have to be manufactured or sourced from an alternative supplier, which results in greater lead time.
- Variability of Demand: If the demand for a product is determinable and stable, a low level of safety stock is appropriate. If a product’s demand exhibits random behavior, then it makes sense to maintain a higher level of safety stock.
- Business Importance and Customer Service Level Goals: If a product is highly profitable and frequently sold, it makes sense to target a high service level goal. If a product does not feature among the top sellers for a company, then it does not make sense to plan as high of a service level.
- Positioning of Safety Stock: If you are manufacturer you must determine whether to hold safety stock at the finished goods or component level. Planning safety stock at the finished goods level will cost more but is appropriate with longer lead times. With very short assembly or manufacturing lead times and highly flexible manufacturing environments, you may be able to hold safety stock at the component level which may cost less.
While statistical safety stock calculations will deliver the best results, they are more difficult to manage in spreadsheets. Fortunately, there is a wide range of inventory planning systems available that can do the calculations for you.
Revisit the Numbers Frequently
Regardless of the method you choose to calculate your safety stock levels, it is important to realize that calculating safety stock is not a ‘one and done’ job. It is essential to continually analyze your safety stock performance to find out if it is meeting its real purpose.
Taking a hard look at data such as the number of stock-outs, the accuracy of your forecasts, and lost sales due to stock-outs, will help you determine if it’s time to revisit your safety stock approach to avoid having too much or too little inventory on hand.
If you’re ready to take the guesswork out of your safety stock calculations, check out this post on making the transition to inventory forecasting software.